1. GFAM 200 9 Ma rket O utloo k
We believe that the recession that began in
December 2007 will likely persist through
much of 2009, followed by a tepid recovery
at best. Given this timing, we expect the
capital markets to remain challenged,
making defensive positioning and bargain
hunting the major focus for our asset
allocation decisions this year.
Before we can develop that forecast further,
we need to ask deeper questions: Are we
in a “typical” cyclical recession or is the
slowdown phase of a deeper structural
change? Has the bursting of the credit
bubble coincided with a new paradigm of
savings instead of consumption? Finally,
what will be the impact of government
stimulus and the debt it entails?
G ov e r n m e n t st i m u l u s p l a n s
Government spending through fiscal
stimulus plans is often an effective countercyclical means of dealing with recessions.
The government does not directly affect
consumer spending, a key component of
the current slowdown, but it can create
spending programs that may be effective if
the multiplier effect (the ripples created in
the broader economy) is sufficient.
Currently, investors worldwide have funded
the US government’s efforts by snapping up
Treasurys at almost any yield for the safety
of principal. At some point, however, foreign
investors may see a greater need for using
their funds for their own domestic stimulus,
Chart 1. Fed Balance Sheet
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2. or they may seek better yields elsewhere.
The likely effect would be some combination
of a falling dollar and rising interest rates.
Meanwhile, the Federal Reserve has been
injecting new cash into the banking system
and buying debt in the financial markets,
including commercial paper and mortgage
related securities. This has increased the
money supply and Fed balance sheet
dramatically. (As seen Chart 1.) But when
the economy begins to turn around and
consumers and businesses are no longer
hoarding cash, the extra cash in the system
may be inflationary, sending interest rates
higher. If the Fed can extract the excess
cash from the system, inflation can likely
be avoided. The potential for higher interest
rates and higher inflation, however, must be
considered in our investment decisions.
Currently, however, the excess supply of
capital and capacity versus the demand
for finished products and services puts
the focus on deflation. Deflation can cause
consumers and business to postpone
spending, furthering the economic slow
down. As demand returns, however, the
Fed must remove the excess liquidity to
prevent inflation. In simple terms, supply
must be balanced with demand, and that is
a tricky prospect in an economy as large and
complex as that of the U.S.
The timing of these shifts is difficult to
forecast. However, while there is a strong
possibility that government bond yields
may head higher, there are two important
reasons why Treasury yields might not
rise. One is the traditional role of the U.S.
Treasury market as a safe haven investment
for investors around the globe. Recently,
investors have even accepted negative
yields on short term Treasury bills. Second,
the Fed is expanding its balance sheet to
pump money into the system, and may seek
to lower interest rates on longer term bonds
by buying US Treasurys.
The likely scenario is that investors will
eventually begin to migrate from safe-haven
instruments into those with higher yields
and credit risk. (We have already seen late in
2008 that foreign demand for longer dated
US government and agency bonds has
waned, with net selling by foreign holders.)
At that point, the Fed may want to remove
some of this money and sell securities from
its balance sheet to accomplish that task.
Meanwhile, the Treasury will likely continue
to issue securities for a fiscal stimulus
plan that will take at least two years to
accomplish its objectives, also putting
more bond supply on the market. (The
infrastructure and other projects floated by
the Obama administration will take some
time to plan, let alone implement.) This
balancing act likely will be resolved with
credit spreads contracting as Treasury yields
rise to a price that will clear the market,
the dollar falling, and corporate bond yields
remaining flat or even declining a little
if investors once again are comfortable
investing in corporate debt.
Consumers turn from
c o n s u m p t i o n t o s av i n g s
There is an added nuance to address in our
2009 Outlook. Consumers have begun to
save more and pay down debt. Every dollar a
consumer saves is a dollar that is not spent,
and that unspent dollar has a multiplier effect
in the real economy. Therefore, increased
savings may keep a lid on economic growth
– but it may help keep a lid on interest rates
as some of the savings are invested in fixed
income instruments.
The shock of the dot com bubble bursting,
followed by that of the housing bubble
bursting, has perhaps left an indelible mark
in the psyche of American consumers.
Now, with assets having fallen in value and
access to credit scarce or unaffordable,
future consumption is much less likely to be
supported by increasing debt or drawing on
inflated asset values. (See Chart 2) Add in
a generational shift as baby-boomers retire
and leave their peak consumption years
behind, and the shift from consumption to
savings may become more pronounced.
What does this mean for the investor?
Money formerly put toward discretionary
spending may be redirected to savings,
which in turn may lower the cost of capital
for corporations seeking to fund investments
in property, plants or equipment. However,
as the American consumer scales back on
consumption (as seen in Chart 3), profit and
sales growth may recede to a rate closer to
that of nominal GDP (with adjustments for
things like foreign trade). Corporate profits
per share will likely be lower, with future
returns to equity investors more in line with
nominal GDP growth. This is in contrast to
3. Chart 2. Household Borrowing
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Chart 3. Discretionary Spending Growth
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the higher returns seen during the 1980’s
and 1990’s, a period of strong growth, falling
interest rates, and healthy P/E multiples.
Slower global trade, whether from weak
demand or government policy, also affects
cross border capital flows. As we buy
Chinese goods, they send the dollars back to
buy US Treasurys. This has helped fund our
budget deficit, but now that we are importing
less, they are sending fewer dollars back to
buy our government debt. Given a backdrop
of massive issuance of US Treasurys to
finance not only the existing trillion-dollar-plus
deficit but also the stimulus plan, we must
hope that we have enough buyers.
A vulnerable corporate profit outlook
and heightened equity volatility point to
alternatives such as investment grade
bonds that offer attractive yields relative to
Treasurys. Care must be taken, however, to
monitor signs of excess money supply and
the resultant inflation that could erode fixed
income returns.
T h e g l o b a l i m pa c t: c a s h
f low s
The recession is not confined to the U.S.;
Europe and Japan are also in a significant
and serious recession, with demand for
exports waning and manufacturers cutting
production. The ripple effects are then
seen in emerging markets that supply the
commodities or export finished goods to
developed markets. Even China is proposing
a fiscal stimulus plan to help employ the
people migrating into the cities by building
out infrastructure (which it certainly needs).
This internal focus around the globe means
a few things for trade and international
capital flows.
Countries import less due to weaker
local demand. Other countries respond
by devaluing their currency to make their
exports more attractive, which inspires
more aggressive responses as countries
seek to promote their trade and defend
against imports. If this is carried to the
extreme, trade wars may develop and
protectionism may result. Protectionism is a
highly dangerous element that can subvert
economic growth globally.
On a different front, a devaluing of the
dollar may present a mixed blessing for the
US economy. On one hand, it will make
imports more expensive and decrease our
purchasing power abroad, ultimately leading
to an increase in inflation. On the flip side,
it will generally make US companies more
competitive overseas, boosting exports.
These forces working in tandem would
continue to narrow the U.S. trade deficit.
The price of oil, difficult to forecast because
of many variables including geopolitical risk,
is an important wildcard in the trade deficit
equation.
Another effect of a falling dollar is that it
will enhance the profitability of investments
made abroad when repatriated into US
dollars. Should US investors become
concerned about the potential for rising
US Treasury interest rates later in 2009,
investing in fixed income instruments
overseas may be appealing, especially when
factoring in the currency gains from a falling
dollar. While overseas equity markets will
likely face similar challenges as those of the
US, at some point entry to those markets
may be compelling. In the US alone a
mountain of cash is sitting on the sidelines
that may be deployed in any number of
instruments as the investing climate shifts
from risk aversion to risk taking.
4. Lo o k i n g a h e a d
When will a shift in risk attitude happen?
The capital markets typically begin
recovering four to eight months before the
real economy, and we do believe that we
are perhaps halfway through the current
market difficulties. But we also believe that
there are several preconditions before the
economy recovers, including:
• Credit must flow smoothly through the
economy, so that homebuyers can get a
mortgage or a business can invest in a
new plant or equipment.
• Housing prices can therefore stabilize,
even if prices do not rebound for several
years.
• That will in turn renew consumer
confidence in the economy and markets,
sparking consumer spending…
• ... which will in turn bring about rising
employment. This is not a precondition for
the markets to recover, but it is still very
important nonetheless.
We do not see these conditions being met
until 2010, which suggests a potential for
market recovery in mid-2009. The rebound
off the November low may ultimately be
seen as a bear market rally spurred by
optimistic hopes regarding federal fiscal
stimulus spending. Tax cuts are temporary,
however, and are likely to be saved
rather than spent. Also, investments in
infrastructure require considerable planning
and overcoming logistical hurdles before
any money is actually dispersed. It might
be 2010 before a significant amount of the
stimulus actually reaches the economy.
While we believe opportunities may present
themselves at various points during 2009
we are positioned realistically for what we
believe to be another challenging year. We
favor companies with strong balance sheets,
demonstrable earnings, and stable cash flow
– in a word, “quality”
.
We are also attracted to securities that rank
higher up on the corporate structure, such
as investment grade corporate bonds, which
we may favor over the equity of the same
issuer. Yields are compelling in our view.
The chart (Chart 4) shown here isolates
the additional yield for Baa-rated corporate
debt over Treasurys, demonstrating a
widening spread in favor of corporate debt
in recent months. And, as debt ranks higher
than equity on corporate balance sheets,
investment grade bonds may offer an
additional measure of safety and potentially
less volatility relative to equities.
We are beginning to see potential
opportunities in emerging economies
with developing consumer societies less
dependent on exports to a weakened
industrialized world. In addition to, or
instead of, investing directly in emerging
markets, we may invest client assets in
companies that export to them, such as the
Domestic Export mandate. We may also
revisit commodities as a way to play the
infrastructure stimulus sometime in 2009
(This will require careful consideration as
the tangible effects of building programs on
commodities may be offset by continued
global economic weakness.) We also may
place greater emphasis on convertible
bonds, which can offer equity upside in
addition to the income characteristics of
bonds.
Chart 4. BAA Bond Yield minus T-Bill Yield
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Yields on corporate debt very attractive compared to Treasurys
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