The Kitchen Sink and "Japanification"
This weekend in the Northeast corner of the United States a very interesting conference took place. It was titled ‘Revisiting Monetary Policy in a Low Inflation Environment: Remarks at the Federal Reserve Bank of Boston’s 55th Economic Conference,’ and the speaker was Eric S. Rosengren, President & Chief Executive Officer of the Boston Federal Reserve Bank (http://bit.ly/biJDTo)
If you’re too busy to read the entire speech, the bottom line is this: even with tax, fiscal and social policies, once you enter a true deflationary period you will run the risk of deflation persisting. The data he draws upon is from the last 20 years in Japan and it's clear that a deflationary spiral is nothing to fool with.
Coincidentally, the NY Times ran a very interesting article this Sunday showcasing some snippets of life in Japan. It was troubling to see this article show the human sides of deflation on the spirit and drive of the Japanese people and its impact on the culture. Low interest rates and government stimulus can't begin to solve the motivational and incentive problems in Japan. You can access the article from my Twitter (@PHCOAdvisors) or directly from here: http://nyti.ms/cHXolC
The Kitchen Sink
Before I get to the kitchen sink, I probably should back up and give a quick primer on GDP in the simplest terms. In fact, I think this will explain what's going on with our politicians right now once we agree on some basics.
Is there really a new roadmap to GDP growth?
First, GDP is a simple formula that is quite easy to explain. There are only a few ways to move the needle on GDP growth. We can consume a whole lot more, have our government spend more, we can invest more in plant, equipment and technology as businesses, or we can export more of what we make and import less of what "they” make. Everything else you read about, listen to and watch, when it comes to economic policy feeds into those basic facts.
Dr. Mohamed Abdulla El-Erian a wise man from PIMCO coined the term "New Normal" when it comes to this investing environment. What he doesn’t go onto suggest is a ‘new normal’ for the one component of GDP that matters most… (drum roll please) CONSUMPTION.
As you can see by the slide it's over 70% of our GDP formula.
I asked my team to run some "What If's" if the "New Normal" meant less consumption by all of us. What would have to go up if we dropped consumption by 10% in the GDP formula? By the way, during the Great Depression consumption dropped by 41% so a 10% drop is not unimaginable.
You can see that all things being equal:
Investment would have to go up by:
Government Spending would have to go up by:
Imports vs. Exports would have to balance out by:
Or you can run a combination of all four to make it less severe on each component:
Let's connect the dots, formula to reality:
- Investments by private business are strained by not having a clear picture of demand from the end consumer. However, we hear about accelerated depreciation ideas and R&D tax credits. These are all incentives to move the needle on planned investments by the private sector.
- Government Spending is something that we’ve all heard a lot about in the last 18 months. We all know the spending spree the government is on and now we know why. It's controllable by them, it can have a major impact on the GDP formula and the government can almost manufacture any amount of GDP growth for a period of time (for as long as they are willing to borrow or until it all breaks down). Ideas like stimulus and road projects are a few examples of this component.
- Imports vs. Exports, or in other words, our Trade Balance. We know the current administration has said several times that we need to import less and export more. It’s not rocket science as to why. Ideas like bailing out poorly operated auto manufacturers, support for unions, trade wars, and our weak dollar all support this policy. One of the problems in playing with this part of the equation is that this is how real wars start. This is a topic that deserves its own article at a later date.
The bottom line, as the slides suggest, is that without Consumption restored the entire formula has limited chances of functioning well over the long term. There is no “New Road Map.”
Now here's the kitchen sink part. It’s clear that:
- Any opinion leader, politician or policy maker is coming to grips with the reality that there are only temporary and likely unsustainable solutions without the consumer.
- Without demand from the consumer, prices of everything will drop until they find a new equilibrium level (deflation).
- If deflation is persistent, and we have probably been in a deflationary environment for 10 years (as evident by housing prices, stock market values, real wages and income, higher rates of poverty, unemployment, under employment, low overall demand), then we are not far from falling into the “Japanification” of our people.
Remember, this is also a behavioral phenomena and not just an economic one.
No one, and I mean no one, wants to see the lost decades of Japan come to our shores. So you can expect the Fed to react in the extreme with more quantitative easing, all while the government tries every policy trick in the book. Even the educational academy will get involved by encouraging all kinds of ideas to fix the formula or change the mix of the formula. They will throw everything at this problem, including your kids and grandkids futures, as well as the kitchen sink.
- The real economy will likely limp along until "they", and I'm not exactly sure who "they" is, find the right combination.
- The stock market and financial economy will likely benefit from all the attempts to re-inflate the economy in the short run.
- The human spirit of investment, speculation and desire for more will be muted until "they" realize we need stability in all areas before we can consume massively again.
There is no “New Road Map”, just attempts at fixing the road we have always traveled on.
My investment themes continue to be:
- Yield, Yield, Yield - deflationary hedge
- Media (Both print and on-line)
- Germany for a weak euro as the 2nd largest exporter in the world
- Technology-especially business processing
- US Mega Capitalized Companies with large cash balances paying dividends
On Institutional Allocations:
Hold steady, but be prepared to have discussions about a very choppy sea ahead and gain alignment with your board on multiyear return expectations. Alignment is more important right now than investment policy tweaks. Rough seas can mean bad decisions especially when it comes to liquidity constraints.