Professional investors are united in their pessimism. Could they all be wrong?
This year I organized three Benchmark Lunches on successive Fridays in August for serious investment professionals who spend their summer weekends in eastern Long Island. I summarized last year’s discussions in an essay entitled Two Gloomy Afternoons. The 2010 sessions ended just before Ben Bernanke’s Jackson Hole speech in which he alluded to the possibility of quantitative easing to stimulate the then faltering economy. The stock market rebounded strongly in the final quarter of last year so the negativism of our discussions was ill-founded in the short term. As we all have experienced, often the consensus of a group of intelligent, well-educated and successful professionals proves to be contrary to the reality that develops.
The mood of this year’s sessions was even more negative than in 2010. There was a clear lack of confidence in President Obama and his advisors, a belief that it was unlikely that Congress would be able to compromise sufficiently on deficit reduction and revenue increases to put the federal budget on a sound footing and initiate programs to create jobs, improve infrastructure and deal with the challenges of education, healthcare and competitiveness. The investors were also concerned that the sovereign debt problems of Europe, now that they have spread to Italy and Spain, would overwhelm the resources of the European Central Bank, the International Monetary Fund and Germany. While believing growth would continue to be relatively strong in Brazil, India and China many worried that tight monetary policies would slow even these emerging economies. Finally there was concern that the Arab Spring might suffer a second wave of unrest if a failure of the new regimes to provide jobs were to result in widespread disappointment.
Over the two weeks separating the first and third sessions, there was a decided change in sentiment. While most of the participants, including some of his early supporters, were disillusioned by President Obama’s lack of leadership and his overall performance in the job, many at the first two sessions thought he would have a second term. By the third lunch, however, the majority thought a Republican would win. Although most expected Mitt Romney to be the candidate at the first two lunches, many thought Rick Perry had a good chance of getting the nomination by the third one and that’s what the polls confirm. Someone pointed out that Chris Christie had hired a personal trainer to get in shape so we shouldn’t give up on him, but some thought he wouldn’t get support from Middle America.
The most common word used in all three sessions to describe the American political process was “dysfunctional” and there was a feeling that there would be no constructive change before the 2012 election, and more than a few wondered if the situation was hopeless because the system was broken. One participant said the debt ceiling and budget debates were rational. A large part of the population simply wants to trim the size of government and they were determined to exercise every effort to make that happen. Perhaps it will take a crisis, as it usually does, for the parties to come together and take effective action.
Part of the frustration of the investors was tied to the fact that the Administration had so few options to deal with the economy’s problems. Quantitative easing was discussed at each session. It was agreed that the first round provided a boost to the economy, but that QE2 had a smaller impact although it created a rally in the stock market and commodities, especially gold. Like a drug that has diminished effects as you take successive doses because the body has gotten used to it, a potential QE3 was expected to have only a limited positive impact. The biggest problem is a lack of business confidence. This can only be restored by a pro-business president and Obama is the opposite of that. But we also have to revise the tax code and get rid of subsidies to agriculture, real estate and the oil and gas industry. We have to reduce regulation. Boeing (ba) should be able to build a plant wherever it wants in the United States. The tax base has to be broadened. Everyone has to make some sacrifices to get us out of this mess.
Almost everyone agreed that creating jobs was the most important task facing the Administration, but if the government was going to make any progress here, it would require spending federal money and there was no appetite in a Republican-controlled Congress for doing that. An infrastructure program which would improve our aging bridges, roads and municipal structures would put hundreds of thousands of unemployed construction workers back on a job, but few were optimistic that anything like that would happen. One participant said that Obama had to come forth with a bold integrated plan for America in September. This would include a program for mortgage holders who were under water but wanted to stay in their homes, an infrastructure bank that would create jobs, a plan for retraining workers for positions now unfilled, a stimulus program to revitalize technological innovation and other initiatives.
Obama should bring back the Bowles-Simpson plan for deficit reduction and revisit the “Grand Bargain” he had with House Speaker Boehner which offered three dollars in spending cuts for every dollar of revenue increases. He should say to the Republicans, “America is in danger of going back into recession and I urge you to put aside party differences to help me get us out of our current economic malaise.”
Some thought that moderate Republicans would respond favorably to this challenge but there would be others, more to the right, who would want Obama to continue to look bad at the expense of the American people and who would say that a program like this would cost real money and just make matters worse. As an aside, I talked to a friend who is very close to the Administration who encouraged me not to get my hopes set too high for what Obama was likely to propose in September. Few were optimistic about the efforts of the joint Republican/Democratic “super committee” that would develop the second phase of deficit reduction. Most worried that lobbyists would have too much influence on the outcome. Most of the participants said they would be willing to pay higher taxes if they had any conviction the money would be used sensibly. Several endorsed the plan of Howard Schultz, CEO of Starbucks, to not make campaign contributions to candidates unwilling to compromise.
Most agreed that the European banks were in serious trouble and that the institutions there lacked the resources to deal effectively with the sovereign debt issue. Even a partial solution would increase Germany’s dominance of the continent and many countries would find that unacceptable. It was thought unlikely that Greece or Portugal would grow fast enough to restore their financial strength or that their people would endure the austerity necessary to bring their deficits into line. Most felt that a temporary solution would be found to avert an immediate crisis and the euro would survive, but that several years from now the European Union would be different, with some of the weaker countries leaving. Many thought that a restructuring of the sovereign debt would be required to get through the current problems and this made them negative on the European banks. European banks were facing a challenge with sovereign debt similar to that faced by United States banks with the subprime real estate loans, but Europe lacks the fiscal authority to provide the financial support to deal with it. Euro bonds might be the answer, but there was disagreement on whether Angela Merkel would support that solution.
Problems in the United States and Europe have increased the attractiveness of gold for many of the attending investors, with some expecting it to reach $2,000 before year-end and higher prices later. Other commodities should also rise because of emerging market demand even if these economies slow somewhat. Oil also should move higher because of the rising standard of living in the developing world, but several knowledgeable participants expected significant increases in natural gas demand as it replaces gasoline in some commercial transportation applications.
The price of oil was viewed as the most important factor in the outlook for the Middle East. At prices above $70 a barrel the political model there works. Oil-rich countries provide lifestyle, education and medical benefits to their people and prevent political turmoil. At prices below that level, budgets would be strained and instability would increase. In North Africa the Arab Spring may be followed by a second wave of unrest. Young people turned against the dictators because of a lack of economic opportunity as well as their yearning for political freedom. While the dictators have been deposed, the economic conditions have worsened and this could give rise to a new round of unrest. In contrast to past years when Iran was a major concern, the view was that sufficient internal dissension was developing there to defuse plans for attacking others whether or not it developed a nuclear weapon.
Social instability is expected to become a more important factor in other parts of the world. The riots in England dramatized how tender the unemployed have become. The social fabric in the United States is also combustible. Half of the working age people in the country don’t pay taxes but are entitled to vote. They receive entitlements and it is in their best interest to support those political candidates who promise a continuation of present programs, at a minimum, or even more generous benefits in the future. Down deep these people believe budget deficits are someone else’s problem even though they are often in favor of candidates who want to reduce the size of government. One of the conundrums is that federal deficits account for almost 10% of Gross Domestic Product. If we cut government programs back too quickly the economy would almost surely go into recession. We have more long-term (more than 26 weeks) unemployed than in any post–World War II cycle. Unemployed young people without a college education have limited prospects. Many laid-off workers over 40 have all but lost hope as their job search has led nowhere. We are unlikely to deal with these issues without spending some serious money.
The real estate people had a mixed view of the outlook. Hotels seemed to be doing well across the country but commercial property was strong in only five or six cities. Low interest rates helped leveraged developers but there were still plenty of bad loans on bank balance sheets. Apartment rentals were firm as potential buyers waited for the housing market to stabilize. Several investors associated with venture capital were upbeat. There were many entrepreneurs coming up with exciting ideas in energy, information technology and healthcare. This was happening not only in Silicon Valley but in New York and in selected cities across the country. This may not be enough to solve America’s unemployment dilemma but it does indicate that innovation in America is not dead.
There was the usual controversy about China. Most agreed the country was over-leveraged and would unwind sometime, but there was no agreement on timing. There may be too many empty expensive apartments, but the country is crying out for more “social housing” for lower income families. Several spoke about fraud as major problem, but with $3 trillion in reserves the government is prepared to support the banking system and China can defer any problems for at least a few years. Civil unrest is a major concern among Chinese officials and events this year in North Africa and the Middle East made them especially apprehensive about this issue. There was not much enthusiasm for India or Japan. Many investors liked Latin America because the countries were run by business people. Generally there was less interest in the emerging markets than in past years.
There is a thirst for “big ideas.” Healthcare in the United States is 17% of GDP and is less effective than in other countries where it is 10%. We have to deal with overspending on heart ailments, cancer, obesity and end-of-life treatment. We should merge Fannie Mae and Freddie Mac and develop a rental program for houses in foreclosure. We should reduce bank capital requirements for loans to small business and make it easy to repatriate overseas profits. We should give visas to all foreign nationals who earn Ph.D.’s and want to work here. It is too hard to get patents approved. After hearing all the suggestions fulminating from the group one participant with government experience lost patience and said, “There is no shortage of good ideas in this country. You people just have no idea of how hard it is to get anything done in Washington.” Several radical ideas were proposed, like devaluing the dollar by 30% to make our manufactured goods more competitive and lowering the minimum wage to provide jobs for younger people and to bring some manufacturing back to the United States. One person thought we should place tolls on more roads and bridges to raise money for infrastructure projects.
A hedge fund manager said some of his clients had been urging him to run for president. He didn’t think that was a good idea, but did say he would provide some serious support (and get others to do so) to a candidate with the following platform:
- 1. Get out of Iraq and Afghanistan. Provide every returning soldier with a free education at a four-year college or trade school of their choice.
- 2. Set up a peacetime WPA effort to help rebuild U.S. infrastructure.
- 3. Unleash the domestic energy industry to develop domestic energy supplies and reserves. This will create employment and reduce our dependency on foreign suppliers.
- 4. Limit government spending to a growth rate at least 1% below the level of nominal GDP growth.
- 5. Freeze entitlements and raise the Social Security retirement age to 70 with an exception for those who work at hard labor.
- 6. Implement a 10% income tax surcharge for three years on those who earn over $500,000 per year.
- 7. Implement a 5% VAT tax to get at the underground economy and deal with the deficit.
- 8. Tackle healthcare in a serious way.
- 9. Ban or curtail high-frequency trading and limit credit default swap trading to those that own the underlying bonds. The high-frequency traders are turning the best capital market in the world into a casino and scaring the public. This is not in the public interest.
One investor wondered why anyone would buy a stock when the macro problems were so great. The middle class has not improved its real income in two decades and young people, those under 35, have not made money investing. When it came to a discussion of valuation almost everyone agreed there were good values, particularly among the recognized brand multinationals with reasonable dividends. Banks with a lot of cash on their balance sheets at low multiples were attractive. Corn supplies were tight and prices were headed higher. Skeptics worried that earnings estimates would be revised downward, but even then stocks did not seem expensive. Moreover, the market exhibited some climactic behavior during August and many sentiment indicators were at levels that were often seen at bear market bottoms. There was so much despondency among the three groups that only a few of the investors were suspicious of the unanimity, but the contrarian in me thought that was a reason for hope.
Byron Wien is Vice Chairman of Blackstone Advisory Partners LP where he acts as a senior adviser to both the Firm and its clients in analyzing economic, social and political trends to assess the direction of financial markets and thus help guide investment and strategic decisions. Prior to joining The Blackstone Group (bx), Wien was Chief Investment Strategist for Pequot Capital and before that served for 21 years as Chief (later Senior) U.S. Investment Strategist at Morgan Stanley.