Change

Like it or not, profound change has come to our government and economy. More change may come in legislation on health care, the environment (“Cap and Trade”), and financial regulation - any one of which could have huge economic impact on its own. But even without those changes, growth in the size and influence of government from changes already enacted will likely have a negative impact on investment prospects. Moreover, this comes at a particularly challenging time as the world is de-leveraging.

Here are recent and projected (by OMB) federal deficits along with government size relative to the overall economy:

After WWII, the size of the federal government remained relatively constant at about 18% to 22% of the economy (it ranged from 18.2% to 20.9% of GDP from 2000-2008). This year, federal government spending is expected to be nearly 35% of GDP! And even under optimistic growth scenarios, federal government spending is projected to average 30% of the economy from 2009-2012. So 20% of the economy was the old standard for the government, 30% is the new. That’s significant.

A recent investment conference concluded with the question: “Zimbabwe or Japan?”, wondering if the US is headed toward hyper-inflation (Zimbabwe) or a long period of no growth (Japan). Perhaps a more realistic option may be … Sweden. In 1970, Sweden’s government was only 22% of its GDP and its GDP per capita was 5th in the world. Then they built their well known welfare state and its government ballooned to 30% of GDP by 1980. “Real growth fell from an average of 4.4% annually in the 1960s to 2.4% in the 1970s and remained low for the next two decades” (Forbes, 7/16/2009). Sweden is but one example. Government is the non-productive part of the economy, and its growth (beyond low levels) tends to choke economic growth.

Deficits must result in some combination of higher taxes, more government borrowing, or “monetization” (i.e., printing more money). Higher taxes tend to directly reduce growth, more government debt crowds out more productive investment, and monetization creates inflation. PIMCO’s Mohamed El-Erian believes low GDP growth for the US will be the “new normal” (http://www.pimco.com/LeftNav/Viewpoints/2009/Viewpoints+El+Erian+6-15-09+Business+as+Usual.htm). Given the prospect that government will be 30% of our economy for some time, we can’t disagree. As we wrote last time, higher inflation now looks more likely, but is not a given. On the other hand, while nothing is certain in economics, lower economic growth looks nearly unavoidable.

Given that, how should we position portfolios? Inflation is easier to deal with since some assets benefit from higher inflation (gold, commodities, inflation-protected bonds, real estate, and non-dollar denominated stocks and bonds). But low growth benefits nothing, leaving few options: hold more cash (with no yield), increase exposure to the non-US economy, increase exposure to market-neutral strategies, and utilize tactical asset allocation (i.e., “market timing”). We’ve done some of these recently, but we may do more.

Emotional, seat-of-the-pants market timing is almost always a value destroyer, and we’ve counseled against it for years. Disciplined, model-driven asset class shifts on the other hand, may potentially add a little value if employed in a measured way, and we’re actively researching that tool. We may never come up with anything good enough to employ, but the fact that we’re looking indicates how concerned we are about the likely effects of massive government expansion.

“It’s different this time” must always be subject to a high hurdle. Fully aware of that, we believe this seismic shift toward government and away from markets coupled with world-wide de-leveraging initiates a new era, one that must be met with a somewhat different investment response. That does not necessarily imply radical change, but it does mean likely changes in required savings rates, in return expectations, and perhaps changes at the margin in how we structure portfolios.