May 31, 2011
In the days before people could do anything “virtually” on the Internet, restless teenage boys used to play a game called “chicken” in which two contestants would race their cars directly toward each other. The first to swerve in order to avoid crashing was the “chicken” and loser of the game. No doubt there are still places in the world where teenagers vent their surplus testosterone by playing a similar game with real automobiles. However, even if there were no such place, the political leaders of the Western world have rushed in fearlessly to perpetuate new versions of the same old game.
First the Republicans in the House of Representatives, under pressure from passionate new Tea Party members, insisted on substantial cuts in the still unapproved budget for the present fiscal year which is more than half over, before they would agree to vote for a resolution to continue meeting the government’s daily obligations. After weeks of rhetorical exchanges about how many tens of billions of dollars to cut out of federal spending for the balance of the year, and negotiating sessions behind closed doors that were designed to leak, the parties announced their agreement to “cut” the federal budget, by implication for the balance of this fiscal year (which ends September 30th) by about $39 billion. This was a surprising outcome, since the last time the Republicans had played this game, with Newt Gingrich driving them to a collision, the result was that the Republicans were simply crushed, like a compact car trying to play chicken with a truck on a one lane bridge.
As it happens the $39 billion in cuts was more than ninety-nine percent political theatrics. A few days after the big deal was announced, the Congressional Budget Office, staffed by both parties, estimated that the actual reductions in spending this year would be only about three hundred million dollars, or less than one percent of the amount claimed. The rest of the $39 billion was all reductions in amounts that had previously been authorized, sometimes in times long past, but never appropriated for spending this year or any other year. Most of it, the Budget Office concluded, would never have been spent in any case. The good news is that there has not been even a small dent in the fiscal stimulus that the United States is getting and still very much needs just to keep the economy sputtering along at nine percent unemployment. The bad news is that there is a bi-partisan, indeed an all inclusive social consensus, to substitute make-believe and play acting for any depiction of real problems and issues, let alone solutions.
Now we have the spectacle of the Republican House saying it will not authorize an increase in the federal debt ceiling (which of course was predictable given the budget they passed six weeks ago) unless there are substantial additional “reductions” in spending. Again it would seem to be an uneven game between a truck (we must honor our obligations and maintain the high credit worthiness of our country) versus a motorcycle (we must start cutting our multi trillion dollar deficits a little bit at a time or force a default on the government debt or an interruption of Social Security payments by stopping that truck). Those of us who think we are still living in the real world are left to hope that there will be no collision with possibly devastating effects on the still wounded national and global economies. At the same time we know full well that if the collision is avoided it will be with yet another theatrical concoction, purporting to show that Obama has again made significant concessions to hasten the day of a balanced budget (with, of course, no new taxes).
In Europe, the policies of retrenchment that have been imposed upon Greece and Ireland have begun to produce their inevitable consequences: contracting economies, rising unemployment and social turmoil, falling tax revenues, rising deficits and rapidly rising ratios of debt to national income, the exact opposite of the purported aims of precisely these same policies. Equally predictably, this combination of events has led the Greek government to seek, behind the thinnest veil of “secrecy”, a restructuring of its debt obligations, presumably to delay the substantial maturities of the next few years into the more distant future. Academic economists, newspaper columnists and these Commentaries have pointed out that a prompt restructuring would be the least painful alternative. However, banks throughout Europe, which own substantial amounts of sovereign debt from Greece and other troubled countries, along with the European Central Bank, which now also owns a very large amount of these bonds, have argued strongly against contemplating any kind of restructuring or default, at least for another year or two. Worse yet, the European Central Bank has threatened to turn a restructuring into a cataclysm by immediately refusing to recognize any Greek debt, or the debt of any other country that restructures, as collateral for loans to banks from the ECB.
The effect of such a collision would be to make nearly every bank in Greece immediately insolvent, to make many other major banks in Europe drastically undercapitalized, and, as is often the case in head on collisions, to destroy more than half of the capital of the ECB itself, along with the Greek banks. The governments of Germany, France and the UK, continue to be paralyzed when it comes to any effective or coordinated responses to these problems. The banks are fighting their usual good fight to be bailed out. They want the ECB and economically strongest European governments to support the markets for weak sovereign debts, to extend new loans and guarantees to weak peripheral country governments and to protect the bonds the banks already own against any consequences of a default, should one occur. Over the past fourteen months Europeans have been more skeptical than their American counterparts of the various wishful solutions and glittering grand agreements that have been paraded before them.
Perhaps in the next few weeks, certainly in the next few years, we will see some combination of debt defaults or restructurings in Greece and probably Ireland and Portugal; a wide spread banking crisis in much of Europe; and a gradual dissolution of the Euro zone, one country at a time. Some aspects of a unified Europe will survive; but the curtain will have fallen on the world’s longest-running and most inspiring vision of a world beyond industrial expansion and beyond war.
Safe Harbors in a Storm
So far, except for bank stocks and the debt of peripheral European countries, financial markets have been remarkably calm, seemingly unaware of serious warning signs. This is all eerily similar to 2007, when another set of warning signs, mostly in the banking sector, were clearly heralding the financial implosion to come. Moreover, sovereign debt defaults have been a common occurrence in the aftermath of previous financial crises, contributing in turn to the even more commonplace prolonged period of economic weakness and high unemployment that has almost always followed financial crises.
One market which has been consonant with our concerns is the market for government debt of the largest and “safest” economies. Yields on ten year bonds issued by Germany, Switzerland, the UK, Canada and the US have fallen close to and even a little below three percent. We have retained client positions in US Treasury and Agency bonds, despite the small risk of a brief default; but we have avoided new purchases at these lower yields. Instead we have sought similar protection in Australian bonds yielding well over five percent, along with gas pipeline companies, utilities and telephone companies yielding between four and six percent. We believe that all of these investments would gain or provide relative safety in any renewed economic decline, while the pipeline companies and Australian bonds would also perform well in an economic rebound fueled by spreading disruption of energy supplies and/or military conflicts. We have been steadily increasing our combined holdings in these areas which now compose more than half of most or our clients portfolios.
We continue to hold investments that might benefit from the rapid growth of Internet-based transactions in a slow-growing economy, although we have reduced them substantially, taking profits to pay for the purchases mentioned above. We are also still optimistic about the growth of consumption in emerging markets and companies in the materials sector in the US which seem reasonably placed to do well in a slow growth or more rapid growth outcome, each of which remains possible. Holdings in all other sectors and in Europe and Japan are now minimal.
While disasters, whether natural or human, have usually had only negligible impacts on national economies, the devastating consequences of Japan’s natural and nuclear catastrophes seem to have created a significant exception to this rule. We will be sending our promised commentary on the Japanese nuclear disaster soon.
Zevin Asset Management, LLC is a global top-down investment management firm whose philosophy is rooted in the idea of avoiding major losses rather than seeking big gains. Our disciplined approach removes the emotion from investing by indentifying attractive regions and sectors from around the world while experienced analysts concentrate on stock selection. For both social and investment reasons, we focus our stock selection on well-managed companies with sustainable business practices.