Experiential Wealth

Quarterly Market Commentary – Q1 2009

Apr 23, 2009 | Individuals, Institutions, Plan Sponsors, Quarterly Commentary

Since the stock market hit decade lows in February, stock prices have rebounded more than 20% and shaved the losses from over 25% to single digit losses. Since the stock market is considered a leading indicator of the real economy, the question on everyone’s mind is “has the economy turned the corner?”

In answering this question we need to separate the stock market from the real economy. Being a leading indicator, the stock market is anticipatory by definition and can be premature in its expectations. Historically, the stock market rises from its lows 6 to 9 months before the economy gets out of a recession. The stock and bond markets have gained strength since the middle of February, signaling investors’ beliefs that the worst of the credit-driven crisis may be over. The latest signs suggest that the rate of decline has slowed and that the economy is no longer in a free fall, but there have been many false starts for the stock market throughout its history.

A range of policy efforts and welcomed low commodity prices are priming the consumer spending pump. Taxpayers are beginning to receive the payroll tax credit included in the most recent fiscal stimulus bill. Even though the amount of tax cuts is not large, households are expected to spend the money quickly. With the current low interest rates, many homeowners (with good credits) have refinanced their loans and will soon benefit from lowered monthly mortgage payments. The Administration is planning on allowing Fannie and Freddie to refinance mortgages with loan-to-value ratios of 80% to 105%. This coupled with the lifetime low interest rates, should be a boost to refinancing. The Financial Accounting Standards Board relaxed its rules for mark-to-market accounting which helps institutions meet their capital requirements and to make money. And finally, the low gas prices and warm winter have also kept household spending on energy down. This is equivalent to a tax refund.

There seems to be a lot of good news lately. Durable goods orders were up 2.1% in February, a sign of economic activities. Even the National Association of Home Builders’ Housing Market Index, a survey-based measurement of sales, as well as sales expectations, rose by more than 50% in April. From bank earnings to consumer spending, many indicators have provided positive surprises. This may be a case of excessive pessimism previously injected into the forecast and, when the actual data was reported, the original estimates were too low and created frequent upside surprises. The general trend remains down for now.

The complexity of the current economic and financial debacle is the melding of two events: the bursting of the credit bubble and a general economic recession. The two continue to feed on each other, albeit at less intensity. The real economy cannot have a sustainable recovery until the real estate market bottoms out and the credit market functions. According to RealtyTrac, foreclosure activity shot up in March with total foreclosure filings reaching 803,489 in the first quarter. That represents a 24% jump over a year earlier and a 9% increase compared to the previous quarter. The biggest problem is unemployment. The nation has lost almost 6 million jobs since the beginning of 2008. The Department of Labor reported that two million jobs were lost in the first three month of this year alone, bringing the nation’s unemployment rate to 8.5%. For the week ending April 11, a record 6,137,000 people filed for unemployment insurance, an increase of 93,000 from the previous week. At this stage, no one is predicting that we have turned the corner here. Unemployment is considered a lagging indicator. Many economists project the unemployment rate to peak in the first quarter of 2010 and expect the economy to be out of recession a quarter prior, but the severity of the labor problem is having a significant drag on all aspects of the general economy. With consumer spending representingtwo thirds of the GDP, the recovery may be further away than most projected. If Americans don’t feel secure and neighbors are losing their jobs and homes, consumer spending will remain suppressed. Unemployment is now the single biggest factor and it is both the cause and the result of this protracted recession.

According to the National Conference of State Legislatures governors are expecting a combined shortfall to exceed $100 billion this fiscal year due to the plummeting tax revenues caused by the current recession. They also must cut $67.5 billion from their 2010 fiscal year budgets before July 1. The $787 billion stimulus package enacted in February has earmarked money for the states, but the federal funds are only expected to close about 40% of the budget gaps. So far, about $14.5 billion from the American Recovery and Reinvestment Act has been released and most has been spent to offset growing Medicaid costs. Plummeting tax revenue due to increasing unemployment, falling real estate values and poor corporate revenue will continue to put pressure on state treasuries. Historically, state revenue does not see pick up until 18 months after the national economy recovers. If this holds true, states have to raises taxes, cut programs and borrow more money in order to make ends meet for a few more years.

We have seen unprecedented financial asset appreciation in the past 30 years. From 1997 to 2006 alone, the US financial sector of the domestic GDP increased from 23% to 31%, while the GDP expanded from $8,113 trillion at the beginning of 1997 to $14 trillion at the end of 2006, a 75% increase over 20 years. During the same period, the increase in the GDP share was over 10% for the United Kingdom and 6% plus for both France and Germany. Even more striking isthe fact that the financial services industry’s share of corporate profits in the US escalated from around 10% in the early 1980s to a2007 peak at 40%.

At the same time, we have experienced a debt explosion where leverage wasa cheap way to get growth and returns. According to the Federal Reserve Board, total debt in the financial sector at the end of 2008 was $17.2 trillion, or 121% of the GDP. Just 50 years ago, the total financials sector debt was $21 billion or 6% of GDP. Household debt at the end of 2008 was 97% of the GDP at $13.8 billion – we owed as much as we produced!Half a century earlier, the financial sector debt was $21 billion which came to just 6% of GDP. The total US credit market debt is over 350% of GDP in 2008. This is unsustainable. There are many contributing factors, and the most obvious are an extended low interest rate environment worldwide, the real estate bubble created wealth effect, and the discounting of risks in search of ever higher returns.

The leverage in finance has been a tremendous source of easy return for many financial institutions during the good times, but when the economic tide turned, leverage waslethal. Take the case of a fictitious commercial bank which has equity of $10 billion to set up a mortgage lending pool. The bank borrows $90 billion and loans $100 billion to residential mortgage borrowers. In this example the bank has a leverage of 10 where the equity of $10 billion represents 1/10thof the $100 billion asset pool. If 10% of the mortgage defaults, asset value falls by $10 billion. The total amount of borrowing outstanding remains at $90 billion. In essence the bank’s equity in this mortgage pool has been wiped out and making the bank less solvent. The impact of a compressed and synchronized de-leveraging process in the financial sector is extremely damaging. In essence, the lenders stop lending to preserve their capital base from further erosion during the time of extreme uncertainty and credit erosion. Stopping lending is insufficient to repair the bank’s capital base. The bank must sell assets. Starting from the best and most liquid assets, the bank starts a rippling effect that contributes to asset-price deflation while at the same time more non-performing loans pile up. Borrowers are forced to liquidate at the same time to perform on loans that are called by the lenders.

The International Monetary Fund estimates that banks and other financial institutions faced aggregate losses of $4.05 trillion in the value of their holdings as a result of the global economic crisis.Of that amount, $2.7 trillion was from loans and assets originating in the US. According tothe IMF, US banks reported $510 billion in write-downs in 2008 and an additional $550 billion in 2009 and 2010. In the euro zone, banks reported $154 billion in write-downs in 2008 and still face $750 billion in projected write-downs. The cycle of credit contraction, risk reassessment, repairing corporate balance sheets and deleveraging means that there will be less money flowing through the global system. This has a long lasting impact on consumer and business consumption, global trade, and standard of living for all. Corporate profit will remain under pressure leading to sub-normal stock returns.

With the massive intervention by government in the US and many other parts of the world, governments have moved from market observers to active market participants. Although free-market capitalism is not dead, it is certainly constrained. Case in point is ex-Treasury Secretary Henry Paulson’s threats against Bank of America’s CEO Ken Lewisto acquire Merrill Lynch last year, the heavy handedness on removing GM president Rick Wagoner, and the House passing legislation calling for a 90% surtax to be imposed on any bonus paid after Dec. 31, 2008, by a company that received $5 billion or more in taxpayer dollars from the Troubled Asset Relief Program (TARP). So far, the governments around the world have substituted private debt with public debt. The US is leading the way in a bottomless approach to save banks, investment houses, insurance companies, homeowners, unemployed, states, the auto industry, and just about any company that can buy a bank and line up to receive TARP money. Most agree that government intervention under extraordinary economic dislocation is necessary, but the timing and conditions under which the government exit is of great uncertainty. It is generally agreed that a totally unchecked free market system has significant shortcomings. Although it may be true that the free market corrects itself over time, the human and societal cost may be too much to bear. Like a pendulum, the US and many developed economies are moving from de-regulation to re-regulation in the financial industry. It is likely that, in the name of protecting the public and for the greater good, a period of excessive regulation will occur and just in time to dampen long term economic revival. Governments will be bigger and play a grander role in all of our lives.

IMF projects the world output to decline by 1.3 percent in 2009. The synchronized global economic contraction is the first in over 50 years. America has benefited from globalization in the past 20 years (some refer to this as the Americanization) and created an in-balanced uni-polar world. Along the way, we became the biggest debt nation with insatiable consumers. In the past few years, the US savings rate dipped below zero as we leveraged ourselves to sustainable levels. Our short term challenge is to get out of this recession; our long term problem is to grow ourselves out of the public debt that we have created. The borrowing cost and the cost to fund more debt to keep our promise to the retirees of tomorrow will be a drag on our economy and our ability to invest. As the world recovers from the economic contraction, the debtor nation will likely be at a disadvantage. A number of the emerging economies are likely lead in productivity and economic growth. Regardless if the spectacular fall in commodity prices is due to a bubble, many of the fundamental contributors to a rise in commodity prices remain intact and sooner or later the principal of supply and demand will prevail and the cost of raw materials will rise. This will again shift capital from resources scarce countries to resources rich countries. The US must learn to adjust to a multi-polar world in the years to come and to readjust our thinking about what we are entitled to as Americans. The American Dream should remain as the American Dream and not the American Entitlement.