What Malkiel had to offer:

Emerging markets generally will shine but specifically China, China, China.  He has visited 6 times and is convinced that China will be the global engine for growth. China is currently the third largest economy in the world. It should overtake Japan in a few years and the US in 15 years.

The government in China is absolutely committed to developing the western part of the country and has a larger and more targeted stimulus plan than the United States.  They have ambitious infrastructure investment plans and are starting to build a safety net so that Chinese consumers will start to consume instead of saving all their money (consumption is only 37% of GDP and savings rate is around 40%). China has the capacity to make enormous investments because its debt to GDP is only 25% today, vis-a’-vis Japan and the US where it is over 100%.

Malkiel’s take away is that China can continue to grow at 9% a year and will be able shift to more domestic sources of growth rather than a reliance on export of cheap goods abroad.

By contrast, the US has strong economic headwinds. He doesn’t think the US will go back into recession but he sees a very long drawn out slow growth type recovery. Bank of America and Citibank are insolvent, for all intents and purposes. Chinese banks by comparison are actually quite well capitalized. Given the significant issues that these banks had with bad loans to quasi-government institutions, this  is saying something.  It reflects a conscious effort to clean up the banks over the last decade so that as the market  slowly opened up the banks would be able to compete with foreign financial institutions.

US household liabilities over the last 50 years have gone from 40% of assets in the 1960s to 150% today.  Household debt as a percentage of GDP has gone from 20% of GDP to 100%. There will be a LONG adjustment period as the country deleverages.  Banks are not lending as they try and rebuild capital while exercising extreme caution.

Dollar weakness may continue, while other countries like China will express appreciation. Malkiel thinks that the Yuan (the Chinese currency) is the most undervalued in the world.

US has 42% of the world’s equity capitalization currently. Our investors have an extreme home country bias and people should consider an international allocation up to 40% (more if including US companies with a significant international presence).  In the short term, he has no idea what returns investors should expect. Over the long run, equity investors will be rewarded. At this point, equities still offer the potential for out performance over government bonds but no should expect  double digit returns.

He stressed the importance of looking at valuations using “normalized” profit margins. Current profit margins are much more realistic than they were a couple of years ago. There is still the challenge of knowing whether you can trust that earnings numbers are accurate. One alternative is to look at dividends, which cannot be fudged. The market is now much cheaper than it was in 1999, but is nowhere close to depression era levels. International values are reasonable, but not dirt cheap, and offer some inflation protection for investors. Chinese valuations, adjusted for growth, are attractive.

Should you diversify into bonds?  The answer is yes, because they are the only thing that is not correlated with other assets in a decline.

The Fed has expanded its holdings by $2 trillion which is concerning to a lot of people because of the challenges in unwinding all of these support programs and the potential for inflation. In the next couple of years, there is very little inflation risk but over the longer term inflation risk is significant.

And, oh yeah, China rocks.

And, oh yeah, Burt Malkiel is now the CIO of a company that is sponsoring China-based indices and investments. Just something to be aware of…

Axel, German by birthright, is hardnosed American free-marketeer to the core. He looked seriously pained describing the US government’s efforts to date to contain the financial crisis and fix the underlying problems that led to this crisis. Containment strategy? Supplant the private market as the supplier of capital. Reform? None.

In general, his views are similar to ours. Some things he discussed (heavily paraphrased):

The only 2 major financial insitutions that may have the strength to survive in their current form are Wells Fargo and JPM Chase.

The Chinese may be fine. The middle class has a lot of savings and the Chinese government, with its 20 years of planned investment, has some real options when it comes to stimulating the economy. This is consistent with our conversations with those actively involved in China who have noted some signs of slowing – emptier restaurants – but no indication that the bottom will fall out.

Within Asia, the winners look to be China, Singapore and Taiwan (through their Chinese connections). He was concerned about Korea with a rapidly aging population and an insular culture and countries like Vietnam whose ability to compete is based very narrowly on lower nonskilled labor costs.

He seemed more concerned about the long-term inflationary impact of the current monetary stimulus than potential short-term deflation. While this is not surprising as Mr. Merk runs a “Hard Currency Fund” whose explicit objective is to protect against a declining dollar, it is something to think about.

Merk offers a free periodic newsletter (sign up) that offers economic commentary. It looks interesting but the usual caveats apply.

This trade recently came undone. Everyone has had to sell their Australian dollars and buyback Yen. The Australian currency has been crushed. Below is a chart of the Yen/ Australian Dollar exchange rate. Sydney for Christmas, anyone?

Foreclosure on a mass scale is really stupid. Some obvious questions:

Can’t we figure out some way to transition buyers back to being renters that saves the cost of foreclosure to the banks and the pain to the homeowner?

Can’t the cities, state governments and non-profits work with the banks to keep perfectly good furniture out of landfills?

Where is our leadership?

The usual caveats apply. Everyone’s financial situation differs. Consult your own advisor or do your own research. We have been wrong before.

[Formatting problems at the bottom are known issue. Webmaster on the case.]

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The financial sector had taken over our economy. Over 40% of all profits in the US were made by financial firms, a statistic more befitting a small Caribbean tax haven. Financial regulation in this country was inconsistent and ineffective.

Your messengers,

Elizabeth and Jessica

The usual caveats apply. Everyone’s financial situation differs. Consult your own advisor or do your own research. We have been wrong before.

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Shocking VP picks, Russian invasions and now a government takeover of Fannie Mae (FNMA) and Freddie Mac (FHLMC)… the news just won’t stop coming.

Our overall view has not changed. The US will have to suffer through a few unpleasant years before the housing market normalizes, financial institutions can get back to business and our economy can get moving again. It will get worse before it gets better. At the end of the day, the financial sector should be smaller and more efficient which would be a positive thing. People will start saving money and that will be a positive thing.

Asset classes around the world have taken a beating lately. The rumors are that many hedge funds have had to liquidate large positions. While this is ugly for current holdings, most of you hold a lot of cash and we have identified a number of compelling investments.

Items of note from the government takeover of FNMA and FHLMC:

Mortgage rates will probably go down. The government is doing a lot of things to get rates down, many of which will eventually cost us all as taxpayers and mean much higher mortgage rates in the future. But in the meantime… there should be some deals available.

Future tax rates will be even higher than we have been assuming. This bailout will cost a lot. If you can contribute to a Roth IRA, you should seriously consider doing so.

This is not the final restructuring. The current specifics of the FNMA / FHLMC deal have the mortgage giants being responsible for something like 90% of all new mortgages over next year or two and then virtually ceasing issuance after that. The concept is that offering really, really low rates on mortgages over the next 18 months will stabilize the situation enough that the government can just leave. Methinks this is not very realistic. Who on earth will step up to fill the void? Homeowners and banks will be dependent on the US taxpayer for years to come. There are some eerie parallels to the Iraq war…

Debt issued by FNMA and FHLMC is money good. Many of you hold shares in your 401(k)s in the Pimco Total Return fund, which had gone “all in” on a bet that the government would do a bail out. It turned out to be a good bet.

In other news:

Washington Mutual (WaMu) got officially placed on super secret probation by its regulators. This is not a good sign. They are offering desperation-level high rates on CDs. This is not a good sign. We have sent out previous warnings about this bank. You should not have more than the FDIC minimum at WaMu. Your family and friends should not either.

Don’t shoot the messengers-

Elizabeth and Jessica

The 2009 unified budget deficit is estimated now at $490 billion. Some of that number is expected and fine – during a recession taxes fall and certain expenses like unemployment benefits rise.

It’s still a really big number – and it turns out that the real deficit is much, much higher.

First, the number doesn’t account for $80 billion in war costs.

Next, the number is for the “unified” budget deficit. “Unified” in federal budget speak means the cash in, cash out budget. This ignores serious obligations the government has taken on this year – veterans benefits to the hundreds of thousands of troups serving overseas, Medicare and Social Security payouts to the baby boomers etc etc.

The real government budget deficit is the number that takes into account all these future liabilities. It is *probably* $200 billion higher than the fictional unified budget deficit, but no one really knows.

Congress mandated that all the major departments of the Federal government start producing auditable financial statements in 1990. Many departments are now compliant but the behemoths – Defense, Homeland Security and State departments – are not.

I love this footnote in a recent report from the General Accounting Office (the government’s internal audit staff) on budget numbers:

Data reported in the Financial Report of the United States Government, hereafter referred to as the Financial Report, for fiscal years 2001 through 2007. GAO disclaimed an opinion on the U.S. government’s consolidated financial statements for these years, other than the 2007 Statement of Social Insurance. As such, the reported amounts may not be reliable.

Or how about this snippet from the same report:

Importantly, emphasis should not be placed on the precise numbers for either a single year accrual deficit or the change from year to year. For the 11th consecutive year, the government was unable to demonstrate the reliability of significant portions of the 2007 Financial Report, from which the data in this update were taken.

The cash on cash number, while in no way an accurate assessment of the government finances is still an important number – because it tells us how much the government needs to borrow every year to pay its bills.

We can project forward 20 and 30 years and the cash on cash number starts looking really, really ugly. All those deferred liabilities start coming due. Our best guess is that they will add $600 billion a year to the current deficit. That will either mean much higher interest rates or higher taxes (50% higher) or elimination of the entire government outside of defense or some combination.

Many of our client’s have written off social security being there for them in their retirement. They are surprised to hear our view that, while we think benefits will be clipped for the wealthy, Social Security will survive. A clear majority of retirees rely on Social Security and Medicare/Medicaid for their retirement and these programs will become even more important as the post- company retirement plan generation retires. These programs cannot and will not go anywhere. We may have an overhaul, eventually, of our health care system but don’t count Social Security or Medicare out.

The good news is that there will be Social Security benefits – the bad news is that tax rates will go up, a lot.

More reading on budget unsustainability

Congressional Budget Office’s report

The GAO’s report

For further reading:

An explanation of why it is a problem if the bond insurers blow up

Barron’s article by Vitaliy Katsenelson that explains why we should value stocks assuming profit margins are lower in future

New York Times article on American’s consumption habits

There are a couple of questions that need to be asked. Will these checks actually do anything on a short term basis? Even if people do go out and spend, is this a desirable outcome? Finally, assuming we are going to spend $150 billion, is this the best we can do?

On a short term basis, giving people money WILL increase spending. How much will it increase spending?

Some families will get their rebate and pay off credit card bills or put the money in the bank. While this may actually the wisest thing to do, it does little for the economy on an immediate basis.

Many people will spend the money. Some will use it to sustain unsustainable lifestyles – those financed by continual dips into their home equity – for another month or two. By summertime, when checks will probably be mailed, home equity loans will be difficult to come by and credit card limits will have been lowered.

There are the poor who have plenty of things they need to buy and can’t. Their checks will be spent the day they arrive – maybe even before (I am sure the same fine financial institutions that specialize in payday loans will lend against rebate payments).

Of the money spent, a portion will enter the US economy and the rest will go abroad. Best Buy keeps some of the cost of a new TV but 75% of it goes to Asia, the land of electronics.

When you balance all these factors and consider who will get what rebate (they are going disproportionately to the well off), you could have $50 billion entering the US economy this summer. That is a lot of money. In a normal downturn, it would be a serious kickstart. What is happening now is far from ordinary.

Headline news right now are focused on the housing bust and financial markets crisis. Construction is plummeting, home sales have plunged and home prices actually fell last year. The financial markets, who got fat off the boom, are now the first to feel the bust.

If we were merely dealing with the aftermath of a housing bubble, it might not be such a big deal. But housing is just one part of the story.

The dramatic rise in home prices and financial market “innovations” have masked over substantial economic problems. A frightening number of American families are spending more money than they earn. This underwater group includes a lot of boomers who should be socking it away for retirement. If families had to publish financial statements like companies do, many would be in the red.

Part of this is a spending problem. The economic statistics for consumption are almost unbelievable. There has been a 10% swing from saving and investment to spending.

We have made it patriotic to go into debt to buy stuff . Our natural competitive streak also applies to keeping up with our neighbors.

Prices have also increased. The cost for health care, energy, education, childcare, food and other essentials has gone through the roof. It is likely that published inflation numbers have dramatically underestimated how much the real cost of living has increased.

Part of the problem is an income problem. We have been transitioning from a manufacturing based economy to a service based economy. This is a trend that started in the 1950s as factories became more efficient and accelerated in the last 10 years with globalization. At this point, the number of workers who make their living in a factory as a percentage of the US work force is almost trivial. Some of this was inevitable and a positive event and some of it is the result of totally laissez-faire industrial policy.

In addition, the balance of power between management and labor has swung far away from the worker. Again, labor flexibility and mobility is a positive but a winner-take-every-little-scrap economy with a diminishing safety net is ultimately not very stable. You need a strong middle class who can save for their future without fear that one medical event will set them back. You need a domestic market that can buy your goods and services without having to take every penny of equity out of their homes. Etc etc.

These are challenging waters to navigate and sensible policy-making has vanished. We appear to be moving away from our problems rather than in the direction of solutions.

I just finished reading Robert Rubin’s memoir of his time as Secretary of the Treasury and the failure in certain key arenas of the policy-making apparatus in the 1990s was apparent, even with an incredibly talented group of people working for the Clinton Administration. I will not even get started about the last eight years.

The point is that throwing some money at the problem does nothing to solve the real problems at hand. It merely postpones the inevitable. The rebates will just about cover the shortfall in American’s need for cash this summer.

There are many things we could do with $150 billion that would start to address some fundamental issues in this country. Health care, basic research, alternative energy, the profound cycle of poverty in the inner cities, encouraging manufacturing innovations.

There is also a strong possibility that this slowdown will look different from ones in the past. Because the manufacturing jobs lost in the last recession never came back, there won’t be the immediate drop off in jobs we have had in previous recessions.

A huge boon in construction and deficit spending took us out of the last recession. This time construction will be part of the problem and the ability of the government to finance aid package after aid package will be limited. Our best guess is a long slowish period. In this case, the best use of tax dollars would be to start making some longer term investments and hold off on a desperate move like rebate checks. Legislators want to avoid the pain, especially in an election year, but we may need an uncomfortable period to make the hard decisions that will get this country back onto solid economic ground.

Some of the adjustment back to a normal level of inventory will simply be price adjustments. These losses will be taken by builders, homeowners and investors. The rest will come from all the houses that will NOT be built over the next few years as the slow but steady natural growth in households finally gets demand back in line with supply. This suggests a serious economic headwind over the next several years.

Five years out, things look much better. The excess inventory should be gone and the baby boomer’s kids start getting married and having kids. Until then though….