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Black Stone Commentary 2010

Black Stone Commentary 2010

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Published by Douglas Funk

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Published by: Douglas Funk on Jul 20, 2010
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Blackstone is pleased to offer the following Market Commentary by Byron Wien which shares his thinkingon global economic developments, market insights and other factors that may influence investmentopportunities and strategies. Learn more about Byron.
The Smartest Man Thinks We Are Writing History
July 2010 
 I had heard from a mutual friend that The Smartest Man in Europe was feeling very bearish, so I waslooking forward to our meeting in late June to learn why. He assured me that he was not profoundlynegative currently, because he thought certain measures being taken in Europe and the United Stateswould provide some near-term opportunities, but in the longer term he didn’t see a clear way out of theenormous debt burden of the developed economies.This is the tenth annual essay I have written about the views of this investor who has impressed me over the past three decades with his ability to anticipate major trends before they were widely understood. Hesaw the end of communism in Russia and the rise of capitalism in China. He identified opportunities inthe developing world before most others and he recognized the growing shortage of commodities as aresult. A descendant of an international mercantile family whose roots go back to the operation of canteens selling food and weather protection along the Silk Road centuries ago, his career has beenspent successfully managing his own and other people’s money, collecting art (from Canaletto toKandinsky) and trying to understand the growing complexity of the world.“Since the end of the Second World War, Europe and the United States have beenaccumulating debt at every level and they finally have gone too far. It’s similar to the oilcompanies drilling deeper and deeper until something really bad happens. Both in thesovereign debt markets of Europe and in the marshes in the Gulf of Mexico, theauthorities are finding that the mess is proving very hard to clean up without enormouseffort, very high costs and personal pain for many participants.“Right now investors still have confidence in U.S. Treasuries. People with serious moneythroughout the world are afraid of what’s happening. The potential default of Greece,Spain and other countries, the lack of progress in the war in Afghanistan, the oil spill in theGulf, the Iranian nuclear threat, the possibility of a double dip taking the U.S. back intorecession and trade issues with China make everyone very uneasy. They want to puttheir money some place they consider “safe” and America is benefiting from this. Your balance sheet and income statement are in very bad shape, but you can borrow moneyfor ten years at 3.1%. Does that make sense? Only if huge amounts of capital arelooking for a place to hide and don’t care about yield. At present the U.S. is in a positionto bail out the banks and bail out the state and local governments when they run intotrouble, but this cannot go on forever. Eventually the U.S. will face its own financial crisisand who will be there to bail it out?“There are basically only two ways to solve this problem. Countries with high deficits likethe United Kingdom and the United States will have to cut their deficits sharply. Politicallythis will be very hard to do. The voters don’t want to give up what’s been given to them.Severe cuts in Medicare, Social Security and defense would have to be made to bring thedeficit down to reasonable levels and there is nobody in Congress powerful enough to getsomething like that through, and Obama lacks the political capital now to do it and I doubtif he ever had enough influence to accomplish a goal that ambitious.“The second approach is equally troublesome and that would be to allow inflation to rise.That would make it easier to pay down some of the debt. Workers would feel better as
 
they see their wages go up even though they might not gain much in purchasing power.House prices would start rising again. As long as inflation doesn’t get out of control andonly goes to 5% or 6%, some of the financial problems would be relieved. If inflationlooked like it was going too high, the government could always put wage and pricecontrols into effect.“My view is that some combination of the two approaches will take place. Thegovernments with high deficits will endure some austerity, but they will probably not getdown to the level where expenditures only exceed revenues by 3%. Taxes will be raisedbut that might have only limited utility. At a certain point, the United States may havetrouble selling its debt, so the Federal Reserve will have to buy it, expanding the moneysupply in a dramatic way once again. This could happen soon if Washington decides tobegin another wave of stimulus to deal with the unemployment problem. Even though theeconomy remains sluggish and there is no sign of overheating, inflation will start to rise. If growth exceeds 3% and jobs are being created, everyone will feel better for a while.“In Europe the financial rescue package will buy some time. Much of the sovereign debtof the weaker countries will have to be restructured, retirement ages will be raised andother benefits will be reduced. The people will grumble, but they will put up with it.Germany will tell the rest of Europe that it went through a period of sacrifice as a result of reunification and others should be prepared to suffer as well. Germany doesn’t want to beseen as the financially strong country, always there to help those who acted irresponsibly.In the end, however, Germany will step up and provide some help as long as othersappear to be making a sincere effort to improve their financial situation. The big risk issocial unrest. So far that has only appeared in a limited way. We’ll have to see whathappens when the austerity measures are actually put in place.“At this point we’re in a deflationary period. Consumers, except at the high end, are notspending and order books are thin, so capital spending is disappointing. The financialrescue package in Europe is a kind of anesthesia. We will have to see how those marketsreact when some of the sovereign debt is written down by 20%–30% and whether thebanks can take that kind of adjustment to their balance sheets. Europe hopes to cutspending but maintain growth. How do you do that? One way is to devalue the euro.German exports are already benefiting from the decline to 1.20. The next stop is 1.15 andeventually it will get to one to one. All of Europe will benefit from that. Every effort will bemade to keep the European Union together. So far they are treating a cancer withaspirin. We will see how they react to the stronger medicine and its side effects. Thesame can be said of Bernanke and Geithner. They haven’t really faced up to the gravityof the problem yet. They have talked about it, but they have not done enough.“Over in Italy the banks are using customer deposits to buy government bonds. TheEuropean Central Bank has also been a buyer of sovereign debt on the continent.Nobody is talking about the insurance companies, which may be in worse shape than thebanks. It’s summer now and people are starting to take it easy, but later in the year everyone will wake up and sovereign debt yields will be 400 basis points higher andgovernments will still have difficulty selling their bonds.“There was much excitement about the decision of the Chinese to unpeg the renminbi tothe dollar. To me it was a political measure before the G-20 meeting in Toronto and anon-event financially. Over the next three years the Chinese currency may appreciate15%. The change will be so gradual it will hardly be noticed. This is not enough of arevaluation to make Chinese goods less attractive or U.S. products more competitive.“There is an important difference between India and China. China had overheated withgrowth at 11.5% and money supply and bank lending were cut back to bring growth downto 8%–9%. India has similar growth but is better balanced. China’s growth is dependenton exports, but India has a vibrant internal economy. They don’t need to export as much.Inflation is a serious problem in India but if they can keep food prices from rising too much,the people will tolerate it. Both India and China need 6%–7% growth to function without
 
civil unrest and that is now happening in both places.”I asked the Smartest Man why the markets of India and China had suffered along with those of Europeand the United States when the economies of those countries continued to do well. He said,“Equity investors in the developing world don’t think their markets can perform if stockmarkets in the West are having trouble. Now, however, stocks everywhere could movehigher. There is plenty of cash around to invest in risk assets. The financial problems thatthe United States had in 2008 and Europe had this year have been solved temporarily,world growth is continuing and earnings are strong, so you see I am not bearish in theshort term. It is the long term I am worried about.“In the future we might have to create a new international reserve currency. It would be abasket with dollars representing 40%, the renminbi 20%–25%, gold 25% and the euro andthe yen the rest. It would require a new Bretton Woods conference to accomplish this andit will probably never happen because of political considerations, but if it did, we wouldfinally have a reserve currency in the world that would be stable because it is partiallybacked up by gold. The goal has to be to restore confidence in the world financial systemand this would do it. The pain would have to be pretty severe to get the relevant countriesto agree to it, however. In any case gold is going higher. Its time has come. I could see itrising to $1500.“We’ll probably know whether my assessment of the current situation is accurate in twoyears. You will know we are in for trouble when interest rates start to rise dramatically.Before that, however, the stock market will go higher, inflation will get to 5%–6% and the10-year U.S. Treasury yield will get to 7%. Earnings are nominal and they will beimpressive, so investors will be happy about that. Even though the Treasury yields willmore than double from present levels, real yields will remain low, so investors won’t gettoo bothered about that. It’s when real yields start rising that the problems will begin.“You may run into some difficulties earlier because of a tear in the fabric of society. If thestock market is moving higher and those working in Wall Street and other areas of financeare doing well, that could cause some unrest. Unemployment is likely to remain high andthe general public will say that the financial service regulatory reform legislation didn’t doenough to bring Wall Street into line. The breach between the rich and the poor will bewidening and the government must do more for the less advantaged. The Tea Party willargue that spending must be restrained, but populism will win out over the conservatives.I don’t see a double dip happening with the U.S. going back into recession.“Regarding the Gulf of Mexico we must realize that man is a Frankenstein to nature. Wemust accept accidents, even serious ones, as normal. A year from now the oil spill won’tbe forgotten, but it won’t be a headline item. British Petroleum won’t go bankrupt. Theywill meet their liabilities. The evolution of man makes us susceptible to greater accidents.When the first 747 went down people said that airplanes shouldn’t be that large. Now wehave the Airbus A380 and the Boeing Dreamliner.“Looking around the world, there are opportunities. The election in Brazil is key. If theLula look-a-like gets in, the economy will probably continue to do well. I am not investingin Japan. They have a huge debt problem and an aging population. It won’t be a disaster,but it is not interesting to me. I see potential profits in places few people would look at. Iam investing in real estate in Africa and, yes, in Baghdad and elsewhere in the MiddleEast.“We are at the point of no return. The developed world created problems for everyonefrom 1945 to 2007 and now we have to solve them. The United States cannot afford astrong military force, health care for all, an adequate retirement program and fullemployment. You don’t have the resources to maintain that. There will be a modestdecline in the standard of living, but life will go on. There is no limit to the humanimagination. There is always something to do. Apple has doubled this year. Solar energyis coming. The future will be led by the emerging markets. It is not the end of the world.

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