August 10, 2010

A Bubble in Conservatism? No Such Thing…

When one thinks of financial and economic bubbles images of reckless speculation, lavish galas and luxurious consumables are conjured. Bubbles are tied to euphoria and new economic paradigms. Bubbles grow out of the expectation of permanent prosperity.

Individuals are drawn into the euphoria with the assurance they won’t lose money and that ‘everybody’s doing it’. Nobody wants to see his neighbour work half as hard and spend twice as much, so jealousy can motivate the average man to become a speculator.

Eventually, in an effort to out-do one another, individuals begin taking more risk – such as investing on margin (or $0-down adjustable rate mortgages) – to achieve bigger returns (or to achieve the same returns when returns on capital inevitably shrink). During a bubble, recent asset price returns provide comfort to the few that wonder about the risks.

At the point when the speculators are plenty and margin debt is high, a small change in the economic winds (usually prompted by businesses scaling back excess capacity) starts a cascade of financial ruin. While bubbles can take form in unlevered environments, it is debt that takes bubbles to ruinous proportions and makes the equity held by individuals so sensitive to otherwise innocuous economic events.

Given that bubbles are classically associated with the pursuit of prosperity, is there such a thing as a bubble in conservatism? When individuals are scared about their prospects they act conservatively by saving and paying down debt. Can a massive wave of conservatism, such as the one we’re experiencing today, hit a threshold that forces it to reverse (i.e. the ‘bubble’ pops)?

While a bubble in risk assets leads to a self-feeding spiral of leverage, overcapacity and low returns on capital that eventually hits a threshold causing it to self-correct, a bubble in conservative assets does not need to self correct. True, after a certain amount of time – months, years or decades – individuals may feel comfortable about their personal balance sheets and begin to reduce their savings rates and increase their use of credit. (If starting from a sound base, this transition can fuel a secular bull market.) But there are no financial constraints forcing such a change in behaviour.

Let’s take this to the micro level. If you make $10,000 a year and feel euphoric about the economy you can increase your consumption – by spending all your earnings, plus borrowing – to a certain threshold. Once a threshold is hit and the bank starts calling in your line of credit, your behaviour must change.

On the other hand, if you make $10,000 a year and feel wary about the economy you can save half your earnings each year. In this case, there is no threshold that is hit that forces you to start spending again. Conservative behaviour can continue indefinitely, and has done so in numerous countries with high savings rates.

Today, many are saying that US Treasuries are in a bubble. I’m not arguing that the US government doesn’t have fiscal challenges, but I am arguing that the supply of funds to finance those challenges can continue flowing for a very long time. The flow of investor (individual, banks, corporate) cash into US Treasuries is driven by conservatism and not by the misguided pursuit of wealth. Individuals are not eying their neighbour’s new Porsche with envy, running to their broker to borrow $100k to invest in government bonds. Quite the opposite: investors are looking at their unemployed neighbour, their decimated 401k and their looming ‘retirement’ (whatever that may look like) and focusing on capital preservation. Wealth accumulation was so 2000s (or dare I say so 1990s).

The new frugality, the liquidity trap and risk aversion are funding the US Treasury…and this ‘bubble’ is being driven by cold hard cash (as opposed to leverage). This is why the flow of funds into US Treasuries can continue for a very long time.

Perhaps bonds are expensive. Perhaps the US Treasury needs to borrow a lot of money. Someday (could be sooner, could be later) the US Treasury trade won’t be a good one. I agree that the US is borrowing extreme amounts of money and Treasuries may not be a good ‘buy and hold’ long-term investment. I also agree that the US may one day implicitly default via inflation, and Treasuries may eventually fall in value. So this is not a commentary on the merits of US Treasuries as an investment (I’ll leave that to experts like Gary Shilling and David Rosenberg who both forecast double-digit returns for long bonds). This is a commentary on the characteristics of a ‘bubble’ – I believe that strong demand for funds does not necessarily characterize a ‘bubble’.

Bubbles are determined by the exuberant supply of capital, not by the demand for capital. And, as previously stated, the supply of capital today can hardly be considered exuberant, as it is generated prudently from incomes and portfolio re-allocation (not from leverage or irrational investor enthusiasm). As long as risk aversion remains dead and US Treasury issuance remains within a digestible flow, US Treasuries will have a firm bid from conservative individuals, banks and corporations looking to park their cash.

Yield and returns for US Treasuries will experience ups and downs – sometimes violent. But throughout those ups and downs, a strong bid for US Treasuries will remain as long as current macro-conditions prevail. To call investor demand for relative safety a bubble is to not understand the definition of a bubble. For there is no such thing as a bubble in conservatism.