A recent article released by the Associated Press has led to some interesting discussions among Sigma colleagues and clients. The article, which can be referenced here, was a Q&A done with David Stockman, a former Michigan congressman, Director of the Office of Management and Budget under President Reagan, and successful private equity investor discussing his (strong) opinions, explanations and predications for the US economy.
Q. The most prominent question that has come my way is very simple – Do you have a take on this? Is he right or wrong?
A. I do have a take and it is multifaceted for a host of reasons.
First, from the broadest perspective, one must consider the source of the information. Stockman is quite wealthy and for that reason has a completely different investment profile (both from a risk and return point of view) than most Americans do. Put yourself in his shoes – worth many millions, never having to worry about making another dollar through working or investment. He is, in essence, wealthy enough to put it under his pillow and make nothing. He is a little bit poorer every day, but will never spend what he has. As a result, the probability that his financial plan fails under this approach is as close to zero as possible. On the flip side, his chance of failure inches up incrementally (albeit by a tiny amount) as he introduces riskier assets into his portfolio. The tradeoff is obvious – he does not need return at this point in his life so he does not need risk.
For most investors the scenario plays out much differently. By taking no risk, most investors are destined to fail because they don’t have enough capital set aside to combat spending and inflation. If you know you’re going to be spending 5% of your portfolio (increasing that value at 3% per year), and earning nothing, you will have no money left in 16 years. That’s a fact. If inflation ends up being higher, that amount of time is reduced. Stockman, on the other hand could probably play the same game for many years and not run out of money.
Getting a little bit deeper into the arguments of the article, there are many things that I agree with. Will Social Security and Medicare have to be scaled back for younger generations and the wealthy? Yes, although many of our current clients will be lucky enough to escape this one. Has monetary policy caused the bond market to become over-inflated? Yes – this is why we emphasized equity investments in client portfolios that need positive after-tax, after-inflation returns. Is the US way over-leveraged? Yes, the government bailouts have simply transferred consumer debt onto the government’s balance sheet. Is the US Treasury destined to default and are equities destined to crash? Now here is where I disagree.
The US is different than Greece because Greece needs to borrow today to pay current bills with a currency that they have no control over. They cannot meet next week’s payroll. The US government on the other hand has the bulk of their obligations in the out years (Social Security and Medicare) and they have an independent sovereign currency. In other words, in the worst case scenario the government can print money to pay their debts. Material changes to government pensions, Social Security, Medicare (both benefits and fraud) are coming and they will have a material long-term effect on the deficit. There is no doubt that we need to improve the country’s fiscal position, but we have time to do so. This can also be a negative though because, at present, nobody in congress is all too worried.
Lastly, when it comes to equities, 10 years of no return is not likely to persist. Such long-term patterns are normal and have happened before (1929-1942, 1966-1982, 2001-2012). In each instance, the subsequent periods were quite prosperous and were marked with economic advances that one could have never foreseen (industrial revolution, telecommunications, the end of the Cold War, the internet, smart phones and the list goes on). Economic prosperity is largely driven by productivity gains, which I’m quite confident, will persist over time. Whether it’s the next iPad, a new clean fuel that frees us from foreign oil, or a cure for aids or cancer, the productivity gains will come and will be unpredictable. Somebody will have to meet the demand of the developing world as those in India and China rise into the middle class and begin to consume goods. Equity investors will be the eventual beneficiaries.
Finally, I will add that one’s view on taxation can often morph as they move throughout their life. For Stockman, he has made his fortune so he is almost indifferent to the future tax code (especially since he is sitting in cash!). It is awfully similar to Mr. Buffet’s most recent comments. For those who are much younger and whose innovation and economic production will drive the next wave of prosperity, I would argue that taxation has a much more meaningful effect. The eventual fix for our maladies is not simply higher tax rates.
If you have any further questions or concerns, feel free to keep the conversation going.
Christopher W. Frayne, CFA, CFP®