Risk & Opportunity

A quarterly political and economic newsletter published by Michael Cuddehe

Q3 '12

Elections and De-Leveraging

The marathon 2012 presidential election campaign is almost finished. Polling has been volatile, but at press time with just a few days to go, Nate Silver’s FiveThirtyEight blog gives Obama an 84% probability of electoral college victory. Intrade has Obama at 67%.

This campaign gets the prize for banality. With almost $6 billion spent on this election according to OpenSecrets.org, one-third of that by the presidential candidates, nothing of substance has even been addressed let alone settled. The entire campaign has been a demolition derby highlighted by the presidential candidates posturing, attacking each other, dancing around the issues and blowing a lot of smoke about how they are going to create jobs and lead us to economic revival.

Ostensibly, the proposals on the table are: (1) major reductions in government spending on social programs (increases for the military) with simultaneous tax cuts for the upper tier and de-regulation that will magically create growth and jobs so the spending cuts won’t be painful and the tax cuts won’t increase the deficit (Romney), or (2) a long, slow, debt financed collective slog into the future and a grand bargain on the deficits that will be enabled because after the election Republicans will see the light and stop obstructing any solutions to the problems their policies created (Obama). We get to choose between fraud and delusion.

Campaign rhetoric notwithstanding, there is not likely to be any substantial change in fiscal policy after the election, and neither candidate is talking much about what they actually plan to do. For some insight into what they are really planning, see Jonathan Chait’s excellent article in New York Magazine entitled “November 7th” laying out the long term agendas of the contestants.

Behind all the spin and obfuscation, and the fairy tales about creating jobs, the reality is that we are in the contracting, dis-inflationary phase of the debt super-cycle and this election is ultimately about how and to whom the inevitable pain from that contraction is going to be allocated going forward. For a clear perspective on where we stand in the debt supercyle, see the BCA Research Special Report “An Update On the U.S. Debt Supercycle: Where Are We Now?

With all the attention the presidential election is getting, the fate of the Senate is flying under the radar. Nate Silver is presently handicapping control of the Senate for the Democrats at 91%. Silver doesn’t handicap the House, but most commentators expect the House to remain in Republican hands, although with a smaller and somewhat moderated majority.

Wild cards — several late developments that could have major impact:

  • Hurricane Sandy has given Obama a high profile opportunity to look benefic and presidential, and highlighted Romney’s previous statements that FEMA should be disbanded.
  • Multiple statements by Republican candidates rejecting access to abortion for rape victims, including Indiana Republican Senate candidate Richard Mourdock’s statement that pregnancies resulting from rape are “something God intended to happen.”
  • The Romney campaign’s blatantly dishonest ads in Ohio claiming that the auto bailout is being used to send jobs to China, drawing public rebukes from both GM and Chrysler.

Noteworthy in this election cycle is the Republican campaign of voter suppression. In what The Economist calls a “Betrayal of Democracy,” Republican dominated state legislatures have passed dozens of laws limiting voting rights, in every case targeting Democrat leaning groups…youth, minorities and the elderly.

Economy

The Fed went all-in for QE at their September meeting with a surprising 11-1 vote to print as much as needed for as long as needed. Judging by this action, we can only conclude that things are considerably worse than they have seemed, which is not good in any case. Noteworthy is the statement from the lone dissenter, Jeffrey Lacker, President of the Federal Reserve Bank of Richmond:

“I dissented because I opposed additional asset purchases at this time. Further monetary stimulus now is unlikely to result in a discernible improvement in growth, but if it does, it’s also likely to cause an unwanted increase in inflation.”

Will there be jobs? Probably not many. The global economy is slowing, and de-leveraging in the advanced economies will keep a lid on growth for quite some time. At the same time, technology continues to steadily displace humans in our economy. Robotics is the big issue that is still flying under the radar. More and more technology….fewer and fewer humans needed. The first all robot factories are being constructed. This trend will continue the concentration of wealth in fewer and fewer hands.

The big philosophical and political battles ahead will be over this issue of wealth distribution in the age of advanced technology. The Tea Party, Ron Paul and Occupy Wall Street are early manifestations of this debate. We are in dire need of a coherent vision that transcends the outmoded 20th century paradigm of Socialism vs Capitalism.

Markets

Financial markets across the board have stopped responding to economic fundamentals and are keyed on government policy. Traders are transfixed by each next meeting of economic ministers, responding euphorically to each announcement of another round of money printing as if it were the announcement of global salvation. But QE can’t hold the markets up forever. See PIMCO CEO Mohamed El-Erian’s recent post, “Central Banks Can’t Inflate the Markets Forever.”

The stock market has been the primary beneficiary of QE. The S&P500 is up 12% on the year at press time; the Dow up 7%. Fed bond buying has kept bonds up, rates low. But the marketplace has become a hollowed out battlefield dominated by front-running trader-bots and giant hedge funds operating arcane, Phd created models designed to undermine other market participants. Market makers and genuine investors are scarce.

Geopolitics

The global uprising of anti-American protests in Muslim countries should not have taken anyone by surprise. The U.S. has been meddling in the affairs of the oil producing Muslim countries for decades. The Arab Spring opened up a Pandora’s Box of long suppressed resentment that is going to take years, perhaps decades, to process and normalize. Obama’s handling of this volatile upheaval has so far been admirable.

Iran is a subset of the Islamic problem that is especially difficult. The prospect of a nuclear Iran is sobering and the U.S. has publicly committed itself to preventing that outcome. Israel, understandably, is concerned that the U.S. guarantee is not hard and is pressing for a red line on Iran’s nuclear development. Relations between the U.S. and Israel are solid, but things are rather frosty between Netanyahu and Obama. Obama refused a meeting with Netanyahu on the latter’s most recent trip to the U.S. Much has been made of this by hardliners but I sense that Netanyahu overstepped his bounds by pressing Obama publicly during the election and was justly rebuked. Notably, Obama also refused a meeting with Egypt’s new President, Mohamed Morsi.

China and Japan are ramping up their dispute over the upopulated but oil rich Senkaku Islands (Japan), or Diaoyu Islands (China). This is a traditional outlet for economic frustrations. When things get difficult at home, then one must look outward for an enemy to galvanize and unify the nation. This was Condolezza Rice’s contribution to George Bush’s foreign policy. “We need a common enemy to unite us.” We can only hope that this flare up dissipates quickly. The last thing the world needs is a re-militarized Japan.

Opportunity

Finding opportunity in the context of a de-leveraging economy is difficult. Basic needs such as food, farming, and alternative health care offer general themes of opportunity in both the short and long term. Inflation assets for the long haul…not housing.

If you have a business that can utilize debt and you can convince a bank to lend to you, this is a great time. But any such strategy needs to have a quick exit built in. When the sovereign debt crisis comes to America, rates will rise precipitously. Until that day, it’s a good time to utilize debt. If you can gain control of good quality cash flowing assets and lock in long term financing at these rates, then you are golden.

Summary

It seems like planet earth is under a cosmic microwave. This is what deleveraging feels like. The flow of ever expanding credit is like an economic endorphin…it feels good and makes everything seem ok, even if it’s not. When the endorphins are flowing, things that irritate, irritate less. Frustrations are swept away with the next wave of opportunity. But take away those feel good generators and the opposite happens. Normal frustrations build on one another and become unbearable burdens. Minor infractions become crimes and betrayals. This holds for nations as well as individuals. This is a volatile situation.

Ray Dalio, CEO of Bridgewater, the world’s largest hedge fund, gave a rare interview recently in which he voiced his concern that another economic downturn could generate a class war and the type of conditions that spawned the Third Reich.

All in all, the outlook is not sunny. We have to weather the consequences of past indiscretions. This is economic law and it will not be pleasant. If we choose to do it equitably, we can make something good out of it. If we choose divisive policies with a few big winners and many losers, then the fabric of society is going to be rent. We will have social unrest and great destruction and suffering. We need some real leadership to get through this with a good outcome, but ultimately it’s up to us.

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