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A River Runs Through It

In the 1980’s I had the luxury of enjoying a few years in northwest Montana before it became a playground for the rich and famous.  Way back then Montana was the near equivalent of Alaska in the lower 48. Huge tracts of uninterrupted pristine wilderness were dotted with small communities resembling outposts more than cities or towns. Long winters and high mountains provided plentiful snowpack for skiers and back country travelers. Quiet beauty, abundant wildlife and solitude awaited the hearty explorer of this winter wonderland.

Spring arrives late in the high country of Montana . The season brings welcome relief from frigid conditions and loosens winter’s grip on mountain snows. Higher temperatures and the forces of gravity bring down from the craggy peaks a racing torrent of snow melt clouded with silt but rich in nutrients. By late June runoff slows and rushing dark waters are transformed to icy clear rivers and creeks revealing hungry trout anxious to dine on nature’s bounty of nymphs and assorted insect hatches. From July through the colder days of fall a moderately skilled and patient man can tempt Rainbows and Cutthroats with hand tied flies that mimick nature’s finest delicacies. On many a warm sunny day the only competition for the river’s grand prize might be a lumbering grizzly gracefully snaring lunch with long curved claws and a marksman’s precision.   

There is so much to love about this beautiful country of ours.

But as the old timers like to say in Big Sky Country, you can’t eat the scenery. Family obligations outweighed the delight of knocking around the mountains in search of adventure. By 1990 a different call of the wild had me trade the tranquility of “The Last Best Place” for the adventure of the fixed income markets and New York . 

More than a small pang of nostalgia struck in 1992 when I first viewed the academy award winning film, “A River Runs Through It”.  Norman Maclean’s 1976 novel turned movie about a prohibition era Presbyterian Minister and his two sons depicts a Missoula family bound together by faith in God and the lure of fly fishing on the Big Blackfoot River . With the stunning backdrop of beautiful water, mountains and expert fisherman bagging fat Rainbows it is no wonder the film won an Oscar for Best Cinematography. Tom Skerritt played the minister and father to two vastly different sons. Brad Pitt’s character Paul defies his conservative upbringing to become a gambling, hard drinking reporter for a Missoula newspaper while his brother Norman (Craig Sheffer) is employed as an English professor in Chicago . Norman is considerably more conservative by nature.

Upon returning to Missoula on sabbatical Norman falls for the lovely and precocious Jessie Burns (Emily Lloyd) who takes him for a joy ride. Sensing Norman’s unadventurous temperament and looking to test his constitution, Jessie jumps the rail road tracks in her model T with Norman riding shotgun. Jessie’s car rumbles on the tracks of a long high bridge and subsequently enters a lengthy, pitch black tunnel. There is no escape, no light and no way of predicting what the outcome will be. Jessie’s unknowable risk becomes Norman ’s deadly peril.

America Hurtles Toward the Unknowable Risk

No matter your politics it is hard to deny that the game of chicken taking place in Washington is threatening to send America into a dark and dangerous place that holds unknowable risk. While still in the shadows of a festering financial crisis we wittingly engage in a warped form of representative government that somehow manages to justify potential ruin for gains on the ideological battleground.

No matter your politics it is hard to deny that the game of chicken taking place in Washington is threatening to send America into a dark and dangerous place that holds unknowable risk. While still in the shadows of a festering financial crisis we wittingly engage in a warped form of representative government that somehow manages to justify potential ruin for gains on the ideological battleground.

Those who deny the potential for financial disaster imbedded in the debt ceiling debacle have little understanding of global markets. Intransigent ideologues short circuit democracy’s mechanisms for compromise and threaten the social fabric of America . The venue to settle a dispute over fiscal policy, no matter how valid, is certainly not this one. No safeguard exists to prevent disaster here because the founding fathers and those who followed could not have anticipated how a routine process might be manipulated in politically cunning fashion to produce potential national catastrophe. Politicians on both sides of the isle have painted themselves into opposing corners jeopardizing compromise with an unfathomable risk hanging in the balance.

Those who deny the potential for financial disaster imbedded in the debt ceiling debacle have little understanding of global markets. Intransigent ideologues short circuit democracy’s mechanisms for compromise and threaten the social fabric of America . The venue to settle a dispute over fiscal policy, no matter how valid, is certainly not this one. No safeguard exists to prevent disaster here because the founding fathers and those who followed could not have anticipated how a routine process might be manipulated in politically cunning fashion to produce potential national catastrophe. Politicians on both sides of the isle have painted themselves into opposing corners jeopardizing compromise with an unfathomable risk hanging in the balance. In 2008 the wizards of Wall Street showed us how little the really knew about risk contagion in the global markets. I have even less respect for members of congress and their abilities in this regard.

Adams, Jefferson, Madison and Lincoln

The book most recently occupying my night stand has been “American Sphinx, The Character of Thomas Jefferson” by the Pulitzer Prize winner Joseph Ellis. Mr. Ellis also penned another best selling favorite of mine, “Founding Brothers, The Revolutionary Generation” I must wonder who among our current leaders has read either?

The book most recently occupying my night stand has been “American Sphinx, The Character of Thomas Jefferson” by the Pulitzer Prize winner Joseph Ellis. Mr. Ellis also penned another best selling favorite of mine, “Founding Brothers, The Revolutionary Generation” I must wonder who among our current leaders has read either?

Mr. Ellis writes that Jefferson did not believe as Ronald Reagan put it that, “it is always morning in America .” Instead Jefferson was pessimistic about the long term viability of the nation he helped create. Jefferson shared with his fellow founders “the realistic realization that all nations, including the United States , had limited life spans.” In 1829 James Madison predicted the republic would last another century, right in line with the start of the Great Depression. John Adams “oscillated between apocalyptic warnings that the end was close and a more sanguine projection ranging up to 150 years.” Jefferson shared with other members of the revolutionary generation the belief that all rising nations must eventually fall”, wrote Ellis.

Another conviction shared by many of the founding brothers as relayed by Ellis was a deep mistrust of political parties. Few despised party politics more (or played them more skillfully) than Jefferson . For many of the founders, parties and factions (in their day, one in the same) are representative of organized minorities whose very purpose is to undercut the public will, often through deception.

A last quote from Abe Lincoln rings loud and true. “ America will never be destroyed from the outside. If we falter and lose our freedoms it will be because we destroyed ourselves.”

It is not our contention that the current episode in governmental malpractice will spell the end our America . We are more optimistic than the founders might be in a similar situation. But we must acknowledge the unnecessary risks being hoist upon America and its citizens.   

America is saddled with a malfunctioning political process driven by extreme factions that have nullified the middle ground of moderation. Let us all hope that our friends in Washington realize what is truly at stake and jump off the tracks before heading into that dark tunnel. The financial system and the global economy are in no condition to withstand another self inflicted wound of this grand magnitude.

The Domestic Economy

The June Employment Report was a nightmare. The economy created just 18,000 new jobs while the unemployment rate bounced up to 9.2%. Newly unemployed, those filing less than 5 weeks prior, rose by 412,000.  44.4% of all who are unemployed or 6.3 million of our countrymen have been out of work for 27 weeks or longer. The 99’ers, those surviving on extended benefits are rolling off the dole. No real numbers are available for them as official figures are not tallied. They will disappear into the abyss of government miscalculation. The average work week declined as did average hourly earnings. Since March the number of unemployed Americans has risen by 545,000. New filings for unemployment benefits have been above 400,000 per week since April 1, 2011. Without jobs consumption cannot rebound and tax receipts will continue to flag. When measured by totaling income rather than spending the economy is no bigger than it was in 2006.

The June Employment Report was a nightmare. The economy created just 18,000 new jobs while the unemployment rate bounced up to 9.2%. Newly unemployed, those filing less than 5 weeks prior, rose by 412,000.  44.4% of all who are unemployed or 6.3 million of our countrymen have been out of work for 27 weeks or longer. The 99’ers, those surviving on extended benefits are rolling off the dole. No real numbers are available for them as official figures are not tallied. They will disappear into the abyss of government miscalculation. The average work week declined as did average hourly earnings. Since March the number of unemployed Americans has risen by 545,000. New filings for unemployment benefits have been above 400,000 per week since April 1, 2011. Without jobs consumption cannot rebound and tax receipts will continue to flag. When measured by totaling income rather than spending the economy is no bigger than it was in 2006.

The housing market is weak with prices sagging throughout most of the nation. Many millions of homeowners in America remain upside down with mortgage debt surpassing equity. Financial institutions are sitting on an untold number of properties facing foreclosure soon to be dumped on the market putting greater downward pressure on prices. Sales are sluggish despite historically attractive affordability (lower prices and low borrowing costs). In the truest form of asset deflation potential buyers forego today’s deal waiting for even lower prices in the future.

Amid the powerful headwinds of disappointing jobs growth and a struggling housing market America must continue deleveraging, using precious income to pay past debts and carrying costs. This deleveraging is slowing consumption and economic growth. McKinsey Global Institute reports that deleveraging has just begun and could continue for up to six to seven years. America entered the financial crisis with very high household and government debt. Americans are making head way, household debt has decreased from 127% of disposable income at the peak to just over 110% today. The collapse of the private economy, the private to public debt hand off and the subsequent fiscal stimulus aimed at jumpstarting growth have contributed to massive public sector debt. This part of the deleveraging process has yet to begin. Our politicians are playing poker. Democrats refuse to put forward serious spending reforms thus far and Republicans ignore the simple math of the necessity for higher revenue. This brinksmanship makes for great reality TV but is awful and arrogant government for the world’s largest debtor borrowing billions each day just to keep the lights on. 

The current lull in economic activity is particularly worrisome as it coincides with a reduction in stimulus and a move toward austerity in government spending. Contributing to the belief that there is no free lunch a recent IMF study of 173 fiscal policy adjustments in rich countries between 1978 and 2009 found that cutting a nations budget deficit by 1% of GDP typically reduces economic output by 2/3 of a percent while increasing unemployment by 1/3 of a percent.

The Fed Chairman Ackowledges Weakness

Chairman Bernanke told congress that the Fed stands ready to provide additional stimulus including the printing of dollars to buy government bonds if the economy appears to be stalling. “The possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge.”

Chairman Bernanke told congress that the Fed stands ready to provide additional stimulus including the printing of dollars to buy government bonds if the economy appears to be stalling. “The possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge.”

Talk of more stimuli and a failure to address budget gaps has weakened the dollar and pushed gold to record prices passing $1600.00 an ounce. The precious metal has doubled in price since December of 2008.  Speculation in the commodities markets runs rampant but so does legitimate fear of the debasement of fiat currency.

In some important ways the Fed and America are boxed in a corner. Austerity and a lack of stimulus will breed slower growth. Interest rates are at or near zero and any alternative measures such as QE3 are unlikely as political resistance remains high. While it is impossible to determine what might have happened regarding employment without the successive rounds of quantitative easing it is clear that this alternative monetary stimulus has not been effective in adding new jobs. Massive doses of liquidity can do little to relieve the structural imbalances resulting from the Techno-Global Revolution. Most troubling to us here at ICM is the knee jerk connection between quantitative easing and rising stock and other risk asset prices. This reeks of bubbling asset inflation. Only the grey-hairs among us recall the ravages of 1970’s style stagflation where economies face higher costs, higher interest rates and contraction.

Europe is a Mess

On July 12th Ireland joined Portugal and Greece as the third Euro area nation to receive a junk rating from Moodys for its sovereign debt. Ireland would now pay nearly 14% to borrow in the open market, if it can borrow at all. And the crisis threatens to move beyond the smaller periphery nations to Italy.

On July 12th Ireland joined Portugal and Greece as the third Euro area nation to receive a junk rating from Moodys for its sovereign debt. Ireland would now pay nearly 14% to borrow in the open market, if it can borrow at all. And the crisis threatens to move beyond the smaller periphery nations to Italy.

Italy is the Euro-zone’s third largest economy and has the largest debt. Italy has $1.2 Trillion in debt outstanding, 120% of its economic output and three times as much debt as Greece, Portugal and Ireland combined. While Italy is in far better financial shape than the other three it is often a slippery slope from illiquidity to insolvency. Should borrowing costs exceed 7% Italy’s situation could soon spiral out of control.

The European Union has a potential contagion problem similar to the Lehman crisis in nature but dwarfing it in size. The answer is complex and centered mostly with Germany. Surely some investors will take losses on Greek bonds, most thoughtful guesses range around 30%. Some European banks will need more capital. That will not come cheap given today’s lack of clear leadership and lost confidence. Germany will need to participate but wants to avoid an open ended promise to bail out the profligate periphery nations for fear of encouraging further moral hazard. Germany fears that if it guarantees the debts of its dodgy neighbors its own borrowing costs may rise. Stay tuned as this situation is fluid and moves fast.

A Quick Note on Asia

China appears to be headed for a soft landing engineered through higher bank reserves and borrowing costs. Growth has come in at a stable 9+%, a tad slower and welcome to be so. The rest of Asia entered the financial crisis sitting on budget surpluses and foreign reserves. Asia appears fairly well cushioned against the global fits and starts of the developed countries. Its consumers are showing robust growth in buying power to offset some of the drop off from traditional customers from the west.

The Continuing Saga and Forgotten Lessons

“So long as there are institutions so powerful and considered so important that they require special support and different rules, the future of capitalism is at risk and our market economy is in peril. To more fundamentally address this issue we must go beyond today’s Dodd-Frank.” These are the words of the President and CEO of the Federal Reserve Bank of Kansas City, Thomas Hoenig, voiced at a June conference on the current state of the banking system. As time passes it allows the political system to break down on this important issue. For a public concerned about jobs and their homes the issue seems to be slipping from view. For the better heeled Americans the recovery in stock market value dulls the memory of a collapse that cost 8.7 million jobs and $6 trillion in household wealth. In June FDIC chairman Shelia Bair said “I see a lot of amnesia setting in now.” This amnesia allows bank lobbyists to do a convenient rewrite of history and to claim that regulations designed to prevent another melt down are actually hurting the economy. While former Federal Reserve Vice Chairman repudiated the opinions of his former mentor, one Alan Greenspan and abandoned his belief that bankers self-interest would keep markets safe, saying,” I placed too much confidence in the ability of the private market participants to police themselves.”

“So long as there are institutions so powerful and considered so important that they require special support and different rules, the future of capitalism is at risk and our market economy is in peril. To more fundamentally address this issue we must go beyond today’s Dodd-Frank.” These are the words of the President and CEO of the Federal Reserve Bank of Kansas City, Thomas Hoenig, voiced at a June conference on the current state of the banking system. As time passes it allows the political system to break down on this important issue. For a public concerned about jobs and their homes the issue seems to be slipping from view. For the better heeled Americans the recovery in stock market value dulls the memory of a collapse that cost 8.7 million jobs and $6 trillion in household wealth. In June FDIC chairman Shelia Bair said “I see a lot of amnesia setting in now.” This amnesia allows bank lobbyists to do a convenient rewrite of history and to claim that regulations designed to prevent another melt down are actually hurting the economy. While former Federal Reserve Vice Chairman repudiated the opinions of his former mentor, one Alan Greenspan and abandoned his belief that bankers self-interest would keep markets safe, saying,” I placed too much confidence in the ability of the private market participants to police themselves.”

But bankers and lobbyists are pouring time and money into the legislative process to water down and delay reforms working to convince an untrusting public that black is white and up is down. Bank of America took its third loss ($8.83 billion) in four quarters on a 54% decline in revenue, an $8 billion settlement with mortgage investors and mortgage loan write offs. Its consumer loans showed no growth and commercial loans showed a 7% decline compared to a year ago. But as the Fed broadcast its policy to depress short rates and promote a steep yield curve the bank managed to make money on 97% of its trading days.  What business are these guys in?

As bankers and lobbyist contort history and the regulatory process arguing that regulation chokes off jobs and lending there is scant evidence to support their cries. The need for additional capital reserves for the “too big to fail” among us aims to protect taxpayers against a repeat of the moral hazard of privatized gains and socialized losses. But with a rigged game where bankers win 97% of the time (as long as the dealer- the Fed- plays his cards face up) bankers know more reserves means less money on the card table, lower profits and bonuses.

The Great Repression

We hear the voices of investors asking, hoping that rates will begin to climb and that meager interest income will return to levels that allow for some offset to falling revenues and rising expenses.

We hear the voices of investors asking, hoping that rates will begin to climb and that meager interest income will return to levels that allow for some offset to falling revenues and rising expenses. One of the most damaging legacy costs left behind by the financial crisis is the public debt that will prove most stubbornly lasting. Solving this problem is complex and will take time. The June 18th edition of the Economist stated “Indebted governments face an unenviable menu of options. Growing their way out of trouble will prove difficult as economies deleverage. Austerity, a second and unappetizing choice can easily choke recovery. Defaults are seen as a last resort. Politicians are searching for an easier way.”

The Easier Way

After WWII many countries reduced debt without defaults or painful austerity through a combination of higher inflation and engineered monetary policy that forced savers and investors to take real inflation adjusted losses. Paying a lower rate of interest than the rate of inflation allowed borrowers (governments) to improve balance sheets at the expense of lenders and investors. This financial repression in which inflation adjusted rates was negative produced results in the decades following the war. A study done by the Peterson Institute for International Studies at the University of Maryland argues that “repression employed during the decade from 1945 through 1955 helped reduce America’s debt load from 116% of GDP to a very manageable 66%.” Since the depths of the financial crisis (2007) real rates have been below the rate of inflation about half the time.

After WWII many countries reduced debt without defaults or painful austerity through a combination of higher inflation and engineered monetary policy that forced savers and investors to take real inflation adjusted losses. Paying a lower rate of interest than the rate of inflation allowed borrowers (governments) to improve balance sheets at the expense of lenders and investors. This financial repression in which inflation adjusted rates was negative produced results in the decades following the war. A study done by the Peterson Institute for International Studies at the University of Maryland argues that “repression employed during the decade from 1945 through 1955 helped reduce America’s debt load from 116% of GDP to a very manageable 66%.” Since the depths of the financial crisis (2007) real rates have been below the rate of inflation about half the time.

While financial repression is not a panacea nor the only tool in the box it hints at what lies ahead in the fixed income markets if Fed policy can persist without setting off Euro style jumps in borrowing costs. This also assumes that America avoids financial default. By design rates will remain below inflation. Sovereign deleveraging has only just begun.

At ICM we hold out hope for an intelligent and appropriate solution to our nation’s debt ceiling issue. We hope that the political process heals itself before extreme factions pull apart the threads that bind our country in common sense and common interest. There is hard work to be done and few easy solutions.

Perhaps all Americans should take some time to visit the cathedrals of this great land and ruminate on the gifts we have been granted. Visit a museum, read a book in the park, take a walk in the desert, go to a ballgame or tease a rainbow with a hand tied fly and remember that at the heart of America a river runs through it.