Liquidity Trap

Forgive me for the gap in entries, my last entry spurred me to circle back and think harder about the direction of the economy and I've picked up "Managing Investment Portfolios. A Dynamic Approach." in order to refresh my memory on portfolio management theory.

Inflation or Deflation? What is the outlook? 

Are we headed down the road paved by Japan of a lost decade with deflation or are we on the precipice of accelerating inflation? Answering this question is a key step in settling on an outlook, and thereby constructing a portfolio.

Currently we are stuck in what the economist Keynes termed a "Liquidity Trap." This occurs when interest rates approach zero and basically means that traditional monetary levers have little impact on stimulating the economy because the demand for money has become almost infinitely elastic. Therefore, non-traditional monetary policies and fiscal policies must be relied on to stimulate the economy.

Clearly the government has been quite active with its fiscal policies in order to stimulate the economy. These policies have had some positive effect, although the extent of the impact is a political hot potato. I argue there are a couple problems with these classic "cut taxes versus increase spending" fiscal debates. The first is that we already cut taxes during the Bush era, reducing both the impact of further tax cuts and our ability to materially increase debt levels (after adding trillions during America's "deficits don't matter" era). The second problem concerns the obvious statement that the increased government spending must lead to greater private spending, or else any recovery is unsustainable. This second problem is where we find ourselves currently, debating whether private spending will now lead us out of the liquidity trap with corresponding rising interest rates, or will the slowing government stimulus and continued lackluster private spending produce a "double-dip" recession with potentially deflationary prices.  

Eventually Poor Investment Spending Decisions Catches Up With Us

The next segment looks at the Liquidity Trap problem from a financial perspective by bringing in the growing use of the financial analysis methodology "Economic Value Add," or EVA. Basically this analysis looks at the difference between a company's cost of capital (basically the blended interest rate on debt outstanding and cost of equity) and its Return on Invested Capital (ROIC) to determine whether the business is creating or destroying economic value. If ROIC is greater than the cost of capital, then economic value is created. From my own analysis, and what one would intuitively expect, I believe the expected EVA of a company describes over 95% of its stock price with swings in ROIC through management decisions dominating.  

For the past few decades the cost of capital for businesses has been declining, highlighted by the declining interest rates but also likely a result of more efficient capital markets. Thus, managers have had a lower and lower ROIC hurdle rate to clear in order to produce a positive EVA. Looking at monetary policy through this prism, the government can actively increase the country's EVA by lowering the interest rates, thereby lowering the cost of capital for companies and making previously negative EVA projects appear positive, even though the cash flow dynamics have not changed. Nice trick, unless you use it too often and for too long and thus managers start making investment decisions based on expected lower financing costs going forward, effectively lowering the returns produced by the economy. If abused, I believe an overly aggressive traditional monetary policy, which does not force the healthy pruning of marginal projects through periodic recessions, becomes a race to the bottom that eventually produces negative returns and thus deflation.

The outcome of the declining cost of capital are large pools of invested capital with low return levels, or bubbles like the housing market. If the macroeconomic forces deteriorate, these low returns can swing to negative returns. The cumulative effect of these management decisions to fund low-level return projects is a glut of assets, highlighted in overcapacity in industries like the restaurant industry. Should lending standards tighten, as banks have recently done, the economy has a tougher time recovering until these low return assets are absorbed by growing demand or shrunk to in-line with demand trends. My concern is that both fiscal and traditional monetary stimulative efforts cannot overcome the structural problems created over the past 10-15 years due to the low returns inherent in the country's investment base.

Paying the Piper, or not

The next three to six months likely answers the question of whether private spending picks up enough to drive a recovery, or remains muted and we slide back into a recession. There are clearly signs that the economy is improving, including an expansionary ISM Manufacturing Survey data, higher volume of freight shipments, and improving consumer sentiment. However, there are also data points that suggest a more muted recovery. Relatively low raw industrial prices and commodity prices offer a mixed picture on demand. The Conference Board Leading Economic Index grew modestly at 0.4% in May, slightly lower than expectations, slower than the 1.4% in March, and following a weaker result in April of flat. One of the main reasons offered for the weaker recovery is the expiration of the federal housing credit in April. (Eek!) 

Of course the government can provide additional spending stimulants and pursue non-traditional monetary actions. The increasing debt load likely makes increased spending measures more politically challenging, especially if the Republicans win more seats in Congress and unseat President Obama. Tax cuts might be offered, but these are likely viewed as more short-term in nature and therefore likely won't have as big a bang, or at least only drive growth in high-end markets while segments catering to the middle class languish. If the economy slips backward I would expect to see more focus on non-traditional monetary policies to stimulate inflation, including active currency devaluation, monetization of the country's debt, and efforts to raise the expected inflation rate in the future through high level policy announcements. If it gets to this point we may see another period of expansion during which I would hope the underlying structural problems are solved. The risk is that either these "hail maries" don't work or the government overshoots and inflation balloons.

If government efforts cannot spur the economy, or burden businesses with excessive regulations and costs for businesses, then the next decade may be lost as business works off the marginal investments of the past.

Investment Strategy

Currently I have a blank canvas, with my portfolio almost entirely in cash. Not ideal, I know, but one of the main reasons I started this blog in order to re-engage and determine an investment strategy. I will also mention that my liquid portfolio is predominantly in a tax sheltered vehicle, thus reducing my interest in more tax efficient investments like municipal bonds. I also have a relatively long term horizon of over 25 years.

My next post will talk about my investment strategy.