Summit view july 2010


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Summit view july 2010

  1. 1. “Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly and applying the wrong remedies.” Groucho Marx How about General Stanley McChrystal? Flying from the opposite side of the planet to be firedby the president certainly cannot be easy on the ego. McChrystals visit to the White Houselasted around thirty five minutes or so. A life in the armed forces comes to a close in a brieffiring from the Commander in Chief. Nothing like going out with a bang is there?What is most interesting in the story is not so much that a man was fired for insubordination. Ofmost interest is a quote from Politico suggesting the writer of the Rolling Stone article, MichaelHastings, was able to write the piece because, as a freelance journalist and not a beat reporter,"burning bridges by publishing many of McChrystals remarks" was not a worry to him. FrankRich, in the New York Times on June 27, 2010 said, "Politico had the big picture right. Its theHastings-esque outsiders with no fear of burning bridges who have often uncovered the epochalstories missed by those with high-level access."Wow! How does one feel? Again, SummitVIEW is reminded that what one often reads or hearsin the news just may not be the full picture. Why would anyone want to report the ugly truthwhen spin is so easily digested by the American populace? What else is not being reported forfear of burning bridges? Where is Clark Kent when you need him? SummitVIEW is beginningto understand the motivations for the creation of Superman in 1939. See Rosenberg’s quotebelow where he compares today to the 1930s.Another news item of interest is the announcement of a trade agreement between Taiwan andChina. For two entities embroiled in a dispute over sovereignty for the last 60 plus years, thesigning of the agreement represents a form of detente. Bloomberg reports in the trade agreementbetween the sovereignties China will also open markets in 11 service sectors such as banking,securities, insurance, hospitals and accounting, while Taiwan agreed to offer wider access inseven areas, including banking and movies, the two sides said. They also signed an agreement onintellectual property rights protection." The agreement appears to reflect the thoughts ofMohamed El-Erian, Chief Executive Officer of PIMCO. El-Erian stated in an articletitled Driving Without a Spare, that the new normal is a world of "changing risks andopportunities." For this global economic transition period, investment with the safest carry willbe "in sovereigns that, due to their economic and financial fundamentals, are truly core countriesin the midst of the global paradigm shift."As readers of prior SummitVIEWs know, a primary concern is the current level of risk in thesystem or, rather, the financial markets. Relying on your local newspaper or news program toprovide the proper insight likely will engender confusion and a belief in false realities. If one
  2. 2. were to follow the national media attention on the imminent threat of inflation, the result wouldbe a belief that the US is doomed to experience inflation very soon. Reality is likely to be quitedifferent. Recent housing data points to the continued decline in real estate prices. Althoughthere does exist pricing power in some industries, with a pillar of economy, real estate, stillexperiencing declining values, the likelihood of inflation rearing its ugly head is very low. Wageincreases? Not happening. Unemployment rate declining? Nope.The data point most telling to SummitVIEW is that which is cited by David Rosenberg below, inthe quote titled The Bottom Line. Rosenberg says “[t]he world is awash with $222.5 trillion oftotal liabilities across public and private sector claims, or the equivalent of 362% of global GDP.Extinguishing this debt will be deflationary even as central banks will be forced to print moneyas an antidote and we are really in the early stages of this deleveraging cycle.”Think about the ratio cited above for a moment. On a global scale there exists over 4 times (andrapidly approaching 5 times) the level of debt as the level of annual global production. As we allknow most of that debt is held in the developed world. Without extend and pretend accountingstandards in the banking and mortgage industries, where would equity values be today? Asleading economic indicators roll over in the United States, few choices are available that havenot already been deployed. How do equity values hold up when the economic engine is slowingand leverage is excessive. As an investor one should seek high earnings yield companies (that islow price to earnings) with little to no leverage, if you have to be in stocks that is. Otherwise,holding cash, high quality debt, and sovereigns of those countries that are recipients of the neweconomic paradigm likely will prove prudent.Protecting one’s wealth in this epochal transition is of primary importance. Long term assetperformance averages are irrelevant when risk is defined as the probability of the permanent lossof capital. In an environment where most underfunded pension funds are holding out for thereturn of an equity bull market, the underfunded state of pensions is likely to get worse thanbetter in the near term. Ironically, Rosenberg just released his view of current financial marketactivity. The closing paragraph in Dinner with Dave, June 30, 2010 dovetails withSummitVIEW nicely: Resolving the pension crisis in the U.S. though [sic] a longer work‐life and  higher contribution rates is surely going to mean that deflation, not inflation,  as it pertains to many discretionary segments of the consumer spending pie, is  going to be the primary trend for some period of time; likely five years or more.   In other words, the time to be worried about inflation is really beyond our  forecasting horizon.
  3. 3. 2010 is likely to go down in history as a seminal year. The confluence of events shapinggeopolitics and geo-economics are starting to make their mark. Although the events will be thefocus of headlines, the response to the events is how our time will be defined. SummitVIEWholds to the belief that, although the transition to a new period of growth will be rife with strifeand stress, a new period of prosperity will emerge on a scale few can forecast.Getting through a stormy sea of debt and traction-less economic growth requires proactive riskassessment and management. As James Montier of GMO LLC says, as quoted below, “[h]avingdefined the target, managers should be given as much discretion as possible to deliver that realreturn. This avoids the benchmark-hugging behavior that is typically induced by policyportfolios.”Francois Trahan, Vice Chairman and Chief Investment Strategist at Wolfe Trahan & Co., expectsthe forthcoming period of deflation to be reflected in the equity markets with lower price toearnings multiples. In research titled Time to Throw Out Your Textbooks, Trahan states, “the factis that the majority of empirical data show that lower interest rates are consistent with lower P/Emultiples for the market.” Echoing SummitVIEW’s sentiment that our time will be defined bythe responses to current economic circumstances, Trahan goes on to say, “[w]e hope policymakers will be somewhat proactive and the market wont have to once again force the "invisiblehand".In closing I turn to the words of Woody Brock: To sum up, what we are experiencing is not an event‐driven turning point as  in 1990, but rather a conceptual revolution in which much received wisdom  about the role of the state and economic prospects for the future is being stood  on its head.  On both sides of the Atlantic, there is a sense that the Social  Contract has been broken, and that government is the true culprit.  What a  change from a year ago when bankers were deemed the sole villains!  The  historian Simon Schama detects the beginnings of the Age of Rage, and he is  probably right.  The stakes are very high, and the political and economic  consequences will be severe.1 Recent market volatility is a reminder to all investors to fasten seat belts. The wild ride is justleaving the station.1Brock, H. Wood, Profile May 2010, Is the “Age of Rage” at Hand? ‐ Sovereign Debt, the European Crisis, and the Euro, Strategic Economic Decisions, Inc. 
  4. 4. Driving Without a SpareOver the next few years, Australia and Canada will constitute the analytical battle-ground aselements of the new normal come head-to-head with those of the old normal. Our sense is thatthe two countries’ exposure to the dynamic components of global growth - through direct tradelinks with Asia and the commodity angel - will likely outweigh the drag from the legacy ofhousehold leverage (Australia) and the economic links to the U.S. ( Canada).For investors, this translates into a secular period of changing risks and opportunities:  The distribution of global outcomes is going through a transformation, both in terms of overall shape (flatter) and tails (fatter);  It is a world where several of the old simplifying adages that once brought comfort to investors - such as industrial country governments constitute interest rate risk while emerging economies involve credit risk - require considerable refinement;  It is a world that calls for a broader investment universe and guidelines and , for those who use them, revamped benchmarks that better capture the world of today and tomorrow rather than that of yesterday;  It is a world of significant country, regional and instrument differentiation when it comes to harvesting equity and credit premiums in high-quality corporates, financials and emerging markets;  It is a world where the currencies of the emerging (as opposed to submerging) economies will continue to warrant a greater allocation over time; and  It is a world where the safest of carry will come from duration and curve in sovereigns that, due to their economic and financial fundamentals, are truly core countries in the midst of the global paradigm shift. Mohamed El-Erian, PIMCO, Driving Without a Spare, Secular Outlook, , May 2010 I Want to Break Free, or, Strategic Asset Allocation ≠ Static Asset AllocationClients should liaise with their managers to set a “realistic” real return target (recognizing thatavailable returns are a function of the opportunity set, not a function of the needs of the fund).After all, the aim of investing must surely be “maximum real returns after tax” as Sir JohnTempleton observed long ago. None but a few very lucky fund managers get to retire on relativeperformance.Having defined the target, managers should be given as much discretion as possible to deliverthat real return. This avoids the benchmark-hugging behavior that is typically induced by policyportfolios.
  5. 5. Of course, it creates problems for measurement. Indeed, as I mentioned at the beginning of thispaper, the most common response when I present these arguments is, “So, how should wemeasure you?” This obsession with performance measurement at the expense of investmentsense is disturbing to me. There is no easy mark to judge fund managers against. This mayactually be a good thing. It may force investors to allocate capital on the basis of process: i.e.,you will only let managers that you trust and understand run your money. [emphasis added] James Montier, GMO LLC May 2010, I Want to Break Free, or, Strategic Asset Allocation ≠ Static Asset AllocationThe Bottom LineThe bottom line is that all levels of society, and across most countries in the industrialized world, have far too much debt and far too much debt‐servicing costs in relation to income. The world is awash with $222.5 trillion of total liabilities across public and private sector claims, or the equivalent of 362% of global GDP. Extinguishing this debt will be deflationary even as central banks will be forced to print money as an antidote and we are really in the early stages of this deleveraging cycle.   David A. Rosenberg, Breakfast with Dave, Gluskin Sheff & Co., June 22, 2010  DARING TO COMPARE TODAY TO THE 30’SComing off a crash (‘29) and rebound (‘30); aftermath of an asset deflation and credit collapsebanks fail (Bank of New York back then, Lehman this time around); natural disaster (dust bowlthen, oil spill now); global policy discord (with the U.K. then, with Germany now); geopoliticalthreats; interventionist governments; ultra low interest rates (long bond yield finished the 1930sbelow 2%); chronic unemployment (25% then, 17% now); deflation pressures; competitivedevaluations; gold bull market (doubled in Sterling terms in the 30s); debt defaults; sputteringrecoveries and rallies; onset of consumer frugality. David A. Rosenberg, Breakfast with Dave, Gluskin Sheff & Co., June 24, 2010 How The Middle Class, Or The New Rentiers, Is Stuck BetweenDeflation And HyperinflationThe world is currently overwhelmed with debt, but underwhelmed with growth. Everyone is trying to export, but no country has embraced the concept of expanding domestic consumption.  Although I personally like consumption, I am an American and therefore over‐borrowed and unable to service the debt loads of my city, my state, and my country, not to mention my own personal debt load.  With the Americans no longer available as consumer of the last resort, and no one else stepping up, global final sales will stagnate in the years ahead. As a result, global debt loads will become relatively larger.  If the world economic pie can not grow strongly, thereby lessening the relative size of global debts, the magic of compound interest will certainly bankrupt many governments and commercial entities.  Currently there is a growing solvency crisis impacting many Eurozone sovereigns and another one that is  occurring within many states and jurisdictions in the United States.  It seems quite obvious that many of these problems will lead to default and the loss of principal on a grand scale. In the next few years, a greatly increased percentage of all outstanding investment grade global debt will default. 
  6. 6. In 2010, the authorities seem to have only two choices: allow defaults, which lead to deflation and tremendous stress to the political system and public order; or inflate so that debts lose their significance, which eventually leads to hyper‐inflation and tremendous stress to the political system and public order.  Growth is a theoretical way out of this dilemma, but with shrinking populations and increased regulation, Europe cannot manage this option.  The US might, but the way will be difficult.  Cascading defaults will strip away many entitlements upsetting the rentiers [the debt owners, or, rather, the beneficiaries of the coupon payments] and those who had planned to become rentiers in the future.  Countries that choose to allow defaults will see their currencies rally as there will be a shrinkage of currency outstanding increasing the value of the rest, but collapsing equity markets will test their resolve at every turn. We rentiers will be lucky if we can enjoy our dotage. John R. Taylor, Jr., Chief Investment Officer, FX Concepts, June 24, 2010For a glimpse of changed societal mores, this headline speaks volumes.....How Many Graduates Does It Take to Be No. 1?Principals say that recognizing multiple valedictorians reduces pressure and competitionamong students, and is a more equitable way to honor achievement, particularly when No. 1and No. 5 may be separated by only the smallest fraction of a grade from sophomorescience. But some scholars and parents have criticized the swelling valedictorian ranks asyet another symptom of rampant grade inflation, with teachers reluctant to jeopardize thebest and brightest’s chances of admission to top-tier colleges. Winnie Hu, New York Times, June 26, 2010