The culmination of the debt ceiling debate was unfortunately timed with a string of weak economic releases giving rise to concern (misplaced in our view) that austerity is dawning right when the economy needs more stimuli.
Europe leads the way
The rancour and brinksmanship of the process has also heightened scepticism of US politicians’ ability to implement sound policy. But probably the larger contributor to the extreme risk aversion has come from Europe. There is much uncertainty on how far the sovereign debt crisis may reach, the ability of European politicians to address it effectively and how any financial dislocation will impact the real economy.
While most economists still think the US and global economies will continue to grow slowly, investors have decided to shoot first and ask questions later, and there is certainly risk that the damage to confidence will prove self-fulfilling.
It is our long-held belief that the root cause of the increased incidence of financial crises continues to be the imbalance in where production and consumption occur around the globe. Simply put, the West consumes more than it produces, and China and other developing economies finance this consumption from abundant savings.
Certain parties – US homeowners, southern European sovereigns – become overextended and debt crises are born. Government responses have aimed at stemming the immediate crisis to prevent a cascading effect, rather than fixing the underlying long-term imbalance. It is like driving on bald tyres and continually plugging the weakest spots that threaten a blow-out.
In the US, this means fundamental tax reform, reining in government spending and making it more effective and overhauling unfunded healthcare and social security entitlements to put them on a sound footing.
In Europe, it means either fiscal union (in effect, if not in name) to match monetary union or a dissolution of the monetary union.
It’s good to talk
Crises are not perpetual, and unsustainable situations are ultimately resolved. Interestingly, there have been recent steps in the right direction – austerity in the UK and tough measures in Greece, Ireland and Spain coupled with an ever-increasing European stability fund. The debates themselves in the eurozone, US and UK, indicate that policymakers are increasingly ready to do what needs to be done.
We have strong conviction that a grown-up solution to these issues would open the doors to long-term bullishness. In democracies, however, political processes can make getting the policy correct difficult and slow. We would be pleasantly surprised (as would the markets) if the Congressional Super Committee successfully tackled any of the long-term structural issues, or indeed if they were addressed prior to the 2012 election. So, it could be tough going over the next year or so, in terms of both the psychology of financial markets and the strength of the economy.
Given today’s S&P 500 valuation levels we believe there is a decent chance of wading through the political and economic uncertainty that may continue over the next year or so. And if our structural problems are addressed thereafter, this could prove a very attractive window to invest for the long term.
