In the macro sense, 2012 was the ultimate “kick the can”/“keep the lid on” year. The US elections validated the status quo, as prediction markets such as Intrade indicated they would throughout the entire year. In Europe, the most important event of the year was ECB head Mario Draghi’s July statement that the ECB would do “whatever it takes” to keep the Euro-zone together, and the second half of the year was relatively quiet on that front.
However, the underlying fundamentals are unchanged. As I predicted in an earlier quarterly, President Obama’s re-election and the Republicans’ retaining the House has led to no substantial movement to address the US structural deficit. The recent moves to raise taxes on “the rich” will lead, over ten years, to less revenue than one year’s Federal over-spending, and is sand on the beach. It is somewhat amazing to me that President Obama and his fellow Democrats refuse to address spending at all, and in fact seem to have dug in their heels with increasingly disingenuous comments that the US does not in fact have a “spending problem”. This in the face of the fact that US Federal spending is about 24% (and rising) of GDP, and revenue is about 16%; this compares to the roughly “20/20%” formula that is the historical average and which most people find tolerable. As the US inexorably ages, that 24% if left unaddressed will rise to 30% by 2030, choking private investment. As the January 5th “The Economist” cover states “America turns European” and within states that “America is building Brussels on the Potomac”.
In Europe, the underlying dynamics remain in place. The “periphery” countries (say, Greece and Spain) are in chaos, with soaring youth unemployment and sagging economies, which are not close to being able to service, let alone repay, their debt. Meanwhile, Germany’s economy is slowing rapidly, and its people are suffering from major “bail-out fatigue”, which has been going on continuously for over 20 years since East Germany was re-absorbed back into Germany. Germans are schizophrenic on this issue: on the one hand, theoretically they prefer to see the Euro-zone remain intact, on the other hand, they think it is crazy that they work ten-plus years longer than the Greeks do and think that these countries should all act more prudently like the mythical “Swabian housewife”, who balances the family ledger and eschews worldly amusements.
The underlying reality in both the US and Europe is that the political class in each believes its interests are best served by not confronting the fiscal realities. This is about the twelfth year in a row in which US consumption will be greater than US production; meanwhile, I read that Greece has the highest per capita ownership of Mercedes-Benzes in the world. One prediction is pretty easy: politicians in both areas will do anything to keep the masses from having to live within their means (or, actually start paying back some debts!). It is far easier to find scapegoats, like the “rich” in the US (the top 1% of tax-payers will pay 37% of total income tax, top 10% pay 76%) or “those nasty Germans” in Greece who dare to want their money back.
While timing is ever uncertain, our base case presumes that these structural problems will not be addressed in any meaningful way, and that ultimately the Euro-zone will collapse and these countries will go back to pursuing their own national interests. In the US, it is clear that the Democrats will not meaningfully address spending (even though Republicans probably would trade some tax revenue increases for meaningful and real spending reductions) because they believe it is their best position politically. Meanwhile, Republicans will continue to want “spending cuts” but will refuse to divulge specifics, due to the justified fear that Democrats would savage them for it. I believe this issue will only be addressed once there is a full-blown crisis (interest rates soaring?) underway.
Now, for the record, I am not a Keynesian, and have written in these pages that the “end game” to our current endless stimulus and free money seems to be what has happened in Japan for over 20 years. It sure does not seem effective to me, and it is obvious it has not been cost-effective. For example, the investment spending that this policy is meant to induce is not happening. If you are a businessperson looking to invest, say, billions in a new-generation semiconductor chip plant, it seems to me that this investment will not take place just because interest rates go down from, say, 3% to 2%. A long-payout project like this must entail other factors, and I dare say the fiscal dysfunction is a bigger deterrent than interest rates.
However, the recent embrace of “the trillion dollar coin” by some leading Keynesians really highlights the sad state of these folks. The genesis of this idea was some money managers making fun of the current scene. The idea is, the Treasury would mint a trillion-dollar coin and then buy back Treasury bonds held by the Fed, and this would dodge the debt-ceiling limit. Dem Representative Jerry Nadler of NY actually said he was “absolutely serious about the idea”. NYT columnist and uber-Keynesian Paul Krugman is upset this idea is not being embraced. His recent column “Coins Against Crazies” is a bizarre polemic that literally ends: Mint this coin!
Fortunately, the comic Jon Stewart has derided, and thus killed, this nonsense! Whew! Close call there, but such is the sorry state of US politics.
All of this tells us that your money must continue to be invested with an eye toward risk and capital preservation. There is a very plausible argument to make on behalf of stocks, ie., that they are very cheap compared to bonds. However, great tail risk exists, and we believe the market is correct to be skeptical towards financial assets. Should this tail risk ease, stocks would probably become a very compelling investment to us (at current prices). In the meantime, we will continue to run a true “hedge” fund.
The “tail risk” we most worry about is inflation; admittedly, waiting for inflation (at least in CPI) has taken on a “Waiting for Godot” aspect. Consumer inflation seems subdued, and there is widespread consensus in the investment community that it is not a near-term risk. However, the free money continues to create rolling bubbles over the financial landscape. Hindsight will show that bonds, particularly USTs, are in a bubble mode right now; secondly, any high-yielding security, particularly risky sovereigns (which have rallied significantly without any improvement in underlying fundamentals), is suspect.
As always, I welcome any questions or comments you might have.
Best Regards,
Robert J. Sanborn
January 18, 2013
About Sanborn Kilcollin Partners
Sanborn Kilcollin Partners LLC is an SEC-registered investment adviser that manages approximately $200 million for institutional and high net worth investors by investing long and short primarily in U.S. equity securities.
Sanborn Kilcollin was founded in 2001 by two of the nation’s leading investment industry figures: Robert J. Sanborn and T. Eric Kilcollin. Mr. Sanborn was portfolio manager at The Oakmark Fund from its launch in 1991 through March 2000, during that time the Fund ranked in the top 10% of value mutual funds and assets grew from $100,000 to more than $9 billion. Mr. Kilcollin held a variety of positions at the Chicago Mercantile Exchange over a 15 year period, including President and Chief Executive Officer from 1996 to 1999. He was instrumental in the development of more than 100 financial products as well as the now-standard worldwide methodology for financial clearinghouses to evaluate and manage portfolio risk. He also served as the Chief Executive Officer of the Investment Services Division of Wells Fargo Nikko Investment Advisors (a $200 billion investment adviser that is now part of BlackRock) from 1994-1996. For more information about Sanborn Kilcollin Partners, please visit www.sanbornkilcollin.com.
Disclaimer:
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The discussion investment strategy and the economic environment represents the views of Sanborn Kilcollin Partners, LLC at the time this document was drafted, and are subject to change without notice. All views expressed in this document are opinions and should not be taken as facts.
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