June 14, 2011
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This essay is excerpted from the most recent version of The Credit Strategist (formerly the HCM Market Letter). To subscribe directly to this publication, please go here. The Credit Strategist is on Twitter - @credstrategist
“The foundation of any liberal society is the willingness of all groups to compromise private ends for public interest. The loss of civitas means either that interests become so polarized, and passions so inflamed, that terrorism and group fighting ensues, and political anomia prevails; or that every public exchange becomes a cynical deal in which the most powerful segments benefit at the expense of the weak.”
As it continues to wrestle with the aftermath of the 2008 financial crisis, America’s policy elites are said to be facing a historic test of leadership. Unfortunately, the way this test is being posed is intellectually flawed and doomed to failure. Democrats and Republicans are arguing over monetary and fiscal policy without adequately addressing the broad legal, regulatory and tax policy regimes that favor debt over equity and speculation over productive investments. The so-called choices being posed are really false choices because they are two versions of the same pro-cyclical ideologies that have trapped the economy in a boom-and-bust cycle. The Obama and Ryan budget plans both leave the United States grossly over-indebted and therefore consigned to years of below-trend growth and financial fragility. Europe is basically following the same path while wrestling with deep structural flaws in its union.
Virtually every public opinion poll tells us that American elites have fallen into profound disrepute. Daniel Bell described an elite as follows: “An elite, at best (as in an Establishment), serves as a source of moral authority and political wisdom.” Speaking of the elite that formed after World War II, he argues that “it was not their interests that defined them as an elite, but their character and judgment. The important consideration was that their opinions had weight because they were respected. Reciprocity between judgment and respect is a necessary condition if policy is to be tempered by the weight of elite opinion.”2 American’s hegemony was always based on moral as well as military and economic strength. While American values have been called into question in the past (for example, during the Vietnam War), there is a sense that the financial crisis broke new ground in sowing doubts about how the U.S. treats the rest of the world as well as its own disenfranchised citizens.
The export of toxic investments to institutions and governments around the world struck an indelible blow against American moral and intellectual leadership. The failure of economic regulators and gatekeepers (such as the credit rating agencies) calls into question the ability of this country to handle the complex intellectual challenges posed by a globalized and interconnected world. Unfortunately, the aftermath of the crisis has done little to dissipate these doubts. Regulatory reform has at best occurred at the margins, and the big issues such as derivatives regulation and “too big to fail” have been left unaddressed. Dodd-Frank appears to be one of the sloppiest, vaguest and most complex (and the contradictions among those adjectives are deliberate) pieces of legislation ever passed by Congress. Fatally, the measures taken to prevent another crisis have been based on flawed ideas such as the Efficient Market Theory and the fantasy that human beings are rational beings when precisely the opposite assumptions are required to forge effective reforms. Until the leaders of the West alter their allegiance to traditional ways of thinking about money and economics, the global economy will stumble.
The U.S. economy
Investment performance for the rest of the year will be determined by the macro-economic views of investment managers. While macro-economic factors are always extremely important in charting investment strategies, they are particularly important today as the U.S. and global economies continue to fight their way through the detritus of the global debt crisis. A compelling case can be made for weaker 2Q112 growth based on a combination of factors that include the following:
- the termination of QEII;
- the Japanese earthquake’s impact on global supply chains;
- higher energy prices;
- slower state and local government spending;
- bad weather; and
- incessant weakness in the housing and jobs markets (which are connected).
Most important, these factors are largely symptoms of policy failures. Even Acts of God are colored by the possibility that man could have better planned for such inevitable but temporally unpredictable events (and this does not even include the possibility – about which we express no opinion here – that global warming played a role).
Accurately identifying the underpinnings of economic growth (or weakness) is particularly important today. If cyclical factors such as energy prices, Japan and even bad weather are the primary drivers of slower growth, investors can justifiably expect the current soft patch to pass relatively quickly. If, however, the structural problems plaguing the U.S. economy (high debt levels, etc.) are retarding growth, the slowdown is likely to be extended. Structural problems are far more likely to lead to a systemic crisis than factors that are likely to fade with the passage of time. As readers familiar with The Credit Strategist would expect, I believe that the problems affecting the economy are structural rather than cyclical. I expect economic growth to remain below trend (until slow growth becomes the trend) unless the current policy regime is altered. I have been called naïve (or worse) for even writing about the possibility of such a policy shift, but I believe that there is no choice but to work toward such change. If we think about how we all felt at the height of the crisis, we can agree that the alternatives are too bleak to accept.
The housing market
One sector clearly suffering from deep structural and cyclical problems is the housing industry. At this point, the evidence is irrefutable that the housing market is not recovering. The most recent Standard & Poor’s/Case-Shiller National Index showed a 4.2 percent drop in nationwide home prices in 1Q11, which followed a 3.6 percent drop in 4Q10. This was the eighth straight decline and brought prices back to 2002 levels. David Blitzer, chairman of Standard & Poor’s index committee, told The Wall Street Journal (“Housing Imperils Recovery,” June 1, 2011, p. A1) that “[h]ome prices continue on their downward spiral with no end in sight.” The most recent report signals “a double dip in home prices across much of the nation.” As Figure 1 below illustrates, rather than a double dip, it is probably more accurate to say that the housing sector never recovered at all but was simply temporarily boosted by government tax credits.
The Credit Strategist thinks it should be a point of particular concern that the Federal Reserve’s sustained zero interest rate policy was unable to stimulate housing. This failure is evidence that what ails housing is structural rather than cyclical, and it will require structural rather than merely cyclical policy changes to fix it. There is still far too much excess housing stock as a result of policies that promoted home ownership to an extent that transformed housing into a financial asset rather than as a utilitarian asset that is primarily designed to provide shelter to its owner. It is time to acknowledge that housing is not a particularly productive asset that has been subsidized far beyond its contribution to economic growth. The fact that there are still hundreds of thousands of housing starts each month truly beggars reason.
Case-Shiller 20 City Index
Home prices are now 35-40 percent below their 2006 peak, but there is no God-given reason why they can’t drop further. If home prices are continuing to decline while the economy is enjoying record low interest rates, it would appear that there is something other than affordability suppressing prices. According to The Wall Street Journal, median earners today can afford 75 percent of all homes sold.3 Among the factors that are likely pushing down prices is the tepid job market, millions of empty and foreclosed homes, and buyers’ beliefs (or fears) that prices are going to continue to decline. While all of these factors should raise concern, the last one –deflationary psychology – may be the most dangerous. If such psychology were to gain momentum (if it hasn’t already done so), it could drive prices considerably lower. After all, isn’t it reasonable to believe that most people who want and can afford a home already own one? And if that is the case, how many people are going to run out to buy second homes? One of the big negative surprises that may haunt the markets and the economy for years to come is not simply that house prices aren’t going to recover quickly but that they may also drop significantly further from their peak. While the Obama Administration has tried virtually every traditional remedy to prop up housing, none of them have worked. It is time to change the underlying policies that created this mess in the first place.
1. Daniel Bell, The Cultural Contradictions of Capitalism (New York: Basic Books, 1978), p. 245.
2. Bell, p. 201.
3. The Wall Street Journal, June 2, 2011, “The Housing Illusion,” p. A18. I strongly recommend this editorial to my readers.
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