CAPTRUST Chief Investment Officer
Art Linkletter, the variety and talk show icon, hosted his enduring radio program House Party and eventual television series Art Linkletter’s House Party for almost 25 years, from 1945 to 1969. Admittedly a little before my time, the broadcasts are best remembered for a popular segment titled “Kids Say the Darndest Things,” in which Art would candidly interview children between ages five and 10. Over the show’s history, more than 23,000 children were interviewed, generating some choice material.1 The segment’s popularity spawned a book, a late-1990s TV show hosted by Bill Cosby, a 1973 Tammy Wynette chart-topping country hit, and several international offshoots.
With three children of our own, my wife Jamie and I have amassed our own choice material over the years, with a recent example worth sharing. Just before the new year, our nine year- old daughter Elle was showing me some email exchanges between her and a classmate. “Exchanges” may be a liberal description given the word count; after an unscientific polling of parents with similar-age children, I can report that nine year- olds vehemently protest exceeding 20 words per email.
Here is a reproduction of the referenced email exchange:
Elle (upon receiving an emailed picture of chocolate chip and sugar cookies from her friend): They look so good!
Friend: I know!!!
Elle: I want to just jump inside the computer and eat them.
Friend: I know, right?
Friend: I am so bored.
Elle: Me too (sigh). (Editor’s note: the child has a backyard, a bookshelf full of literature, two siblings, and a room that is likely in need of cleaning; she is clearly fibbing.)
Friend (Editor’s note: remember that this is a nine-year-old.): I am so excited for 2013 except for the fiscal cliff
Elle: Me too!
I recognize that I find this email exchange much more humorous than you may, given that it was my child and her friend bantering about a significant focal point for me and anyone else wearing an investment hat in this profession. CAPTRUST’s fiscal cliff preparations began long before the cliff ’s deadline, including delegation of responsibility for analysis, definition of our client communication strategy, discussions with our investing partners and research providers, content creation, and — apparently like the nine-year-olds highlighted in the earlier tête-à-tête — waiting for an actual outcome. While Elle did not watch CSPAN all New Year’s Day like her father, she, like many others, braced for the ultimate congressional outcome, which arrived at 11:35 p.m. on January 1, one day after the fiscal cliff technically began. Globally, asset classes responded with vigor the next trading day, with equities, high yield bonds, and other traditionally risky asset classes racing higher while government bonds fell.
While the fiscal cliff deal (more formally titled H.R. 8, the American Taxpayer Relief Act of 2012) provided capital markets with a temporary salve, the deal’s contents did not address its root cause: a massive cumulative imbalance between savings (revenue) and spending. The nonpartisan Congressional Budget Office (CBO) offers two perspectives regarding the fiscal cliff bill. First, in the event no deal materialized and the economy had gone “over the cliff,” the CBO estimated that the H.R. 8 legislation would reduce revenues and increase spending by nearly $4 trillion between 2013 and 2022 (and by defi nition increase net debt by the same amount, all else equal).2 However, had the existing tax policies from calendar year-end 2012 carried forward into 2013, the CBO estimates that the fiscal cliff bill reduced budget deficits by $600-$700 billion less than what they would have been without the deal.3 Crystal balls forecasting trillion-dollar budgets 10 years forward may be better described as obsidian balls, but note that the CBO sees the 2022 budget deficit at just under $7 trillion, subject to a more complete analysis later this year.4
We Americans are not alone in our savingspending imbalance; smaller economies have gained unfortunate notoriety for spiraling debt levels as a percentage of their Gross Domestic Product (GDP), particularly from 2005 onward. Figure 1 provides a sampling of countries and their debt-to-GDP ratios, with all countries listed showing an increase in their debt position relative to GDP, save Norway, whose debt to GDP fell more than 7% during this time period thanks to robust energy exports and prudent government finances. Greece, Japan, and the United States all had triple-digit percentage increases, and note the steep ramp higher for all countries (again, except Norway) between 2005 and 2012.
This phenomenon’s development is certainly country-specific, but a common thread across each country was unprecedented government stimulus during the financial crisis in 2008 and beyond. Governments stepped in for beleaguered private consumers and businesses, leaving significant IOUs in their wake. We have used a relay race analogy to describe this situation, and right now several governments are still running with the growth baton (through spending and stimulus programs), desperate to pass that baton back to consumers. Consumers have long been in deleveraging mode since the credit bubble popped in 2008, shoring up personal balance sheets through more rational spending. Governments are aching to do the same thing, but they can’t pass the baton until anemic growth improves.
Capital markets pay attention to debt-to-GDP levels, fearing an inverse relationship between a country’s indebtedness and its ability to make good on those debts. As Figure 2 shows, the government bond issuances by countries such as Italy, Spain, and especially Greece spiked higher as a function of indebtedness, impacting financial institutions, investors, and the economy at large. Put more simply, when countries relying upon debt fi nancing face sharper borrowing costs, bad things can happen to economic growth, equity returns, and unemployment. Japan, which has a massive debt-to-GDP ratio yet low government bond yields, has been forced into decades of central bank intervention, including money printing and encouraging Japanese banks to buy newly issued paper to keep rates low. As decades of sluggish Japanese economic growth and equity returns show, not even low bond yields can mask underlying fiscal fundamentals.
So where are we in this relay race? Again, country-specific analysis provides a more precise answer, but as a general statement, the major regions have not made enduring progress, or at best it has been unbalanced. For the United States, CBO data suggests that without higher taxes and with prescriptive spending cuts (pushed to later in 2013 during Congressional H.R. 8 negotiations), the fiscal cliff deal still adds to the budget deficit. While Spanish, Italian, and Greek bond yields have fallen materially and provided some funding relief, debt reform has yet to occur. Most of the bond yield contraction came thanks to European Central Bank chief Mario Draghi’s willingness to buy bonds from troubled countries who submit to fiscal reform; not a single country has signed up for that program. Japan continues to rack up debt through ongoing efforts to overcome a surprisingly strong yen and unfavorable demographics. Even the U.K., which has started to take hard medicine in the form of austerity measures and fiscal belt tightening, doesn’t expect public debt to start to fall until 2016-17, according to their Office for Budget Responsibility.
If my claim is correct about minimal progress on the debt destruction front, then why did asset prices have such a strong 2012? Haven’t investors learned from the Greek, Italian, and Japanese examples, where stock markets have lost 67%, 47%, and 10% since 2005 in local currency terms, respectively? The answer lies in hope regarding the denominator of this equation: GDP growth. GDP growth is the elixir indebted countries require to ease their pain. As of this writing, investors anticipate some global growth in 2013, thanks largely to a potential Chinese rebound, a firmer footing in the U.S. housing market, and ongoing domestic demand in developing economies. While many question the linkage of GDP to stock market performance, doubters tend to oversimplify this relationship, and given historically low bond yields, economic stability could mean another solid year for risk asset classes, particularly global equities.
We do not expect a linear move higher, however. While CAPTRUST sees the path forward with a glass-halffull perspective, this is not a time for portfolio heroism. Our current economic and policy tightrope walk remains perilous, and those tough political decisions our elected procrastinators pushed into the first quarter of 2013 (i.e., the debt ceiling debate and sequestration) invite further rancor. Like my daughter and her friend awaiting their report cards, central banks, bond rating agencies, and investors of all shapes and sizes await true fiscal progress. Without credible progress, riskier asset classes could live up to their name. Should the high-wire act unwind, traditionally safer options like fixed income will prove to be helpful portfolio tools despite their low current yields.
True progress must come from policy makers willing to compromise and make tough choices. It will also come from policy makers and an informed electorate who truly understand what is at stake, an understanding not achievable from relying on slick political catchphrases, tweets under 140 characters, or email exchanges with the brevity of my daughter and her friend. While I am proud that Elle and her friend are at least aware of the fiscal cliff, I fear that they will bear the brunt of our fiscal disorder should the United States and other peers trudge down this dubious path. As Edmund Burke famously said, “those who don’t know history are destined to repeat it.” As Elle and her friend would say… “I know, right?” (sigh)
1 Dunning, John. On the Air: The Encyclopedia of Old-Time Radio. Oxford: Oxford University Press, May 7, 1998, pp 333-34