Q1 ’04:   The Home Stretch

As we enter the home stretch of the presidential cycle the risk side of the ledger is laden with issues. In this letter I will highlight a few interlocking social, political and economic trends that will have a big impact in shaping our future and which bear monitoring as we close out this presidential cycle and move into the “piper paying” phase of the next cycle.

Aggregate Debt

The elephant in the issue room is aggregate debt. The reckless spending by the Bush Administration, aided and abetted by Congressional Republicans who have betrayed their heritage and the public trust, has pushed the federal deficit to its highest level ever — well over $500 billion in one year; closer to $700 billion by some counts. In addition, states and localities are in dire straights. California voters have just approved $27 billion in new debt, more than half of that just to cover deficit spending from the past two years. Household debt, excluding mortgages, has doubled over the past 10 years, increasing 10% last year alone. Despite an all time high in aggregate household wealth, driven by spiking home prices, personal bankruptcies are at record levels. The only bright spot in the debt picture has been the improvement in corporate balance sheets courtesy of the massive stimulus of recent years, to be paid for by John Q over the next two generations. But even this positive is being overshadowed by the record number of small businesses going bankrupt (a strange phenomenon in the middle of a recovery), and the troubles at the Pension Benefit Guaranty Corporation after two years of record failures by corporate pension programs.

Let’s face it. We are debt junkies. The IMF issued a loud warning in January that the U.S. is running up a foreign debt of such record breaking proportions that it threatens the financial stability of the global economy, further noting that the U.S. budget deficits are also reaching dangerous proportions. The twin deficits equaled well over $1 trillion last year. Moody’s has made some noise that it is contemplating downgrading U.S. sovereign debt. Maybe that would wake some people up.

And as sure as winter follows summer, following on the fiscal lunacy of the first Bush term will be increased taxes. If you have been employing any strategies to roll forward or otherwise delay taxes you should probably give some thought to paying up soon. Tax wise, it isn’t going to get any better and is inevitably going to get worse.

Fiscal Madness

On the fiscal side of things we have probably seen the end of the reckless run-up of the deficit as this issue has finally become a political liability for Bush. Thank God for that. Even so, much damage has been done and we are going to start paying the price after the election. Exactly how the price is going to be paid; how much pain we are going to feel and in what form is difficult to read right now. Investors are facing a dilemma. Both inflationary and deflationary forces are on the rise. Will either of them gain the upper hand, or will the crosscurrents continue, backing us into an inflationary recession? Considering that we have had precious little inflation resulting from three years of historic stimulus one would think that the weight has to be given to deflation. However, it’s not that simple. Stubbornly high oil prices, a weak dollar and spiking housing prices are a short list of things that are creating inflationary pressure. It’s worth noting that the esteemed Bank Credit Analyst is calling for steadily increasing inflation for at least the next two years. Their track record is enviable and their forecasts are not to be taken lightly.

John Mauldin has been focusing on this complex topic recently and I encourage my readers to consider his balanced assessment of the matter. Read the February 20th issue of Mauldin’s newsletter “Barbarians at the Fed.” The previous two issues, February 6th “The Unemployment Quandary,” and February 13th “The Bond Uncertainty Principle ” also shed light on this topic. In particular the Feb 6th issue contains a description of the debt supercycle taken from the Bank Credit Analyst. I recommend that my readers subscribe to this excellent free weekly newsletter at www.frontlinethoughts.com.

The following quote taken from the Feb 20th issue goes to the heart of the matter: “According to economic theorist Joseph Schumpeter, economic recoveries that are purely a consequence of fiscal and monetary stimulus must ultimately fail. Schumpeter writes: ‘Our analysis leads us to believe that recovery is sound only if it does come from itself. For any revival which is merely due to artificial stimulus leaves part of the work of depression undone and adds, to an undigested remnant of maladjustments, new maladjustments of its own.'” (The Daily Reckoning) This seems to be pretty simple and straightforward to me, but simple wisdom doesn’t necessarily carry the day in Washington.

Like the dam builders of the Army Corps of Engineers who spent 100 years damming every river in America only to finally realize that they were violating nature’s law in a fundamental way and were doing more harm than good, it is my contention that policymakers will come to realize that their economic engineering has been violating natural law in a fundamental way and has also done more harm than good. We will have a serious economic crisis, or more likely a series of them, that will be exacerbated by the buildup of excesses caused by constant manipulation and failure to allow the natural purification cycles to play themselves out.


There has been a great deal of press lately focused on the issue of jobs, especially a heated debate about job outsourcing prompted by the President’s chief economic advisor Gregory Mankiw’s comment that outsourcing is good for us, as we send away the tedious jobs and will eventually produce more high end jobs by virtue of improved productivity. This is economic canon but of little comfort to the growing legions of American workers who are struggling to keep up. This argument assumes that displaced workers have or can gain the knowledge and skills needed to compete, overlooking the decrepit condition of our education system, which is not preparing its graduates for the demands of the increasingly high-tech, hyper-competitive global job market. Proponents of outsourcing are also ignoring the fact that, on balance, the jobs we are producing are paying 40% less than those we have been losing. This is a rather shocking statistic, not what should be happening according to theory, and not a very auspicious sign for “growing” the economy.

Capitalism on the steroids of advanced technology has unleashed a seemingly endless wave of “creative destruction” that is overwhelming the ability of many people to adapt. Like fighter pilots who black out in high performance jets that can perform beyond human tolerances, ordinary humans are being overwhelmed by the adaptive demands of our increasingly high-tech economy and culture. It’s increasingly a machine culture that we live in and we mere humans can’t keep up. This is one of the driving forces behind the steadily growing divide between rich and poor and the steady erosion of the middle class. Capital can keep moving with the relentless changes, and benefit from the huge productivity gains from technology. However, individual workers who have been downsized, Walmarted or otherwise displaced have to go through a long adaptive cycle and more often than not end up coming back in to the job market at a lower level than they were dropped out from. And they are not safe from further displacement after re-entry.

In the long run proponents of outsourcing are right but in the long run we are also all dead. Given the very real difficulties of the growing legions trying to keep up, and the hyper-partisan and polarized political environment, it is doubtful that we have the political will to tough out this cycle without resorting to a self-destructive binge of protectionism.


Conservative Republicans are determined to win the culture war at all costs, and the sudden appearance of gay marriage on the political scene has made this objective an imperative. As they see it, winning the war hinges on getting to appoint conservative judges to the Supreme Court, and that in turn hinges on getting George W re-elected. No price is too great to pay for this, and I do mean no price. With the country polarized to an extreme not seen in my lifetime and Democrats equally determined to get rid of Bush, expect to see new lows in political depravity, if that is possible, and growing enmity among Americans as a consequence. What is it they say about a house divided?


The situation in Iraq is deteriorating even as we move toward transfer of governing authority and a declared victory by the Bush administration. Violence is escalating as Islamic radicals have made it their purpose to deny victory to any effort to reshape Iraqi society by the U.S. This will be done by murdering any Iraqi’s who co-operate with the U.S. Ominously, the entire Arab world is beginning to close ranks around the cause of resistance to the U.S. campaign to “remake the face of the Middle East,” giving both popular and tacit government support to the radicals throughout the Arab world. See an illuminating Op-ed piece by Graham Fuller, former vice chairman of the National Intelligence Council at the CIA, entitled “A Sharp Point in Iraq’s ‘Pointless’ Violence .”

The world is seething with unresolved tensions and steadily growing resentment and resistance toward the U.S. In England, our strongest ally in the war against Iraq, 75% of the people feel that America is a negative force in the world right now.

For now, we are effectively forcing our will on an increasingly resentful world, but we can continue to do so only as long as we have the political will and financial resources to do so. We are suspect on both counts. Regarding political will, the Bush team is not desperate to get out of Iraq for nothing. Americans are simply not interested in shedding blood for Empire. In our hearts we are the defenders of freedom, not the imposers of our will on others. Most Americans don’t realize how far down the road of Empire we have already gone and how much it is costing us. Colin Powell put forth an eloquent statement of the Bush Administration’s global agenda in the January 1st issue of the NY Times (“What We Will Do in 2004 “). This is a noble vision but the practical, and most importantly for our considerations, fiscal, implications of imposing this vision are enormous.

We spend as much on our military as the rest of the world combined. The cost of sustaining our military “footprint,” which spans the globe, including the “arc of instability” from Columbia through North Africa and the Middle East to Central Asia, Afghanistan, Korea, the Philippines and Indonesia, with over 700 bases, is simply not sustainable. Sooner or later we are going to take that one last step which is going to break the fiscal camel’s back, if we haven’t already done so. Once that step has been taken domestic spending will first come under the knife, as it is even now. Note Alan Greenspan’s recent call for cuts in Social Security and Medicare. At a certain point, and it won’t take much, the domestic cuts will create so much political backlash that military spending will then come under the knife and we will have to start withdrawing our global deployment. It may happen gradually and we can hope for that. But it could also happen suddenly, in which case the withdrawal may look more like the evacuation of Saigon, only global. Either way, as the withdrawal proceeds, American interests will come under attack in its wake. We are sooner or later likely to end up “fortress America” for a long stretch. This does not augur well for the existing global economic paradigm. I once again refer my readers to “False Dawn ” by John Gray.

Another geopolitical issue to be aware of is that demographics are destiny. The West is aging. The U.S. is barely expanding its population; Europe and Japan are contracting. But the Muslim world is exploding. The average family in Pakistan, for example, has five children. This is a long term trend and it is going to affect everything. The fast growing Muslim world will invest its youthful vitality in economic competition or it will vent its frustration in violence.

Considering the fiscal and demographic realities, we would do better spending our borrowed money cultivating friends than bombing the daylights out of third world countries and threatening “shock and awe” for anyone who opposes us. Intimidation and violence can only take us so far and will create inevitable backlash down the road. As soon as we demonstrate any weakness we will begin to pay the price for our arrogance and violence.

One final thought on the geopolitical scene. There is growing concern among oil analysts that stubbornly high oil prices are here to stay, prompted by the emergence of China and soon India as big energy importers and the steady decline for decades now in new oil discoveries, which presages an inevitable leveling off and eventual decline in oil production. Unless we make a serious effort to find better ways to generate energy we are facing astronomical oil prices in the not too distant future. If Arab radicals get their way it will be sooner rather than later. Similar dynamics are in play regarding water and other natural resources. Resource wars are coming. Or are they already here?


It is very difficult to predict where the best opportunity is going to be at this time. We are certainly headed for a crisis of some sort, which will generate big changes, and where there is change there is opportunity. But there are two basic approaches to opportunity at this time and they are diametrically opposed. On one hand there are large and growing deflationary forces bearing down on the economy, and with so many stimulus cards already played any slowdown could get easily out of hand. Under this scenario cash is king; debt is death.

On the other hand there are also inflationary forces at work, including the above mentioned pressure on natural resources and the multiple efforts of our government, which is doing everything it can to stave off deflation. The manipulative capabilities of the U.S. government should not be underestimated. The Fed has announced that it is willing to take extreme measures to insure that deflation does not take hold, including revving up the printing presses, ignoring, for now at least, the history of disastrous consequences for those who have gone down this path. If reflation efforts are successful then assets are most desirable, and leverage even more so.

So where are the opportunities? To use an inverted sports adage, there are times when a good defense is the best offense. It is my opinion that this is one of those times. As a hedge it may be a good idea to buy some leap puts, as far out as you can get them. A modest position in gold and natural resources is a good idea, and currency diversification is also a good idea. In general, any leverage that you cannot hedge or get out of quickly is not a good idea. Various alternative investments remain excellent opportunities. See past letters for more specifics on alternatives and for other ideas.


Expect increased volatility in all markets this year and a resumption of the bear market after the election. Note that historically the presidential cycle peaks closer to inauguration day than election day. Stocks are most likely to finish higher this year, although considerably less so than last year. Rates are going to rise some time but every effort will be made to hold them down until November. After the election all bets are off. I expect that by the end of ’06 we will see the stock market testing the bear market low and possibly making new lows.

Upcoming events to be aware of:

March 20th – Taiwan votes on whether to increase missile defense against the 500 missiles China has pointed at it and whether to hold talks with China to normalize relations. China considers this referendum a step toward a declaration of independence and has vowed to take military action to reclaim the island if such a declaration is made. The U.S. is sworn to defend Taiwan. China is the primary buyer of US bonds. The Bush Administration is working feverishly to try to defuse this growing crisis. Would the U.S. abandon Taiwan in exchange for a currency float and/or a deal on North Korea?

June 30th – Karl Rove’s date for transfer of governing authority to the Iraqi interim government. Clearly Iraq is not ready but the election calendar must be accommodated. Can Iraq transition without civil war?