Two Comments for the End of Year

by: David Merkel, CFA
  1. When I was seven years old, my parents gave me a colorful wind-up alarm clock. I thought it was beautiful. They taught me how to wind it up each evening so that I would wake up to go off to first grade. Being a boy, after a while, I wondered how tight I could wind it, but there seemed to be a limit to that. One night, I found I could wind it one “click” tighter than usual. A week or so later, another “click” tighter. After some time, I wound it one click too many, and I heard a snap, after which the clock rapidly moved in reverse for about 30 seconds, and then moved no more. I was heartbroken, because I really liked the clock. Perhaps its “death” was not in vain, because it is a great analogy for a full swing of the credit cycle. The spread tightening in the bull phase of the cycle is initially relatively rapid, and gives way to smaller bits of incremental tightening, until it is too much, or an exogenous force acts on it. Eventually, when cash flow proves insufficient for debt service, the credit cycle turns, and the move to spread widening is rapid. Once spreads get really wide, the cycle can resume, when those with strong balance sheets can tuck bonds away and realize a modest return in the worst scenario, if they just buy-and-hold. Though it did not happen for me, it would be the equivalent of buying the little kid a new clock. Then the cycle begins again.
  2. Economically, Japan has had a lost decade. It is beginning to verge on two decades. During this time, interest rates have been low, and growth has not been forthcoming. The main reason why low rates did little to stimulate the economy is that the banks were impaired, and could not lend. The secondary reason was demographic; equity markets tend to do well when there are more savers versus spenders. For Japan, that peaked in the early 1990s. For the U.S., that will peak in the early teens. Now, it is possible that the more market-oriented culture of the U.S. has reacted to this factor faster than Japan would, thus the relatively stagnant equity market in the 2000s in the U.S. This is also a cautionary note to those that think that lower short-term rates will benefit the U.S. markets; after all, what good have they done for Japan?

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