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of all guest columns written by Dennis C. Butler, CFA
Former President Clinton created something of a stir recently when in a speech to a Labor Party conference in the U.K. he said, “Society is important because of Ubuntu.” On the following day the British press set out to explain what he meant — Ubuntu? It turns out that Ubuntu — a difficult-to-translate word from the southern African Bantu language — refers to a concept meaning that a person is defined through their relationships with others: “I am because you are.” Or, according to Archbishop Desmond Tutu of South Africa, “My humanity is caught up, is inextricably bound up, in what is yours.” (Ubuntu is also the name of a variant of the open-source linux computer operating system, whose creators are based in South Africa.) Mr. Clinton’s use of the term in a political/social context has fairly obvious connotations. We believe it has descriptive power in the more mundane world of economics as well — after all, what is economics but the study of people interacting under a particular set of circumstances? These interactions and relationships have a great impact on whom we are in a material sense.
Economically speaking, the world has become a very small place where actors from banking institutions to individuals are more and more dependent on each other. Products made in Asia turn up on the shelves in shops in America’s most rural areas. Prices of important commodities from gasoline to cocoa are influenced by faraway supply and demand forces. Financial markets worldwide have become more interconnected and correlated, meaning that events (both positive and disruptive) influence all of them together more so than before, and diversification among them is harder to achieve. Vast changes in industry and employment have occurred as relative cost advantages shift from area to area. Currency fluctuations with trading partners impact relative purchasing power and the prosperity of millions. Hence, what we are economically is to a great extent bound up with others.
Another type of economic relationship came to our attention recently that also made us think of Ubuntu. In late September The Wall Street Journal reported that for the first time in ninety years the United States is paying more to foreign creditors than it is receiving from investments Americans have made outside the country. The tipping point was reached because of recent increases in short-term interest rates — the majority of the U.S. sovereign debt is short-term and much of it is held abroad — and the deficit could reverse if rates subside in the future. Nevertheless, the country has reached an important juncture.
Consider some of the statistics cited in the article. Since 2001 U.S. spending has exceeded income by $2.9 trillion. Total foreign debt is now $13.6 trillion, or $119,000 per household; net debt (debt less what foreigners owe us) stands at $2.5 trillion. Foreigners have met over 80% of the $1.3 trillion of U.S. government borrowing needs since 2001. A one percent increase in the relative cost of foreign debt (the rates we pay versus the rates they pay) would increase our payments by 1.1% of GDP, versus 0.5% in 1995.
The gap between foreign debt payments and investment income from abroad is relatively small at present when viewed in the context of a $13 trillion U.S. economy, but the deterioration in the payments balance is notable, and has potentially far-reaching consequences. The generosity of foreigners has permitted the U.S. to live far beyond its means. Furthermore, it is questionable whether our spending on consumer goods, SUVs, new homes, wars and tax cuts, fueled by foreign resources, represents the kind of investment that will expand our future wealth. Unless the country and its citizens decide to change their behavior (in other words, to spend less and save more), an increasing portion of whatever future growth we do achieve will go to debt payments to outside lenders. The U.S. can truly say to the rest of the world, “I am because you are.”
There is no indication that the change in the country’s status from a creditor nation has had any impact so far on the financial markets, or that behavior has shifted much. The appetite for new bond issues remains “insatiable,” according to reports, despite “expensive risk premiums” — another way of saying there is no reward for taking on risk. Indeed, the strength in the bond market has been feeding a boom in leveraged buy-outs reminiscent of the 1980s — almost any amount of debt can be sold to eager buyers. Abundant financial liquidity has also boosted worldwide merger and acquisition activity to record levels — $2.7 trillion year-to-date. To the surprise of most forecasters, interest rates declined during the quarter just ended— longer-term treasury rates went from 5.25% in July to about 4.6% at the end of September. Mortgage rates fell somewhat as well, which in turn may have stabilized a housing market that appeared to be in serious trouble.
The stock market did reasonably well as falling rates and lower oil prices led to visions of bigger profits in the corporate world (not that corporations are short on net income now — the rates of profitability are the highest in history at over 10% of GDP, or about twice the long run average). The popular averages rose 4-5% during the three months. The Dow Jones Industrial Average even hit a new all-time high of 11,742 on an intra day basis (besting the 11,722 January 2000 peak), but the other indexes still have quite a ways to go before reaching record territory (the NASDAQ stands at less than half of its 2000 high point). There has been much chatter about the 30 Dow stocks reaching a record, but there is no real significance in the move, beyond the fact that those silly enough to pay peak prices in 2000 waited almost seven years to get their money back. That’s not too bad — it took 20 years after 1929.
Stability
It has been said that “in finance, ignorance is only briefly bliss.” An article in Barron’s earlier this year helped to explain why this is the case. There is a school of economics which maintains that, paradoxically, financial stability is ultimately unstable. Investors (businesses, institutions, individuals) make their commitments under conditions of uncertainty. That uncertainty normally induces investors to include a “margin of safety” in their return expectations, to avoid disaster should future results disappoint — especially important if borrowed money is involved. This is a familiar process akin to diversification in a stock investment portfolio. If the outcome is favorable, the previous margin of safety comes to be viewed as excessive, so future investments are made with narrower margins. Should positive results repeat often enough, comfort and overoptimism on the part of investors cause the real margins of safety to disappear and a corresponding rise in the risk of financial loss (contrast this view with that of “modern portfolio theory,” which maintains that smaller margins of safety — or “risk premiums” — signify less risk). Hence, apparent stability masks inherent instability.
Such reasoning is consistent with our observations of the financial markets. The longer a period of rising prices and strong investment results continues (stability), the longer such happy experiences are expected to persist, encouraging more and more people to participate — heedless of the fact that higher prices have made that expectation much less likely of fulfillment and purchases of securities a more risky proposition (instability). Since a large number of these tyros are unaware of this risk, or choose not to pay attention to it (ignorance), a pleasant time can be had by all (bliss) — at least for a while. For the least savvy latecomers, that period is the briefest.
Applying this analysis to current financial and market conditions leads to worrisome conclusions. Most quarters of the globe have now enjoyed several years of relative prosperity and economic stability. Surprising as it may sound to those still traumatized by the dotcom bust, volatility in the financial markets has been at a low ebb, and returns healthy. On the other hand, evidence of aggressive risk-taking and diminishing margins of safety is mounting. Stable markets and historically low interest rates have fueled record debt issuance, which is being more than adequately absorbed by demand from holders of cash “seeking yield.” Immense amounts of capital thus raised are being routed by hedge and private equity funds into highly leveraged transactions at ever higher prices. In residential real estate exotic mortgages and loose banking standards have finally begun to cause alarm among regulators. A boom in commercial real estate is leading to transactions at lower and lower “cap rates” — higher prices and lower returns on investment. In addition to historically low rates, the bond market continues to be characterized by unusually narrow “yield spreads.” Adjusting seemingly “appropriate” stock market valuations to account for unsustainably high profit margins reveals they are actually more expensive than commonly believed. Foreign investment funds are eager to participate in Chinese bank initial public offerings, although it has been estimated that the country’s entire foreign exchange reserves (approaching a trillion dollars) would be needed to repair a banking system burdened with bad loans. Thus are the temptations brought on by stability.
A general letting down of guards is reinforced by government and regulatory policies that some argue have created a “moral hazard” in the financial world. Authorities such as the U.S. Federal Reserve, and indeed the entire U.S. government, appear ready to act not only to counteract economic weakness, but also to spare the public the consequences of excessive speculation in markets. Needless to say, such policies, while preventing some short-term pain, are neither sustainable nor affordable over the long run.
Some economists and market observers maintain that a time of reckoning will inevitably be forced upon us. We concur. The kinds of imbalances and excesses seen today have existed before, and have in each case been exorcized from the system in one way or another. Governments cannot run massive deficits forever, nor can individuals keep adding debt loads or relying on asset price appreciation for their retirement. Neither can depend on the continuation of low interest rates or healthy employment conditions. As investors we cannot predict when the ultimate settling of accounts will occur, or how severe the consequences will be. Our job is to be aware of the risk and ensure that an adequate margin of safety is present at all times, despite a continuing positive climate full of supportive economic news and good investment results.
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Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation,
investment counsel. He has been a practitioner in the investment field for over 23 years and has been published in
Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html.
"Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
President
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
Telephone: 617.441.9695
Email: cscc@comcast.net
URL: http://www.businessforum.com/cscc.html
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