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Caution: Danger Ahead — R. Rodriguez/FPA

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Feb 21, 2012
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CAUTION: DANGER AHEAD Speech to Institute for Private Investors. By Robert L. Rodriguez, CFA

Managing Partner and CEO, February 15, 2012


I hope that this brief historical review of my career should help allay fears that what follows does not come from the likes of a perennial pessimist and doomsayer. Neither does "CAUTION: DANGER AHEAD" spring from recent capital market volatility. Oh, No! When I left to take my sabbatical for a year in 2010, I conveyed to my associates and clients that the current crisis was only Phase 1, and the coming year would prove to be simply an interlude. If the nation's unsound fiscal policies persisted, within 3 to 7 years, it would face another financial crisis of equal or greater magnitude, and it would emanate from the federal level. I wish I had said sovereign level, covering all my bases, but I did not arrive at this conclusion until once away on sabbatical when my attention and thinking shifted to the international area--European sovereign debt in particular.

Phase 2 is now beginning and I think we are on the cusp of a decade of extreme economic and financial market turbulence. Uncertainty as to the effects of high system wide financial leverage and the outcome of the battle to determine what the proper roll and magnitude of government should be within an economy are key elements in this future turmoil.

The final member of this trio of fiscal misfits is our own United States. Exhibit 5 below shows that U.S. total debt to GDP is nearly 350%, and this is before taking into account off balance sheet entitlement liabilities and guarantees that would bring it to more than 500%.

I have been highly critical of our nation's fiscal policies and budgetary trends for years. Both political parties disgust me because of their incredible fiscal ineptitude and unwillingness to be truthful with the American people. A chaotic future will be the result if our representatives continue to fail at their fiscal restructuring responsibilities. It is easy for me to speak of Europe and Japan in cold clinical terms, but not the U.S.; this is home and our nation's fiscal mess is like a life threatening cancer that is not being treated.


I believe 2013 is the most crucial year, of the past 80 years, for fiscal budgetary reform and the potential of new health entitlements makes a grand bargain more difficult to attain. Success or failure in this process will determine this nation's economic stability in the next decade.


Finally, tax reform is desperately needed. The following exhibit demonstrates, in a quantitative fashion, how the U.S. tax code has grown and become totally bazaar at nearly 72,000 pages and has nearly tripled since 1984.


If credible and material fiscal reforms are not implemented by the end of 2013, I fear that, between 2014 and 2016, this nation will confront a crisis similar to that of Europe. Time is running out because, starting in 2018 and continuing through 2024, various entitlement trust funds will be either depleted or beginning the process of liquidation. Budgetary financial pressures will explode.


Every additional year wasted beyond 2013 will increase the size and scope of the necessary fiscal response; furthermore, negative capital market reactions are more likely. Congress and the president should not become complacent, given today's low Treasury yields. Without reform, this is only a temporary calm before a much larger storm.


My bond market view is worse. Exhibit 8 on the next page demonstrates how much risk, and little return, there is if interest rates rise by 100 basis points in one year for the Barclays Aggregate Index.


Without a material improvement in the fiscal outlook, these low rates should prove to be unsustainable. Remember the suddenness and magnitude of the interest rate rise for Italian and Spanish ten-year sovereign bond yields this past year. Over the next decade, I expect low single-digit to negative total returns for intermediate and long-term bonds.


In stocks, we are cautious -- defensive but opportunistic.


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