orth to Alaska, we're goin' NORTH - the rush is on."

I learned several things during a recent twelve-day cruise to the Inland Passage of Alaska. For one, I discovered that you can’t start a dogsled by yelling “mush.” Sergeant Preston of the might have been able to, but that was at least 30 years ago and today’s dogsled isn’t your father’s Oldsmobile – so to speak. Twenty-first century huskies only pull when they hear the word “hike”, so I found that if you’re going to quarterback an Alaskan sled these days, you literally have to pretend you’re Joe Montana, but without the “huts.” When I cornily attempted to interject “Hut-1”, “Hut-2” into my doggy cadence, I wound up on the receiving end of a sit-down strike instead of an Iditarod trophy. So much for my career as a dogsled jockey, or even an NFL quarterback, I suppose. Any such dreams were quickly turned back to “mush."

I also learned a lot of fascinating details about the Alaskan/Yukon gold rush of 1898-99. Getting to the nuggets of the Yukon's streams was no easy task – as it turns out far more difficult than their grandfathers had it nearly 50 years before in California. The 500-mile inland journey beginning in Skagway, required the scaling of mountains resembling Mt. Everest, which by itself was Herculean. Check out the kicker though: each miner was required to carry in 1000 pounds of supplies to insure his survival once he arrived. To do THAT meant that these 99’ers had to scale the ice laden peaks not once but literally 5 or 6 times as they backtracked up, then down, then up again with 200 pound loads of grain and smoked meat. Where was Webvan back then, I ask you!

Less than half of those that began the trip actually made it to the gold fields and fewer still, of course, struck it rich. That is the way of the world, I suppose, and even more so the way of capitalism. Optimism drives companies and investors to unheralded peaks of excess, backtracking up and down mountains of risk with the hope of high profits at the end of the journey. That there are nuggets on the other side of the mountain is beyond doubt, but who gets them and at what cost is the fascinating part of this historical, nay, ongoing saga. What was and remains certain is that the optimism of capitalists is a powerful force for economic progress but one which is often subject to setbacks and individual or even collective disappointment. We appear to be at just such an ice laden juncture in July of 2001. To find out why, put on your warmest boots and muskrat-lined jacket and hop on board this dogsled of mine to see where it might take us over the next few months. Mush you Huskies… I mean Hike!Last month’s Investment Outlook described at length the secular dilemma of “weak links” that threaten to derail or at least weaken any U.S. economic recovery, and therefore keep interest rates and stock prices relatively low. Five percent annual returns for both bond and stock markets over the next few years would be a cryptic yet accurate description of the markets as we see them for several years to come due to muted productivity, yet still benign inflation, and a developing skepticism of equity investors over the inevitability of guaranteed double-digit corporate profit increases. Still there are games within games and business cycles within secular movements that necessitate adjustments to the reins of almost any portfolio managers’ dogsled – no matter how long the race or how far the destination. And now as we head towards summer’s end there is the growing anticipation among economists and money managers alike of the economic recovery to come. 275 basis points of Fed cuts, $300 refund checks for almost every taxpayer, and a liquidation of excess business inventories have sparked the hopes of prospectors everywhere that the good old days are just around the corner. While its timing might be in doubt, let me join the chorus and admit that there is no question of a future economic recovery. Recoveries always follow downturns. There is a recovery out there, but its magnitude, not starting point is the more important question. And to describe it, analysts have simplistically employed the old economist’s game of alphabet soup. Extreme optimists believe in a V-shaped recovery, implying a quick return to the good old days. More cautious forecasters speak of a U, which signifies a more gradual ascent. And bearish curmudgeons babble in terms of Ls, which is meant to portray a muted recovery that only goes so far and no further. Actually, although I find the L-shaped recovery most probable for many reasons soon to be advanced, the L letter itself is a rather inaccurate graphic portrayal of a muted recovery. The L actually portrays an economy that goes down and stays down – for the count. What I think we’re about to experience is more like a half H: down, then back up, but with only half as much growth as experienced in the heyday of Greenspan’s New Economy juggernaut.

The explanation for my half H rests almost entirely on the assumption of a wounded consumer and investment sector, that will be extremely difficult to restart let alone bring back to pre-slowdown levels of growth. I and others have discussed in past months the substantial levels of overspending and excess investment that have characterized the American economy in recent years. Negative personal savings rates and investment in excess of 14% of GDP have combined to place the American private sector in hock to not only its own savers, but the rest of the world as well, which in turn has cheerily agreed to serve as our banker via an accelerating current account deficit. The combination, as shown in the chart below, portrays the U.S. private sector moving from a 4% surplus to a near 6% deficit in less than a decade. It could be rightly argued that it was this total swing of 10% that allowed the U.S. economy to grow at an annual rate nearly 2% faster than historical averages. Forget about productivity miracles. We simply borrowed more and more, then spent it before lenders had second thoughts.

Well, why stop now? An objective answer would have to include the possibility that we don’t have to stop – that we can turn this economic slowdown back into a V-shaped recovery quicker than you can yell “hike”, by continuing to drive the private sector financial balance deficit further and further into red ink. To do so, though, would require a rejuvenation of business and consumer “animal spirits” that has typically been produced by easier money and lower interest rates from the Fed. Granted, Greenspan has moved quickly to re-induce confidence into the American – and therefore – global economy, but aside from some mild upticks in several consumer confidence surveys, something seems to be missing this time. In normal business cycles, six months after aggressive easing by the Federal Reserve the following three events have taken place: 1) stock markets have risen by 10-15%, 2) bond markets have declined in yield by at least 50 basis points, and 3) the U.S. dollar has depreciated in value. In combination, these three factors have been the reason why a V and not a half H-shaped recovery has invariably taken place. Stocks going up have promoted the consumer wealth effect as well as accelerated business investment. Bond yields going down have allowed for lower mortgage rates and generated substantial refi activity, which in turn has led to more consumer spending. And the weaker dollar has given manufacturing the breathing room to increase exports and profit margins as well.

To date none of this has occurred as pointed out in part by the following chart:

To complete the statistical triangle, since January 3rd when the Fed first started to ease, stocks are down over 10% by most index measurements, and the dollar is up by 8% or so on a trade-weighted basis. The Fed’s magic then has so far failed to convince private investors, whether they be in stocks, bonds, or currencies, that their markets should be following the Greenspan “Hike!” – thus starting the dogsled forward in typical V-style recovery fashion. By perversely moving in the opposite direction, they more or less insure that it won’t take place. Until stocks go up, bond market yields go down, and the dollar weakens from current levels, then, we are looking at a muted recovery and the near certainty of a half H recovery – up, but only half as much as in prior recoveries.

The U.S. and many global economies are most certainly goin’ north as we approach year-end – just like the 99’ers of the Yukon gold rush, but no – “The rush is (not) on.” Greenspan has yelled, “Hike” but like yours truly, he may have interjected a few “Hut-1s” and “Hut-2s” into the equation. These 21st Century dogs don’t seem to be responding, and the warming huts of Iditarod and the V-shaped recovery are still a long way off. Look for more Federal Reserve cuts in the immediate future to get our economic dogsled up to crusin’ speed.

William H. Gross
Managing Director