By Anders Maxwell

In his 1970 bestseller, “Future Shock,” sociologist Alvin Toffler put forward a thesis that individuals would be increasingly overwhelmed by the accelerating rate of social and technological change, popularizing the phrase, “information overload.” Forty years on, the U.S. economy itself is in Future Shock.

The credit crisis triggered by an overbought and overleveraged housing market has resulted in the worst recession since the 1930s Depression. Without due appreciation for the complexity and scope of an economic decline propelled by housing prices, in response government has pursued conventional fiscal stimulus coupled with an unproven and controversial monetary initiative, dubbed “quantitative easing.” Now, three years after the trauma of a failure of such iconic corporations as Lehman Brothers and AIG, rather than sustainable recovery, the U.S. economy continues to be dogged by faltering demand and systemic overleverage. How capital markets assimilate the impact of these pervasive issues will define risk and frame investment opportunities looking forward.

To appreciate the magnitude of the impending changes, interest rates have moved in one direction—down—since 1980. Following former Federal Reserve Chairman Paul Volcker’s effective stand against inflation, over this period, equity markets have been in a prolonged rally. At the same time, total debt, including government, corporate, as well as household, has grown more than tenfold, twice the rate of growth of gross national product. Reflecting the extraordinary effects of the Federal Reserve’s quantitative easing, adjusted for inflation, real rates of interest are now negative. Yet, measured by at least three key indices—unemployment, consumer confidence and housing—there is cause for concern the economy is poised for a “double dip.”

Given current conditions, interest rates have nowhere to go but up. The traditional prescription for reinvigorating the economy, government’s ability to spend its way out of the current stall, is seriously compromised by excessive deficits. By elimination, policymakers are left to extend a reliance on open market purchases of U.S. Treasury bills (and the occasional GSE mortgage-back). Signaling the magnitude of these market interventions, Federal Reserve purchases this spring have exceeded 70% of the new issuance of Treasury bills. Of further concern, this $14 trillion Treasury market is now dominated by three holders, the Fed, China and Japan, representing 26% of total U.S. debt.

However viewed, the Fed’s ability to continue its quantitative easing on such a scale will be challenged by the central banks of China or Japan as either responds to their respective domestic political and economic demands. This portends a curtailment of this level of U.S. bond holdings. Highlighting this prospect is the extraordinary capital demands represented by the March 11 “Great East Japan Quake and Tsunami,” with a rise in interest rates increasingly likely as a result.

As capital markets confront the inevitability of rising rates, the U.S. faces a sea change reflected by the crosscurrents underlying the current economic malaise. Declining housing values and compromised monetary policy are a cause for concern, seriously constraining potential remedial action. However, much more consequential are equity market valuations, which are estimated by Smithers & Co. as 60% overvalued measured by such standard ratios as market value-tonet worth and adjusted price-to-earnings. Furthermore, contrary to the view of Wall Street research that U.S. corporate balance sheets continue to strengthen, data from the Fed and the Bureau of Economic Analysis show net debt-to-equity at record levels adjusted for inflation. Propelled by corporate stock buybacks which, in turn, have been fostered by artificial liquidity from quantitative easing, inflated equity valuations, when magnified by corporate overleverage, substantially increase the likelihood of a major correction.

As though these issues are not concerning enough, looking forward, a recent white paper from the McKinsey Global Institute, “Farewell to Cheap Capital? Implications of Long-Term Shifts in Global Investment and Savings,” based on emerging market infrastructure demand, projects a material rise in interest rates, regardless of how governments manage deficits or the Fed’s burgeoning inventory of Treasury and mortgage securities.

Wall Street, it appears, has found little cause for alarm, at least prior to 2012’s election. This presumes Washington can manage the federal budget and, much more problematic, reverse prevailing trends so that U.S. households resume deficit spending to support GNP at least until the election. This seems wishful thinking, at best. Not only is the secular bull market over, but the buyers of Treasurys are under siege. Moreover, there is growing evidence of anemic performance of U.S. business in faltering sales. Coupled with high corporate leverage, markets are precariously balanced, poised for a major step down in a bear cycle. Overwhelmed and disoriented, the economy is, indeed, in Future Shock. Deep value investors are advised to focus on defensive credits, buttress hedges, and marshal liquidity in anticipation of the opportunities dislocation always yield.

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