Discern what is.  Decide what can be. Do what is right.

by J. Dwight

Dwight Investment Counsel is an Independent Registered Investment Advisor.  The firm manages core investment portfolios of stocks and bonds, and no-load mutual funds for families, individuals, trusts, estates, retirement plans, municipalities, and non-profits. It is paid fees based on the value of a client’s assets or hourly fees, not commissions. The ideas expressed herein are meant to convey principles of investment management, and may or may not represent actual investment portfolios.

Definition of Investing versus speculation: Benjamin Graham in his important work Security Analysis (1934) “An investment operation is one which, upon through analysis, promises safety of principal and satisfactory return.  Operations not meeting these requirements are speculative.”

“Experience is a brutal teacher, but you learn. My God you learn.” C. S. Lewis

A lot of market and political commentary, has been centered on two themes lately: one, the dollar is doomed; and two, the US economy is loosing strength and global dominance soon to be overrun by the emerging economies, particularly China.

Two things have made investors (and the general public) uneasy: rising public debt and an expectation of runaway inflation. Many have concluded that the US dollar is doomed, and its days as the world’s reserve currency are numbered.

The notion that a government can abuse its monopoly on currency issuance is very seductive.  It has been the cause of high inflation, collapsing currencies, and sovereign debt defaults throughout history.  Americans understand the nature of this dangerous temptation.

At risk is America’s the historically proven path to greater health and wealth, greater charity and compassion, and greater tolerance and openness for everyone.

Based on these concerns, and on the latest data available, about $42 billion has been sold out of US equities, while $80 billion has been put into emerging market funds, and $10 billion into gold funds.

The legitimacy of these concerns and their implications for the dollar and the US economy are the subject of this letter.

Fiscal Deficits and US Debt

The US budget deficit is high. It grew to 10% of GDP in 2009, the highest level since World War II, and well above the historical average of 3%.

Federal debt rose to 53% of GDP, $10.1 trillion, by the end of 2009. Direct Federal debt is currently close to $13 trillion, about 83% of GDP.

Part of the deficit is from the recession.  It should improve next year as the economy is expected to recover this year. Historically for every 1% of nominal GDP growth, tax revenues tend to grow by 2.6% the following year.

Growing structural deficits are more troublesome. The growth in spending on entitlement programs (Social Security, Medicaid and Medicare) is expected to outgrow GDP by 2.2% on an annualized basis over the next decade, growing from 10% to 14% of GDP by 2020.

Concerns about runaway inflation are valid, but is runaway inflation a foregone conclusion?  Conceptually, here are the primary scenarios.

Scenario One:

Lacking the political will to cut spending, and faced with ever-spiraling deficits, policy makers let inflation rise reducing the debt burden.

This is the historically the way irresponsible governments collapse.  Those dependent on governments spending then suffer the most during these episodes.

Such collapses and defaults have become even more common in the twentieth century, as pointed out in the book This Time is Different Eight Centuries of Financial Folly, by Harvard economists Carmen Reinhart and Kenneth Rogoff.

The effects of this global financial crisis, “The Second Great Contraction” as Reinhart and Rogoff say, have “deep and lasting effect on asset prices, output, and employment” extending for five or six years. They add, “...global financial crises can be so much more dangerous than local or regional ones.”

They note however, that governments that took action to close budget gaps before structural shifts in inflation occurred were successful.

Those that failed, well, they failed.

Today, Americans have the liquidity and the ability to easily shift to more stable currencies away from their “home” currency. In Europe that has traditionally been the Swiss Franc. Gold is also an option. This should hopefully dis-abuse politicians and policy makers of pursuing this dangerous course of action. 

There are precedents for fixing high deficits in recent US history.

In 1993 when Democrats controlled the House, Senate and White House – similar to today’s political situation – policymakers passed a fiscal reform bill after the Republicans swept into the Congress in 1994.  It helped swing the fiscal balance from a deficit of 4.7% in 1992 to a surplus by 1998.

It seems that if current incumbents lack the political willpower to exercise fiscal restraint, constituents will then ultimately elect a replacement who will.

The Scott Brown victory, and the shift of the electorate in New Jersey and Virginia, may presage a shift in Congressional action on this front.

Scenario Two:

The history of the Weimar Republic of Germany during the early 1920’s is one of many examples that have been compared to the current day US Government balance sheet.

The contention is that the Fed’s rapidly expanding balance sheet will ultimately expand the money supply well beyond the growth of output, causing hyperinflation. Thus, destroying confidence in the dollar.

However, very little of the growth in the Federal Reserve’s balance sheet has entered circulation. In fact, broader monetary aggregates such as M2 have been flat over the last six months.

The majority of the Fed’s monetary stimulus sits on banks’ balance sheets as excess reserves earning interest. If banks begin aggressively lending, these reserves could ultimately find their way into the economy, but banks have tightened underwriting standards considerably, and are being discouraged from loosening them any time soon.

Equally notable, the Fed now has many tools at its disposal to withdraw this excess liquidity before it becomes problematic. The Fed could also raise the Fed funds rate, if signs that inflation and/or inflation expectations were rising sharply.

Disinflationary Macroeconomic Factors

In addition, a number of macroeconomic disinflationary trends exist.

One, the unemployment rate is close to its 26-year high, and capacity utilization near its lowest levels ever.  As a result of the slack in the economy, unit labor costs remain depressed, creating a very different environment than what existed during the inflationary 1970s.

Two, the disinflationary trend due to globalization and global trade remains alive, and active. It could increase as emerging economies look to sustain their growth through competitively- priced exports.

In other words, inflation expectations remain low and contained at this time.

Though neither of the above two scenarios are inconceivable, the odds of both scenarios playing out in the US for the dollar seem low.

Implications for the Dollar

Against the above analysis, the reports of the dollar’s demise, to paraphrase Mark Twain, “are greatly exaggerated.”

One, realistically, there are no alternative currencies that can challenge the reserve currency status of the US in the foreseeable future. Since 64% of the world’s foreign currency reserves are dollar denominated, the dollar is de facto the global currency.

Two, the recent economic crisis confirmed the safe haven status of the US dollar: It rose as world markets collapsed from March 2008 to March 2009.  

So, our legislators and Congressional representatives shouldn’t expect a return to high growth rates.  They should not increase taxes or impose new government costs during a weak and nascent recovery.

It is notable that the dollar’s currently depressed valuation reflects negative sentiment toward the current administration and Congress policy pursuits: Cap & Trade, Obamacare, restricting exploration for and development of natural resources, and labor union ‘card-check’, and other economically reckless policy ideas.

What are the Policies for Prosperity?

Economists agree that the most important ingredient to controlling inflation and currency devaluation is a strongly independent central bank, whose policy emphasis is on stabilizing and reducing inflation.  Recent moves by the Obama Administration and the Democrat Congress to reduce Federal Reserve independence should be strongly discouraged and opposed.

Low inflation and stable currencies have historically led to the greatest growth periods in history.  This should be the policy objective. This is the historically proven path to greater health and wealth, tolerance and openness for societies all over the world.

In summary, Global financial crises are much more dangerous than local or regional ones. Despite the powerful nature of the “Second Great Contraction”, the world’s economies and markets are coping and adapting and growing.

We would be wise however, not to believe that we are smarter than our predecessors, or better at dealing with crisis situations. 

“But, highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked,” as Rogoff and Reinhart say.

A combination of fiscal restraint, economic slack, and a viable Fed exit strategy could keep inflation expectations under control, lower the US budget deficit, and ultimately reduce debt issuance. Additionally, cyclical forces are already in motion to sustain growth this year, which will prove to be of benefit.

This does not mean that interest rates will remain at sustained low levels, just because deflation is the primary credit market characteristic. Credit demand is on the rise by nations and businesses, and risk of sovereign default being higher.

Against this backdrop, and surging growth in emerging economies such as China, pundits have declared the end of US dominance on the global financial and economic fields.

I disagree. As noted in This Time is Different real estate asset bubbles (as are being exhibited in China today) are the best historic indicator of pending contractions.

Many convincing arguments have proclaimed the end of the US in the past.  In every case, those who advocated such have been incorrect.

America’s distinct geopolitical position and economic and military dominance mean that these problems are serious but not fatal.

America’s unique culture, positive attitude and optimistic outlook remain present in every part of the globe.

America exemplifies the historically proven path to greater health and wealth, greater charity and compassion, and greater tolerance and openness for societies all over the world.

It all depends on the American People: their indomitable spirit and individual will.

This generally optimistic view does not mean that as an investment advisor that I can take a ‘blind-eye’ to the dangers or opportunities. Companies with relative exposure to faster growing emerging markets or countries should be researched and scrutinized.  The longer the US takes to return to its Where appropriate to a client’s needs, objectives and risk tolerance such investment tools will be added to client portfolios.

The preceding was provided by Dwight Investment Counsel, 120 Orchard Dr., Wilton, ME 04294.  This report has been derived from information considered reliable but it cannot be guaranteed as to its accuracy or completeness. It does not constitute an offer or recommendation to buy or sell any security directly or indirectly mentioned herein.