Capital Ideas Newsletters



March/April 2011

Sixty-six years after the U.S. dropped the atomic bombs on Hiroshima and Nagasaki, nature, rather than man, caused the nuclear reactors in Japan to explode and leave an uncertain wake of destruction and potential disease in the Nippon lap. Our deepest condolences to the families in Japan who have suffered.

The Four Billion Dollar Problem

That is approximately what the U.S. deficit is per day!!! Clearly, the municipal deficits have taken center stage. Fortunately, politicians such as Mitch Daniels, the Governor of Indiana, and Chris Christie of New Jersey are starting to introduce responsible economic policies to bring them voters’ admiration. Unions are not necessarily happy about this; nor are some older Americans, but ultimately altering entitlement programs (i.e., Social Security, Medicare, and Medicaid) are necessary to keep this nation solvent and strong.

“Derivatives are financial weapons of mass destruction,” said Warren Buffet in a prescient 2002 letter to Berkshire Hathaway shareholders. Financial companies in the U.S. have approximately $7.38 trillion of gross exposure. This exposure is mainly among J.P. Morgan Chase, Bank of America, Citigroup, Goldman Sachs and Morgan Stanley… talk about diversification!? We believe this represents an unacceptable risk to our entire financial system… it appears that the lessons of 2008 may have gone largely unheeded. If we had our way, the notions of authority, responsibility and accountability would be clearly aligned. Enough is enough.

The markets had a great run in the first 45 days of the year, up almost 7 percent. As the Tunisian and Egyptian people stirred, so did the markets. Then as Libya followed, oil prices soared, metals and treasuries rallied, as did the Norwegian Krone, the Canadian Dollar and the Swiss Franc (the two former currencies have oil as a major resource) and the markets dropped, scared of the financial impact of higher oil prices. Then came the disaster in Fukushima…

Also dampening the markets was the report of downward adjustment of U.S. growth in the last quarter of 2010 from 3.2% to 2.8%.

With commodity prices rising significantly, including agricultural commodities, and growth slowing, could stagflation be around the corner? We believe this to be a strong possibility. Unfortunately, although there is plenty of slack in the U.S. labor market and in our manufacturing capacity, this is not the case elsewhere in the world, and certainly not in China. We believe that ultimately we will be “importing” inflation along with the purchase of electronic goods, clothes and furniture from overseas.

The junk bond rally, in our view, is close to its end. Buyout firms were paid dividends with a large measure of the junk money raised, and deal covenants have become excessively liberal for the issuers.

Mortgage rates have been inching up and with a high number of adjustable mortgages resetting in April, there may be a rude awakening for variable rate mortgages.

All of the factors above are reasons the Fed is stuck between a rock and a hard place. Too much printing of money and the Fed fuels inflation. If it is not accommodating enough, there is the risk of a double dip. I would not want to be Ben Bernanke.

The markets are becoming more volatile after a steady rise… mixed messages and uncertainty are difficult for the markets to digest.

Don’t be bearish on the USA! We have a GDP three times as large as China’s. Yes, their rate of growth is higher, but we are a transforming nation steeped in a long economic curve that has stalled. Once we figure it out (and we are) America will boom again.

Christie and Daniels are proving that Americans are ready to elect and support politicians who are responsible governors. To regain our financial footing, we must address Medicare, Medicaid, defense spending and raise the retirement age for Social Security. Now, because the U.S. is in a weak financial state, we can no longer dictate to the world. We need to learn to build consensus. After all, when you pick up the check, you can choose the restaurant… China’s move to purchase arms and build its military can be viewed as a positive as it moves to share responsibility to police the globe with the western nations.

Further, we applaud President Obama’s position of asking other nations to help the U.S. police the world and share responsibility for keeping peace.

As a recent World Street Journal editorial read, “The responsibilities of power, and the realities of a dangerous world, tend to be educational.”

The U.S. will be printing money through June, and this will probably keep things humming through September. Once that source of credit ends, the question is whether the private availability of credit will pick up the slack… in other words, when the patient is taken off life support, can he breathe on his own? Only time will tell.

AMEN! Hope “Springs” eternal. Happy Holidays.

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