John Nyaradi: Hi everyone, I’m John Nyaradi, publisher of Wall Street Sector Selector, a financial media site specializing in exchange traded funds, global markets and economic analysis. Today, I’m really pleased to welcome our special guest Russ Koesterich. Russ, welcome to Wall Street Sector Selector.
Russ Koesterich: Thanks for having me.
John Nyaradi: Russ is iShares Chief Investment Strategist and global head of investment strategy for BlackRock Scientific Active Equities. He’s writes the iShares blog and he has a new book out from McGraw’ Hill called The 10 Trillion Dollar Gamble: The Coming Deficit Debacle and How to Invest Now. Today, we’re going to talk about The 10 Trillion Dollar Gamble and Russ’s outlook on today’s economy about today’s economy, and what he sees going forward. Let’s start with the title, Russ, The 10 Trillion Dollar Gamble. What’s that all about?
Russ Koesterich: The 10 Trillion Dollar Gamble really is about the deficit, not only today, but about the next decade. 10 trillion dollars represents what the cumulative US deficit is likely to be this decade, and the point of the book is really to explore the investment ramifications of that.
We all see these astronomical numbers. We look at the Wall Street Journal. We see the headlines, but it leaves the question what do you do about it, and that really is what the book is designed to answer. How should investors consider the deficit in an investment context and how should it change their investment strategy accordingly?
John Nyaradi: Certainly a very topical subject for today. In your book you have a quote by former Vice President Dick Cheney who said that deficits don’t matter, and you say they do. So let’s talk about why they didn’t matter then and maybe do now and what’s the difference.
Russ Koesterich: Vice-President Cheney’s comments got a lot of press, and it makes a good headline, but I don’t think it’s accurate economically and it certainly isn’t accurate today. You don’t have to look any further than Europe to realise that deficits do matter.
Now, in the US, it’s a little bit different, and the US has several advantages over Europe because we are the world’s largest economy. We issue the world’s reserve currency, and we have the world’s largest most liquid bond market. So the way that deficit is going to impact the US, both in the near term and longer term is somewhat different than the way it’s impacting Europe, but clearly deficits do matter.
If you look at over the next 5 to 10 years, it’s important to keep in mind that many of the same challenges that are right now hurting Spain and Italy, and the most extreme case being Greece, are challenges that the US faces.
In other words, you have an unsustainable fiscal past that is not going to hold up over the long term. If you don’t change the nature of how we fund our government, the size of that government, then we’re going to see some very significant problems down the line.
John Nyaradi: You say that the long term outcome of all of this could be rising taxes, slower growth, and inflation. Can you touch on each one of those?
Russ Koesterich: Sure. The first two we’re already seeing some evidence of and the slow growth mode in the U.S. is going to persist for years. Our enormous debt is a drain on resources. It is a drag on economic growth, and it’s one of the reasons we’re stuck in this slow growth mode we are in today. So this is the first problem.
The second that we’re already seeing inklings of is the possibility of higher taxes. We’re seeing these proposals out of the administration. They may or may not pass, but certainly, there will be more pressure to raise taxes in light of these deficits.
Now, the third issue: inflation is not something that I think people have to worry about in the near term. As I mentioned in the book, this is something that I don’t think is going to become much of an issue before 2013 at the earliest. But ultimately, the question that investors want to ask themselves is how does the US deal with the deficit? Does it tackle it head-on by trying to align spending with revenue, or do we other things? Other things like having the Federal Reserve buy debt. This is so-called monetizing the debt, and in the process of doing that, you raise the supply of money, and you raise the likelihood of inflation.
John Nyaradi: Greece, of course, is in the news everyday. Are we worse than Greece? Where do we stack up in the pantheon of global debt?
Russ Koesterich: This is a great question, and I guess the answer depends on which metrics you look at. Certainly, the US is not Greece. Greece right now is almost certain to default on its obligations over the next 5 years. No one believes that it’s going to happen to the US. But what the US has, which is arguably as bad as Greece, is a very large debt obligation relative to the size of government revenue. When you look at the size of our debts relative to government revenue, it’s actually as high as it is in Greece.
So again, it’s not a near term problem. We don’t have a funding problem in the US, but arguably long term, we do have a solvency problem, and that is, I think, what will ultimately trip us up if we don’t address it.
John Nyaradi: In your book you mention that almost 50 out of the last 100 years have been spent in long-term secular bear markets. What is the retail investor’s answer to that problem?
Russ Koesterich: The conventional wisdom back in the late ’80s and the ’90s was that you buy stocks, you hold on to them, and over a long period of time, stocks are going to outperform other asset classes and keep up with inflation. And there is some truth to that, but you have to hold on for a very, very long time, much longer than most people expect. You can go 10, 20 years with stocks being effectively in the rut.
Now, I think the most important thing for investors to think about when they buy stocks is no different than when they buy anything else. What is the price you’re paying? There have been a lot of headwinds to the global economy within the last 10 or 11 years, but arguably, the biggest problem that investors are faced with is that back in the late ’90s and 2000, stocks were ridiculously expensive. Investors were paying about 32 times earnings to buy the typical stock in the S&P 500. That is about twice the long-term average multiple.
So when you buy something that expensive, it’s going to take a long time to grow into that price and that’s exactly what’s happened over the last dozen years. The one bit of good news right now is that while we do have a lot of challenges in the US and globally, stocks are more reasonably priced. Now I don’t think that means we’re going back into another secular bull market, but I would feel much better buying a stock today with a long-term horizon than I would have in 2000.
John Nyaradi: You mention three basic asset classes in the book. You just touched on stocks. We also have bonds. What do we do with bonds today?
Russ Koesterich: You know, bonds are a part of a portfolio, and I think one of the key points I try to get across in Chapter 9 is it’s always about mixing the ingredients. It’s never one or the other. There’s a proper mixture of both depending upon your age and your level of risk appetite, but certainly, right now, I would own fewer bonds than I would have 10 or 15 years ago, and the reason for that is you have to look at what is the real rate of return. In other words, what is the interest I get minus the level of inflation I expect?
And today, the US Treasury bonds are at less than 2%. Unless you believe we’re going into Japanese styled deflation, unless prices in the US are going to fall year after year after year, you’re getting a negative real return on most treasury bonds. Locking into a long-term government bond at these levels effectively means you will only get no real return on your money over the long term.
John Nyaradi: You say, “Sell paper and buy stuff.” Let’s talk about that.
Russ Koesterich: This is a reference to the third asset class which is commodities. Some people are very bullish on commodities. They want to put it all in gold and bury it in the backyard, and others just don’t see the point in owning a lump of metal, and I think the truth is somewhere in between. And again, I’ll go back to my comment a second ago. It’s about a portfolio with different assets that perform differently in different environments. And in that mix, there is a place for commodities.
If you worry about purchasing power over the next 5 or 10 years, if you worry about keeping up with inflation, commodities do a particularly good job of that. One of the recommendations in the book is for investors to have some small portion of their portfolio allocated to physical commodities: oil and metals and even gold because this will give you some protection on purchasing power over the longer term.
John Nyaradi: One thing that makes your book really stand out is that you not only talk about the debt problem but you also talk about solutions, about how countries like Ireland and Sweden, Canada solved similar problems. Is it too late to get out of this? Is it too late to step back? And how do we do that?
Russ Koesterich: Well, honestly, it’s not too late, but it’s arguably a little bit too early. When I look at the historical examples you just listed, Ireland in the late 1980s, Canada ’93, Sweden ’95, there’s a very consistent pattern about when and how countries address their deficits, and generally, what happened is, first of all, politicians don’t act, although they have to. You need the bond market to effectively force their hand to have real reform, and obviously, that’s not the case in the US when the market’s still willing to lend long to the United States at 2%. Second of all, there’s generally an election. There’s a change in government, and changes happen after that new government comes in place. In other words, you need a mandate.
A lot of the deficit over the long term is going to be driven by the current entitlement programs. Adjusting those for changing demographics, adjusting those for changing life expectancy, will go a long way to addressing some of these problems, but the issue is, the longer you put it off, the more debt you accumulate in the meantime. Sooner is better than later. It’s not too late, but the longer we put it off, the more dire the ultimate solution is going to have to be.
John Nyaradi: Let’s talk about iShares. You’re Chief Investment Strategist. iShares is the biggest provider of exchange traded funds. Tell us about your work there.
Russ Koesterich: Sure. My mandate is to create an investment team and provide investment content, investment advice, and explain what’s going on from a macroeconomic perspective and how investors can use iShares to meet their investment objectives. The great thing about this platform is it’s so broad. You know, ETFs give you exposure to stocks across all different countries, to bonds, to commodities, to different types of investments, so it is a very rich pallet with which to work.
John Nyaradi: I always like to end these conversations by asking if there’s anything else you’d like to add right now, you know, the one thing that’s really on your mind. We’re talking now in autumn, 2011, what should the average retail guy look out for today?
Russ Koesterich: There are two things that I’d watch over the next 3 or 4 months because I really think they’re going to determine the course of the economy and the markets over the next few years. The first is Europe. If Europe can muddle along, that will go a long way to help lowering the risk in the economy and lowering the risk in financial markets. If Europe dissolves, if it leads to a banking crisis, that’s going to be very, very serious, not just for Europe but for the US.
The second issue is to pay attention to the government discussions this fall as the so-called Super Committee tries to tackle the deficit. There are ways to do it which could help over the long term, and there are ways they could do it which are going to hurt over the short term. If you have significant changes to, let’s say, things like unemployment benefits in the near term, this is going to come at a time when the US economy is very weak, arguably too weak to be making those changes right now.
So it’s really going to be incumbent upon politicians to get the right mix of policies to address the long term fiscal problems while also taking into account just how fragile this recovery is. So I think the next few months are going to be crucial, both in Brussels and in Washington.
John Nyaradi: Well folks, we’ve been talking with Russ Koesterich, iShares Chief Investment Strategist and author of a new book, The 10 Trillion Dollar Gamble: The Coming Deficit Debacle and How to Invest Now. The book has received great reviews from people like Arthur B. Laffer, CEO of Laffer Associates; Vadim Zlotnikov, chief market strategist of AllianceBernstein; and S.P. Kothari, the deputy dean at MIT Sloan School of Management. I’d like to add my humble endorsement and say it’s a great book. I learned a lot from it and it’s a very hands-on, easy way to prepare and position yourelf for the new environment we’re in.
To learn more about Russ’ book and his work, just follow the link at the end of this interview and it will take you to this page Amazon.com where you can learn more.
Russ, it has been great chatting with you today. Thanks for joining us. I know we’re all looking forward to talking with you again soon.
Russ Koesterich: Thanks again. I really enjoyed it.