The Age of Uncertainty

By Buck Klemosky -- Guest blogger. Buck is the former Dean of the Graduate School of Business at Sungkyunkwan University in Seoul.

“The world seems more uncertain today than at any other time in my life,” stated Howard Marks, a successful money manager for nearly 50 years, to his Oaktree clients. John Bogle, the legendary founder of Vanguard echoes the same message in the New York Times: “This is the worst time for investors that he has ever seen – and after 60 years in the business that is saying a lot.”

The source of this uncertainty comes from the Eurozone, the U.S. economy, the global economy, the Chinese economy and other developing countries, QE3, corporate earnings, confidence on the part of both consumers and corporate leaders, structured deficits and sovereign debt, the fiscal cliff, the depressing state of politics, and government regulatory initiatives

A long list of problems and challenges, to be sure. But they all lead to four possible scenarios for the U.S. economy:

1.       The U.S. replicates Japan’s experience of slow growth and deflation in the next decade.

2.       The U.S. economy falls into a recession in 2013.

3.       The U.S. economy returns to normal with real growth of 3.0-3.5 percent.

4.       The U.S. economy experiences higher than expected inflation (2 percent annually), which could be coupled with a growing economy or a stagnant economy.

Because of the uncertainties mentioned earlier, it is extremely difficult to assign reasonable probabilities to the four scenarios with any degree of confidence. Europe continues to be an unsolved problem with huge risks and much uncertainty. We are not sure what should be done to fix the problem, what can be done, let alone what will be done. The best that can probably be expected is that Europe will muddle through.

The U.S. fiscal situation is a mess. Long term, the entitlement programs need to be curtailed, the fiscal deficit needs to be reduced, and government debt kept at a reasonable level relative to GDP. State and local governments have the same problem, plus the federal government continues to download fiscal burdens to the states. If spending on government health and retirement programs cannot be curtailed, there is no hope of getting federal deficits and debt under control. The present value of all federal entitlement programs is $60-80 trillion versus GDP of $15 trillion in 2012. The programs are not sustainable, especially with the 76 million baby-boomers reaching retirement age and living longer than expected.

Politicians have refused to take any action to solve some of these problems. The fiscal cliff looms ahead. Nothing certainly will be done before the Nov. 6 election, but come January 2013, the Bush tax cuts could expire in combination with massive spending cuts at the federal level. The combination of tax increases and spending cuts could push the U.S. economy off a cliff into recession. Hopefully Congress and the president can put away their partisanship and ideological purity to take actions to prevent the cliff scenario.

The Chinese economy has slowed, not so much by government economic statistics, but by more measurable statistics such as electricity usage, exports and imports of material resources. Global economic weakness and inflation have eroded China’s cost advantages in exports, the main prop of China’s economy. It will make a big difference whether China’s economy will experience a soft landing or a hard landing.

Confidence plays a big role – perhaps a self-fulfilling one – in influencing economic growth. While consumer confidence has perked up recently, they still appear to be affected by the trauma of the financial crisis, the decline of home and stock prices, unemployment, government bailouts, and political uncertainty. Given the depth of the trauma, it may take time for consumer confidence to fully recover. This has certainly been reflected in the stock market. While the S&P 500 has more than doubled in value since the March 2009 lows, investors have withdrawn nearly $500 billion from U.S. stocks during that period, and the trend continues.

Corporate confidence and investment play a big role in economic growth, and right now confidence among U.S. chief executives has reached a three-year low, according to a recent survey by the Business Roundtable. The end result being that corporations are sitting on $2 trillion of cash and not making the capital expenditures needed for economic growth. Corporations face the same uncertainties listed earlier, plus the possibility of new regulations, Obamacare, slowing export markets, and a host of others. It will take sustainable economic growth for them to regain their animal spirits and invest the cash sitting on the sidelines.

The Fed has been extraordinarily aggressive in its monetary policy since the financial crisis and recession. Short-term and long-term interest rates are at historical lows. The Fed has also implemented quantitative easing, QE1, QE2 and QE3, as well as Operation Twist. QE1 and QE2 resulted in the Fed purchasing more than $2 trillion of U.S. government securities and mortgage-backed securities. Operation Twist resulted in the lengthening of the duration of the Fed’s bond portfolio. While QE1 and QE2 had definite upper bounds in the amount of bonds to be purchased, QE3 is opened ended in that the Fed will purchase $40 billion of mortgage-backed securities each month until the employment market improves. The QEs have taken the Fed in directions never taken before. Risks abound, especially the possibility of higher inflation because of the massive amounts of liquidity pumped into the economy and the risk of exit if and when inflation picks up. There is now $2 trillion to $4 trillion of excess liquidity available and where it goes could have good or bad consequences for the U.S. economy.

To quote Donald Rumsfeld, the U.S. Secretary of Defense in 2002, “There are known knowns – there are things we know that we know. There are known unknowns – there are things we now know we don’t know. But there are also unknown unknowns – there are things we do not know we don’t know.”

It appears the world economy today is dominated more by the unknown unknowns. But uncertainty doesn’t always mean downside. There could be an upside to all of the problems and challenges facing the U.S. economy. So  things may not turn out as bad as expected. While the U.S. has been experiencing the slow growth scenario lately, there are some economic positives. Both U.S. manufacturing and service sectors have shown positive growth recently, U.S. home prices have increased 6.9 percent over the first six months of 2012, stock prices are up 14.6 percent over the first three quarters of 2012, corporate earnings, while growth has slowed, have held up in the slow-growth economy, and the U.S. is becoming more self-sufficient in energy.

But the bottom line is that it’s probably wise to be cautious until some of these uncertainties become more predictable and/or resolved. While uncertainty creates both risk and opportunity, it may be better to emphasize safety over aggressiveness in the foreseeable future. There could also be some event not listed above or predictable that could impact investment results. We live and invest in interesting but uncertain times. More things can happen than will happen. But that is what uncertainty is all about.