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JAForlines Global: Austerity and Its Discontents

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New York, December 4th, 2012, Advisor Update®
Much has been said in recent months and years about the US fiscal deficit and the proper method for reducing it.  Given the importance of this topic, we thought it would be worthwhile to look across the pond to Europe for lessons.  Since early 2010, the Eurozone has been mired in a debt crisis which has seen strict austerity measures implemented in many member countries.  To date, these policies have been almost uniformly unsuccessful.  This should give pause to policymakers in the US who are calling for similar measures.

The chief purpose of instituting austerity measures is to stabilize a country’s debt-to-GDP ratio.  Policies in Europe have failed because they have aimed solely at cutting deficits, rather than stimulating growth.  Budget cuts and tax hikes have put a drag on economic growth, which in turn has reduced tax revenues.  As a result, budget deficits have not been reduced to the extent that was hoped, and contracting GDPs have further increased debt-to-GDP ratios.

What is to be learned from this experience?  The chief lesson, in our estimation, is that deficit reduction policies must be accompanied by pro-growth policies. Tax reform, regulatory reform, infrastructure investment, and welfare and labor market reform would all fit the bill.

It is important to keep in mind that the consequences Europe’s failed austerity measures extend beyond poor economic conditions.  Social unrest has spread across the continent, with many protests turning violent.  Many countries have also seen the rise of radical nationalist parties, as people look across borders to direct blame.  This same phenomenon has also manifested itself in the success of various separatist parties, for example in recent Catalonian regional elections and in Belgian national elections in 2010.

These developments in Europe have counterparts in the US.  The Occupy Wall Street protests reflected a lot of the same sentiment as many recent protests in Europe.  The polarization of our two political parties and the emergence of the Tea Party are in some ways similar to the rise of radical parties in Europe.  Lastly, there have been several petitions for secession which, while purely symbolic, reflect real sentiment.  To be clear, the US is not Europe.  But they have set a poor example of how to deal with deficits, and we would be wise to take notice.

As we head towards the end of the year, we have positioned our portfolios with relatively low levels of equity.  We have done this for several reasons.  Part of our rationale is that we do not view equities, outside of a few specific sectors and countries, to be particularly attractive at the moment.  Economic growth is subdued, profit margins are at all-time highs and therefore have little room to expand, and price multiples are somewhat extended given the underlying growth fundamentals.  We do see opportunity in a few places, such as Japan, as we discussed two weeks ago, and some emerging market countries, and we will continue to target those areas for our equity exposure. At the moment, however, we prefer to focus on high yield corporate debt.

With upside somewhat limited for equities, we believe we can generate similar returns with high yield bonds while taking on less risk and achieving a lower standard deviation. We expect economic growth to remain strong enough to keep high yield defaults near their current level of 2%, well below their long term average of about 4% (see chart below).  These strong fundamentals limit their downside and make them attractive as we go into 2013.

Additionally, we expect interest rates to remain low next year as a result of the underlying growth dynamics and strong supply and demand fundamentals.  Net sales of US fixed-income dollar debt with maturities of more than a year are set to decline by 17% next year to $1.12 trillion.  At the same time, the Fed has increased its purchases and will buy $1.02 trillion in Treasuries and MBS if it extends its Treasury buying program next week, as expected.  In essence, after accounting for the above Fed purchases, only $100 billion in new issuance will be supplied to the private sector. This will put downward pressure on interest rates and therefore limit risks in debt markets.

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