Happy New Year. We enter 2012 with a great deal of hope, but our hopes are not for more bailouts, or money printing, or any of the myriad policies that investors seem to hope will save bad investments and sustain elevated valuations. Instead, our hope is that in 2012, the market will finally "clear," in the sense that bad debt will be recognized as bad and restructured; that overleveraged financials will be taken into receivership instead of forcing austerity on every corner of the economy in order to make them flush again; that rates of return will rise enough to compensate and encourage saving - and high enough to encourage borrowers and other users of capital to allocate the funds productively. Of course, in order to restructure bad debt, someone has to accept a loss. In order for rates of return to rise, valuations must decline. In short, our hope is for events that will unchain the global economy from an irresponsible past and open the gates toward a prosperous future. Maybe that is too hopeful, but we are not entirely convinced that bailouts and "big bazookas" will be as easily procured in the year ahead as a confused public has allowed in recent years.
We begin 2012 with the S&P 500 priced at valuations from which we estimate 10-year total returns of just 4.9% annually. This figure would be less discouraging if it were not for the fact that valuations - properly normalized for the cyclicality of earnings - have been tightly related to subsequent returns as far back as one cares to look, and as recently as the past decade. It is true that rich valuations did not prevent the late 1990's bubble (corresponding to late 1980's 10-year total return projections), but the ultimate and predictable outcome of that bubble has been more than a decade of stagnant returns. Back in 2000, it seemed inconceivable that we could be projecting negative 10-year total returns, but that outcome was the natural result of the valuations we observed at the time. Weak returns over the coming decade (hopefully front loaded as a few years of negative returns, followed by normal or above-average returns in the out-years) are likely to be an equally natural result of present conditions.
With 10-year Treasury yields below 2%, 30-year yields below 3%, corporate bond yields below 4%, and S&P 500 projected 10-year total returns below 5%, we presently have one of the worst menus of prospective return that long-term investors have ever faced. The outcome of this situation will not be surprisingly pleasant for any sustained period of time, but promises to be difficult, volatile, and unrewarding. The proper response is to accept risk in proportion to the compensation available for taking that risk. Presently, that compensation is very thin. This will change, and much better opportunities to accept risk will emerge. The key is for investors to avoid the allure of excessive short-term speculation in a market that promises - bends to its knees, stares straight into investors' eyes, and promises - to treat them terribly over the long-term.
Again, we enter the year with great hope. But our hope is not for continued speculation and the maintenance of rich valuations (that only look reasonable because long-term cyclical profit margins are at a short-term peak about 50% above their historical norms). At present, we have a situation where saving is discouraged by desperately low interest rates, where unproductive uses of capital are not discouraged because the bar is so low, and where central banks recklessly facilitate economic stagnation by bridging the gap between a puddle of unrewarding savings and a mountain of unproductive speculations. So our hope this year is for a return to a proper investment opportunity set - where saving is encouraged and rewarded by sufficiently high prospective returns, and the cost of capital is high enough to discourage high-risk, low-return investments and unsustainable fiscal deficits. The longer policy makers wait to begin the orderly restructuring of bad debt and overleveraged financial institutions, the greater the risk of a disorderly restructuring.
Europe Update
The Eurozone Purchasing Managers Index (Markit) is already well into recessionary territory. Notably, production and new orders continued to hit fresh lows in the latest report - the slight uptick in the index reflects only a slowing in the rate of decline. The accompanying commentary observed "Production declined for the fifth consecutive month. The fall was less sharp than the 29-month record seen in November, though it remained steep compared with previous downturns prior to the financial crisis. Output and new business fell across the consumer, investment and intermediate goods sectors, with the latter reporting the strongest declines in both cases. For the second consecutive month, all of the nations covered by the survey reported lower levels of output... the fall in production at euro area manufacturers reflected a seventh successive monthly decline in new orders received." Markit's chief economist noted that the latest data "suggests that operating capacity will be slashed in coming months unless demand revives."
Meanwhile, the European Central Bank is more tapped out than we suspect investors recognize. The balance sheet of the ECB now stands at about $3.55 trillion (2.73 trillion euros), compared with EU GDP of about $16 trillion. This puts the European monetary base at about 22% of EU GDP, which is even greater relative to the economy than the Fed's balance sheet ($2.97 trillion on $15 trillion of GDP as of December 28, which works out to 21 cents for every dollar of GDP). Forget the "zero bound" - given the bloated size of the ECB balance sheet, combined with the lack of credible safe-havens in Europe, distrust of the banking system, and an apparent aversion to cash-stuffed mattresses, German 3-month debt is now sporting a yield of -0.17%, which means that investors pay the German government for holding their money.
As noted in Why the ECB Won't, and Shouldn't Just Print (see the section on inflation and the value of fiat currencies), this expansion in the central bank's balance sheet is not necessarily inflationary provided that market participants are firmly convinced that it is temporary. The value of one unit of currency stems from the stream of transactional and value-storage "services" that the currency unit is expected to throw off over time (as measured against the marginal value of other goods and services). If a large volume of new currency is created, but only for a short period of time, the expected long-term value of the existing currency stock is not seriously diluted, and you shouldn't expect to see inflation. It's when the currency creation is effectively permanent that you see large dilution of the value of existing currency units, which is another name for inflation. The ECB will not purchase unlimited amounts of distressed European debt precisely because nobody would expect the ECB to have the ability to reverse the transaction, and worse, if the debt were to default, the result would be immediate and rapid inflation because the money stock would suddenly be viewed as permanently high.
In lieu of printing euros to buy distressed debt, the ECB initiated a massive round of 3-year loans to European banks last month, taking securities from those banks as collateral. It's important to recognize that the ECB does not take credit risk by doing this. Regardless of how the collateral fluctuates in value, the ECB has a claim to repayment of the original loan, plus interest, and that claim stands ahead of the claims of existing bank bondholders and certainly stockholders.
While some observers hope that the massive round of ECB loans to European banks will spur bank purchases of distressed European debt in an attempt to "arbitrage" the higher interest rate on that debt against the 1% rate charged by the ECB, this really isn't what investors should expect. What's actually happening here is that European banks, already spectacularly over-leveraged against their own capital, can no longer successfully access the commercial paper markets for funds, so have had to turn to the ECB for this liquidity. The sheer size of the recent operation was not an indication of potential new bank demand for distressed European debt, but instead was an indication of how strapped the market for short-term and unsecured funding has become for European banks. Moreover, the whole "arbitrage" idea is flawed in the sense that it implies that the capital shortfall of European banks can reliably be bridged out of the pockets of the most distressed EU member countries.
Let's be clear about this - if European banks were to use the funds from the ECB to make significant new purchases of European debt, their capital ratios would become further strained, their portfolios would become more unbalanced, the market for new short-term and long-term bank funding would become even more deserted, and the timeline for European bank receivership and restructuring (a phrase that we prefer to "failure") would simply be accelerated.
I expect that we will see some further progress toward a "fiscal union" among European member states, but without explicit changes to the EU Treaties ratified by all of its members, we will not see any move toward unlimited ECB buying of European debt. At best, the ECB will act as a collateral-taking intermediary in an attempt to ease increasingly frequent liquidity strains in the banking system. On fiscal union, the real issue is credibility - how do you really impose fines and other penalties against countries who are already unable to pay their bills? In the end, hopefully sooner than later, it would be best for European member states to begin adding convertibility clauses into their debt, giving them the option to convert the debt from the euro into their legacy currencies. This would substitute credible market discipline for ineffective political sticks, and given that the average maturity of European debt is only about 7 years, much of it front-loaded, it would also remove the specter of massive sovereign defaults within a fairly short period of time.
That said, it is important to remember that the attempt to rescue distressed European debt by imposing heavy austerity on European people is largely driven by the desire to rescue bank bondholders from losses. Had banks not taken on spectacular amounts of leverage (encouraged by a misguided regulatory environment that required zero capital to be held against sovereign debt), European budget imbalances would have bit far sooner, and would have provoked corrective action years ago. The global economy has not been well-served by the financial companies that leaders are trying so desperately to protect. Our vote is for receivership and restructuring so that losses can be taken by those who willingly accepted the risk of loss, and the legacy of bad investments and poor capital allocation doesn't have to be converted into a future of suppressed economic growth.
