We welcome the day when more space can be directed towards discussing individual investment ideas and less time spent discussing macroeconomic and exogenous risks. After all, Black Cypress is first and foremost a “bottom-up”, value-oriented investment firm. But the investment landscape is about as complicated as it can be which requires a greater focus on the “big picture” that ultimately impacts our underlying securities. Within this environment, we am trying to maintain no bullish or bearish biases, but merely laboring to go only where the data takes us. And right now, even in the midst of turmoil, it still makes sense to be patient and wait for more clarity.
As expected, Congress passed and the President signed a debt deal compromise that will allow the debt ceiling to be raised and America’s long-run fiscal nightmare to remain intact. The agreement requires $917 billion in spending cuts spread over the next decade. A Joint Select Committee is charged with recommending an additional $1.5 trillion in deficit reduction, which could take the form of spending cuts or tax increases. According to Macroadvisers, the plan, if implemented in its entirety, including the JSC’s recommendations, will have limited economic impact. The deal fails to address the trillions in unfunded liabilities our country faces in the decades ahead. It does, however, mark another U.S. step towards austerity, despite Europe’s display of the futility of that direction.
The Euro zone countries implementing cuts and tax increases remain mired by low to negative economic growth and worsening fiscal budgets. On July 21, in an effort to halt a Euro zone crisis, the Council of the European Union released an outline for yet another bailout of Greece. The new bailout requires additional government spending cuts, tax increases, and the privatization of government assets. The council hopes these counterintuitive (or, in our opinion, ill-advised) measures will return the Greek economy to a sustainable growth path.
The Euro council, the IMF, and private investors are to work together to cover Greece’s funding gap. This will come by debt maturity extensions, reduced interest rates, and for now, voluntary haircuts (principal reduction) born by the individuals and institutions–mostly banks and insurance companies–willing to take their medicine now and accept new debt in a lower amount. Holders that do not accept haircuts voluntarily today risk a larger forced reduction in the future.
The healthier countries aren’t exempt from action. They are required to adhere strictly to new fiscal targets and cut deficits below 3% by 2013. This would undoubtedly be a positive within a solid economic recovery, but such rigid targets within a weakening economy are an error. Are governments and central banks around the world preparing to make the same mistakes their predecessors made in 1937, as economist and professor Paul Krugman suggests? They tightened policy when it should have been loosened, causing the economy to relapse back into depression. Mr. Krugman recently blogged, “we’ve obsessed over the deficit in the face of near-record low interest rates, obsessed over inflation in the face of stagnant wages, and counted on the confidence fairy to make job-destroying policies somehow job-creating.”
Greece–and Greece alone–will be allowed voluntary haircuts from private sector involvement, and every other country (think Portugal, Italy, and Spain) will be required to pay all their debts. This creates an obvious slippery slope: why should “X-periphery” and its citizens bear repayment of all their debts when Greece was allowed to selectively default?
Ultimately, the plan is dead on arrival. That’s because the higher interest rates that have resulted from investors selling European sovereign debt are the effect–and not the cause–of something else. Extending maturities, providing lower interest rates and allowing Greece some principle relief is only treating the patient’s symptoms. The country is barely growing, has structural and cyclical deficits, and a debt load that is likely too big for it to bear even with voluntary reductions. And the new bailout requires even harsher austerity which will likely push the country back into a recession, making deficit reduction all the harder. That developed economy governments and central banks are seeking to tighten policy in the face of economic deterioration is mind-boggling.
As we wrote in last month’s commentary, economic data has softened considerably as of late. The U.S. Bureau of Economic Statistics released revised data for GDP as well as personal income and consumption. It turns out that the recession was far worse than originally thought and the current recovery weaker. In fact, real GDP grew a mere 0.4% in the first quarter of this year, while the advance estimate of the second quarter is 1.4% growth. We find this puzzling, as recent data has been markedly poorer than it was in the first quarter.
Personal consumption, adjusted for inflation, has fallen in five of the last six months. In fact, its decline has reached a level that historically has coincided with recession having already begun or having been mere months away. The ISM Manufacturing Report also signaled contraction. Last month, new orders and inventories both fell below the level that indicates expansion. It is still a bit too early to predict a recession with high enough probability to induce action, but recent data is disconcerting.
Our value-oriented, domestic equity portfolio should provide better downside protection, with its valuations below both company-specific historical averages and intrinsic worth, as well as broad equity market multiples. Our equities yield more than any developed equity market index and the 10-year Treasury as well. And we have built cash positions to take advantage of further market weakness. For these reasons and despite all the uncertainty, we are maintaining our current positioning. However, should economic data markedly deteriorate further, we may significantly alter our portfolio positioning in the days or weeks ahead. For now, we wait.