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The Politics of Investments

Friday, September 18, 2009   The Race from Bretton Woods

Friday, September 18, 2009

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The Race from Bretton Woods

Poignancy will not be lost in
this edition of the strategist.  I write to you this week from Bretton
Woods in
New Hampshire as I prepare to embark on a 200-mile relay race with 12
friends from all over the country.  We will begin at Mount Washington,
and
we will finish on the coast.  For 30 hours or so we will all be locked
in vans, cheering on our teammates, reminiscing and debating the
pressing
issues of the day.  Inevitably the conversation will turn to the topic
du jour, politics.  The tempers around the political issues of the
day will manifest and ultimately lead to concession or divided
silence.  Sound familiar?  I am devoting this week’s email to address
a dangerous investment trend brewing:  The emotional degree of today’s
political debate undermining the rational investment
decision-making process.  Many who feel under-represented or
un-represented by the ruling administration of the day have used their
portfolios to
express votes of “no confidence.”  Selling stocks, buying bonds and
raising cash most often represent the “no confidence” ballot, and yet,
as I
will argue, this strategy actually expresses the utmost confidence in
today’s political characters.  While the financial panic of last
year led to a series of emotional responses, I am finding the political
panic of this year contains even more hyperbole.  I will do my best to
examine the root causes of this hysteria, peer forward to prognosticate
most likely outcomes, and detail how we will position our portfolios
accordingly.

Twitter Me This

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In graduate school, one of my
finance professors gave me a “C” on a research report I had written on
a
telecommunications company.  My spreadsheets were flawless, my
investment thesis was sound and my target price for the security ended
up being
right on the money.  The flaw? My headline was boring.  She told me
that ultimately my reports would compete against an infinite number of
Wall Street research reports and that the differentiator would not be
the quality of my analysis but the seductivity of my title.  How
prescient.  Today’s technological prom queen, Twitter, requires users
to limit entries to headlines only (140 characters max).  With
newspapers terminal, content has become so passé.    Journalism has
become editorialism and incendiary emails spread like
viruses.  (I recognize that by default my observations and opinions
populate your inbox weekly, making me party to the mania, but my
highest
objective would be to be your chosen filter).

Want to be recognized?  Say
the most combustible thing you can think of.  How much type became
devoted
to the MTV Video Awards spat between Kanye West and Taylor Swift this
past week?  Enough so that the President of the United States tied off
the
event by labeling Kanye West a “jackass” (full accord with the Pres on
that call).  What bothers me most is that I know about this tiff, the
President knows about this tiff, and it’s because technology attacks us
through various channels, piercing our intelligence, violating our
intellectual domains and injecting us with toxins.  Technology has
become obnoxious.  The stimulative properties of today’s
technology mixed with the limited time in our schedules for further
inquiry leave us more susceptible to emotional baiting than ever
before.  So
at a point in time when the nation has chosen to debate and re-evaluate
major social institutions, ubiquitous technology and editorialists have
sensationalized even the most benign variables.  Investors must protect
themselves from the resultant emotional acceleration.  Decisions
made at the height of emotional energy are seldom the correct ones.  So
we must recognize that political anxiety transitions poorly into
investment strategy.  However, policy decisions do influence investment
returns.  The key is to sift through the rhetoric and identify the
macro-policies within.  Once these macro-policies have been distilled,
the strategies become clear.  In many cases I may not personally like
what the government is doing, but I know precisely how to make money on
it.

The Government Playbook

  1.  
    1. Grow the Economy – In the 1930’s the monetary and
      fiscal stimulus measures deployed by the US government amounted to
      8.3% of GDP.  To combat the most recent recession, the government has
      allocated nearly 30% of GDP.  Recovery has begun and corporate
      earnings growth will follow.  This is a certainty.
    2. Swap Private Debts for Public Debts – To mitigate
      the trauma of a marketplace resolution to the unsustainable debt levels
      in
      the private sector, the government has chosen to simply absorb the
      excess debt levels on to its balance sheet.  Debt levels have not been
      reduced
      by these actions; they have merely been shifted from individual
      institutions to the collective taxpayer.  This has bloated the deficit
      to a
      projected $9 trillion over the next decade.
    3. Entitlement Reform – Over the
      next 10 years the government projects spending of $43 trillion.  Of
      this
      amount, social security, defense and net interest payments account for
      48% of the outlays.  Non-defense discretionary spending accounts for
      15%,
      and 13% of remainder spending services diminishing programs like TARP. 
      Medicare and Medicaid not only make up the largest component (24%) but
      also the fastest growing at 7% annually.  Clearly the most meaningful
      reductions in government spending come through health care reform,
      hence
      the current debate.  Whether appeasing all of the constituents
      necessary to acquire the votes for passage leads to cost savings is
      another
      matter.  The truth remains, either systematic cost has to be reduced,
      or benefits must be reduced.
    4. Restructure GDP – The US and
      China have engaged in a codependent economic relationship for years. 
      By
      pegging the Chinese yuan to the US dollar at a low level, China boosted
      its manufacturing and export sector while the US boosted its consumer
      sector.  The excess cash China accumulated simply became re-invested in
      US debt, keeping interest rates low.  The combination of low
      interest rates and cheap imports…you know the rest.  The new reality is
      that the US needs to reduce the consumption portion of GDP while
      China increases the consumption portion of their GDP.  The US needs to
      increase its manufacturing and export components while China reduces
      their
      reliance on manufacturing and exporting.  The easiest way to look more
      like China is to act more like China.  If the undervalued yuan
      stimulated exports and manufacturing while suppressing consumer
      spending, why wouldn’t an undervalued US dollar do the same?  A weak
      dollar is the economic agent to restructure our economy.  Furthermore,
      the only way to get China to appreciate the yuan is to force inflation
      upon them.  By pegging to our currency, they adopt our loose monetary
      policy, which simply adds accelerant to an already speedy economy.
    5. Social Re-organization – Points
      1-4 translate directly into portfolio strategy, as I will exhibit in
      the next
      section.  Debates around the restructuring of the healthcare, financial
      services and energy industries are nothing more than that at the
      moment.  Furthermore, any re-organization of these enormous sectors of
      our economy will take years
      to accomplish. And, as
      Americans, if we are not happy with our chosen path, we simply vote in
      new pathfinders.  To me, these incendiary topics have “potential”
      labels
      on them while 1-4 have “essential” labels on them.  The investment
      implications of these re-organizations shift hourly as the debates
      migrate.  Trying to align your portfolio with the legislative process
      is like sailing a rudderless boat.  Who knows where you will end up,
      and you will likely get seasick.    

W&A’s Playbook

  1.  
    1. Capture Market Upside – The
      amount of fiscal and monetary stimulus administered globally ensures
      economic
      recovery.  Our outlook for stocks and corporate bonds has been and
      remains positive.  Furthermore, as risk appetites improve, riskier
      market
      segments tend to outperform.  Our exposure to small cap stocks and
      emerging markets demonstrates this thesis. 
    2. Avoid Government Debt – To
      finance the government’s strategy of absorbing private sector debt
      balances,
      the Treasury must issue substantial quantities of bonds.  While the
      global appetite for US debt remains robust, a successful restructuring
      of the
      global economy will potentially diminish demand.  Greater supply and
      lower demand leads to lower prices and higher yields for government
      paper.  Municipal paper adds significant tax advantages to Treasuries
      but yields tend to correlate.  Any municipal or federal paper should
      be held in short maturity.  The government has four methods to reduce
      debt balances over time.  First, they can increase taxes. 
      Second, they can reduce expenditures.  Third, they can rely on robust
      economic growth to increase tax receipts.  Fourth, they can simply
      inflate the obligations away.  Obviously, inflating away our debt would
      irritate our creditors and would be the worst singular solution. 
      However, blaming inflation on “necessary” stimulus measures might offer
      some political cover, and the threat of inflation needs to be accounted
      for in
      portfolios.  Inflation is cancerous to bond portfolios and therefore
      necessitates cautious construction of any fixed income allocation. 
      Managing bonds during rising rate regimes requires vigilance.
    3. Align Portfolios with Global Restructuring – Although
      the US represents 20% of global GDP, it will account for
      only 5% of its growth rate in 2010.  Brazil, Russia, India and China
      will account for 70% of global growth.  The development and strength of
      these economies will dictate industry growth patterns.  For example,
      the highly successful Chinese stimulus package led to sizable commodity
      purchases, increasing values across fuels and metals, benefiting US
      materials and energy names and jumpstarting the US stock market.  Our
      portfolio benefited from having direct exposure to the buyers and to
      the sellers.  Moving forward, the increase in emerging market
      consumption
      could be substantial, by some estimates perhaps even greater than US
      consumption by 2011.  This means terrific opportunities for US
      exporters and
      emerging market retailers and financial services firms.  The weaker US
      dollar will also contribute to these developments, and provide greater
      dollar adjusted returns for our international holdings!
    4. Respect the US – While we have
      steadily been reducing our exposure to the US over the last year, the
      flexibility
      of the US should not be underestimated.  If the government’s
      initiatives on entitlement reform reduced our long-term obligations,
      the US
      dollar would soar; further attracting global investors (see
      1995-2000).   While the US may produce relative underperformance in
      global
      advances, it produces relative out-performance in global retractions. 
      Remember that in 2008, the US dollar advanced, and the stock markets
      held
      up much better than those of our more fleet-footed friends.  US policy
      debate may be heated, but that process defines democracy, the most
      proven
      economic governance system ever.  While W&A’s long-term investment
      strategy revolves around the developing world, so do the strategies of
      many US CEOs.  Recall that through the first eight months of 2009,
      General Motors has increased car sales in China by 50% over last year. 
      US headquartered corporations will provide their investors with global
      earnings power, and our portfolios will benefit.

Back to the Poignancy

As I stated, the race from
Bretton Woods that will be underway as you read this proves poetic.  In
1944,
representatives from 44 allied nations gathered at the Mount Washington
Hotel in Bretton Woods to establish the US dollar as the world’s
reserve currency.  Now, 65 years later, in the aftermath of 2008’s
financial crisis, confidence in US fiscal sovereignty has eroded
significantly.  With the dollar’s relative valuation extending its
declines to ever lower levels, it may seem that the world is running
away from Bretton Woods.  Add to this ego blow the cacophony of
political discourse and the inflammation of today’s invasive
technologies,
and this can be a very unsettling time for Americans.  It seems as
though our governing principles, values and institutions are all being
interrogated at the same time. 

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Many I talk to simply cannot
bear the confusion and have chosen to increase levels of cash and
bonds. 
Ironically, if the US truly is in a state of decline, the worst place
to hide is in cash and bonds, which will suffer significantly with a
weakened
currency and higher inflation.  If you find yourself troubled by the
path being drawn by the leaders of the US, consider the path being
drawn by
the leaders of the planet.  At no other point in history have so many
global inhabitants been exposed to the benefits of democracy and
capitalism.  Truth be told, “Americanism” is not in decline, it’s
spreading like wildfire.  Our share of the global economic pie may
shrink, but the overall growth of the pie benefits us much more than a
larger chunk of a smaller pie.  The S&P 500 hasn’t climbed back
above 1050 because US policies have ignited growth, but through the
collaborative policy efforts of our global partners.  While this shift
in
leadership may feel awkward to us, distributed responsibility makes for
a more balanced and resilient global economic regime. 

As I leave Bretton Woods, I
can’t help but admire the remarkable work that was done here to
construct a
post WWII global economic order and the position of US economic
strength at its center.  Alas, 65 years have passed and the economic
prosperity
of the globe has improved immensely, poverty has declined and peaceful
interrelationships abound.  Mission accomplished!  It is also not
lost on me that finishing the 200 mile race we are embarking on
requires the effort of twelve of us and could not be accomplished by
any one of us
alone.  The current G20 will meet next week in Pittsburgh to discuss
various measures, but it is clear that ex-US contributions and global
coordination continue to increase.  While many may claim that these are
the worst of times, I assure you they are not.  Do not confuse the
sensationalized relative decline of America with the very real global
rise of Americanism.  We have not ended an age of prosperity, we have
simply entered a new one…and there is money to be made in this age too!
 

 

 

Remember:  Performance is not an outcome, it’s a discipline.

 

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David S. Waddell

Senior Investment Strategist

 

More Information:

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David S. Waddell, W&A biography.

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Waddell and Associates.

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* Equity model & bond model composite information and disclaimers are available upon request.

**This blog represents the opinion of W&A and is for
informational purposes only. It is not intended to be construed as tax
or legal advice by
the recipient. Past returns of investment are no guarantee of future
results.

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***Any data reported in this blog has been compiled from the Wall
Street Journal, Morningstar, Investors Business Daily, or various other
informational internet sites.

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