November 14, 2011

Nothing to Fear Except Fear Itself... and the Politicians

Arnold & Porter Advisory

By Jason Thomas, Ph.D., CFA

As the Great Recession has given way to the Great Uncertainty, the light at the end of the tunnel has dimmed. The global economy continues to suffer from too much debt and not enough growth, with very little to give investors confidence. At the time of this writing, the inability of the European leaders to respond effectively to the financial crisis is at the top of the list of worries. Once the acute crisis is resolved, we expect that to be replaced with yet another concern.

What's an investor to do? Our analysis and expectations do not support the fear that we read about in the headlines every day, so we categorized our thoughts into "three things that should not keep you awake at night" and "three things that should."


The U.S. "losing" the economic game to the rest of the world. As laborers, we Americans are competing with workers in other countries for jobs. But as business people, we are selling American goods to them and collaborating with them in joint ventures. Even more importantly, as consumers we are benefitting from foreign companies creating better products and driving costs down. Thinking of this dynamic as a zero-sum game overlooks the benefits to business innovation and consumers, even if it comes from foreign firms and workers.

Periods of economic stagnation, commonly associated with Japan's economy in the 1990s, are much more common than is generally thought. Defining stagnation as an extended period of sub-par growth in GDP per capita, a recent study looked at more than 100 years of history and found 93 episodes, worldwide, that fit this description. Stagnations tend to be characterized not just by sluggish growth but also by high and sticky unemployment and lower inflation. The important point is that adjustments by businesses and consumers during these periods create the conditions needed for recovery, causing the stagnation to eventually end.

Inflation/higher interest rates. It is very telling that many of us are simultaneously concerned about a deflationary spiral and the next runaway inflation, two fears that the media eagerly stokes. What has been lost in these conversations is common sense. Inflation is not determined by random forces outside of the economy, but rather is largely determined by the supply of money being spent relative to other goods. Though the Federal Reserve has increased the supply of money, banks are reluctant to lend, and consumers and businesses are reluctant to spend. And with tremendous spare labor and production capacity in the global economy, the pricing power of providers of goods and services is limited.

Municipal bond risk. It is difficult to make sweeping generalizations about the "municipal" bond market – there are more than 80,000 issuers with bonds guaranteed by state and local governments and individual project revenue. But we believe that media coverage has been a little one-sided. While issuers have faced revenue difficulties, states and municipalities are taking extreme measures to cut expenditures and are committed to servicing existing debt. Underfunded pension liabilities, while a serious long-term issue, do not create a near-term cash flow crisis. Moreover, we're seeing states and municipalities using the crisis atmosphere to finally make some important changes to their pension, healthcare and other obligations that should, over time, put them on better financial footing.


Disruption in the global financial system. One of the most important elements in any financial system is confidence. The events of the past two years and perceptions about the government response around the world have, understandably, shaken confidence. The impact of new regulations and policies remains to be seen and the most fundamental dangers (under-capitalized banks, shadow banking system, under-regulated derivatives markets) have not been aggressively addressed.

Depletion of natural resources. Demographers expect the world population to peak in 2050 at 10 billion people, just after a period of rapid economic growth in the most populous countries. There is a lot we do not know about the limits of agricultural productivity and resource extraction and depletion. We expect economic forces to bring resource use and exploration into alignment over the long run, but if resource depletion happens quickly or governments introduce distortions (e.g., U.S. ethanol policy), the impact on the global economy could be profound.

Failings in global political institutions. We believe that the global economy is positioned to experience significant economic growth in the coming decade, as huge populations in emerging economies migrate to cities, plug into the global economy and become more productive very quickly. The expanded markets for goods and services will provide attractive opportunities for both companies both local and global. But there will be winners and losers in this transition, and entrenched interests and political shortsightedness present formidable challenges to the achievement of this potential. The current crisis in Europe is best understood as a failing of politics rather than of economics.


As investors, we must derive wisdom from past experience, balancing opportunity against risk. The world has faced incredible financial stress and social upheaval in the past, but the human drive and capacity for adaptation and innovation is resilient. We believe the global economy will return to health and the markets will begin providing attractive returns prior to that.

The key challenge as investors is to find a way to participate in profitable economic growth (through, for example, public equity markets) while mitigating the extreme downside risk. The good news is that exposure to growth (e.g., in emerging markets equities) and risk management (e.g., through direct holding of commodities) has never been less expensive or more liquid.

These comments are not meant to be exhaustive or to offer a final word on these enormously complicated issues. Instead, they are intended to provide some insight into the unconventional thinking of the Aspiriant investment research team.

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Dr. Thomas is Chief Investment Officer of Aspiriant, a leading independent wealth management firm, with eight offices across the United States and assets under advisement of more than $7.5 billion. Dr. Thomas was previously associated with Wilshire Associates, Goldman Sachs and the Federal Reserve Bank of San Francisco. A Chartered Financial Analyst, Dr. Thomas earned Ph.D., M.A. and B.A. degrees in Economics from the University of Southern California and an MBA from the Stanford University Graduate School of Business.

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