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Blackstone is pleased to offer the following Market Commentary by Byron Wien which shares his thinking

on global economic developments, market insights and other factors that may influence investment
opportunities 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 was
looking forward to our meeting in late June to learn why. He assured me that he was not profoundly
negative currently, because he thought certain measures being taken in Europe and the United States
would provide some near-term opportunities, but in the longer term he didn’t see a clear way out of the
enormous 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. He
saw the end of communism in Russia and the rise of capitalism in China. He identified opportunities in
the developing world before most others and he recognized the growing shortage of commodities as a
result. 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 been
spent successfully managing his own and other people’s money, collecting art (from Canaletto to
Kandinsky) and trying to understand the growing complexity of the world.
“Since the end of the Second World War, Europe and the United States have been
accumulating debt at every level and they finally have gone too far. It’s similar to the oil
companies drilling deeper and deeper until something really bad happens. Both in the
sovereign debt markets of Europe and in the marshes in the Gulf of Mexico, the
authorities are finding that the mess is proving very hard to clean up without enormous
effort, very high costs and personal pain for many participants.
“Right now investors still have confidence in U.S. Treasuries. People with serious money
throughout 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 the
Gulf, the Iranian nuclear threat, the possibility of a double dip taking the U.S. back into
recession and trade issues with China make everyone very uneasy. They want to put
their 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 money
for ten years at 3.1%. Does that make sense? Only if huge amounts of capital are
looking for a place to hide and don’t care about yield. At present the U.S. is in a position
to bail out the banks and bail out the state and local governments when they run into
trouble, but this cannot go on forever. Eventually the U.S. will face its own financial crisis
and who will be there to bail it out?
“There are basically only two ways to solve this problem. Countries with high deficits like
the United Kingdom and the United States will have to cut their deficits sharply. Politically
this 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 the
deficit down to reasonable levels and there is nobody in Congress powerful enough to get
something like that through, and Obama lacks the political capital now to do it and I doubt
if 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 and
only goes to 5% or 6%, some of the financial problems would be relieved. If inflation
looked like it was going too high, the government could always put wage and price
controls into effect.
“My view is that some combination of the two approaches will take place. The
governments with high deficits will endure some austerity, but they will probably not get
down to the level where expenditures only exceed revenues by 3%. Taxes will be raised
but that might have only limited utility. At a certain point, the United States may have
trouble selling its debt, so the Federal Reserve will have to buy it, expanding the money
supply in a dramatic way once again. This could happen soon if Washington decides to
begin another wave of stimulus to deal with the unemployment problem. Even though the
economy 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 debt
of the weaker countries will have to be restructured, retirement ages will be raised and
other 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 be
seen 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 others
appear to be making a sincere effort to improve their financial situation. The big risk is
social unrest. So far that has only appeared in a limited way. We’ll have to see what
happens 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 not
spending and order books are thin, so capital spending is disappointing. The financial
rescue package in Europe is a kind of anesthesia. We will have to see how those markets
react when some of the sovereign debt is written down by 20%–30% and whether the
banks can take that kind of adjustment to their balance sheets. Europe hopes to cut
spending 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 and
eventually it will get to one to one. All of Europe will benefit from that. Every effort will be
made to keep the European Union together. So far they are treating a cancer with
aspirin. We will see how they react to the stronger medicine and its side effects. The
same can be said of Bernanke and Geithner. They haven’t really faced up to the gravity
of 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. The
European 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 the
banks. 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 and
governments will still have difficulty selling their bonds.
“There was much excitement about the decision of the Chinese to unpeg the renminbi to
the dollar. To me it was a political measure before the G-20 meeting in Toronto and a
non-event financially. Over the next three years the Chinese currency may appreciate
15%. The change will be so gradual it will hardly be noticed. This is not enough of a
revaluation to make Chinese goods less attractive or U.S. products more competitive.
“There is an important difference between India and China. China had overheated with
growth at 11.5% and money supply and bank lending were cut back to bring growth down
to 8%–9%. India has similar growth but is better balanced. China’s growth is dependent
on 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 Europe
and 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 stock
markets in the West are having trouble. Now, however, stocks everywhere could move
higher. There is plenty of cash around to invest in risk assets. The financial problems that
the 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 the
short 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 a
basket with dollars representing 40%, the renminbi 20%–25%, gold 25% and the euro and
the yen the rest. It would require a new Bretton Woods conference to accomplish this and
it will probably never happen because of political considerations, but if it did, we would
finally have a reserve currency in the world that would be stable because it is partially
backed up by gold. The goal has to be to restore confidence in the world financial system
and this would do it. The pain would have to be pretty severe to get the relevant countries
to agree to it, however. In any case gold is going higher. Its time has come. I could see it
rising to $1500.
“We’ll probably know whether my assessment of the current situation is accurate in two
years. 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 the
10-year U.S. Treasury yield will get to 7%. Earnings are nominal and they will be
impressive, so investors will be happy about that. Even though the Treasury yields will
more than double from present levels, real yields will remain low, so investors won’t get
too 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 the
stock market is moving higher and those working in Wall Street and other areas of finance
are doing well, that could cause some unrest. Unemployment is likely to remain high and
the general public will say that the financial service regulatory reform legislation didn’t do
enough to bring Wall Street into line. The breach between the rich and the poor will be
widening and the government must do more for the less advantaged. The Tea Party will
argue 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. We
must accept accidents, even serious ones, as normal. A year from now the oil spill won’t
be forgotten, but it won’t be a headline item. British Petroleum won’t go bankrupt. They
will 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 we
have the Airbus A380 and the Boeing Dreamliner.
“Looking around the world, there are opportunities. The election in Brazil is key. If the
Lula look-a-like gets in, the economy will probably continue to do well. I am not investing
in 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. I
am investing in real estate in Africa and, yes, in Baghdad and elsewhere in the Middle
“We are at the point of no return. The developed world created problems for everyone
from 1945 to 2007 and now we have to solve them. The United States cannot afford a
strong military force, health care for all, an adequate retirement program and full
employment. You don’t have the resources to maintain that. There will be a modest
decline in the standard of living, but life will go on. There is no limit to the human
imagination. There is always something to do. Apple has doubled this year. Solar energy
is coming. The future will be led by the emerging markets. It is not the end of the world.
It is just the end of the world as we know it.”
I left the meeting with my head spinning between calamity and hope. I can hardly wait to see him again
and hear his assessment of the response to the challenges we are facing.