Last week, I attended a breakfast hosted by the esteemed Robert Arnott.
Arnott runs Research Affiliates LLC, a respected research and investment firm. More importantly, Arnott is erudite, opinionated and contrarian.
Arnott's presentation was disarmingly candid. If a tad scary. Unlike many of the institutional research professionals from the banks and brokerage firms, Arnott is able to cut to the heart of the issue without fear of undermining the firm's efforts to sell something. No hidden agendas.
According to Arnott, the global economy faces a 3-D hurricane force headwind. He defined the three 'Ds' as our Deficit, Debt, and Demographics. Each, he claims, represents a serious headwind for the global financial schooner.
Over the long run, stocks have outperformed bonds by 5 percent per year. And while the last decade was not good for equities, the markets incurred a "massive revaluation of risk." The risk premium over this period has been negative. And given the vicious bear markets of 2000 to 2002, and again in 2008, it's a wonder that investors are willing to take on any risk at all.
Yet, with asset prices having dropped, and the prospective rewards for risk taking on the rise, one might think that stocks are priced to deliver a large risk premium, right?
Well, no.
Even though the S&P 500 underperformed inflation over the last decade, Arnott believes that stocks are still not cheap.
Citizens, corporations and small business have done their part. But the government leviathan has become accustomed to spending like a teenage girl with a credit card at Christmas time.
What do we have to show for this public sector spending orgy? Our massive budget deficit and the debt load it rode in on.
Arnott believes that the true budget deficit, the figure that would be reached should the government use GAAP accounting principles (like everyone else) is far higher than the official statistics.
When one includes the debt of government sponsored entities (GSEs like Fannie Mae, Freddie Mac, The U.S. Postal Service, etc.), and then adds unfunded entitlements like Medicare, Medicaid and Social Security, the figures become onerous.
Unfortunately, it's bound to get worse before it gets better. Because when you take the same aforementioned culprits, and net them out against the actual revenues collected by the Federal government over the last decade, you realize that we have been spending 10% more than we've made. Per year. For 10 years.
Public debt and entitlement programs are growing at a frightful pace. "We are addicted to debt and consumption," Arnott explained.
When you aggregate U.S. debt and unfunded obligations, Greece's problem begins to look like a small credit card balance.
Yet, we are not alone in our fiscal foolhardiness.
Addicts abound in the dilapidated crack house of debt-financed consumption. Japan and all of Western Europe are there. Unshowered. Unshaven. Wallowing in the filth. They too have shirked their families, friends and all accountability in order to smoke from the pipe of debt-financed consumption.
What of Germany, the sainted savior of the European Union? Germany is fiscally responsible only when compared to its profligate neighbors. It is hardly capable of bailing out a row boat, let alone the Titanic that is all of Europe (pre-Iceberg)
Alas, let us focus on the U.S. Our domestic problems, lack of will, understanding and resolve are more than most can digest.
Consider our unfunded liabilities.
Entitlement programs represent about 850% of GDP. Combined government and GSE debt is approaching 200% of GDP. And both continue to grow at a frightful pace.
Further, our demographic trends provide less comfort that a kidney stone.
In the mid '70s, the U.S. had 2.3 new workers for every citizen age 65 and up. Today, that ratio is nearly one to one. And in ten years, as the boomers continue to retire, we will actually run a deficit of new workers to retirees. According to trends, we will have about 1.75 retirees for every 0.25 new workers.
What's more, life spans are increasing. Quality of life is improving.
So, why does the longest retirement in the history of the world remain a birthright? Why should boomers be able to fan out across the globe in search of golf courses, cruise ships and casinos, while my sons face the devastating deficits left in their wake?
It's the generational equivalent of leaving the party right as the house begins to burn. "Thanks for having us... And good luck, kids!"
We've been consuming and borrowing against our future prosperity for the last decade. We thought we were so rich. So smart. But we were spending borrowed money. And deficit spending creates phony GDP. Brings the cost of debt service. Now, we are getting older, right when we need to become more productive.
It's like Rumpelstiltzkin. We fell asleep, and woke up old. And Japanese! Japan was the most productive nation in the world for a decade. And then they had a financial catastrophe from which they've never recovered. Right as their demographics turned against them.
Regardless of what we've been told, real GDP these last 30 years is closer to 2.4%. Given the slowing global economy, 2% GDP these next five years would be a home run. Yet, the Congressional Budget Office continues to project an average of 3% GDP per year.
Kind of like when my eight year old gets upset that six times eight does not equal 56. "No, dad, you're wrong." Wishing it so does not change the numbers. And based on the numbers, the government projections are overly optimistic, at best.
So, the nation is left with three options. Pay the debt. Declare bankruptcy. Or reflate.
Each of these options carries a price. Equities will come under pressure. Inflation will increase. Retirees will be selling assets to a proportionally smaller pool of buyers, and so they will not likely receive the prices for which they may have hoped.
Arnott speculated that the real 10-year returns for stocks and bonds will be in the range of 5.5% and 2%, respectively. So, this will not be an atmosphere that rewards a buy and hope mentality.
Selective opportunities will exist. Investors will be rewarded for diversifying into the relative safe havens of emerging markets. Alternative markets and asset classes will provide opportunities. Inflation hedges will protect and preserve capital.
But, caveat emptor. The fast-food approach to investment management currently offered by the brokerage firms will continue to disappoint. An actively managed, cost-effective global macro approach will offer the only means of staying ahead of the curve.
And what of Arnott's 3-D hurricane?
If you are a political spectator, you have seen politicians and their strategists handle the deficit argument by explaining it as tomorrow's problem. "It doesn't affect us today. And, as the world's reserve currency, we have the ability to postpone judgment day until such a time when we are readily able to deal with it."
But, like much of what emanates from politicians, this is only partially true.
The debt, and corresponding deficit, does affect us today. By denying us the productivity that a less debt-laden economy would bring. By forcing us to allocate capital to debt service, forcing us to raise revenues to meet all of the obligations, we deny millions an opportunity to find the work that might be available in a normal economic cycle. We deny companies an opportunity to hire, increase capital expenditures, upgrade facilities, expand. We deny entrepreneurs the seed capital otherwise needed to take a calibrated risk. We deny our seniors the opportunity to derive an income from their bond portfolios. We deny our young people the opportunity to enter a healthy workforce. We deny our children the opportunity to have the same opportunities that their parents and grandparents had--free from the shackles of massive debt obligations.
Finally, I asked Mr. Arnott when he felt that politicians might realize that the time to contend with these problems was upon us? And how might those in office gain such resolve?
"Nobody knows," Arnott responded. "This situation could unravel in one, three or ten years. The problem is, we will never know until after the fact. These debt issues are like an invisible wall. You know it's out there. You don't know how far out until you've crashed into it. Then, it's too late."