Q2 ’04:   Marking Time

Things have not changed much since my last letter. Oil is $10 higher, at an all-time high of $43 at this writing, but otherwise markets, risk factors and opportunities remain pretty much the same. For the most part we are marking time, waiting for the outcome of the election.

Markets & Economy

Complacency has been the dominant sentiment in the marketplace for the past few months but anxiety has been rising lately over rising rates…how high and how fast will they go? The first uptick in rates was a delicate 25 bp increase on June 30th, which still leaves the cost of money far below growth, expected to be in the neighborhood of 4% this year, and inflation — currently running in the neighborhood of 3%, with consumer inflation over 5% by some measures. By any measure the Fed is still holding to a very stimulating stance.

Is the recovery really that fragile? Apparently so. After surging for several months, June economic numbers showed softness across the board and the July numbers have continued the trend. Are the stimulants of the past four years wearing off already? According to Alan Greenspan the soft numbers are a transient phenomenon, and the recovery is in a self-sustaining phase.

Someone who takes a different view is Stephen King, head economist at HSBC, a British bank, who recently published a paper entitled “Dicing with Debt.” The Economist reviewed King’s paper in its July 3rd issue. According to King, U.S. policy makers have overreacted to the deflation of recent years, which he claims was not the much feared debt deflation, but rather a benevolent kind of deflation with historic precedent, caused by technology, improved trade relations and other factors. By misreading the threat, pushing rates to historic lows and running up the debt, policymakers have inadvertently created conditions that may well yield the more malevolent variety of deflation.

The Economist summarizes King’s argument…”If money is too cheap, then rates of return will fall, companies will tend to use capital rather than labour, and people will spend money on riskier assets; on things that have little to do with underlying economic growth; and on things that are in short supply. As it happens, this is a decent description of America in the past few years.”

“There is thus a distinct danger that by pushing real interest rates back to where they should have been in the first place, monetary tightening will reveal the economic recovery to have been more fragile than most think – and threaten a hard landing and the malign sort of deflation that the Fed was so keen to avoid. This could even mean that rates need to fall next year, not rise. And with rates so low and budget deficits already high, America ‘s economic armoury is much depleted.”

We will soon know who is right.

Meanwhile a general malaise has overtaken professional investors, who are lamenting the imminent loss of easy money from the “carry trade” and who don’t see a lot more upside in this market. P/E’s are once again at nosebleed levels and a big part of the E’s has been the direct result of record low interest rates, which are soon to be history…we think. General concern is also rising that Al Queda or related Islamic terrorist groups will try to mount attacks on U.S. soil as we approach election time.

Investors are also suffering from the loss of vitality of the latest fad in investing – “market neutral” strategies. Over the past 10 years or so computer technology has enabled a whole new generation of arbitrage strategies with fancy names like volatility arbitrage, statistical arbitrage and pairs trading to produce outsized returns for awhile, but their success has drawn so much money into these low volatility strategies that they have stripped most of the “inefficiencies” out of the market and have effectively been reduced to operating between the wall and the wallpaper. Returns from market neutral strategies have fallen off dramatically and are not likely to come back. Worse, the low volatility/high return historical profile of these strategies has given investors some twisted ideas of what a good track record should look like. Most investors now want free lunch in the form of outsized returns without the risk and volatility required to earn those returns.

Fiscal update

The fiscal insanity has only slightly abated. House Republicans, having abandoned traditional Republican values and wholeheartedly adopted the “starve the beast” strategy (see the Q3 ’03 letter, “The Twilight Zone “), with White House encouragement, have been pushing for more tax cuts in the face of record budget deficits. Senate Republicans, however, are worried about voter retribution if they run up the deficit even more going into the election, as well they should be. Also, some of the so-called “deficit hawks” are belatedly finding their voices and complaining about the fiscal madness. We will hear more from this group as we approach November, anxious as they are to pretend that they are not in league with those borrow-and-spend Stepford Republicans. Add these cross-currents together and the result is that additional budget busting legislation is unlikely for the time being.

Meanwhile we ran up a whopping $144 billion trade deficit in the 1st quarter!!! Policymakers have been asleep at the wheel on this matter for a long time, but ignoring it is like ignoring the soil eroding from under your foundation. When it finally lets you know it’s a problem is when your house washes away in a heavy rain.

Recommended reading: an upcoming release entitled “Running on Empty: How the Democratic and Republican Parties Are Bankrupting Our Future and What Americans Can Do About It” by Peter Peterson, former Secretary of Commerce in the Nixon Administration.

Risk Factors

Bill Gross of PIMCO fame has put forth the most relevant analysis of economic risk factors I have seen recently in his May/June letter, the theme of which is “walking the tightrope,” with inflation (fire) on one side and deflation (ice) on the other. You may read the entire letter at www.pimco.com. The following quotes sum up Gross’s outlook.

“In a financed-based economy, which the U.S. surely is, the only real way to keep an economy going is via cheap money, more and more tax cuts, and/or additional leverage. With tax cuts politically unpalatable and recent yield movements along the curve making leverage less profitable, the beginning of the end is in sight.”

“What has changed this year in our 3-5 year forward economic forecast is that the conditions for instability have accelerated – more U.S. consumer leverage dependent on cheap financing; more Treasuries in foreigners’ hands; more geopolitical instability; and more risk of a slowdown/shock in Asia…”

The following charts, courtesy of PIMCO demonstrate some of the major challenges facing the economy and U.S. policymakers. These charts tell their own story.

According to Morgan Stanley 98% of global GDP for the past 10 years has been generated by the U.S., and two-thirds of that has been generated by consumers. With U.S. consumers having nearly doubled their debt load over the past 20 years to 80% of GDP, it is not likely that they will continue to be the locomotive that drives the global economy for much longer.

Housing Update

From Mark Zandi of Economy.com, courtesy of John Mauldin, the following housing statistics: housing has been a huge generator of jobs – in the neighborhood of 750,000 over the past five years, which is approximately 30% of all jobs created over that time. Housing was responsible for roughly two-thirds of inflation adjusted GDP growth since the beginning of 2000, and has continued its contribution during the recovery, adding 25% to real GDP growth over the past year. As for consumer spending: for every dollar of housing value gained, consumers spent 8 cents in that year, but for every dollar of housing value lost, 30 cents not spent.

Virtually all of the “experts” assure us that housing will not go down; it may go flat for an extended period of time but not down. But if there is one thing I can tell you with certainty it is this: markets do not go straight up for years and then go flat; they correct. The super-EZ credit and low, low rates have brought in legions of unqualified borrowers, leveraged speculators and other weak hands. During the next recession large numbers of these people will be forced to sell. With virtually everyone who can qualify, even with 100% financing, having bought something, and many having leveraged those purchases to buy additional houses using “subject to” and other creative financing techniques, or having cashed out of equity to meet expenses, who will be the buyers when the market starts down? And how far down will the market have to go with tighter credit and higher rates before new buyers can be found? A typical market correction is 50-65 %; a shallow correction is 30-35 %. Can’t happen you say? That’s what every cab driver, construction worker and actor tells me. I say that in this regard housing is not different from any other market.

Another piece of the housing puzzle is the potential for big problems at Fannie Mae and Freddie Mac, holders of $4 trillion of heavily leveraged mortgage debt between them. Many economists and politicians, including Alan Greenspan, have been publicly expressing their concerns about the twin mortgage giants, particularly about hedging operations. My sources with deep roots in the mortgage business are more concerned about the big banks that are on the other side of these hedges. Fannie and Freddie are fairly well hedged against losses on their portfolios but those holding the other side of these hedges could become liabilities for meltdown if housing comes under pressure, creating counterparty default risk for Fannie and Freddie and the potential for a crisis on the scale of Long Term Capital or worse. Read The Economist , April 7th issue, “Playing With Fire .”

Regarding housing, the question is not what will happen – housing will correct — but when will it correct, how deeply will it correct and how much of an impact will that correction have on the overall economy? The notion that housing values are going to simply level off is a fantasy.


Until just recently it seemed as though the nasty rhetoric had calmed down quite a bit. I confess that I even had a fantasy about an honest national debate emerging from this relative calm, but clearly I was engaged in wishful thinking. The venom is flowing freely again as partisans are warming up for the home stretch, and the media are only too willing to give broad exposure to every inflammatory remark and attack ad.

Every kingdom divided against itself is brought to desolation.”
Matthew 12:25, Luke 11:17

An encouraging counterpoint to the gloomy state of our politics is an article by John Tierney in the June 13th Week in Review section of the New York Times entitled “A Nation Divided? Who Says? ” This upbeat article points out that most voters are still centrists and that our basic differences have actually been shrinking over the past two decades. According to Tierney “…the polarized nation is largely a myth created by people in the Beltway talking to each other or, more precisely, shouting at each other…it’s not the voters but the political elite of both parties who have become more narrow-minded and polarized.”


I think we can sum it up at the outset and say that things are not going our way on the global scene. Events in Iraq and Afghanistan have soured both enemies and allies alike toward us. Adding to the enmity, it seems that the Bush folk seldom pass up an opportunity to stick a thumb in someone’s eye.

The perception of American omnipotence, a major stabilizing influence in and of itself, has been dealt a serious blow by our inability to force our will in Iraq, and the stain on America ‘s honor from the Abu Ghraib scandal has not helped either. Nor has our failure to follow up and finish the job in Afghanistan where elections have been delayed again due to killings of election workers and registered voters by a resurgent Taliban. Recently, NATO’s Secretary General made an unusual public plea for co-operation on Afghanistan and Iraq, stating that both are doomed to become failed states (read: terrorist incubators) if we don’t all work together to save them, and castigating the U.S. for ignoring NATO except when it wants something.

We are paying a big price in terms of blood, dollars and political capital in order to pursue our “war on terror.” Result: we have killed a lot of people but global terrorist activity has surged since in the years since 9/11, particularly since the Iraq invasion, to 20 year highs. Clearly our “war on terror” has not had the desired impact to date.

Reflecting the seriousness of our global position, the CIA has cleared the publication of a book entitled “Imperial Hubris: Why the West is Losing the War on Terror” by an active senior agent, Anonymous, who was in charge of the Bin Laden station at the CIA. Anonymous laments the “imperial mindset” of U.S. policymakers and predicts that unless we learn to view world events from the perspective of our adversaries, and thus learn to understand them, we are going to lose this war on terror. Michiko Kakutani has written an in-depth review of this important book.

For those who want to follow Anonymous’ advice, see Control Room , a documentary by Egyptian-American director Jehane Noujaim that looks at Al Jazeera’s coverage of the Iraq war. One insightful GI labels Al Jazeera the Muslim version of Fox News. Indeed, Al Jazeera recently announced an ethics standard of “balanced and sensitive” reporting.

China update: World stability was granted an extension in March when Taiwan ‘s independence initiative failed on a technicality: the election failed to draw the required 50% participation for the referendum to be considered valid. Tensions remain high in the area however, and not ones to miss an opportunity, the neo-con geniuses running the Pentagon have arranged to deploy seven aircraft carrier battle groups for what may be the largest military exercises in history off the coast of China and have invited Taiwan to join in. A typical deployment in a genuine crisis, like Iraq or Afghanistan, is three or four battle groups.

Not surprisingly, China has not taken kindly to this provocation. China will be conducting its own military exercises and has announced a crash program to beef up to a level able to counter seven carrier battle groups. Keeping in mind the Powell Doctrine that no nation should be allowed to challenge American military supremacy, a more muscular China will probably not be a stabilizing influence in Asia. Also, any bets on Japan ‘s response? And since it is China that is financing our debt addiction right now, might they decide to exercise a little muscle of their own and dump a pile of U.S. Treasuries on the open market, or maybe just stop buying?

Now that we are bogged down in two unfinished wars in Afghanistan and Iraq and stirring the pot in Asia, neo-cons are beating the drum for war against Iran. Numerous articles have appeared recently about the connection between Iran and Al Queda. The 9/11 Commission raised the question, “why did we go to war with Iraq when, given the rationale for the war, the case was actually much stronger against Iran?” The White House is “investigating” this matter. The Wall Street Journal in a June 14th editorial entitled “Coddling the Mullahs” called for applying the doctrine of pre-emptive war to Iran.

All of the above is promoting general instability in global relations and undermining the co-operative foundations of global trade. Western interests in general and American interests in specific are now and will increasingly come under attack first in the Islamic world and then elsewhere. If you are doing business or holding interests internationally and have not already done so, you would do well to develop contingency plans to deal with attacks on your interests and even on your person if you need to travel internationally.


No change here since the last letter. See the March ’04 letter, “The Home Stretch .”


Barring a sudden shock from one of the many potential sources of geopolitical or economic trouble, the Presidential cycle will continue to dominate. Stocks will continue sideways to higher into the election and probably into January. An alternative scenario is a sell-off into September followed by a rally to a new or secondary high in November or January. Rates will rise slightly for the time and more sharply after November and inflation and deflation will continue to co-exist side-by-side. With due consideration of the opening caveat, we are not likely to see any big trends or trend reversals developing prior to November but we are likely to see some market gyrations as positions are unwound going into the election and/or bets are put in place. Most likely is an uneasy peace between the bulls and bears.

One could say that the foundation of my macro outlook going forward is that efforts to manipulate endless “controlled” inflation and avoid recessions have introduced latent instability into the system and are doomed to failure. Recessions are natural corrective phenomena. With each corrective cycle that we charge our way out of, we increase the burden we must carry during the next expansion. This simply can’t go on forever and the longer we delay paying what we rightly owe, the bigger the debt will be and the more painful it will be to pay it. We can only violate natural law for so long before nature takes action to restore balance.

The power brokers in Washington have become highly skilled in manipulation and deception, so we have seen and can expect to continue to see many delaying tactics, but in the end I believe that we are going to experience a period of extreme dislocation as the accumulated excesses, weaknesses and corruption are purged from the system. The trigger for this purging could be economic or geopolitical, but once begun, instabilities in both spheres will feed off of each other until the process is complete.