Deflating Fears & Inflating Hopes

July 27, 2009

The era of excessive spending with cheap credit and a strong currency is over.


The era of cheap stuff is over. What has arrived is an age of hypertension for national cash flows with our symbiotic trading partners.

The post-World War II baby-boomer generation passed its spending peak in 2006 when the average boomer was close to 50 years old. Back then, the U.S. personal savings rate was close to minus 2.5%.

Comparatively, it was close to 13% and 9% during the 1981-82 and 1991 recessions. It is now 6.9%. It will continue to climb rapidly as long as we do not get negative wage growth, which would reduce the conversion of more personal disposable income to savings.

This is going to be a decadelong process of adjustment, of less spending and debt reduction. As investors, our task is compounded by consumer spending’s 70%-plus share of the U.S. economy, our precarious savings, tight consumer and corporate credit, state and local government debt limits, a crowding out of the private sector’s share of available credit by governments (domestic and foreign) and our dependence on foreign capital.

The 2009 fiscal deficit is exploding. It is on track to be more than $2 trillion this year and about $1.5 trillion a year over the following two years due to bailouts and fiscal stimulus. The Fed has lowered short-term rates to near zero while buying billions of dollars in Treasury (TSY) securities, government agency securities and mortgage-backed securities, to save its large inner circle of financial institutions from imploding.

Many international investors are selling TSY and/or shortening TSY duration. These acts have contributed to a rise in long-term TSY interest rates and a weak U.S. dollar. Inflation/deflation fear has ebbed and waned, even though our huge debts create a deflationary environment.

So far, as foreign bond investors sold TSY, domestic investors were buying more TSY securities in 2009. Yet net TSY liquidations have been greater than the Fed’s 2009 purchases. The AI 75/50 Portfolio is short 20-year TSY and long many inflation hedges because TSY prices decline as inflation and insolvency fears mount.

During times of de-leveraging, economic growth remains well below its trend, financial asset returns are low, P/Es and risk premiums rise. Equity/bond sectors with low external debts and high export growth perform best. Emerging growth economies in developing markets with low external debts do the same.

The China Factor

We have our doubts about China’s rate of sustainable growth (Figures 1 and 2). Weiss Research recently reported that China’s loans to the private sector mushroomed by $244 billion in May with a total of about $1 trillion year-to-date compared with only $700 billion last year – and $500 billion in 2007.

China’s high growth is built upon huge fiscal stimulus, loan growth and its conversion to domestic consumption, which increases their systemic risk because until the U.S. and other developing economies resume their normal growth, their exports will remain weak.



Figure 1. China May Be Overstating Economic Growth



Figure 2. China May Be Overstating Corporate Profits



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