Developed World Debt: Cardiac Arrest And Treatment Regimen

Includes: DIA, QQQ, SPY
by: Christopher Begg, CFA

Market Summary

Equity markets reacted negatively to political and macro-economic instability in the third quarter. In the US we witnessed the debt ceiling debate and in Europe the survival of the European Union appears to be in jeopardy. The S&P 500 fell 13.87% during the third quarter and MSCI All Country World Index lost 17.32%. International benchmarks were even weaker with the MSCI Emerging Markets down 22.49% and the MSCI EAFE down 18.92%. While gold moved 8.24% higher, most commodities pulled back materially as the economy showed signs of weakening. We are very pleased with how our holdings have performed in this environment and as usual you will find your portfolio performance and positioning in your quarterly report. [1]

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Developed World Debt - Cardiac Arrest and Treatment Regimen

We live in a post credit bubble world. When the bubble popped in 2008, a meaningful percentage of the excess debt was transferred through bailouts and bankruptcies from over-leveraged businesses and individuals to government balance sheets. These sovereign central banks have further expanded their debt burdens through stimulus actions to help mitigate the inevitable slowdown as the world recalibrates to normal spending levels.

We are in Phase 2 of this cycle where these sovereigns now must figure out how they can afford to pay off these debts. There are only three solutions to deal with this new reality: tax more, spend less, and/or “inflate away” [2] debt.

The sovereign debt issue is a developed world disease yet it is contagious given the fact that developed countries still consume nearly two-thirds of the world’s output. The developed world is a very sick patient. Our elected officials, with differing viewpoints, are the doctors charged with the responsibility to administer the right cocktail of tax more, spend less, and inflation the patient should receive.

This has and will continue to be a hotly contested political debate. The United States debt ceiling fiasco and ultimate credit downgrade was proof of just how ridiculous things can get. At least in the case of the United States, we have only one culture politicizing the right medicine.

In Europe we have doctors from 17 different countries trying to arrive at a treatment regimen for a patient currently on life support. The reality is the United States, Europe and Japan are in intensive care after a near fatal heart attack. While these three regions require a long term course of medicine around tax more and spend less, there will be life-saving procedures required to keep the patient alive during the expectant recurrence of other cardiac infarctions. The printing press is the crash cart, perhaps more aptly named “cash cart”, which will revive these countries until they are well enough to leave the ICU to continue on their long-term meds of tax more and spend less.

We are fortunate that Bernanke understands this regimen better than most. Dr. Bernanke is a student of the Japan case study where the patient endured a decade long coma because CPR was administered when the defibrillator [3] paddles should have been used. Bernanke will continue to administer the appropriate medicine when it is politically acceptable, which usually means after a cardiac event.

Today the “cash cart” has been wheeled over and the US is receiving some “inflate away” to restore effective rhythm. “Inflate away” has been around for hundreds of years and is typically evoked after a credit binge when countries have their own reserve currency.

In these cases, it is the treatment with the greatest efficacy. Alternative treatments after a credit binge that rely only on austerity and tax increases can bring on a prolonged recession and at worst depression scenarios that are unpleasant and politically intolerable. Dr. Bernanke will continue to use the “cash cart” when the United States goes into cardiac arrest and he will get creative so not to bore us with how he describes the “inflate away” medicine. He might call it quantitative easing, this quarter he coined a new term naming the medicine a “twist” - a scheme to sell short bonds and buy long bonds.

Just as we have a lot of brand names for ibuprofen like Advil or Motrin, don’t be fooled by the names our Fed Chairman is prescribing as it is 100% pure “inflate away.” There has been a change in rhetoric that has shifted dynamically from austerity to jobs. A jobs focus is stretching across party lines and borders and we find this data point particularly important. A focus on jobs here in the United States and across the globe will drive the political fortitude to use the power and efficiency of money supply to remedy an ailing world.

If you pick up a newspaper in any country you will see the social unrest due to a frustration over citizens seeking work. We see this today in our country with the 'Occupy Wall Street' protests. We ask ourselves, if a jobs focus becomes the “elephant in the room”, what political motivation will there be to use larger doses of the slower release medicine of tax more and spend less versus a more direct mainline infusion of “inflate away”?

We conclude that the remedy of the jobs dilemma will ultimately be housing. The credit binge put homes in the hands of people that could not afford them. Now we need time for household formations to sop up the excess inventory of homes created during the binge. When we see these levels equalize we will begin to see meaningful job growth which will bring overall unemployment down. Jobs that are directly and indirectly related to housing make up a large part of our economy. Housing is in a great depression scenario right now while the rest of the economy is recovering.

Our prognosis on the equity markets from these attractive valuations is quite bullish. However, we expect corrective periods to occur during this recovery like the one experienced in the third quarter. While we plan on taking full advantage of buying opportunities that occur during these episodes, we feel trying to time getting out of equities before every dip to be a futile, foolish, and truthfully, a nearly impossible activity.

In Europe, the patient is nearly flat lined with a very irregular heart beat; if the 17 countries of the European Union do not get together and administer life-saving coordinated money printing medicine, the EU will cease to exist. We have looked carefully at the various scenarios that could unfold and we have talked to experts on this topic. We conclude that key players such as Germany will eventually act appropriately to keep the EU intact through a large-scale bail out of the weaker EU constituents. The inevitable “inflate away” remedy has many implications for long-term investors with accumulated wealth.

The value of paper currencies will be worth far less in the future, just as the purchasing power equivalent of the dollar has lost 95% of its value since 1930. Investors should not feel overly secure in bonds and cash and should be looking to allocate capital to areas that can survive and thrive in an “inflate away” paradigm. There is a very large disconnect between the prevailing emotional sentiment and truth.

The vast majority of investors are tightly huddled in a consensus of uncertainty and fear. Fundamentals and merit appear in solitude at the edge of chaos. The questions of the majority are the same and the cacophony of the echo chamber deafening. We sadistically love these environments for the bargains they produce. We are in awe of the opportunities that exists in the world today for the investor who can raise their focal point beyond the myopic chaos of the here and now.

Below I have summarized how we are constructing our portfolio to mitigate global macro risks and position for compounding opportunities.

Portfolio Construction - Go!

When I was younger my father introduced me to the game of GO. GO is an ancient board game played between two players that originated in China over 2000 years ago. Very simply, the object of the game is to use stones to surround a larger portion of the board than the opponent. Placing stones close together usually helps them support each other and avoid capture, while placing stones far apart creates influence across more of the board. The strategy of the game stems from finding a balance between these conflicting interests. Players strive to serve both defensive and offensive purposes and choose between tactical urgency and strategic plans. Dr. Henry Kissinger summed up the game with the following description:

Chess has only two outcomes: draw and checkmate. The objective of the game is total victory or defeat – and the battle is conducted head-on, in the center of the board. The aim of GO is relative advantage; the game is played all over the board, and the objective is to increase one's options and reduce those of the adversary. The goal is less victory than persistent strategic progress.

Portfolio construction for us should always resemble a GO board. We want to build offensive strategies toward our long-term strategic compounding goals in balance with the tactical urgency of the existing economic and political environment. Today we are finding great opportunities to own the equity of the some of the best businesses in the world at bargain prices.

We have continued to raise our equity exposures as prices fell during the quarter, making some mis-priced stocks even more attractive. We feel our allocations will be rewarded handsomely and will in turn be the foundation of future returns. However, we still continue to operate with caution and with tactical urgency to protect our portfolio in the short-term through a focus on margin of safety and with adequate liquidity of cash, short-term bonds, and real assets.

These options continue to serve as a source of funds if the market dislocation continues. The inevitable “inflate away” central bank strategy being followed presents us with the long-term risk of purchasing power loss. The best way to counterbalance that offensive action on the GO board is by owning a healthy allocation of global, competitively entrenched businesses that have pricing power.

Ownership of these businesses today at free cash flow yields ranging between 7 – 20% strikes us as a very common sense approach that maximizes our options. We do not view the outcome of our decision to own equities at these levels as potential for victory or defeat. We view the decision as an essential move which gives us the ability to gain strategic progress and a relative advantage over many of the large risks that exist in today’s investment environment, both seen and unseen.


[1 ]The S&P 500 Index, the MSCI All Country World Daily Total Return Index, the MSCI Emerging Markets Index, MSCI Europe Asia Far East (EAFE), and the Barclays Aggregate Bond Index are representative broad-based indices and include the reinvestment of dividends. These indices have been selected for informational purposes only. East Coast’s investment strategy will not seek to replicate the performance of these or any other indices.

[2] As the government creates money out of thin air to pay its obligations it serves to reduce the purchasing power of those dollars. However, the debt for the most part is a fixed amount. Inflation is a good thing for debtors and a bad thing for creditors. Thus these actions are serving to “inflate away” the value of the debts.

[3] A defibrillator does not restart the heart. It stops a dysfunctional rhythm (e.g. pulseless tachycardia: beating too fast without effective pumping, or fibrillation: irregular beating without pumping) in the hope that the heart's intrinsic mechanisms will restore an effective rhythm.