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The New Normal

Following the macro-economic analysis provided by the folks at Pimco, we review Hyman Minsky’s tri-partite concept of debt structure. This topic sounds esoteric, but we guarantee it will seem strangely familiar. We add a fourth category to the Minsky model, however, which corresponds to the conservative and austere mindset that we expect to gradually dominate economics on Main Street as the slow deflation of various asset bubbles progresses.  

Pimco’s think tank expects things to get better on the margins, selectively, on a country by country basis. We believe Brazil and Chile will be among the early gainers. Accordingly, we profile Banco Bradesco (BBD), Brazil’s second largest bank, and Sociedad Quimica (SQM), which has a monopoly on fertilizer production in Chile. We also take a closer look at APAC Customer Service (APAC), a small-cap outfit with a growing presence in the medical field.

Detail

Once a year, the managers from Pacific Investment Management Company’s (PIMCO) global offices converge at the Newport Beach home office for a closed-door conference on the secular trends in the global economy and their implications for asset management. The purpose is to align Pimco’s fixed income strategies with a 3-5 year view of the worldwide investment risks and opportunities. Bill Gross, Paul McCulley and Mohamed El-Erian are the principal managers and spokespersons for the company.

If you watch financial television, you have seen these gentlemen. The only institutions in the U.S. that run more money than PIMCO are entities like the Fed and the U.S. Treasury. El-Erian et al. get paid to see the forest and not get stuck admiring the green-shoots of the trees.

Crack Economics

In our view, Pimco’s three managers have been particularly savvy throughout the credit crisis. For example, McCulley began warning about the risky practices in the “Shadow Banking System†(the world of unregulated derivatives) in August of 2007, when he addressed the Federal Reserve’s annual symposium at Jackson Hole.McCulley shook his finger at the Fed for allowing the Shadow Banking System to create explosive growth in leverage, and therefore in risk, outside the purview of the Fed or other regulators.

According to McCulley, the credit surge applied upward leverage to all asset classes (equities, real estate, commodities and bonds) in the U.S. and around the world, creating a bubble. The asset bubble bequeathed a huge windfall on U.S. consumers, who were encouraged to enjoy the fruits via home equity withdrawals (HEW). The HEW wave was roughly equivalent in magnitude to the entire 2009 Obama stimulus program each year during that period. It fueled virtually all GDP growth in the U.S. from 2002-2006. As crack cocaine was spreading around the country, crack economics was in full flower as well.

Minsky Moment

McCulley cites the “Financial Instability Hypothesis†by Hyman Minsky published in 1992 as the seminal work on the non-linear dynamics of financial markets. He summarizes Minsky’s theory thusly, “The longer people make money by taking risk, the more imprudent they become.†The journey to eventual destabilization progresses in three phases, according to the dominance of three types of debt structures: hedge, speculation and Ponzi.

Hedged debt structures are stable and can pay the entire principal on demand. For example, think of an airline that hedges fuel costs or a farmer who hedges crop income using wheat futures. Hedges (not hedge funds) are bets designed to improve things on the margins; no one is betting the farm.

Speculative debt structures, however, are capable of paying interest, but not principal, on demand. For example, many individuals and businesses carry credit card or loan balances that they cannot pay off in full each month, but they can pay interest and some principal regularly. Certain types of mortgages would represent the more extreme aspects of this category, such as option ARMS that allow for interest-only payments for a few years.

Crossing the ‘P-Line’

Ponzi debt structures, on the other hand, are so highly leveraged that they cannot pay interest unless the underlying assets are appreciating. If the assets fail to rise in value, then Ponzi-based debt structures must liquidate assets to meet demand for payments.

Quite a few hedge funds & investment banks found themselves in this position last year. They are not Ponzi schemes, because they are real businesses, but they fit the definition of Ponzi debt structures according to Minsky, in that they are overleveraged (say 30:1) to the point where they cannot tolerate even a small correction in underlying asset prices. In the consumer sector, mortgages with negative amortization are representative of this type of debt. In those cases, not even all the interest is paid each month and what remains is added to the loan principal.

We now know that many conventional banks and insurance companies, including Bank of America and AIG, UBS and RBS, appear to have crossed the “P-line†along with the hedge funds. General Motors fits the definition as well, even though the company did not speculate in derivatives. The jury is still out on whether General Electric will have to divest assets to cover toxic levels of debt in its financial unit.

Pop!

McCulley believes that the Ponzi phase of the asset appreciation bubble burst in August of 2007 and we are now in a “reverse Minsky process,†working backward through the three phases. We suspect, however, that Minsky may have overlooked a 4th structure, one that we would call ‘conservative.’ This is the mindset that characterized many in the generation that lived through the Great Depression.

These individuals are savers, not spenders. They pay cash for goods and services. They are “mattress people,†i.e. mistrustful of fancy financial instruments and keep money in FDIC insured CDs and bonds. It is possible that the Minsky snap-back may send a core portion of the U.S. economy back into that most conservative of strategic mindsets.

McCulley points out that the Minsky process is pro-cyclical on the way up and on the way down. In other words, lacking full sovereign backing, the Shadow Banking System is particularly vulnerable to runs during the reverse Minsky phase.

We wrote a piece on this thesis a while back entitled ‘The Age of Austerity.’ David Rosenberg, the former Chief Economist at Bank of America recently echoed this concept, stating “This isn’t some flashy two or three quarter deal. This is a secular change in household attitudes. This is going to be a new era of frugality.â€

New Normal

Mohamed El-Erian, PIMCO’s CEO agrees that the violent developments over the last 12-18 months affecting markets, households, institutions and governments are unlikely to be reversed in the next few years. According to El-Erian, it is as though the global economy suffered a heart attack, with industrial production falling off a cliff edge that had been in place since post- WWII. El-Erian believes that the seriousness of the circumstances should not be minimized. He writes, “Put another way, markets are recovering from a shock that goes way, way beyond a cyclical flesh wound.†He adds that trust can be lost quickly and takes a long time to restore.

In an interview on Bloomberg Radio this week, El-Erian opined that by this time next year, “the market will realize that potential growth for the U.S. is no longer 3%, but is 2% or under.†He added, “We are transitioning to what we call at Pimco a new normal.†This is not particularly good news as the last time the U.S economy grew at an annual rate of less than 2% for an extended period was in the 1930s.
In summarizing the conclusions drawn by the Pimco Secular Forum, El-Erian did not sound at all optimistic about a spontaneous and sustainable recovery in the global economy. Quite the contrary. He states that for those who are trapped in the dominant business-as-usual mentality, the new normal will feel like a huge shock.

El-Erian foresees a long, drawn out sunset with respect to the role of the financial sector in post-industrial economies, as financial risk is transferred to the sovereign governments themselves. Ironically, he sees the mainstream banking system becoming a “shadow of its former self.†El-Erian also expects a 3-5 year transitional period in which the global economic focus gradually shifts away from the dominant Western countries toward emerging markets led by China.

The International Monetary Fund projects a contraction in the world’s advanced economies in 2009, but emerging economies are expected to grow 2.5% on average, and some countries will grow significantly faster. With the bigger Western players sidelined, El-Erian foresees economic differentiation on a country by country basis, depending on local conditions and trade relationships.

We consider Brazil, Canada, Chile, China and India as five leading candidates for enduring prosperity and for growth at a faster pace than will be achieved by the U.S. or Europe over the next 3-5 years. We recently featured several Chinese companies in our profiles. Over the next few weeks we will profile additional investment ideas in these countries.

http://spearfinance.com/tsr/new-normal.htm

About the Author

Spear Finance offers a variety of financial articles, from an overview of the stock market, to ETFs and Options.

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