YCG Investments
“If you buy above average businesses at below average prices, on average, we believe you should come out ahead.” — Brian Yacktman

Presidential Race and Econ 101 on Debt & Inflation

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We’ve had some clients ask our views on the Presidential race and the effect it will have on stock prices. In the short-run, some pundits have suggested it’s a win-win outcome. In other words, if Obama wins, then the economy is perceived to be recovering and good for stocks; and if Romney wins, he could put policies in place that will be favorable to business enterprise, job creation, and growth. They add that a Republican president could resolve the “fiscal cliff,” which refers to the end of this year when the combination of automatic spending cuts and expiring tax breaks could siphon over $500 billion out of the economy next year. Thus, either outcome, they say, is thought to generate more demand for stocks in the short-run.

Of course, we’re more concerned about the long-term, and, from this perspective, the real threat is the massive national debt and deficit. Markets continue to crave growth through monetary stimulus even though this does not address the underlying sovereign over-indebtedness issue. Nevertheless, commitments from the ECB and Federal Reserve to “Do whatever is necessary…” and essentially implement “QE…to infinity and beyond!” have convinced many to brush debt imbalance concerns under the rug and buy risky assets for fear of standing in front of a tidal wave of monetary stimulus and missing out on a rally when money sloshes around and drives up prices.

But when you consider the numbers, it’s clear we are on an unsustainable path. U.S. national debt, for example, now over $16 trillion, exceeds GDP (gross domestic product – or the annual economic output of the country). In simple terms, not even speaking of current deficits, this means that GDP needs to grow faster than the interest rate the U.S. pays just to keep pace with the current debt level. If the budget were balanced, during a period of sub 2% interest rates, this appears manageable. But when you throw the primary deficit on top of these interest payments, our national debt is being added to by $1 trillion per year, which means that GDP needs to grow by 6% right now just to keep debt to GDP constant! Now, imagine if the government had to pay interest on that debt at pre-crisis rates from the 2007 period – interest costs would increase by about $500 billion, which would further widen the deficit to the point where GDP would need to grow by 9% per year to keep debt to GDP constant! At the current trajectory, it wouldn’t be long before interest constitutes the largest piece of the budget and would send us into a fiscal crisis.

Some believe this concern is overblown, arguing we are in a new era of low interest rates. If true, this utopia would go against both theory and history. After studying centuries of data, the late Milton Friedman wrote, “I know…no example of a rapid increase in the quantity of money that was not accompanied by a roughly corresponding substantial inflation.” (Money Mischief, 195). Given that we are in the middle of the largest monetary experiment of all time, with the monetary base having more than tripled in the past four years and the Fed, the ECB, and the Bank of England having conjured up money that amounts to 30% of the their markets’ total equity capitalization, we find it hard to believe that “this time is different.” Inflation is certainly low currently, possibly because banks are still tepid towards lending and consumers continue to deleverage, both of which reduce the money multiplier effect. In fact, we are currently experiencing for the first time in history a negative money multiplier. However, these circumstances will not persist indefinitely, and we question whether the Fed will be disciplined and agile enough to withdraw this excess liquidity when monetary velocity eventually increases.

This is not to say that we don’t understand Ben Bernanke’s point of view. The Fed has a dual mandate of 1. Keeping inflation in check, and 2. Growth. Since inflation has remained in check, as mentioned earlier, Bernanke has stated they will seek growth through monetary stimulus if the labor market remains weak. We’re sure he feels further pressure because all of the government’s other tools are used up. In an unleveraged economy, increasing government spending will provide a short term boost to growth and employment. However, since the United States is already so leveraged and is adding to that leverage every year through a big fiscal deficit, we can’t provide any more fiscal stimulus. We could try and increase taxes to gain more firepower for fiscal stimulus, but history has shown that the taxes will reduce private spending and reduce savings and investments by more than the benefit we would get from increased capacity for fiscal stimulus. Thus, the only real alternative is to fund the increased government spending by creating money out of thin air, i.e., monetizing the debt. Monetization refers to converting something into cash, so debt monetization is the Fed creating new money by purchasing government bonds to fund the debt (quantitative easing).

The problem is this will inevitably lead to inflation at some point. If you think of money in terms of supply and demand, if the supply of money significantly increases, then prices drop. In other words, the dollar devalues and is unable to purchase the same quantity of goods, i.e., inflation. On the one hand, this will fortunately make past debt loads feel smaller (because those debts are priced in devaluing dollars), but on the other hand it will simply serve as another form of taxation without legislation as commodity prices and costs increase. This takes you back to the same problems of taxation hampering growth and employment. As alluded to earlier, it could also potentially lead to a spike in interest rates which could create an inflationary debt spiral scenario in which our fiscal deficit worsens because interest rate payments go up, we monetize the debt to fund these increases, the bond market responds by forcing our interest rates up even more, we monetize our debt, etc. Even if a low probability outcome, this is one that we should try and avoid at all costs due to the severe negative long-term economic consequences.

Overall, we see depending solely on monetary stimulus as the wrong prescription. Monetary stimulus is the prescription for a liquidity crisis, but our problem is not liquidity; our problem is too much debt. In our view, the best way one gets out of debt is by either living within ones means or by growing out of it. Obviously, monetary policy cannot control fiscal spending and budgeting, and the trouble of leaning on monetary policy for growth is that it only determines nominal gains, not real growth. Therefore, the missing prescription is for the branches of government that oversee fiscal policy to 1. Budget and 2. Set policies that encourage savings, investment and growth.

We do not know what fiscal policy will be over the next four years, but what seems clear is, of their dual mandate, the Fed is more focused on the labor market at the expense of allowing inflation to run rampant. For this reason, coupled with sky high valuations, we agree with Warren Buffett when he stated months ago that bonds should come with a warning label.

This is why we continue to focus our search on quality businesses trading at attractive valuations that will continue to produce strong cash flows even during turbulent times and have the ability to raise prices to maintain margins in an inflationary world. We found one such new investment this past quarter.

Disclaimer: The specific securities identified and discussed should not be considered a recommendation to purchase or sell any particular security. Rather, this commentary is presented solely for the purpose of illustrating YCG’s investment approach. These commentaries contain our views and opinions at the time such commentaries were written and are subject to change thereafter. The securities discussed do not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. These commentaries may include “forward looking statements” which may or may not be accurate in the long-term. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable. Past performance is no guarantee of future results.

Posted by: Brian Yacktman | November 02, 2012 | Permalink

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