The Looming Political Inflection Point

There is a growing chorus of sensibility on the global political scene. Federal governing bodies from from Europe and Asia, as well state and local policy makers in the US are finally facing up to the reality that you can't mandate prosperity.

China is openly rejecting the policies of bubble economics. For the past six months the Chinese government has tightened restrictions on speculative housing, allowed funding rates to rise, let fiscal stimulus initiatives run off without renewal, and most recently expressed a desire to reform its currency regime in an attempt to find a true equilibrium that discourages speculative inflows. The Chinese are long-term thinkers who realize that bubble economics is ultimately destabilizing and their recent moves are a blatant rejection of the failed policies of the west over the past decade.

Europe has climbed on the reality bandwagon as well. Unlike the proactive Chinese, Europe's sudden piety is reactive; bond market vigilantes have awakened from a 20-year slumber and forced the hands of Germany, France, the UK, etc. Suddenly, fiscal austerity is De-rigueur across the European continent. EU policy makers are finally getting the joke that long-term wealth creation is the product of hard work and saving rather than debt growth.

In the US, state and local governments hands are being forced by constitutional edict - quite simply their budgets must be balanced unless the federal government plugs their deficits with printed money. Much of today's plump local government infrastructure is structurally unsound. It was designed during the heyday of bubble economics, a paradigm that sent artificial signals about long term growth and revenue prospects. When stocks and houses were perceived as a one-way street to riches, it was rational for elected officials to project perpetually rising tax revenues around which bloated municipal bodies could exist. Today, the painful reality is coming home to roost and local governmental establishments are being forced to right-size accordingly.

Notice anyone missing from the list of the nouveau austere? You guessed it; the very creator of bubble economics and the politics of alchemy. The US government still has its head buried deeply in the sand. The big-money dominated entrenched status quo simply does not want the good times to end. Like the Duke brothers from the movie "Trading Places" the US government is hell-bent on "turning those machines back on!" Apparently, zero rates, double-digit deficits, unaccounted for off-balance sheet obligations, and flailing attempts to induce private sector consumption in the US aren't enough. The top dogs from the US economic policy team are openly lobbying the rest of the world against austerity ahead of the G-20 meeting this weekend.

An important inflection point is dead ahead. If the politics of reality are finally crowding out the alchemists, a long overdue austerity-induced recession lies directly in our path. Recessions are an important part of capitalism. During these intervals, redundant capacity gets shuttered and excessive leverage is purged which clears the way for a restoration of equilibrium; short term pain, long term gain. In contrast, if those that preach the status quo get their way, be on the lookout for extended stimulus, new and bigger bailouts, and MORE PRINTED MONEY.

The investment implications of this inflection point are critically important. If the realists win the day, investors will want to be in cash, awaiting lower prices and valuations. Some of the greatest buying opportunities in history have been provided in the aftermath of similar scenarios. If the bubble bullies get their way, investors should own gold, equities of US companies with protectable pricing power, and assets denominated in the currencies of places that have no need for austerity, like Canada.

The Economic Recovery Is Toast, But There Is A Silver Lining.

Much to the chagrin of the public relations machine comprised of mainstream economists and strategists, the highly anticipated classic cyclical recovery appears to be AWOL. After the sharpest recession in modern times during the first half of 2009, conventional wisdom suggested that a V-shaped recovery was well underway with heady 4% real growth driven by self-sustaining private sector demand. Upon closer inspection, the recovery has been alarmingly anemic and now, even that halting performance is loosing altitude.

Let's briefly dissect what 0% policy rates, ~$2 trillion of quantitative easing, and a 13% federal budget deficit has provided us. At its pre-crisis peak in Q3 2008, US nominal GDP (IE real top-line GDP measured in Joe Lunchbox's pay check dollars, not US government "inflation-adjusted" dollars) was $14.547 trillion. For Q1 2010 with the recovery seemingly well established, nominal GDP was $14.601 trillion. So, let's see, over the past six quarters with unprecedented monetary and fiscal stimulus as the lead dog, the US economy has managed to grow by a whopping .37%. That's right, about 1/3 of 1%. On an annualized basis, that equates to .25%. That pales in comparison to to long-term historical average nominal growth of nearly 7%!

The composition of that growth is equally troubling. First, the public sector was a net negative contributor despite massive federal stimulus as the budget-constrained state and local governments more than offset the outsized federal spending. Second, roughly half of all recent growth was from the rebuilding of depleted inventories which is obviously a non-recurring phenomenon. Consumption provided the balance of the growth. It seems a tad bit curious that with the unemployment rate hovering around 10% and consumer credit experiencing never-before seen contraction that private sector consumption could be a growth contributor. Perhaps Meredith Whitney's theory yesterday on CNBC is correct - that consumption has been artificially boosted by the mortgage modification programs which have allowed thousands of households to temporarily reside in dwellings that are free of mortgage payments or rent of any kind.

Fast forward to today. Virtually all leading indicators are pointing down. The housing market has soured anew on the heels of the expiration of the home buyers tax credit as measured by the weekly mortgage applications data. The labor market has stagnated as well, evidenced by the rise in the four-week moving average of initial jobless claims since the beginning of April. Moreover, The US dollar has rallied smartly since the start of the year which is certain to represent a headwind to export demand and repatriated earnings during the back half of the year. Quantitative easing is over, and fiscal tightening at the state and local level is becoming pervasive. China is tightening and Europe has embarked on an emergency austerity plan in an attempt to ring-fence its currency crisis. US leverage ratios remain at all-time highs of roughly 370% of GDP providing little room for incremental debt as a growth engine. In short, the nascent recovery is toast, and the markets have not priced in this reality. Contrary to popular positioning, stocks and yields are headed lower.

I do think there is room for longer term optimism. Recessions are a fundamental part of capitalism. However, the short-sighted culture of today's policy bodies has taken the opposite tact, going out of their way to prevent losses, foreclosures, or pain of any kind. To me, that sounds more like communism than than capitalism. To the extent that the developed world is on the verge of a cleansing recession where redundant capacity is shuttered, balance sheets are de-leveraged, and markets are free of monetary manipulation, a self-sustaining global recovery can then begin in earnest, driven by the exciting potential of the developing world - reason for optimism to be sure.

China's Currency Regime Shift Will Ultimately Be Deflationary

The knee jerk reaction to this weekend's announcement out of China is that it's a green light to take risk. To the extent that Chinese acquiescence on its currency policy might derail the growing protectionist momentum within the US Senate, the move higher in asset prices today is justifiable.

But a deeper dive into the implications of a stronger RMB reveals that running headlong into risk may be exactly the wrong reaction. Over the past decade or so, many developing countries have either implicitly or explicitly pegged their currencies to the US dollar. As a result, the foreign exchange reserves of these nations grew by an eye-popping $6 trillion since 2002, a 300% increase. Most of those reserves have been recycled back into western bond markets which has artificially suppressed interest rates and facilitated credit growth well in excess of any logical equilibrium.

Even as the Chinese allowed for modest appreciation of their currency from 2005 to 2008, the gains were simply not large enough to correct trade imbalances or discourage speculative inflows. China's FX reserves continued to grow throughout this period.

In total, this decade-long phenomenon almost entirely explains the credit and housing bubbles that developed in the US and Europe. Moreover, during the past year, growing FX reserves combined with quantitative easing provided cover for already overly-indebted nations to ease the pain of the bubbles' bursting by leveraging up pubic sector balance sheets.

The end result is that with quantitative easing over, the excessive leverage in the developed world will require continued inflows of foreign capital in order to remain sustainable. Therein lies the fly in ointment of a stronger RMB.

The 2009 global recession has caused China's heretofore large trade surplus to dwindle to generational lows and incremental gains in the RMB will likely eliminate the surplus altogether. Additionally, the stronger the RMB becomes, the less artificially undervalued it will be - eventually this will discourage speculative flows into China.

As the US dollar approaches a true equilibrium versus the RMB, FX reserve accumulation will slow and ultimately stop. At that point, the artificial subsidy to the US bond market that recycled reserves created will be gone. All else equal, real rates will be higher and asset prices will be lower creating a highly deflationary economic scenario.

Gold's Rally On Economic Weakness Is Perfectly Intuitive

Most official government estimates for GDP growth over the coming quarters are exceptionally robust. The Fed, the CBO, and others foresee upwards of 4% real growth stretching out over at least the next six quarters. It should be obvious that they have no choice other than to be exceedingly optimistic for a number of important reasons.

First, The only way to justify the massive fiscal hole that the US finds itself in today, is to assume that we'll "grow our way out of it". Mathematically, the CBO's estimates of ~4% real growth for the next several years are about the lowest possible number they could solve for to justify their conclusion that US public debt to GDP will level off at credible ratios. In contrast, a more reasonable 2% real rate makes the US look increasingly insolvent over the very near future.

Second, pom-poms and cheerleading exercises are one of the only tools left at the government's disposal. Policy rates are already at zero, making further reductions literally impossible. At the same time the recent reemergence of the bond vigilantes in Europe and the growing clamor of the Tea Party movement in the US have very definitely reduced the potential for incremental domestic fiscal initiatives.

Thus, aside from an economic pep-rally, the only remaining weapon in the government's arsenal is more money printing. This is likely the reason that gold is rallying to record highs today in the face of highly disappointing US economic data. That logic tracks the following sequence: A) Simple math reveals that ~2% real growth in the US for the next four quarters will RAISE both the unemployment rate and the domestic debt to GDP ratio from already high levels. B) A deteriorating labor market will raise the volume on the the discussion for incremental job-creating stimulus. C) With Fed funds tapped out and new fiscal initiatives not possible, the Fed will resort to more of what worked during the recent crisis - the printing press. D) The relative scarcity of gold compared to the seemingly bottomless supply of fiat currency leads to a flight to the yellow metal.

Ergo, this week's price action in gold is simply a logical game of connecting the dots between the inevitability of weaker growth leading to even more quantitative easing.

Anatomy Of A Value Trap

There is a widely held view among mainstream prognosticators that equity valuations are cheap. Their thesis is simple; the ongoing cyclical recovery will evolve into 2011 driven by the customary hand off from stimulus-induced demand to organic, self-sustaining economic growth. Accordingly, corporate America's operating leverage will transform that 3%-4% GDP growth into 15%-20% earnings growth. As a result forward P/E's of below 15 are cheap based on "historical" precedent.

There are serious flaws in this thinking. First, conventional wisdom says that a ~15 P/E is the correct historical average and therefore a forward P/E of say, 13 is cheap. But the historical context used in that analysis is typically the last 25 years or so, a period where massive tailwinds created a favorable environment for owning equities. Today's backdrop of regulatory uncertainty, heavy-handed government, emergency monetary policies, rising taxes, unfunded retirements, etc., is far more reminiscent of the 70's than modern intervals. Specifically, during the roughly ten-year span of political and economic uncertainty between Nixon's 1974 resignation and Regan's 1984 reelection, the S&P 500 sported an average P/E of approximately 9.6 and stayed in a range between roughly 7 and 13.5 for the entire period. After all, the P/E of the stock market is really just a barometer for the public's desire to own risky asset classes. So, much like the 70's, today's high degree of tumult probably warrants lower mean valuations.

Today's FDX earnings press release provides a perfect example of this. CEO Fred Smith describes a reasonably favorable economic backdrop over the recent quarter. But in the outlook section of the release he cites significant headwinds to the forward operating environment. "we expect the growth in earnings in fiscal 2011 to be constrained by significant increases in fixed pension expenses... along with higher anticipated health care costs." Thus, one of the premier franchises in America, sees structural constraints to its operating environment for the foreseeable future, all else equal. Hardly the kind of commentary that inspires investors to stick their necks out.

Moreover, the consensus economic view is also potentially flawed in that it employs a similar mean-reverting mentality. In reality, is 3%-4% real growth even possible when forward-looking CEO's are forced to play defense? To the degree that the looming second quarter earnings releases reveal a creeping macro-induced conservatism on the part of America's CEO's a'la Fred Smith, the market could be heading straight into a period of downward adjustment for expectations around not just earnings and growth but valuations as well.

A 13 forward P/E is only cheap if we're in a secular bull market. We're not.

You know who you are

"This market is just stupid" you're screaming to yourself. The age old adage that says the markets will do that which causes the greatest pain to the largest number of traders is so painfully true! "Who are the idiots buying it here" you think as you watch the bell weather S&P 500 engage in a waltz with key resistance levels on super thin volume. Of course you are watching idly from the sidelines, having been forced out of risk positions during May's volatility resurgence.

Sure, the year started out on the right path. The consensus world view was that a classic cyclical recovery was under way. Your aggressive long positions were established accordingly but faced a gut check during the early-stage Greece jitters which culminated on February 8th. Happily, you were one of the strong hands that withstood that swoon and ultimately felt mighty vindicated as risk assets surged through March and April. The fundamental data seemed to cooperate with your bullish view as Q1 earnings and the heretofore reticent labor market flashed a bright green light during April.

By the end of April all of your wrong-headed bearish counterparts had been carted out. It was simply too hard for them to withstand the barrage of positive data that proved them wrong and day after day losses on short positions. As the S&P crossed 1200, you were in hog heaven - there were simply no shorts left standing. You were on fire, and couldn't resist adding a few more longs during the meaningless dip on the last trading days of the Month.

But those STUPID Europeans ruined everything, right? You were forced to pare risk positions as losses mounted during May but those worthless sell-side traders were hiding under their desks and wouldn't give you any bids. And everyone knows that if there are only sellers the risk reduction task is all but impossible. Correlations evaporated, technical trading tools became ineffective, and relative value analysis was useless. The only truly logical position was not to have one. "If only I'd been a teacher like my Dad" you'd lie awake at night and think as your mounting losses soured in your belly.

By early June you had hobbled to the sideline. FINALLY you had no risk position. Yes, you'd given back all of your year-to-date gains and were now minimally down as the 2010 half-way point approached. But at least the bleeding had stopped, Phew!

But over the last 5 trading days, the market has ripped higher in your face on no volume. "How can the market be rallying so hard on no real news" you screamed to no one in particular this afternoon over your uneaten lunch. "Who is buying this thing after that horrible housing data?" "What kind of idiot does that? It's got to break down from here into the close right?"

You DON'T want to buy it right here do you? But, there it goes again, up another three handles on NOTHING - Damn it! But it sure is hard to resist. What if it surges right back up to the 2010 highs and you're not riding the wave? You're going to get fired if that happens on the heels of May's disaster performance right? BANG, the 200-day moving average was just toasted as upside resistance. Go ahead, pile on, you're going to miss it for sure. EVERYONE'S getting back in and Europe seems to have it's act together now. May was just an aberration and you were rightly bullish all along anyway. Go ahead and buy it, it will feel good to get back into the game! Quick, the market's about to close and Asia will take it higher for sure. Go ahead, I dare you.