Waiting for Godot
By Sam Stewart
January 9, 2013
Dear Fellow Shareholders:
Like the enigmatic title character inÂ Waiting for Godot, clear signals of U.S. economic health remain much anticipated but elusive. The year 2012 saw consumers and businesses mimicking the Samuel Beckett playâ€Šâ€”â€Šwith optimists waiting for things to get better and pessimists waiting for things to get worse.
First we waited for the presidential election. Then we waited to find out if our Christmas stockings would be stuffed with new taxes (better known as â€ślumps of coalâ€ť). The outcome in each instance, when it finally was known, did little to provide the clarity we had hoped. The New Year brings its own schedule of events, and after each one we will probably still be waiting for Godot.
The reality is that nothing much is happening on the economic stage. Nor is much likely to happen. Godot, in the form of resolution, will not arrive for a long time, if ever. And certainly not until the lingering effects of the balance-sheet recession have made their final exit. To one degree or another, most developed countries appear to be following a similar script.
The principal factor restraining global economic activity continues to be too much debt. More precisely, there is too much debt that canâ€™t (or wonâ€™t) be readily repaid. Political leaders have responded with programs designed to transfer this troubled debt to the government. While that approach has helped alleviate some symptoms of the debt binge, it has created its own set of problemsâ€Šâ€”â€Šnot the least of which is uncertainty about who ultimately will be forced to pick up the tab.
Resolving distressed debt requires both the reckless borrower and the imprudent lender to come to grips with their foolishness. Rarely does this happen quickly. For one thing, the structure of the debt often does not force the issue, as servicing the debt requires only a small interest payment relative to the large, unlikely-to-be-repaid principal. Also there is always the possibility that sufficient procrastination will be rewarded with a government program devised to allow both the borrower and the lender to escape full responsibility for their actions. In addition, the borrower must decide whether to admit defeat and file for bankruptcy, or to make the required interest payment and risk throwing good money after bad. Finally, the lender must decide whether to work with the borrower (possibly only to preserve the fiction that the loan someday will be repaid), or to begin foreclosure and take the distressed property onto his or her own balance sheet.
This negotiation between borrowers and lenders is inherently a long, drawn-out process. It is the reason balance-sheet recoveries are tedious and slow. Until all assets are properly marked to market, uncertainty prevailsâ€Šâ€”â€Šaffecting not only the borrowers and the lenders, but casting a pall on the entire economy. In the face of such uncertainty, many companies preserve their cash rather than invest in the future. With jobs scarce, households remain cautious as well.
It is becoming increasingly clear that present U.S. monetary policy at best has outlived its usefulness and at worst may actually be hindering economic growth. By interfering with markets, the central bankers may be preventing the vital cleansing function of a recession. At the very least, the sheer magnitude of monetary stimulus in the system leads one to suspect the Federal Reserve (Fed) may be setting a stage from which each further round of easing will make a graceful exit more difficult. In that respect, one harbinger of Godotâ€™s arrival would be an unwinding of the Fedâ€™s monetary interventions. Unfortunately, monetary policy is not a good tool for creating jobs; by tying policy to the unemployment rate, the Fed may be setting us up for a very long wait.
In the meantime, artificially low interest rates are inhibiting the banking system. Minuscule savings yields have discouraged savers and slowed the pace of productive investment. Pressure from shareholders and regulators is preventing banks from making any but the safest loans. The Fedâ€™s zero-interest-rate policy enables large banks to pay little or nothing on deposits and earn a modest spread by investing in Treasury securities. Excess liquidity remains trapped in the banks with no transmission mechanism to places in the economy where it is most needed. The result is that credit is channeled only to the government and to the largest, most-creditworthy borrowers. Small entrepreneurs generally canâ€™t get credit on any terms.
The data indicate that the economy continues to muddle along. While muddling along wonâ€™t do much to help job seekers, it continues to put food on the table for the 90+% of the workforce who are employed. Ultimately, just like a local train, a muddling economy will get us to our destination. It just wonâ€™t be at the express speed that could be achieved via appropriate monetary and fiscal policies.
In terms of our Godot analogy, the U.S. bond market has in many ways become its own Theatre of the Absurd. The Fedâ€™s voracious appetite for debt securities has long since ended any useful price signals among market participants. Moreover, the income securities held by the Fed are subject to the same interest-rate risk as anyone elseâ€™s of similar duration. By actively encouraging inflation, not only is the Fed promoting its own insolvency, but it also is seeking to destroy the low-interest-rate environment it has worked so hard to create. Suffice it to say that interest rates are at dangerously unsustainable lows, and investors should proceed with extreme caution.
Although the S&P 500 Index fell 0.38% in the fourth quarter of 2012, the Index gained 16.00% for the year including reinvested dividends. While that was a welcome outcome, it should be viewed in part as an offset to 2011â€™s very modest return of 2.11%. For the two-year period the Index had an average annual return of 8.84%, which is about what one should anticipate in the muddling economy we expect to prevail.
A subdued economic recovery is the perfect environment for a stock-pickerâ€™s market. I believe quality companies with defensible business models purchased at reasonable valuations will outperform.
More than ever, I believe investors should continue to â€ślean against the windâ€ť during periods of obvious market optimism and pessimism, as the market ebbs and flows in response to our fibrillating economy. A modest cash position may also be appropriate as a source of dry powder for when the market gets overly pessimistic.
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