Same Chapter, Different Verse



In 2011 the S&P 500 Index was up 2.1% and the Barclays U.S. Aggregate Index was up 7.9%. The Barclays fixed income index returned 3.75 times the S&P 500. Fixed income was the place to be in 2011, especially in long maturity U.S. Government bonds. They were up 29.1% in 2011. At the beginning of the year and through July 2011 everyone thought the stock market was the place to be, and that the U.S. economy showed signs of improving. In August 2011 all of that changed; Europe’s debt problem came to the forefront and money moved from stocks to the safe haven of U.S. Treasuries, in spite of the U.S. credit rating being lowered from AAA to AA+ by Standard & Poor’s.

We just received an update from James W. Paulsen, Chief Market Strategist at Wells Capital Management. You see him on CNBC and Bloomberg periodically. His update talks about how consumer confidence is rising and this will cause interest rates to go up. He points to historic trends comparing consumer confidence to interest rates. He ignores the fact that we are in a completely different environment now. He ignores the fact that the Federal Reserve has stated its plan to keep the Fed Funds rate at or near zero until the latter half of 2013, and that it is employing Operation Twist as I write. What planet is this guy on? There are others that continue to give the same old examples, completely ignoring that the U.S. debt is $15 trillion and rising. They ignore that Europe is even worse off and is entering a recession.

There are some, however, that are telling a different and more plausible story, like Robert Prince, co-chief investment officer at Bridgewater Associates, a successful hedge fund. In fact, the world’s largest hedge fund firm. He describes the U.S. and European economies as “zombies” and says they will remain that way until they work through their mountain of debt.

“What you have is a picture of broken economic systems that are operating on life support,” Mr. Prince says. “We’re in a secular deleveraging that will probably take 15 to 20 years to work through, and we’re just four years in.”

The problem for the U.S., says Mr. Prince, is that it is on the wrong side of a long-term debt cycle. “We were in a leveraging-up period for 60 years, from the 1950s to 2008,” he says. This debt bubble was self-reinforcing on the way up, and “when it tipped over, it set about a self-reinforcing process on the way down.”

Against this backdrop, the Federal Reserve will need to do more quantitative easing—buying of government bonds—but Mr. Prince says the purchases will probably be sporadic.

Europe, meanwhile, is headed into a potentially deep recession with policy makers boxed in by an interconnected banking and sovereign debt crisis.

“You’ve got insolvent banks supporting insolvent sovereign debt, and insolvent sovereign debt supporting insolvent banks,” he says.

The ECB (European Central Bank) is loaning money to the insolvent banks so they can buy the bonds of their insolvent countries. This provides liquidity to the banking systems, but doesn't solve the debt problem of the sovereign countries.

In our opinion the market will continue to face the same problems it faced in 2011. Europe is still the big problem. There are only three ways out of their problem. One is to break up the European Union and everyone go back to using their own currency. This will be devastating for the weak countries in Europe and will create a deep recession for all of Europe and probably the world. The second is to throw the weak countries out of the Euro and have a smaller European Union. This will be detrimental to all the countries, but not as bad for the stronger countries. There will still be a recession. The third, and the one that everyone is hoping for, is for the European Union to truly become a union and issue Eurobonds backed by all of the countries. This would lower interest rates in the weak countries but raise rates in the stronger countries like Germany. This option has been discussed over and over again, but Germany is reluctant to do this because it will hurt its economy. Keep in mind that the debt in Europe is huge and it will take many years to pay down without any defaults. Austerity will have to be put into place, causing a lengthy recession.

The U.S. is going down the same road as government debt continues to rise. The Federal Reserve is buying our government bonds and keeping interest rates low to the banking system. This provides liquidity to the system but doesn’t solve the problem. Mr. Bernanke needs to pound the table in his next meeting with Congress. He must tell them that all he is doing is buying them time to fix the debt problem. He needs to explain that only Congress can fix the debt problem through fiscal policy changes. Unfortunately Congress appears incapable of acting unless we are in a severe crisis like 2008. We are afraid that they will not act until the next great crisis.

In spite of these problems, we must continue to invest and find ways to grow your assets. We will be talking with you about our ideas during our quarterly meetings. We look forward to seeing you then.

Jamison Monroe, CIMA®
Chairman & CEO