Why 2010 Looks So Dicey
The defining characteristic of this asset and credit collapse has been the implosion of the largest balance sheet in the world: the U.S. household sector. Even with the equities rally and the tenuous recovery in housing in 2009, the reality remains that household net worth has contracted nearly 20% over the past year and a half. That's an epic $12 trillion of lost net worth, a degree of trauma never seen before. As households assess the damage, the impact of this shocking loss of wealth on spending patterns is likely to be enormous. Frugality is more than just the new fashion; attitudes towards discretionary spending, home ownership, and credit have undergone a secular shift toward prudence and conservatism.
Complicating matters is the approaching 53rd birthday of the median baby boomer. Many members of this critical mass of 78 million (who have driven the economy and capital markets over the past five decades) are now in their 60s. They're realizing they may never fully recoup their lost net worth, and yet they'll probably live another 20 or 30 years. So what is happening—at once both fascinating and disturbing—is that people over 55 are the only part of the population seeing any job growth now. Retirees who left the workforce are rejoining it to make up for their lost wealth.
They're certainly not banking on the current bear market rally, which is being driven by investors purchasing stock to cover their short positions and hedge funds, the only two major sources of equity buying power this year. What has impressed me is that the general public has been allocating more of its savings to fixed-income strategies. For every dollar the household sector has invested in capital appreciation funds since the March lows, more than $10 has flowed into income funds—bonds, hybrids, dividends, and the like.
When I look at household balance sheets, what I see on the asset side is a 25% weighting toward equities and a 30% weighting toward real estate. There is a lot in cash and deposits, life insurance reserves, and consumer durables, and the weighting in fixed-income securities is still less than 7%. This is the part of the asset mix that will expand the most over the next decade.
People have understandable concerns about inflation right now, but the history of post-bubble credit collapses shows that even with massive stimulus, deflation pressures can dominate for years. This was certainly the case in the U.S. in the 1930s and in Japan from the 1990s until today. All the talk right now is about efforts by central banks to create inflation. The facts on the ground, however, show that the inflation rate for both U.S. consumers and producers has turned negative for the first time in six decades. To protect a portfolio in this deflationary landscape, a pervasive focus on capital preservation and income orientation—whether in bonds, hybrids, or an emphasis on consistent dividend growth and yield—would seem to be in order.
It's becoming clear that the government's attitude to the beleaguered greenback can only be described as benign neglect. With midterm elections in 2010, the Obama Administration will do everything it can to tack every last possible basis point onto gross domestic product growth and to prevent the unemployment rate, the most emotionally charged statistic of all, from reaching new highs. The decisions to give 57 million Social Security recipients an additional $250, and not only to extend the tax credit for first-time home buyers but to expand the subsidy to higher-income, trade-up buyers, smacks of a populism that will stop at nothing to generate growth, even with the deficit-to-GDP ratio already at a record of more than 10%.
While I believe a sustainable return to inflation is a long way off, there is little doubt we will see continuous efforts at reflation, which means the U.S. money supply will continue to expand rapidly, a positive for commodities, which are after all priced in U.S. dollars. And it appears that strong Asian growth—in China and India in particular—has been a key reason why the Canadian stock market, with its resource exposure, has continued to do well compared with U.S. markets, especially in light of the strengthening Canadian dollar. I expect commodities to continue to outperform. Typical of a post-bubble credit collapse, I see the range of possible outcomes in the markets and the economy to be extremely wide. That's why defensive strategies that minimize volatility and downside risks are the right course.