Friday, July 2, 2010

PIGS Headed Off to Slaughter

The largest financial crisis in history has spread from private to sovereign entities to paraphrase Nouriel Roubini, founder of Roubini Global Economics..Europe’s recovery will suffer and the falling euro will subtract from growth in its key trading partners. At its worst it conceivably precipitates a double-dip recession.

Now, governments everywhere are releveraging to socialize private losses and jump-start private demand. But public debt is ultimately a taxpayer’s burden. Governments subsist by taxing private income and wealth, eventually governments must deleverage too, or else public debt will explode, precipitating further, deeper public and private-sector crises.

This is already happening. Greece is first over the edge; Ireland, Portugal and Spain (yes, the acronym for these countries is pigs) trail close behind. Italy, while not yet illiquid, faces serious risks. Even France and Germany have rising deficits. UK budget cuts are starting. Eventually Japan and the US will have to cut too.

At home, recent data on employment, GDP and personal income highlight the complexity of information, which is sometimes contradictory and adds to the difficulty in making appropriate decisions. What the numbers suggest is that underlying demand in the economy remains subpar relative to the typical recovery. Therefore the rub is: there is a recovery (granted it’s a recovery only a statistician could love) but it remains disappointing relative to expectations and therefore disappointing relative to the financial markets - the Dow 30 recently fell from 11,200 in April to under 10,000 in early June.

This recovery is going to take more time to coalesce than those in the past. Job growth will remain disappointing compared to prior recoveries and therefore personal income and eventually consumption will be disappointing. Moreover, persistently high unemployment suggests the labor market is seeing lots more structural unemployment, which is a mismatch between the needs of employers and the skills and training of the labor force) compared to earlier recoveries. Slower growth is also associated with continued low inflation and steady interest rates. Yet, despite very low mortgage rates I don’t see a jump in housing starts any time soon. But given the current state of the Euro community and the headwinds facing us domestically, I continue to see a subpar recovery.

I’ve said it before and I’ll say it again. A successful portfolio funds your future needs or liabilities; anything short of this is a failure. It makes sense, then, that the portfolio must handle future events, not those of the past. Investment analysis uses past returns as the essential data for risk and return statistics. Consequently, the advisory business puts too much emphasis on past returns of funds and managers, when in fact it is subordinate.
Returns are the result of an economic environment. An economic environment has vast numbers of variables that play out in unpredictable ways. A portfolio defined today must play out in the uncertainty that is our future.
Proper diversification weights the portfolio toward asset classes with the strength to handle the future.

Since the stock market is not going anywhere anytime soon why not take a look at the debt side of your balance sheet. With 15-year mortgage rates at about four percent it may be wise to compare the cash flows of your 30-year loan to with those of a 15-year mortgage at the current market average of four percent (don't forget to factor in points). Running my own mortgage comparison, I found it was a cash flow push, meaning I would pay the same monthly mortgage payment on the 15-year note as I am on my 30-year mortgage, with one huge exception: my mortgage would be paid off 84 months sooner. That means huge interest cost savings (sorry Mr. Banker).

Christopher Blakely 07/02/2010


Sources: Roubini Global Economics, Bloomberg LP.