September 20, 2010
"Series that represent early stages of production and investment processes (new orders for durable goods, housing starts, or permits) lead series that represent late stages (finished output, investment expenditures). Under uncertainty, less binding decisions are taken first. For example, hours of work are lengthened (shortened) before the work force is altered by new hirings (layoffs)."
Victor Zarnowitz and Geoffrey Moore, "Sequential Signals of Recession and Recovery"
Last week, we got a fresh set of economic indications from the Philadelphia Fed Survey. While the market evidently took relief from the modest uptick in the composite index to -0.7, a quick look at the component indices suggests a worsening of economic conditions in the latest report. Specifically, the Philly Fed new orders component fell to -8.1 from -7.1, which is the third month in negative territory. While there was a slight uptick in the index for number of employees (to 1.8 from -2.7), the better leading measure is the average employee workweek, where the index weakened to -21.6 from -17.1.
As I've emphasized in recent weeks, the U.S. economy is still in a normal "lag window" between deterioration in leading measures of economic activity and (probable) deterioration in coincident measures. Though the lags are sometimes variable, as we saw in 1974 and 2008, normal lags would suggest an abrupt softening in the September ISM report (due in the beginning of October), with new claims for unemployment softening beginning somewhere around mid-October. It's possible that the historically tight relationships that we've reviewed iin recent weeks will not hold in this particular instance, but we have no reasonable basis to expect that. Indeed, if we look at the drivers of economic growth outside of the now fading impact of government stimulus spending, we continue to observe little intrinsic activity.
The strongest forces driving economic expansion during a post-recession recovery phase is expansion in credit-sensitive expenditures such as housing, durable goods (such as autos) and gross investment, and in particular, inventory rebuilding. While capital expenditure for upgraded information technology is the clearest bright spot in recent GDP reports, it also represents a very small share of the economy. Other credit-sensitive classes of expenditure continue to face strong headwinds.
It is also important to understand that while consumption represents roughly 70% of economic activity, it is by far the least volatile component of GDP, particularly when durable goods are excluded. The main sources of fluctuation in GDP growth are credit-sensitive expenditures and inventories. Given the recent buildup of inventories and the expenditures on autos and home buying that were brought forward by programs such as cash-for-clunkers and the first-time homebuyers' credit, we are likely on the downside of those bursts of spending. For that reason, it appears likely that the positive growth of GDP in recent quarters will have relatively poor follow-through. A careful examination of sub-components of GDP growth leaves little reason to expect actual economic activity to deviate from what is already suggested by weak leading indicators.
If we observe both an improvement in those leading indicators and an improvement in market internals, our evaluation of investment conditions would be more constructive. For now, however, we remain defensive about risks that still appear significant.
On the housing front, last week's comments from Rick Sharga, the V.P. of RealtyTrac, are worth noting - "We're on track for a record year for homes in foreclosure and repossessions. There is no improvement in the underlying economic conditions. Whether things fall precipitously depends on government and lenders controlling the inflow of new foreclosure actions. If the market is left to fend for itself, you may see more serious price depreciation."
Lender Processing Services concurred, with its senior V.P. noting "Loans that have been delinquent for a historically long period of time are just now beginning to move through the pipeline. As of July 2010, the average length of time a loan in foreclosure had been delinquent was nearly 470 days. Now, after the intensive efforts of the last year or two, remaining home retention options appear to be exhausted and servicers are beginning to process more of these seriously delinquent loans."
My view remains that the underlying condition of the U.S. housing market is one of deep insolvency. The Treasury, Fed and the FASB have effectively made a policy out of opaque disclosure, so that at least the deterioration in the housing market is slow to appear on the balance sheets of major banks and financials. At present, the FASB allows "significant judgment" in the valuation of mortgage-backed securities, which I suspect are being carried at a higher level than the value that the underlying cash flows (mortgage repayments) can actually support. Given that there is little pressure to disclose losses, and that mechanisms are in place (at least until the end of 2012) for the Treasury to bail out the entire flow of bad mortgages that funnel through Fannie Mae and Freddie Mac, it's not clear whether the growing mountain of delinquent and unforeclosed mortgages will provoke an abrupt crisis. My own expectation is that fresh economic pressure would provoke contagious pressure on the housing market to an extent that would be difficult to obscure.
That said, if the U.S. economy averts a period of fresh economic weakness, we could instead observe a more drawn out period of stagnation and price pressure. Ultimately the bad assets have to be placed on the market, which suggests further price pressure in the next few years. Weak labor conditions would also contribute further mortgage deterioration. Long-term, deficit-led inflation might be able to avert mortgage losses as home values gradually rise above the principal balances, eroding the real value of the debt, but this appears very unlikely in the immediate few years.
On the subject of inflation, I should emphasize that while I expect inflation pressures to be contained for several years, the impact of massive deficit spending should not be disregarded simply because Japan, with an enormously high savings rate, was able to pull off huge fiscal imbalances without an inflationary event. We may be following many of the same policies that led to stagnation in Japan, but one feature of Japan that we do not share is our savings rate. It is one thing to expand fiscal deficits in an economy with a very elevated private savings rate. In that event, the economy, though weak, has the ability to absorb the new issuance. It is another to expand fiscal deficits in an economy that does not save enough. Certainly, the past couple of years have seen a surge in the U.S. saving rate, which has absorbed new issuance of government liabilities without pressuring their value. But it is wrong to think that the ability to absorb these fiscal deficits is some sort of happy structural feature of the U.S. economy. It is not. It relies on a soaring savings rate, and without it, our heavy deficits will ultimately lead to inflationary events.
Hyperinflation is a much different story, and as I've said before, I am not in that camp. This doesn't exclude the possibility that enough policy mistakes will change that, but for now, my inflation outlook is flat for several years and then accelerating in the second half of this decade.
As Peter Bernholz notes in Monetary Regimes and Inflation (an economic study of inflation, including more than two dozen cases of hyperinflation), "The figures demonstrate clearly that deficits amounting to 40 per cent or more of expenditures cannot be maintained. They lead to high [inflation] and hyperinflations, reforms stabilizing the value of money, or in total currency substitution leading to the same results. The examples of both Germany and Bolivia suggest that at least deficits of about 30 per cent or more of gross domestic product are not maintainable since they imply hyperinflations... [In nearly all] cases of hyperinflation deficits amounting to more than 20 per cent of public expenditures are present."
At present, U.S. federal expenditures are about $5 trillion, versus about $4 trillion of revenues, and GDP of about $14.6 trillion. So the federal deficit is running at about 20% of expenditures, but less than 7% of GDP. This is not a profile that is consistent with hyperinflation, but it is also not a benign policy. Continued deficits will have substantial economic consequences once the savings rate fails to increase in an adequate amount to absorb the new issuance, and particularly if foreign central banks do not pick up the slack. We're not there for now, but it's important not to assume that the current period of stable and even deflationary price pressures is some sort of structural feature of the economy that will allow us to run deficits indefinitely.
Finally, given probable economic pressures and continued strong demand for default-free instruments, the likelihood of sustained upward pressure on bond yields remains limited here. At some point, probably years from now, we'll face a likely sustained increase in bond yields. We're often asked how that sort of environment would affect the Strategic Total Return Fund, given that we don't short bonds, and we don't buy "inverse floaters" or the like. A simple answer is that just as poor valuations and weak market returns have kept us from taking much exposure to stock market risk during the past decade, while the S&P 500 has gone nowhere, rising interest rates will limit the ability to profit from interest rate exposure. Water can't be squeezed from stones. Frankly, however, the returns of the Strategic Total Return Fund since its inception have not been dependent on a great deal of interest rate exposure in the first place. Even our present portfolio duration of 4 years is well below the average duration of the bond market.
So to a large degree, I expect we'll simply continue what we normally do, which is to vary our exposure in proportion to the expected return/risk profile of the various markets and security groups that we invest in. Markets rarely move in a straight line, and there is typically enough cyclical fluctuation within secular trends to present many opportunities to vary market exposure and portfolio duration. We have the ability to invest in a range of assets such as inflation protected securities, precious metals shares, and foreign currencies, as well as utility shares and other assets. An extended period of rising interest rates is likely to produce a bias toward shorter portfolio durations rather than longer ones. However, I don't expect that economic cycles would be eliminated, and to that extent, I don't expect that we'll be at a loss for opportunities to vary our investment exposures over the course of those cycles.
As of last week, the Market Climate for stocks remained characterized by unfavorable valuations, mixed market action, increasing bullish sentiment (approaching levels of overbullishness), and clear overbought conditions. As we've observed for months now, the stock market is still trading between widely followed support and resistance levels, with the S&P 500 bouncing off of the higher end of that channel last week. My primary concern is still the "recognition window" that I believe we have entered. The next several weeks will be important. As noted above, however, if leading measures of economic activity improve and internals improve, we'll be willing to accept a moderately more constructive position, but even here, our latitude to do so is somewhat restricted by valuations that are historically rich. As always, our intent is to align our position in proportion to the return/risk profile we expect. There's a moderate positive range that we'd be willing to operate within if we observe improvement in various economic measures, but for now, the evidence continues to warrant a strong defense. Both the Strategic Growth Fund and the Strategic International Equity Fund are tightly hedged.
In bonds, the Market Climate remained characterized by moderately unfavorable yield levels and favorable yield pressures. The Strategic Total Return Fund continues to carry a duration of about 4-years, and we are maintaining a range of 15-20% of assets allocated between precious metals shares, foreign currency exposure and modest holdings of utility shares.
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