Barron's: How bad has the macro economy gotten?
Pomboy: It is certainly the toughest one any of us has lived through. My fear is that it's actually just in the early stages and that it is going to get substantially worse on the economic side, although all the government measures that have taken place so far might help to insulate some of the damage on the financial side.
What about the short-term outlook?
Having been bearish, for me the real challenge is to identify the turn. One thing at work right now is what I call the cattle prod -- essentially the Fed poking people to take risk. They are taxing cash by having negative real returns on cash. At the same time, yields on investment-grade and junk bonds are incredibly alluring. You can pick up 15 percentage points over cash buying junk bonds. Or you can pick up 8.5 percentage points on investment-grade paper. At some point, the cattle prod will get people moving, as it did in March of '03 when the market turned.
What else do you see happening in the near term?
With the government guaranteeing all manner of private-credit claims, many investors may decide to get long "socialism," for lack of a better term. Or, as some euphemistically put it, this is partnering with the government. So in the short run, we could see a rally in risky assets and a selloff in Treasuries. But the economic deleveraging has barely begun, and that's my longer-term thesis. It all revolves around the idea that U.S. consumers are actually going to do the unthinkable -- they are going to save -- and that we will be more like Japan than anyone believes is possible.
Hence, consumption declines.
Right. Wages have been silently crowded out by benefits as a share of total compensation, as companies look to offset rising health-care costs. The result is that the share of income that consumers can actually spend is at its lowest in the post-war period. It had not been a problem, because consumers would just borrow to fill that gap. But now, they don't have appreciating assets against which to borrow. So while we could get a rally in risk assets -- including high-yield debt -- it's likely to be a short-term rally within a context of a secular bear market.
Any other important longer-term trends you expect?
We are going to see a secular rotation from paper assets to hard assets like gold. The whole global competitive currency devaluation, including that of the dollar, plays right into that.
Do you see any asset classes besides junk bonds benefiting from a short-term rally?
There is a chance that equities participate in that rally as well, although I think investment-grade corporate credits look much more attractive than stocks. But when you think about pension funds that are trying to make 8% annual returns, they are not doing it by getting 1% on two-year Treasury notes. They can't use the secret sauce of leverage anymore.
If I was going to hold my nose and buy anything, I probably would buy higher-quality corporate credits. If you want to get long socialism, one of the next segments of the market that will be given a guarantee will be municipal bonds. That's because state and local governments are a huge share of total [gross domestic product] and employment, and we can't afford to have them down for the count.
One thing that caught our eye in one of your recent notes was the steep decline of Treasury-buying by foreigners. What are the ramifications of that?
We are acting as though there are no consequences to basically running the money off the printing press and handing it to the Federal government to backstop financial markets or bail out homeowners or what not. There is no consequence to doing this, unless or until the rest of the world says to us, 'We don't like this game' and 'We don't want to have all the dollar claims we are holding debased by [Fed Chairman Ben Bernanke] running his printing press.'
So if foreign investors stop buying Treasuries, or even significantly pare their buying, that means higher rates in the U.S.
That's correct. But then [Bernanke] will start buying Treasuries to arrest the rise in interest rates. I've always had a very simplistic view about this: Either we are going to pay for our policy sins via higher interest rates or a weaker dollar. And for an economy that is as levered as the one in the U.S. is, the former choice is not an option. We can't pay through higher interest rates; we barely got to 4.5%, 5% before the whole subprime crisis erupted. So a weaker dollar is the natural valve. But right now, we are enjoying some real competition in the ugly contest from the currencies of the European Union and the United Kingdom, and that will probably persist for a while because they are in pretty bad shape, and they are a little bit behind the curve relative to us.
Could you elaborate on that choice between higher rates or a weaker dollar?
If we rely on foreign creditors to lend us the money to sustain our lifestyles -- and that's what we do -- we need to compensate them for that risk of lending to us. As the economy weakens and our credit quality should theoretically be deteriorating, the only way we can really attract that same capital is by offering a higher interest rate or making our assets cheaper to them, in this case by having our currency be weaker.
