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What Tops Pat Dorsey's Worry List

Pat Dorsey, CFA

Pat Dorsey: Hi. I'm Pat Dorsey, Director of Equity Research at Morningstar. In honor of Risk Control Week at morningstar.com, I thought I'd run through my personal worry list of stuff that either keeps me up at night or at least makes me sleep a little bit less soundly, kind of ordered from the most immediate to the further out into the future.

The most immediate, of course, is the current situation in Europe, particularly in Greece, in past weeks spanning out to Portugal, and the risk for the "contagion" in those financial and credit markets to wend its way over to this side of the pond.

Now I'm not terribly worried about a global credit lockup the way we had in late 2008 when Lehman failed, largely because policymakers have seen that picture before. It wasn't a very pretty one. And they are going to pretty much do all they can to avoid that kind of a credit lockup. So in that sense, I'm not terribly worried about contagion.

In the sense that what's going on with Greece's and Portugal's and Italy's sovereign debt, might heighten awareness of these parlous financial situation that the U.S. government is in, that is a bit of a worry, as it could force the day of reckoning for the U.S. deficit to move forward a bit. And so that's something I think to keep in mind, and I'll kind of return to that a little bit later in this video.

Second thing that I'm worried about a little bit and kind of keeping an eye on is margin sustainability. So far, for U.S. corporate earnings, profit margins have held up pretty darn well. There has been a lot of cost-cutting. We've talked before about companies saying that they've done three years of restructuring in three months during the Great Recession. And so far companies have not had to add a ton of cost back, even as revenues have increased. So, the question is simply how long they can keep going?

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It seems like from the evidence we have so far that we've got another few quarters to go, and we could get some meaningful – these positive margins being sustained for a little bit while longer, but it's a pretty tough thing to get your arms around. And so, that's something I think to keep a very close eye on in the upcoming earning season as to the degree to which companies have been able to keep their cost structures down, even as revenues have come back up or whether they need to add cost back in, just to meet renewed demand for their products.

Third on the list I would say is credit demand, especially here in the U.S. people talk a lot about the supply of credit, kind of berating bankers for not lending enough, when the real issue, as I've highlighted before, is that demand for credit in the U.S. is simply down, as both consumers and businesses deleverage or pay down debt.

And so, really it's tough to have a very robust economic expansion without the expansion of credit, and so that's something to keep an eye on, because it sort of constrains spending, both on the consumer and the business side of things.

So, paying down debt is certainly a good thing in the long run, but the paradox of thrift is that in the short run, it means you're spending a bit less. And we've had a nice rebound so far on a snap-back from the very depressed levels of our early 2009, late 2008. But watching the credit demand I think is pretty critical. You can use the Fed Senior Loan Officer Survey that comes out monthly for this.

And again, moving a little bit further out on the time frame, in the big inflation-deflation debate, consensus seems to be that we're going to have some risks of deflation in the near term and then inflation will definitely rear its ugly head at some point. Of course, the full question being at what point, because as I pointed out before, the Fed hasn't so much printed money as it has created reserves.

So much of the excess liquidity that's been created is pretty much just sitting on bank balance sheets or held in reserves at the Fed. Not a lot of it is being lent out into the economy, creating the monetary velocity that really causes inflation to rear its ugly head. And there is still a fair amount of manufacturing slack in the economy as well with unemployment at 9.5%. There is not a lot of our cost push from workers, pushing wages up. So we did see a little bit of wage growth recently--still not a very big issue.

So again, this is something that's probably not an immediate issue, but the risk of inflation is that it is so pernicious when it gets embedded in the system, as is deflation, that they are big enough things to worry about that you want to keep a close eye for signs of a sustained uptick in inflation.

And then finally, pushing things out even further but a very, very big issue of course is the U.S. deficit. 99% of the political rhetoric in Washington surrounds discretionary spending, Medicare waste, Bridges to Nowhere in Alaska, things like this, which comprise virtually none of the actual spending of the government. Very small percentage of the budget is discretionary, about three-quarters of the U.S. budget is spent on defense, Medicare, Medicaid, social security and other entitlements.

And I don't know about you, but I have not heard a lot of discussion coming out of Washington about meaningfully reforming any of those entitlements, which really are the only way to make a long-term dent in the spending patterns of the U.S. government that are getting us into the mess that we've gotten in so far.

So, that's a bit of a worry to be honest, because credit is based on the full faith that you'll actually repay it at some point in time; right, the full faith and credit of the U.S. government.

Now that faith word is pretty critical, and the question is at what point does the bond market basically lose faith in the ability or desire of U.S. policymakers to make a meaningful dent in our spending patterns. And the way to make that meaningful dent again is not on the discretionary side, it's on the entitlement side, which frankly does not seem to be a much of a topic for discussion in Washington right now.

I don't think we actually need to necessarily overhaul Social Security tomorrow, or the bond market is going to blow up, but the point is that you need to at least see meaningful discussions moving in that direction to give the bond market the confidence that we can deal with these problems in time and that U.S. bondholders or Treasury holders will get their money back, which is of course, what they want.

So that is a pretty far-out issue, I don't think it's an immediate one. But it's one to think about because as we saw with Greece, the faith of the credit markets is no problem until it's a problem. And since you don't know when it's going to be a problem, it's not a bad idea to head it off at the pass.

I am Pat Dorsey and thanks for watching.