As panic once again grips the financial markets, let me first tell you what I am not scared about. I am most certainly not scared about the current markets. The “tempest in a teapot” in Europe (I know using Jamie Dimon phraseology is to some extent tempting fate) will pass. The Greeks know full well what is good for them, and after a lot of belly aching, they will find a way to remain in the European Union and maintain the common currency. The Germans also know full well what is good for them too. After all, they have been the biggest beneficiary of the common currency, having restructured their economy on the back of massive exports to the European periphery. The German economic doctrine of no reward without great pain will fade. Pro-growth policies are coming. I am most certainly not worried about European growth. In fact, despite all its travails, European growth has been much better than what most would have expected. There is more wood to chop on the fiscal front, and it will weigh on growth I have no doubt, but, I also know that it is not getting worse. If anything, the economy is stabilizing as evidenced by Eurozone gross domestic product coming in flat in the first quarter.
This brings me to what I—a bond investor—am scared about. Call me crazy, but the U.S. economy’s cyclical components are getting quite strong. More importantly, they are gaining traction. If the housing sector stabilizes, as it seems to be, the implications for the broader economy are going to be profound. The recent equity market stress may not help my view, but as long as employment growth is decent and housing prices are stable, consumer confidence and consumption drivers will do quite well. After four-plus years, the deleveraging cycle will finally be over. If you are not scared yet, let me tell you what that means: good, stable growth and meaningfully rising rates. I exaggerate a little, but the consumption data and consumer behavior are strong enough and ought to scare the pants out of the throngs of investors lending money to the U.S. Government for 10 years at sub-1.80% interest rates. Either the markets or the policymakers will force rates higher in the short to medium term. It’s a scenario that would be great for equities, but the days in the sun for us fixed income types will be over for a long time.
But, here’s what could go wrong for investors. By the end of the third quarter, politicians—basking in the glow of positive economic news in an election year—will be tempted to consolidate fiscal spending and cut the deficit, just as the economy looks to be steadying. Unfortunately, as fate would have it, the U.S. is facing a looming fiscal cliff. My hope (and the base case) is that we don’t repeat the mistakes of the Japanese and consolidate the fiscal balance. Fiscal consolidation would mean cutting deficits and raising revenue, which would stifle growth and take us back to lower interest rates. My ultimate fear (and the tail scenario) is that we can’t get over the politics and douse ourselves with kerosene in a public square and light a match, so to speak.
Lower rates may be good for my bond portfolio, but they would be terrible for everything else in America. That is what investors should be afraid of.