Yesterday’s Syntrinsic Commentary spoke to the larger implications of an unsustainable approach to capitalism, specifically, capitalism that requires inexhaustible credit to function.
Today, as you may know, Standard & Poor downgraded the United States debt rating from AAA to AA+ with a “negative outlook,” meaning that they expect future downgrades. Let us share a few thoughts on this action, what it means and doesn’t mean, and at least some the implications.
Who is Standard & Poor?
S&P is one of the three major rating agencies charged with providing credit ratings to companies and governments. It is a for-profit entity, like the others. It is hired and paid by the issuers it rates. The other two major rating agencies are Moody’s and Fitch.
Was this downgrade predictable?
Yes. But first, we think it bizarre that so much credence continues to be assigned to credit rating agencies that very recently assigned AAA ratings to subprime and Alt-A mortgage backed securities, auction rate securities, and other asset back issues that they did not understand and did not act particularly interested in understanding. The credit rating agencies have not yet meaningfully changed their outlook on the municipal bond market, a market that is just screaming to have its risk profile reassessed. Clearly, when one is in a “pay-to-play” relationship with issuers, one’s judgment gets cloudy.
Given that lack of rating-agency creditability, we think it is far more important to look to the markets as a barometer of the risk of a security. As far back as March 2010, corporations such as Proctor & Gamble (AA- at the time), Berkshire Hathaway (AA+), Johnson & Johnson, and even Lowes were paying lenders less than the US Treasury, implying that they were perceived by the markets as less risky than loaning to the US government. At that time, Moody’s reported that the US was at risk of losing its AAA rating, and that was well before health care reform was adopted, 8-9% unemployment proved unexpectedly persistent, and the debt ceiling required a $2.1 Trillion or 15% increase. (See: “Obama Pays More than Buffett as US Risks AAA Rating,” Bloomberg, March 22, 2010).
In short, this downgrade has been coming for a very long time, was well telegraphed, is well-deserved, and we think, probably insufficient. If a credit rating communicates the likelihood that a lender will be able to get its money back and its interest paid, then it is completely reasonable to downgrade the US still further. The only way the US can pay back lenders is by finding more/new lenders; our lenders are getting skittish and our government buys too much of our debt in its effort to force interest rates lower than the market would otherwise determine. Since the US borrows without the intent of paying down the debt, it has become a risky borrower. If anything, the credit rating agencies have been exceedingly lax in acknowledging this.
Then why have investors been BUYING Treasuries and driving yields down? Doesn’t that imply Treasuries are even less risky than before?
Ah, if only markets were truly efficient. Scared investors do scary things. We do not think that it makes sense to dump the stocks and bonds of profitable companies in order to buy the debt of a government that is being downgraded, but that is precisely what has happened over the past few weeks. Why would you sell the stock of a profitable company with excellent prospects that is paying a 2.5% dividend in order to loan money to a government that is finally being called into account for its poor fiscal management and charge them only 2.5% interest per year for 10 years? It’s a completely counterintuitive response.
For several years, we have advised that clients avoid US Treasuries and Agencies (other than Treasury Inflation Protected Securities after January 2009). That call hurt in October-November 2008 when Treasuries became a safe haven from riskier equity and commodity markets, but at that time, Treasury debt itself was not the cause of the crisis. Now it is.
But aren’t Treasuries the safest investment option during a scary time, even if the Treasuries themselves are causing the crisis?
US Treasuries are safe so long as the markets determine that they are safe. But consider some of the very tangible risks to the US Treasury market:
Imagine the impact if China, Russia, Korea, Brazil and other foreign owners of US Treasuries decide to sell into this rally and reduce their Treasury exposure and diversify across other issuers and currencies. They curtail or even cease new Treasury purchases. They announce their decision and scare other investors who also sell or reduce their purchases. Yields rise.
As yields rise, the value of Treasury bonds drops. If values drop enough, many investors may sell, particularly if they have total return objectives and are holding bonds that mature over longer periods of time.
If the duration of your bond is 4 years, then the principal value may drop 4% for every 1% rise in interest rates; if the duration is 8 years, then the value would drop 8% for every 1% rise. How much of a decline in bond values will investors accept if interest rates rise 1%? 2%? 4%? Will they really feel confident to hold to maturity? Some might, but that will not be the uniform response.
If sentiment grows that US Treasuries are not reliable and that the US dollar will continue to weaken against global currencies, then we can’t simply print our way out of this by issuing debt that our own government buys. Those who still think that the US Dollar is omnipotent and beyond reproach for all time and across the globe are ignorant of history and the other great civilizations that failed—as we have been doing—to take care of their day-to-day business like responsible adults.
Well, if Treasuries are not risk free, shouldn’t we just put everything into gold?
Gold is certainly an appropriate part of a portfolio, though far from the risk-free asset that some think it may be. Were it as risk-free as some wish, then we would not have seen gold stocks crashing this past week, nor would so many commodities have outperformed gold over the past two years as this crisis has been unfolding. Gold can whipsaw. It’s notable that while gold has appreciated significantly against the US dollar, it has not changed nearly as much versus stronger currencies. Ultimately, the world will settle on a price for gold and the rate of appreciation versus US dollars will slow.
Gold—whether bullion, futures, or related stocks—certainly has a place in a portfolio concerned about hedging currency risk.
Well then, what else should I be doing to manage my investments? Should I go to cash?
While it sounds cliché, every investor needs a portfolio that reflects their investment and/or business objectives, liquidity needs, tolerance for uncertainty, and long-term spending requirements. There are some investors who should be in cash, but then, they probably should have been in cash three weeks ago or three months ago when risky assets were far more highly priced and thus communicating more even more risk than they are today when 10-20% cheaper. There is no news this week that we did not know several months ago; the market is simply digesting a recent and high-profile policy-level failure to effectively address financial concerns about which many have known for some time.
There is no one answer to the question about the ideal portfolio for current events. That said, there are a few fundamentals that remain true:
1. High quality companies with strong balance sheets, compelling businesses, and strong management should over time provide shareholders a reasonable return on their equity.
2. When making loans to companies and governments (i.e. buying bonds), select those that are fiscally sound, likely to payback the principal and to make interest payments in a timely manner. Weak corporations, municipalities, or sovereign nations should be avoided unless you are being paid a substantial risk premium.
3. Commodity prices (energy, agriculture, metals) should appreciate over time if demand—or anticipated demand—for those resources increases. Depending on the commodity markets you are considering, look at the likelihood of increased demand and invest (or not) accordingly.
4. Real estate prices are impacted by two key factors. The first, is Location, Location, Location. You may not want to invest in office buildings in certain US downtowns or suburbs, but may find a shopping mall in the Czech Republic represents an excellent opportunity. The second is pricing and its doppelganger, liquidity. People need to live and work and play. That will not change. Real estate at a fair price makes sense.
In short, we do not see the Standard & Poor downgrade to be a reason to materially alter investment strategy unless your investment objectives have changed or you were not prepared for this environment in the first place. If your portfolio is overweight the US dollar and betting on low-quality companies, then this will be a rocky road.
As American citizens, we recognize that our country needs to do something dramatic about our revenues, expenses, balance sheet and financial decision making process. But we have been saying that for years now and investing accordingly. Perhaps S&P’s action gets the attention of a few more people who are willing and able to make a difference. If so, then we welcome the downgrade. Going forward, we hope that we can play our part in helping the United States earn back the financial credibility we once possessed.
Saturday, August 6, 2011
Friday, August 5, 2011
Bad Capitalists?
Are Americans bad capitalists? As we confront the consequences of an unsustainable economic model, it’s a question we must consider.
Bad capitalists:
· misallocate assets
· lock themselves into a cycle of perpetual borrowing to finance operations
· lack a plan to meet debt obligations (other than refinancing it)
· maintain insufficient cash reserves
· lose the confidence of their stakeholders
· manipulate lenders and investors to keep them engaged
· do not acknowledge that their strategy is fundamentally flawed
· argue that time will solve their problems, or minor adjustments on the margins, or one more chance, or more of the same
Worst of all, bad capitalists undermine capitalism. They say to the world, “Human beings are too greedy, selfish, careless, and irresponsible to be entrusted with an economic system that requires discipline, self-sacrifice, hard work, and a long view.” An already skeptical world is often quick to buy that argument, ignoring its inaccuracy.
At the business level, a bad capitalist eventually looses wealth or goes out of business as it competes with good capitalists who invest more intelligently, adapt better to changing market conditions, attract and retain more talented employees, and otherwise strive for financial sustainability. But what if a nation’s economy is based upon and rewards poor capitalistic practices? We all recognize that the capitalist business cycle includes periodic failures at the business level; but, have we adequately considered the implications of failing as capitalists at the macro-economic level?
In some quarters, posing such a question would amount to heresy, for critiques of our economic model are too often viewed as criticism of capitalism rather than as a desire to improve our practice of it. The distinction is everything. And when society is rapidly losing the confidence of its neighbors and its own citizenry, a little heresy is necessary.
So where does one turn to critically examine at least some of the practices of bad capitalists? To the Marxists, of course. Countless theoretical discourses have been written since Karl Marx and Friedrich Engels published “The Communist Manifesto,” in 1848. Most critiques of capitalism have focused on how owners (a.k.a. capitalists) allegedly “exploit” employees (a.k.a. labor). But there have been economic philosophers who have focused on matters outside of capitalist-labor tension, issues that are relevant today.
In 1923, Hungarian economist and political theorist, György Lukács published his treatise, History and Class Consciousness. As a founder of what is known as “Western Marxism,” Lukács’ concluded that capitalism is inherently flawed, a conclusion with which we disagree. That said, elements of his critique are timely for those concerned with enhancing the sustainability of our economic system.
Lukács explores the concept of “reification,” which implies that capitalism is an abusive fiction that unperceptive—and unaware—participants have bought into without recognizing its true ugliness. The concept is reminiscent of the illusory world in the Hollywood trilogy, The Matrix, a fictionalized world in which citizens have been fooled into believing the visual reality around them without realizing that they are just oblivious players in a massive computer simulation.
Lukács presents capitalism as an artifice constructed by those most able to profit from moving funds around without adding genuine value. In his construct, capitalism constantly requires new participants and new monies which can feed those already in the system, seeming to create wealth but really just moving it from one unwitting owner to a more powerful one. Lukács presents capitalism as similar to a Ponzi scheme (though he does not use that term); in his worldview, people with the greatest power and influence profit from the wealth (i.e. labor, resources, monies) of those who possess less influence or control.
Defenders of capitalism might counter that capitalism creates new wealth by using public and private credit markets to facilitate the launching of new endeavors that otherwise could not happen. In effect, they argue, capitalism sets up a series of arbitrage opportunities through which someone can borrow from others at a lower rate than they expect to make by investing the borrowed funds in a venture. Much of the difference represents “new wealth” created, wealth that circulates through the economy through profits and wages that are converted into consumer spending, tax revenue, and ultimately, further opportunities to invest.
Defenders of capitalism also could look to public and private equity markets as opportunities to create new wealth by enabling owners to sell their stakes to others. The buyers expect their ownership will be rewarded through gains and income or by selling their ownership stake in the future for a premium over the purchase price. Buying and selling ownership (or expanding the ownership base through diluting current owners) can be generative if it enables new investment that adds value to the venture and its stakeholders.
So, why should capitalism’s defenders feel defensive? Don’t they adequately address Lukács’ accusation that the capitalist economy is an artifice? Aren’t credit and equity markets excellent examples of how capital can create more capital and thus generate new wealth throughout the system?
In theory, the capitalists have a sound argument; in practice, however, practice gets in the way. What happens, a Lukács advocate might ask, when one uses credit without any intention of repayment? Is a society creating new wealth when it rolls its debt over again and again with no intention of paying it back? If there is no intent to settle the debt, then can one really recognize the scenario as constructive arbitrage? If society’s functioning requires borrowing it will not repay in order to “stimulate” spending that makes it appear the economy is expanding, then hasn’t that society affirmed its members are willing participants in a Ponzi scheme?
Or look at the equity side. What happens if changing ownership is not a generative process but simply represents a transfer of wealth between parties? What if one party buys ownership, leverages up the company by borrowing beyond what is reasonable for the company to pay back, then sells it off to other public or private owners at a value inflated by the leverage it now carries but cannot repay? In this instance, there is not wealth creation for the broader economy, merely a profit for the seller that is paid for dollar for dollar by the other parties (and then some if debt financed). In this scenario, there is simply the appearance of appreciated value and wealth creation. Ideally, no one would engage in such a transaction, but if a society such as ours richly rewards buyers to perpetuate the cycle of artificial economic value generation, then the game will be played until, like any Ponzi, the jig is up and someone gets caught holding the rather expensive bag.
These observations deserve more thoughtful consideration than these few lines allow, and yet raise essential questions for us today. What action is society taking to ensure that we are not willing (or unwilling) participants in a Ponzi scheme? What sacrifices are we making so that we borrow only when we intend to pay it back with near-term assets? How do we mitigate the risk of being a society of bad capitalists? What systems or cultural shifts are necessary to increase the likelihood that we practice good capitalism?
When companies that have been “bad capitalists” fail, society absorbs those losses and enables the people impacted to try again as owners and/or employees of other ventures. However, whole societies that have been “bad capitalists” have no such safety net. If a society becomes economically unsound, it simply fails. Such failures hastened the ends of Ancient Rome, the British Raj, and the Soviet Republic. Societies that practice bad capitalism create fear and economic uncertainty amongst their citizens, causing people to distrust individual initiative, risk-taking, and the free flow of capital just when such behavior is most needed to stimulate the economy and make investments that can generate new wealth.
Lukács is wrong. We are not ignorant dupes participating in a massive Ponzi scheme; and yet, we must not willingly propagate a system that confuses perpetual leverage with sustainable growth. We stand together at a critical decision point. Generations from now, will we be remembered as bad capitalists? Or will we be honored as those who did what was necessary to preserve and improve the world’s most effective system for fostering personal freedom and opportunity?
Bad capitalists:
· misallocate assets
· lock themselves into a cycle of perpetual borrowing to finance operations
· lack a plan to meet debt obligations (other than refinancing it)
· maintain insufficient cash reserves
· lose the confidence of their stakeholders
· manipulate lenders and investors to keep them engaged
· do not acknowledge that their strategy is fundamentally flawed
· argue that time will solve their problems, or minor adjustments on the margins, or one more chance, or more of the same
Worst of all, bad capitalists undermine capitalism. They say to the world, “Human beings are too greedy, selfish, careless, and irresponsible to be entrusted with an economic system that requires discipline, self-sacrifice, hard work, and a long view.” An already skeptical world is often quick to buy that argument, ignoring its inaccuracy.
At the business level, a bad capitalist eventually looses wealth or goes out of business as it competes with good capitalists who invest more intelligently, adapt better to changing market conditions, attract and retain more talented employees, and otherwise strive for financial sustainability. But what if a nation’s economy is based upon and rewards poor capitalistic practices? We all recognize that the capitalist business cycle includes periodic failures at the business level; but, have we adequately considered the implications of failing as capitalists at the macro-economic level?
In some quarters, posing such a question would amount to heresy, for critiques of our economic model are too often viewed as criticism of capitalism rather than as a desire to improve our practice of it. The distinction is everything. And when society is rapidly losing the confidence of its neighbors and its own citizenry, a little heresy is necessary.
So where does one turn to critically examine at least some of the practices of bad capitalists? To the Marxists, of course. Countless theoretical discourses have been written since Karl Marx and Friedrich Engels published “The Communist Manifesto,” in 1848. Most critiques of capitalism have focused on how owners (a.k.a. capitalists) allegedly “exploit” employees (a.k.a. labor). But there have been economic philosophers who have focused on matters outside of capitalist-labor tension, issues that are relevant today.
In 1923, Hungarian economist and political theorist, György Lukács published his treatise, History and Class Consciousness. As a founder of what is known as “Western Marxism,” Lukács’ concluded that capitalism is inherently flawed, a conclusion with which we disagree. That said, elements of his critique are timely for those concerned with enhancing the sustainability of our economic system.
Lukács explores the concept of “reification,” which implies that capitalism is an abusive fiction that unperceptive—and unaware—participants have bought into without recognizing its true ugliness. The concept is reminiscent of the illusory world in the Hollywood trilogy, The Matrix, a fictionalized world in which citizens have been fooled into believing the visual reality around them without realizing that they are just oblivious players in a massive computer simulation.
Lukács presents capitalism as an artifice constructed by those most able to profit from moving funds around without adding genuine value. In his construct, capitalism constantly requires new participants and new monies which can feed those already in the system, seeming to create wealth but really just moving it from one unwitting owner to a more powerful one. Lukács presents capitalism as similar to a Ponzi scheme (though he does not use that term); in his worldview, people with the greatest power and influence profit from the wealth (i.e. labor, resources, monies) of those who possess less influence or control.
Defenders of capitalism might counter that capitalism creates new wealth by using public and private credit markets to facilitate the launching of new endeavors that otherwise could not happen. In effect, they argue, capitalism sets up a series of arbitrage opportunities through which someone can borrow from others at a lower rate than they expect to make by investing the borrowed funds in a venture. Much of the difference represents “new wealth” created, wealth that circulates through the economy through profits and wages that are converted into consumer spending, tax revenue, and ultimately, further opportunities to invest.
Defenders of capitalism also could look to public and private equity markets as opportunities to create new wealth by enabling owners to sell their stakes to others. The buyers expect their ownership will be rewarded through gains and income or by selling their ownership stake in the future for a premium over the purchase price. Buying and selling ownership (or expanding the ownership base through diluting current owners) can be generative if it enables new investment that adds value to the venture and its stakeholders.
So, why should capitalism’s defenders feel defensive? Don’t they adequately address Lukács’ accusation that the capitalist economy is an artifice? Aren’t credit and equity markets excellent examples of how capital can create more capital and thus generate new wealth throughout the system?
In theory, the capitalists have a sound argument; in practice, however, practice gets in the way. What happens, a Lukács advocate might ask, when one uses credit without any intention of repayment? Is a society creating new wealth when it rolls its debt over again and again with no intention of paying it back? If there is no intent to settle the debt, then can one really recognize the scenario as constructive arbitrage? If society’s functioning requires borrowing it will not repay in order to “stimulate” spending that makes it appear the economy is expanding, then hasn’t that society affirmed its members are willing participants in a Ponzi scheme?
Or look at the equity side. What happens if changing ownership is not a generative process but simply represents a transfer of wealth between parties? What if one party buys ownership, leverages up the company by borrowing beyond what is reasonable for the company to pay back, then sells it off to other public or private owners at a value inflated by the leverage it now carries but cannot repay? In this instance, there is not wealth creation for the broader economy, merely a profit for the seller that is paid for dollar for dollar by the other parties (and then some if debt financed). In this scenario, there is simply the appearance of appreciated value and wealth creation. Ideally, no one would engage in such a transaction, but if a society such as ours richly rewards buyers to perpetuate the cycle of artificial economic value generation, then the game will be played until, like any Ponzi, the jig is up and someone gets caught holding the rather expensive bag.
These observations deserve more thoughtful consideration than these few lines allow, and yet raise essential questions for us today. What action is society taking to ensure that we are not willing (or unwilling) participants in a Ponzi scheme? What sacrifices are we making so that we borrow only when we intend to pay it back with near-term assets? How do we mitigate the risk of being a society of bad capitalists? What systems or cultural shifts are necessary to increase the likelihood that we practice good capitalism?
When companies that have been “bad capitalists” fail, society absorbs those losses and enables the people impacted to try again as owners and/or employees of other ventures. However, whole societies that have been “bad capitalists” have no such safety net. If a society becomes economically unsound, it simply fails. Such failures hastened the ends of Ancient Rome, the British Raj, and the Soviet Republic. Societies that practice bad capitalism create fear and economic uncertainty amongst their citizens, causing people to distrust individual initiative, risk-taking, and the free flow of capital just when such behavior is most needed to stimulate the economy and make investments that can generate new wealth.
Lukács is wrong. We are not ignorant dupes participating in a massive Ponzi scheme; and yet, we must not willingly propagate a system that confuses perpetual leverage with sustainable growth. We stand together at a critical decision point. Generations from now, will we be remembered as bad capitalists? Or will we be honored as those who did what was necessary to preserve and improve the world’s most effective system for fostering personal freedom and opportunity?
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