Editor's note: On Mar. 9, 2009 Boston money manager Andrew Parlin wrote a column on GlobalPost that called the bottom of Wall Street's crisis-ridden slide. Since that day the S&P 500 Index has risen about 75 percent. So when Parlin said he's had a recent change of heart, we listened. Here's an edited version of what he recently sent to his clients.
BOSTON — Until well into 2009, the highly stimulative monetary and fiscal policy initiatives implemented around the world were met with widespread skepticism. Few thought they would do little more than arrest systemic failure in the global banking system. Most projected a limp recovery at best. Even ingrained optimist Warren Buffett foresaw a U.S. economy “in shambles throughout 2009” and “probably well beyond.”
As we now know, the vast majority of investors and forecasters totally underestimated the impact of what amounted to a pro-growth policy shock last year.
A global economic recovery is now underway, with last summer marking a turning point. In nearly every major economy, purchasing manager indices continue to point higher, industrial production is in sharp recovery, export growth is accelerating, capital expenditure is gaining traction, auto sales are booming, broad-based retail activity is strengthening, and many of the sickest housing markets around the world are stabilizing.
It's time to get out of the stock market.
A self-sustaining global economic expansion is at risk. Although the troubles brewing are unlikely to become widely evident until later this year, markets have a long nose. Remember, markets made their March 2009 lows amidst utter despair over frozen credit markets and massive job losses around the world. This was several months before the first tentative signs of economic improvement. Likewise, markets may now be making a major top as an odd mix of hope and complacency has replaced skepticism and fear.
One thing is for sure: markets do not stage 70-100 percent advances in just 14 months in the absence of an enormous appetite for risk.
The $14-trillion U.S. economy, almost three times larger than either Japan or China, is widely perceived to be back on track. The key assumption is that the American consumer is once again ready and willing to do the heavy lifting and power the economy forward. With consumption accounting for 70 percent of the U.S. GDP — double what it is for China — forecasting future spending activity is crucial.
But there are reasons to be pessimistic about this consumer boost to economic growth.
Let’s step back and revisit the well-known story. Owing to the long-term decline in interest rates and the relaxation of credit standards over the past 30 years, Americans saved ever less and bought more than they could afford. In the last stages of the great consumer binge, they used their homes as a source of income, sucking equity out of their largest asset in order to keep spending.
From World War II until 2008, Americans had equity in their homes accounting for 60-80 percent of the value of that home (meaning mortgages accounted for the rest of it). Following the 2008 collapse, that picture was turned upside down. Banks now own more than 60 percent of the average American home.
In addition, the catalyst for another slowdown in consumer spending is likely to be higher taxes at the local, state and federal levels.
A Mar. 15 Barron’s cover story nicely details the roughly $2 trillion state and municipal pension fund shortfall. The article cites a Pew Center survey asserting that “eight states … lack funding for more than a third of their pension liabilities” while “13 others are less than 80 percent funded.”
Then there are the state and local budget cuts being enacted in the face of tax revenue shortfalls.
In the past, state and local fiscal woes typically occurred in isolation. Now the problem is a national blight. Governments are responding to underfunded pensions and budget deficits by raising sales, property and income taxes.
The fiscal picture at the federal level is also grim. The huge wealth disparity that has evolved over the past 30 years poses a serious problem for prospective consumer activity. According to the IRS, the top 1 percent of earners accounted for 8.5 percent of total adjusted gross income in 1980. Having risen steadily over the past three decades, the top 1 percent of earners now account for 22 percent of total income.
In 1980, the top 1 percent paid 19 percent of all personal federal income taxes. Not surprisingly, given its giant share of national income, the top 1 percent now pays 40 percent of total personal taxes at the federal level. The top 10 percent of earners pays a staggering 71 percent of total taxes.
In an effort to reduce unsustainably large annual budget deficits, there will be mounting pressure to cut spending and raise taxes. It is beyond question that the tax burden faced by upper income America will escalate dramatically. With a small percentage of upper income earners driving a disproportionately large portion of spending, it is hard to see how U.S. consumption, 27 percent of the world economy, will show longer term resilience. Even in the face of a pickup in job creation and vigorous growth in exports and business investment, the math is ugly.
Moreover, the notion that small business will somehow escape higher taxes is misplaced.
While various tax credits designed to help small business have received a lot of publicity, these will be more than offset by the upcoming tax regime changes. Half of profits generated by small business are paid at the personal level, not under the corporate tax structure. Perhaps this helps to explain why confidence at the level of small business remains relatively subdued.
On the macro front, things are also troubling.
The European Union, the world’s largest economic block at $16 trillion, is in the midst of trying to avert a crisis with frightful destructive potential. The collapse of 2008 laid bare the fragility of Europe’s single currency and monetary structure.
In a Feb. 21 article in the Financial Times, George Soros did not mince words: “The construction [of the euro] is patently flawed. A fully fledged currency requires both a central bank and a Treasury. The Treasury need not be used to tax citizens on an everyday basis but it needs to be available in times of crisis.”
How and when the Maastricht guidelines are modified or tossed out altogether in favor of a new and smaller currency union are anybody’s guess. The appetite among politicians to muddle through for as long as possible seems high.
Nonetheless, the longer-term investment implications seem straightforward. Fiscal austerity throughout southern Europe will restrain growth. Portugal and Ireland are particularly vulnerable, with budget deficits projected to be around 10 percent this year and 7-8 percent nex year.
Spain and Italy are in deep deficit positions as well. The debacle in Greece cannot be comforting for the finance ministers in these countries and is sure to harden the resolve to cut government spending as aggressively as is politically tolerable.
China represents perhaps the biggest wild card of all.
Two key observations stand out. First, the current leadership is clearly concerned about an overheated real estate market. The government has enacted various forms of tightening measures aimed at curbing the flow of credit to areas of the market it deems to be extended. Whether a series of incremental tightening steps will lead to an orderly decline in the rate of house price appreciation is unclear. The important point is that this lack of clarity is in itself terrible for investment psychology.
The second observation is that no major economy has grown its money supply at rates of over 30 percent with impunity. Torrid rates of money growth, if history is any guide, always seem to end up leading to a mountain of bad loans.
The central aftershock of the twin credit and property market collapses of 2008 is the sharp rise in sovereign debt risk throughout most of the developed world. Should the global economic recovery falter, many nations will face risk of default. Sovereign defaults tend to come in great waves often separated by several decades.
Some of the most thought-provoking work on financial crises has been done by Carmen Reinhart and Kenneth Rogoff. "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises," was published in April 2008, five months before the fall of Lehman and the ensuing recession. It is a sobering reminder that throughout civilization, profligate government spending has been the norm, not the exception. Iceland, Dubai and Greece look increasingly like the tip of a very large iceberg. The debt of much of Europe will need to be aggressively restructured in what is apt to be tantamount to “soft defaults," where creditors are not completely wiped out, but neither are they made whole. Japan, with a 2 to 1 ratio of debt to GDP, is perhaps the least talked-about ticking time bomb.
A full blown sovereign debt crisis throughout the developed economies is a distinct possibility. Is it any wonder, then, that gold continues its steady and relentless ascent? No currency is safe. Equity investors should take note.
These are, of course, dark notions to entertain.
It could be that we are in the early stages of a multi-year expansion. This would generate the tax receipts needed for municipalities around the world to fund their pensions and for governments to pay down public debt.
But should the global recovery falter, a domino effect would be set in motion that would bankrupt many a nation. Share prices are no longer pricing in enough risk. Just the opposite. In response to extremely low interest rates, investors have been chasing risk in financial assets of every flavor. It’s been quite a party.
I say it’s now time to get out and run the other way.
Andrew Parlin is a founding principal of Parlin Investments LLC in Boston.