An Interview with the Chief Investment Officer

The past 12 months has been a roller-coaster ride for the global economy and capital markets. What are we to make of the current situation? The list of topics we would like to cover is so broad that we’ve chosen to present a few key thoughts in an interview, "Q & A" format. We look forward to presenting a more detailed analysis, with graphic displays, in an audio slideshow which will be available in the next few weeks. Please feel free to submit any questions or comments in advance to questions@aspiriant.com.

Q: What is happening with the global economy?

A: The US and global economies are showing signs of stabilizing, by some measures having already turned the corner. Retail sales, auto sales, durable goods orders, and home sales all seem to have found a bottom in recent months. Many economists feared that the recession would last well into 2010, but the current data seems consistent with the recession ending sometime in the second half of 2009

We are confident that the global economy will, at some point in the near future, resume growth. Most very well-informed commentators, like the Federal Reserve and the IMF, agree. However, the rate of growth may be modest and it may look different than the economy of the past. Key themes will be:


  • The emerging markets are here to stay. Though firms from the developed markets have long recognized the growth potential in emerging markets, they are only now recognizing that emerging markets will also be a source of competition.

  • Workers in developed economies have been protected from the changes in the global economy through protectionist policies that cannot be sustained. Governments around the world will need to work hard to ensure workers are prepared for new economy jobs.

  • After decades of deregulation, increased regulation looks likely. Governments around the world will try to harness the power of markets while reigning in the excesses of capitalist competition. Expect at least some unintended consequences.

Q: Has the equity market come too far, too fast? Are the markets overly exuberant and should investors take profits or delay equity investments?

A: The US equity market has historically rebounded well in advance of the end of a recession. Since WWII, the median advance of the S&P 500 began 4.6 months prior to the official end of a recession, gaining 26.4%, on average. We should not expect the market to wait for a clear end of the recession, so the market rebound is not premature in that sense.

After suffering the worst peak-to-trough decline (as of March 9, 2009) of any bear market since WWII, the S&P 500 posted the best 1- and 3-month performances since that time. While we think that the direction of recent market movement makes sense, the dimension of that performance over such a short time period is mostly noise and cannot be reliably used to time investments

Q: Will we see a “V” shaped economic recovery?

A: While there are economists predicting both “V” and “L” shaped recoveries, we find arguments against a rapid recovery of economic growth to be most compelling.

Historically, deep recessions have typically been followed by strong recoveries. The process of recession – consumers postponing their spending in order to build up savings; businesses allowing their inventory levels to decline – pushes the economy down, like a loaded spring. Once the fear and uncertainty are pulled away, the spring unloads and rapid growth ensues. But, two important factors undermine the global economy’s ability to rebound rapidly this time.

First, we are at the tail end of an increase in debt burden among consumers and financial firms which lasted several decades. The process of paying down that very high level of debt (“delevering” in investment parlance) will limit the ability of businesses, and especially consumers, to spend.

Second, the stress at financial institutions has caused a credit crunch, limiting the ability of consumers and businesses who do want to spend. While the Federal Reserve has made the provision of credit a top priority, the programs have had mixed success.

But underlying economic growth and the performance of investment markets, while of course linked, are often not contemporaneous. New technology and global integration should allow more profitability even with less economic growth, so this is likely a fine time for long term investors to invest

Q: What is the biggest source of near-term risk in the US economy?

A: It will be difficult to sustain a rebound in the economy without consumers. The pace of job losses is slowing, but labor market conditions will stay weak for some time. On July 2nd, the DOL employment report was much worse than expected. Employers cut 467,000 jobs in June, 100,000 more than the average of forecasters’ expectations. The unemployment rate in June rose to 9.5%, the worst since 1983; but, as we remark elsewhere, the unemployment rate is a slippery statistic and is usually the last to improve.

Q: What is the biggest source of longer-term risk in the US economy?

A: Given the unprecedented level of monetary and fiscal stimulus, economists have raised concerns over the long-term impact of those programs. If the government tries to end the programs too soon, the fragile economic recovery may collapse. If the programs are maintained too long, higher interest rates and inflation may take hold.

For the most part, we believe the administration is taking the right approach by planning for the withdrawal of stimulus. By noting that many of the programs have built-in expirations and by telegraphing the process of ending other programs, the Federal Reserve and the Obama Administration are cautioning investors against becoming dependent on the stimulus. The actual implementation will determine whether this is successful.

Q: What are the chances of an inflation spike in the next two years?

A: With respect to consumer price inflation, the only place where inflation pressures are evident in the US in the near term is in commodities, which, by itself, would not likely boost the inflation rate of other goods and services. As of 12/31/08, the biggest (by far) component of the Consumer Price Index was housing, at 43%. The food and beverage category is a distant second at 16%. While high on people’s minds, energy is only 7.6% of the index.

Inflation can appear in other parts of the economy, but there is little danger given the low level of production in the economy. The output gap is the difference between actual economic output and the most the economy could produce given the capital, know-how, and people available. When actual output exceeds potential, demand for products and labor bids up prices and wages, fuelling inflation. When actual output falls short, competition for scarce consumers and scarce jobs puts downward pressure on inflation. We’re in the latter situation.

The Congressional Budget Office estimates that the gap topped 6% in the first quarter of this year and will average more than 7% in 2009, which would be the largest figure on record. Given that core inflation (excluding food and energy) was so low when the recession began, it is not a stretch to believe that, with so much slack in the economy, inflation could even turn negative (the rolling 12 month CPI, in fact, has been negative over the past few months). The Federal Reserve statement released after its policy meeting on June 24th notably omitted the warning from its three prior meetings that “inflation could persist for a time below rates that best foster economic growth and price stability”. With the economy gradually finding a bottom and the rate of decline in home prices slowing, the chances of a downward spiral of deflation and economic activity have diminished, the Fed now confirms. Still, pessimists will continue to worry about deflation as long as a large output gap persists.

Q: What does this mean for my investment strategy?

A: This is one of our favorite topics and we look forward to sharing our views with our clients one-on-one. We have made and will continue to make some changes to some clients’ strategic allocations, increasing fixed income allocation, accepting more credit risk in municipal bonds, increased allocation to private real estate and private equity, and global public equity allocations more in line with global market capitalization. It should be no surprise that we continue to favor a long-term perspective which allows clients to make high-probability long term investments without worrying too much about the short-term noise in capital markets. From an investor’s perspective, the current capital markets are far more attractive (reasonable prices and expectations for future growth) than they were in 2007. While we do not attempt to time markets, the characteristics of the current environment are similar to past periods which offered above average returns. The same opportunities may be present today.

Jason Thomas, Ph.D.
Chief Investment Officer

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