The (Skeptical) Macro Economic Case for Optimism

Jan.31.09 | About: SPDR S&P (SPY)

The global economy is in decline. That is blatantly clear and I don’t mean to state the obvious. Some economists and advisors remain so pessimistic on the global economy that they suggest simply holding cash and not investing money in any securities. Quite simply they are suggesting that investors should invest in what is happening and not what you think will happen over some long term time horizon. However, to forgo all forecasting of the future might very well be foolish and naively pessimistic. We don’t know when the end of the recession will occur. Maybe this recession will actually last for a decade in the United States and continue for nearly as long in several other countries. However, the fact remains that governments around the world are putting forth every possible policy they can think of to restore stability to the global economic system.

In my opinion there are only two logical outcomes of the government policies being put forth and enacted around the world: the policies fail or the policies succeed. Seems obvious, right? Knowing that there are two different outcomes likely, it would be prudent to explore the probable future and implications of both scenarios (failure and success).

First, we will explore the outcome of failure. Under the failure scenario the stimulus package being debated right now in the Senate will undoubtedly fail at its job of stimulating the economy. The eight hundred billion to one trillion dollars will evaporate into the de-leveraging black hole that seems to be relentless and ultimately not result in much, if any, material addition to jobs. In addition to the failed stimulus, the good bank bad bank policy will fail as well. Ultimately, both banks will be crippled into bankruptcy and ultimately nationalization.

Taking this to the extreme, an argument might be made that ultimately when the good/bad bank policy fails the Federal Reserve, and quite frankly the U.S. Government, will be put into serious jeopardy. The Treasury will not be able to issue bonds to finance the continuous re-capitalizing of the good/bad banks. Hyper-inflation will likely occur under this scenario because the U.S. may actually run a serious risk of defaulting. Since this article is concerned with macroeconomics, the U.K., EU, China, etc. will all have failed policies as well. Although, this might not be realistic since many countries throughout the world are experimenting with different approaches to deal with the crisis. Surely one of them will get it right? Ok, fine…maybe they won’t.

So what, who cares? The implications of this scenario will ultimately lead to the appreciation of anything that is not denominated in U.S. Dollars. Real commodities that are consumed, scarce, and in high demand will be the assets of choice. Furthermore, many of the countries examining and enacting stimulus packages are attempting to use infrastructure as the means of stimulus. So, from a worst case scenario, it seems logical to invest in relevant commodity related companies. Maybe the stimulus won’t work, but if your currency holdings are going to decline in real value anyways, you might as well invest in the area that will be superior to holding U.S. Dollars anyways.

The areas that seem most interesting are copper, iron, steel, silver, gold, etc. It is important to remain globally diversified, in particular away from companies that do a majority of their business in the U.S., after all this is the worst case scenario we are talking about. Granted, these companies are anything but recession proof. However, we are not talking about going from economic-boom-level prices to total collapse prices. We are talking about deep-in-a-recession prices to throwing everything possible at it prices–which is to say, the prices of many of the companies throughout the world have already discounted a tremendous amount of bad news…if not total collapse. What would failed policies in the environment of near, if not new, all time lows in consumer, investor, and business confidence really mean for share prices from here?

Ok, so enough of the negative. The other possible outcome is policy success. What would that environment look like? Well, to start off, the government stimulus package will actually work. It will succeed at stimulating the economy, thus adding jobs. It will involve a substantial amount of infrastructure spending. What infrastructure? It will likely include stuff that needs steel, copper, iron, concrete, asphalt, power lines, and all sorts of fun junk that congressmen hope voters will remember come re-election time (forgive my cynicism). Even if every dollar of the stimulus package were to stimulate the economy, it will not likely be entirely used on “old school” infrastructure i.e. roads, bridges, sewer systems, etc. It will surely include material spending on telecom infrastructure, utility infrastructure, and energy infrastructure as these are all areas that the United States needs serious work on.

Beyond the stimulus package, the good bank bad bank plan will actually work. The Fed/Treasury will be able to successfully spin-off new banks with only good assets; recapitalize them and privatize them (assuming they were nationalized in the process). Maybe this will be like the George Soros plan that he has put forward? The point is that there will be an array of new banks capable and willing to diligently and intelligently lend new money to worthy businesses and individuals.

On the global front, the majority of policies put in place by other countries will succeed. China will successfully spend an absolute ton of money and manage to develop more of a middle class and domestic demand with new modern infrastructure (which uses a lot of steel, copper, iron, asphalt, concrete, etc.). China also needs quite a bit of telecommunication development and utilities development as well as energy development. Other countries in the world have similar stories to a large extent.

So what, who cares? The implications for this scenario, interestingly enough, are virtually the same as those of the worst case scenario. The governments around the world are doing everything they can think of to stabilize the system, and their policies are aimed at particular areas. PIMCO has been talking about front-running the Fed for months now with respect to buying assets that the government is currently buying or about to buy in an effort to fix the system. Other institutions similar to PIMCO have been following suit, buying up many types of debt securities that the Fed is buying or about to start buying.

What can we learn from their actions? Maybe being a contrarian, with a long time horizon, will pay off? By researching and investing in material companies such as steel, copper, iron, silver, gold, telecommunication and telecom infrastructure companies, utilities such as power and water companies, etc. you are effectively front-running the governments of the world and will be paid handsomely for it in the future. Maybe these government policies won’t work; however, the companies in these industries have tremendous real assets and those real assets will be the only thing of value in the event of a severe global depression with declining currencies. Granted, a global depression will certainly hurt these companies in terms of sales, cash flow, and earnings…so it is certainly important to properly analyze a company’s cash and debt positions.

The underlying theme here is that these companies may end up ironically being the best companies to invest in, in either outcome.

It is time investors stop thinking about next quarter and start thinking about the next 5-10 years. Sure, no one can precisely forecast what the world will look like in 5 years let alone a decade without a tremendous amount of luck. But that doesn’t mean investors should forgo all contrarianism, optimism, and skepticism in an effort to arrive at approximately logical conclusions for long term investment themes.

Disclosure: Long RIO and Long PCU.