QUESTIONS FOR 2011

Fidelity Investment’s Director of Global Macro recently answered some interesting questions on behalf of clients and I thought I’d take a crack at the same questions.  If you want to add to the list feel free to do so in the comment section.  Reader answers are welcomed and encouraged.

When do you think the secular bear market might end for U.S. stocks?

The secular bear market will likely persist until the severe global imbalances are worked off.  These problems are widespread and certainly global.  This is most apparent in Europe where the single currency system has created severe disequilibrium.  In addition, there are worrisome trends in China where their flawed currency peg creates disequilibrium within their own economy.  They are now attempting to fend off a severe inflation problem and lack the proper tools to do so (or misunderstand them) because they have largely ceded control of their monetary policy to the USA.  Finally, in the USA we continue to suffer from a severe balance sheet recession.  Private sector debt levels remain far too high and need to be adjusted to lower levels before a sustained economic boom can continue.  These hurdles are likely to remain in place for several years and I am quite confident that a strategy of keeping “asset prices higher than they otherwise would be” will ultimately fail to ease this disequilibrium across the global economy.

Is the U.S. headed for a debt crisis the way the European periphery has, or can it muddle through like Japan?

The USA has a very severe private sector debt problem.  What it does not have is a public sector debt problem.  Just like Japan (and unlike the nations of Europe) the USA is a supplier of currency in a floating exchange rate system.  This means that the vast majority of the USA’s liabilities are denominated in a currency that only it can create.  Therefore, the term “debt” is not technically accurate in describing the US deficit because, unlike a US household, state or European nation they are never solvency constrained.  The USA can never be late on a payment unless Congress has a mental lapse.  What a nation such as ours needs to focus on is price stability and the US economy as a whole is suffering a disinflationary environment that is very similar to that of Japan in the 90’s and 00’s.  Unfortunately, because our leaders continue to be fooled into thinking that we are going bankrupt like Greece they continue to implement flawed policies that have contributed substantially to the very weak US economic recovery.

What might cause another four years of economic malaise in the U.S.? How about the vast amounts of public debt that America has accumulated in the aftermath of the credit crisis?

The greatest risk to continued economic malaise is fiscal austerity and exogenous risk such as China and Europe.  Unfortunately, our Congressional leaders fail to understand that the Federal Government can never become insolvent (aside from a pseudo form of insolvency in the form of hyperinflation).  This has led to a near non-stop coverage in the media for a need to cut our deficit and implement fiscal austerity.  Unfortunately, if we want economic growth we cannot save at the public AND private sector levels in unison.  This is simply an accounting identity.  During a balance sheet recession a deficit is a benefit to economic growth.

The bigger risk in this environment is likely to be exogenous as Europe continues to battle with their own balance sheet recession and China attempts to fend off the ill advised effects of non-stop and unnecessary stimulus that is now causing severe inflation.  Defaults and defections in Europe could cause severe strains in the global economy while a slow-down in China will likely weigh on the global economy as China remains one of the few truly strong legs.

Will gridlock be good or bad?

As I’ve previously mentioned gridlock has the potential to be very bad.  If we substantially reduce the deficit in the midst of a balance sheet recession we will only compound our problems.  Exhibit A remains Ireland where fiscal austerity has failed spectacularly.  We are seeing similar trends across much of the rest of Europe.  There are pockets of austerity in the USA and cutbacks have begun to have a marginal impact, however, the current deficit, at $1.3T remains accommodative even though it has been very poorly allocated and inefficient.

Will the European Union hold together? Will the PIIGS default? Will the ECB need to print? Who wins?

Yes.  Yes.  Yes.  Germany.  Ultimately, the primary flaw in the European Union is a lack of monetary sovereignty.  There are great benefits to this currency structure during the boom days, but during the bust each nation is reliant on self defeating cost cuts to attempt to combat spiraling economic trends.  Without a central treasury and an independent currency there is no ability to print money or devalue ones currency.  The effects are clear in Ireland where depression has ravaged the nation.  The beneficiary of such a currency arrangement tends to be trade surplus nations such as Germany.

The European Union will hold together, but it will come with great costs (as we are seeing in Ireland and Greece where millions remain unemployed).  Ultimately, I believe the economic malaise will result in severe political changes and a citizenry in the periphery that demands change.  I think there is a very high probability that several periphery nations will leave the currency union and be forced into a partial restructuring of debt.  Otherwise, the single currency system will continue to impose these imbalances on several nations and the lack of a central treasury will continue to make it impossible to defend against economic downturn.  This is simply unacceptable from a societal and governmental perspective and as the citizenry slowly realize this they will demand change.

The other option is that the ECB simply prints money.  This would not be dissimilar to what the US government did in August when they disbursed $26B in funding to support the states.  Unfortunately, Germany is severely concerned that this is the equivalent of money printing and would likely cause inflation fears.  This sort of fiscal unity would be the equivalent of a first step in creating a United States of Europe, however, Germany is deeply concerned that such an arrangement would create a Weimar version 2.0 risk.  Besides, this whole currency arrangement works so well for them it’s difficult to imagine them agreeing to major changes.  Plus, can these nations overcome thousands of years of social differences and disagreements and truly unite?  I have my doubts.  I think Germany will ultimately kick the can as long as they can before political unrest in the periphery nations forces real change.  That will either come in the form of true unity or defaults and defections.

Which currency might “win” the race to the bottom?

This is an interesting question.  The Renminbi has technically won the race to the bottom by forcefully  staying at the bottom via their peg.  In terms of other nations we are likely to see continuing severe fluctuations as Europe, Japan and the USA all battle to devalue their currencies and export their way out of their economic malaise.  Ultimately, I see lots of volatility and no clear cut winner aside from the Chinese.

Will the U.S. economy recover and will QE2 be gasoline on the fire?

The US economy is recovering though the pace of this recovery is well below trend.  As mentioned above these severe imbalances and a kick the can policy by the government likely mean the risks will remain and the recovery will remain below trend.  QE has little to no impact on the real economy (more below).

Can the Fed ever exit QE?

The Fed will not exit QE as long as the misguided monetarist beliefs of the Federal Reserve persist.  As I’ve explained in great detail QE is simply an alternative form of standard monetary policy.  Instead of swapping reserves with short dated instruments the Fed is swapping long dated instruments with reserves.  This does not increase the money supply and is therefore in no way inflationary.  It does not make a bank more able to lend.  And as we’ve seen in recent months it does not therefore alter interest rates or the value of the US dollar.  This was also clearly seen during QE1, QE in the UK and QE in Japan.  As Richard Koo says, this is the greatest monetary non-event.  In a balance sheet recession monetary policy of all types becomes futile.

What will QE3 look like?

It will look just like QE1 and QE2.  It might have some effect on bank balance sheets should we experience a severe double dip in housing, however, in terms of helping Main Street it will have almost no impact.