No, not “shock” and “awe” as in how the military uses the terms, but rather shock as a characterization of what has hit the US and world economies recently and awe in terms of how resilient both have been. Just think of the variety of shocks that financial markets have had to digest and synthesize.
First there was the financial crisis, the shutdown of the commercial-paper and mortgage markets, and broad concerns about systemic risk. Then there were failures of major private-sector and government-sponsored institutions, government injections of capital, and guarantees of bank liabilities.
Europe has been wrestling with its own debt and fiscal finance problems, and these have caused politicians both in Europe and the US to face the hard realities that governments – local, state, and federal – can’t continue to run increasing deficits forever; and the public has sent a strong reaffirmation of that fact.
We see the US fighting two wars, in Iraq and Afghanistan, that have sapped our military capabilities and have not been particularly well received in that part of the world. Then, the self-immolation of a street vendor culminated in the toppling of an autocratic Egyptian government. Demands for freedom and liberalization have spread farther and faster in the Middle East than one could have imagined.
Now, a third military front has been opened in Libya, and there is much concern and confusion both in the US and the rest of the world as to what the objectives are and how to define success. And then there are the triple disasters of earthquake, tsunami, and nuclear reactor farm meltdown, which promise to further worsen Japan’s deficit, in order to finance rebuilding. Oh, and did I mention the flooding in Australia and major quake in New Zealand’s capital? The global political economy is facing as much uncertainty as has ever been experienced in recent times.
Yet, in the face of all these events, the US stock market has essentially regained its lost value. To be sure, the job market is lagging and has a long way to go to recoup the 7.4 million or so jobs that were lost during the recession. The housing market faces a glut of excess supply that will take a long while to work off. However, corporate profits are at an all-time high, interest rates are low, and inflation has so far remained contained. Real economic growth has been positive and has increased at a steady, albeit modest, pace. State tax revenues are recovering. Consumer spending on services, durables, and nondurables are all positive and have been for the last few quarters. Who would have guessed that outcome, despite the best efforts of politicians and economic policy makers?
An individual investor, however, is likely to be shell-shocked to the point of numbness by now. Witness the reaction to assertions about the municipal bond market that have triggered large sell-offs – especially by uninformed investors. Both risk and uncertainty are still high, and one wonders where the next shock will come from. Will it come from Europe or the UK, as policy makers begin to raise interest rates out of concern for domestic inflation, which is clearly on the increase? Will the surprise come from the FOMC, in an early truncation of its most recent QE II purchases of government securities? Will it come from a pullback in US consumer spending, as food and energy costs continue to rise? (Consumer confidence has recently taken a large hit, due in no small part to the increases in headline-inflation components.) Or will it come in the form of an external shock due to an acceleration and spread of the turmoil in the Middle East, which would further threaten world energy supplies?
What are the best policies for governments to follow under such circumstances? First, they should recognise that the real economies don’t seem to be as fragile as many fear. US GDP is currently at an all-time high, in both real and nominal terms, – and exceeds its level at the onset of the financial crisis. This means that somebody is making something, somebody is selling services, and most people are still working. The economies of the world will pick up again when governments act to remove imbalances, that is, when fiscal responsibility is restored, tax and spending programs are brought into balance, promises that can’t be kept are revoked, central-bank balance sheets are restored to normal, and clear strategies for dealing with political unrest and their implications for energy policies are formulated and articulated. When all this is done, uncertainty will be reduced and risks clarified. Then businesses can begin investing and hiring again.
What is an investor supposed to do while the risks and uncertainties are being clarified and resolved? First, we note that many markets – and especially the US equity and debt markets – have already discounted many of the risks and have priced the uncertainties we have identified. Second, the turmoil has created many opportunities. One such opportunity is in the municipal securities market, where many good credits are mispriced and represent bargains for the informed investor. Cumberland principals have written extensively on this issue, citing specific examples. Third, hedging interest-rate and inflation risks seem prudent at this time. Fourth, there is diversification, both between bonds and equities and across the world. Finally, there is a need for flexibility and being willing to change portfolio compositions as events dictate.
Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable.