To lose money realized or unrealized is painful. To lose without learning useful lessons is tragic. Frank Holmes of US Global Investors quotes Baron Rothschild, writing, “The time to buy is when there’s blood in the streets, even if the blood is your own.”
My analysis of what happened last week was not a reaction to the appropriate, if not overdue, Standard & Poor’s downgrading of some US Treasury debt. (The focus of the downgrade was the political unwillingness to stop the growth of the federal government’s deficit, not an inability to pay.) What caused the decline, in my view, was the increasing recognition of the seriousness of the European fiscal, political, and therefore economic problems, and how they may and probably will, impact credit conditions globally.
The fear transmission line
One of the louder voices of concern was Mohamed El-Erian, the co-chief investment officer of PIMCO, probably the largest professional bond manager in the world, who wrote, “Any further mis-steps from American and European policymakers risk converting raging crises within the global economy to a more devastating crisis of the global system. That is how fragile the situation is, and why the world risks not just a recession but -- even more worrisome -- a prolonged one.” His fears are being heard by the American people. In a recent Marist Poll, 68% believe that the worst of the country’s economic conditions are yet to come. What was surprising, 57% of the Democrats agreed. Another poll (Thomson Reuters/University of Michigan) measuring consumer sentiment, reported a sharp drop from the month before to a level that had not been seen since May of 1980 (no misprint). Jeremy Grantham stated in a recent interview that Americans respond to a market signal better than almost anyone.
The historical perspective
Governments of all types have believed that they can only maintain power if their people are well fed. The best example of this management technique was the ancient Romans. Rome's government had to produce “bread and circuses.” To support these basic needs, wars were initiated to bring back marketable tribute, including slaves of both sexes. When the wars became defensive in nature, the costs of these adventures, particularly the military costs of defending borders, grew to a point that the tax burden was crippling the economic growth, which subsequently weakened defense spending and promoted corruption. Substitute the welfare or “nanny state” for “bread and circuses,” with the size of the deficit absorbing all of the gross national product, and you have a good description of Mediterranean Europe, and a fear for the US and the UK.
The role of the banks
In most civilizations, the governments control the banks or the banks control the government. In modern society, banks extend credit often to governments directly or to government favored activities, e.g., mortgages, car loans, commercial loans to faltering employers, etc. In the cases of those countries with well-known problems, the banks are full of domestic loans as well as other allied sovereign debts. The US market reacted to fears that the French banks were following in almost lock-step fashion behind the Irish and Spanish banks, with the Italians not far behind. These concerns on the part of both US investors as well as those beyond, has propped up the prices of US Treasuries regardless of the downgrade, which was not a surprise to anyone who reads financial reports. In just the last week, investors put $50 billion into money market funds, reversing the $49 billion outflow the week before.
What are the lessons for me?
When I look across the Atlantic to Europe, I see an aging population of workers not being replaced by younger people who want to work. In addition, there is an incredibly weak military structure and a population that does not want to declare income to pay taxes. On the other hand, as the surviving economists who have escaped from Lord Keynes’ grip will point out, across the Pacific (with the exception of aging Japan), the populations are younger, eager to work, and possess a healthy combination of savings and higher quality consumption. To me, last week crystallized the need for our clients’ accounts to increase exposure to Asia. We already had significant exposure through exporters in Germany, Chile, Brazil, Mexico, Canada and a number of US companies in our funds’ portfolios. These investments are not riskless due to economic and political cycles, but the secular investment trend is up.
What did you learn last week?
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