January 11, 2011
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This essay is excerpted from the most recent version of the HCM Market Letter. To subscribe directly to this publication, please go here.
“For it must be cried out, at a time when some have the audacity to neo-evangelize in the name of the ideal of a liberal democracy that has finally realized itself as the ideal of human history: never have violence, inequality, exclusion, famine, and thus economic oppression affected as many human beings in the history of earth and humanity. Instead of singing the advent of the ideal of liberal democracy and of the capitalist market in the euphoria of the end of history, instead of celebrating the ‘end of ideologies’ and the end of the great emancipator discourses, let us never neglect this obvious macroscopic fact, made up of innumerable singular sites of suffering: no degree of progress allows one to ignore that never before, in absolute figures, never have so many men, women and children been subjugated, starved, or exterminated on the earth.”
Jacques Derrida (1993)1
While the late French philosopher Jacques Derrida wrote these words almost two decades ago, they still describe the state of much of the world. After all, it was barely a year ago that Haiti was virtually destroyed by a catastrophic earthquake, and that cursed island remains in the throes of a cholera epidemic and terminal poverty and political chaos. So while much of the financial world is trying to celebrate the start of a new year with optimism, HCM would like to keep things in perspective. The world remains a deeply troubled place, and the amount of intellectual and financial capital that is devoted to money-spinning rather than to productive investment and improving the lives of others is a continuing tragedy.
The consensus has reached the conclusion that financial markets will enjoy a strong start to 2011. This is reason enough to approach the markets with caution as the year begins. When everybody is leaning to one side of the boat, the vessel is far more likely to tip over, particularly if it hits an unexpected wave. The VIX is back down to just a hair above 17, a level that raises warning flags (we always pay special attention when the VIX trades below 20). The complacency to which that VIX level speaks seems misplaced despite the fact that the investing environment has clearly been improving from a lousy base. There are other signs of overexuberance as well, such as the AAII investor sentiment poll hovering above its historical norm for 17 straight weeks, margin debt rising by 16 percent since July to its highest level since July 2008, ETFs attracting gobs of new money, commodity prices going haywire, and the media cheering on the party like it’s 1999. While HCM would certainly take the view that the glass is half full, it isn’t three/quarters full. The balance of positives and negatives is extremely balanced, which means it is a stock picker’s and bond picker’s market.
Interest rates have risen, which HCM considers a good thing since abnormally low rates are always a sign of economic infirmity (as well as policy confusion). It appears that, at least until the next financial crisis, the direction of global interest rates is decidedly upward, despite the Federal Reserve’s obvious goal of negative real interest rates (Federal Reserve Vice Chairman Janet Yellin was quoted as saying during the financial crisis that “[i]f it were possible to take interest rates into negative territory I would be voting for that.”2) The question is whether rates have moved sufficiently higher to negatively impact other markets, particularly the equity and commodity markets. Thus far, the answer is a definitive “no.” Global interest rates are still very low on a historical basis, and certainly not low enough on an absolute basis to retard economic growth or, more importantly (and more destructively in the long run) speculation.3 The issue remains whether the animal spirits of entrepreneurs and investors are awakening, and there are increasing signs that they are.
At the end of the day, however, the economic infirmities of overspending and overborrowing still ail the economy and no painless cures have been discovered. We are very sympathetic with something that Marc Faber wrote in the December issue of his fabulous The Gloom, Boom & Doom Report: “I don’t think that Mr. Bernanke and other central bankers around the world have any intention of ever implementing an ‘exit strategy.’ Maybe on paper the intention is there. Maybe the intention also exists in overstaffed office buildings – full of academics who have never worked a single day in the real economy. However, the reality is that central bankers around the world will continue to pursue expansionary monetary policies. Therefore, I don’t believe that the S&P 500 and other stock markets will retest the March 2009 low.” Based on our agreement with this statement, we continue to recommend that investors continue to accumulate physical gold equivalent to up to 10-15 percent of their portfolios. If history has taught us (and is continuing to teach us) anything, it is that central banks and governments will continue to trash fiat currencies until the end of time. That said, while we think that most of the systemic problems have not been addressed but have largely been pushed off to the future, we also agree with Dr. Faber that the S&P is unlikely to revisit the satanic 666 level in the foreseeable future.
Wall Street strategists were falling over each other to raise their economic growth estimates as 2010 drew to a close. Consensus 2011 GDP estimates are now in the 3.5-4.0 percent range, a sharp increase from the 2-2.5 percent range that dominated discussion earlier in 2010. The revised estimates are likely correct, but like many statistics they fail to tell the entire story. Such growth will only be achieved with a fiscal 2011deficit of approximately 9.5 percent of GDP, which follows deficits of 8.9 percent of GDP in fiscal 2010 and 10 percent of GDP in fiscal 2010. It is safe to say that 2011 GDP growth would be nowhere near 3.5 percent if the U.S. government were not running its budget on steroids. As a new Congress gathers in Washington D.C. with the alleged goal of undoing the fiscal damage of previous Congresses, spending discipline is priority number one. Of course, the lame duck Congress was able to get in its last licks with a tax bill that included payroll and income tax provisions that needlessly benefitted the wealthiest Americans, so the fiscal hole is that much deeper than it needed to be. The Republican-led House of Representatives will have a chance to put its money where its mouth is, so to speak, by proposing meaningful spending cuts, while Democrats try to absorb the lessons of the November 2010 mid-term elections. The most important economic question, however, is whether the private sector will be able to pick up the mantle of economic growth from the government as 2011 progresses and governments at the federal and state levels reduce their spending.
Government bond markets are suggesting that the handoff will not be so easy. When President Obama announced his tax surrender on December 6, the 10-year Treasury bill yielded 2.92 percent, sharply higher than its October low of 2.38 percent. HCM never entertained any serious doubts that the President would cave on the tax issue, which was one of the reasons we started to think that Treasuries were a short when they moved under 2.5 percent. The benchmark bond ended the year at 3.3 percent, and most forecasts see it moving to the 3.75 to 4.0 percent range by the end of 2011.
U.S. 10-Year Treasury Yields – 2010
The German bund bottomed at 2.12 percent at the end of August and ended the year yielding 2.93 percent. Hopes (or fears) that its yield would drop below 2 percent were dashed by another outbreak of European credit-sclerosis, this time in Ireland and now threatening to spread to Portugal (whose first bond sale of 2011 came at 3.686 percent compared to 2.045 percent last September), Spain, Belgium and who knows where else.
German 10-Year Bund Yields – 2010
1. Jacques Derrida, Specters of Marx (New York: Routledge, 1994), p. 106.
2. For some reason, this statement reminds us of Cecil Rhodes boast that “I would annex the planets if I could.” This is not a non sequitor if you really think about it.
3. Our friend David Rosenberg points out that banks are engaging in massive proprietary trading activities again. According to Mr. Rosenberg, banks trading assets surged by $64 billion in the last month. See David A. Rosenberg, Gluskin Sheff, Breakfast with Dave, January 4, 2011, pp. 11-12. Perhaps they are trying to get in their last licks before the Volcker Rule takes effect.
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