Joseph Rodriguez : Northwestern Mutual - Economic Commentary - December 2009 : Article: Economic Commentary

Economic Commentary - December 2009

Christopher Bremer

Senior Investment Consultant

In November the world celebrated the 20th anniversary of the fall of the Berlin Wall. The political significance notwithstanding, from an economic perspective, the fall of the Wall instantaneously changed economic outlook and perceptions for both East and West Germans alike. When the U.S. Treasury forced Bear Stearns to sell itself to JP Morgan in March 2008 and through the ensuing Lehman Brothers bankruptcy six months later, the global financial walls crumbled, changing the face of global finance.

The foundations for both events, the fall of the Wall and the near fall of the global financial system, were set, although mostly overlooked, in the years prior to the actual events. Mikhail Gorbachev, the Soviet leader, informed Eastern European leaders in 1985 that the Soviet Union would not interfere in domestic affairs. Leverage, credit default swaps and the packaging of toxic loans into investment grade securities all planted the seeds for the ensuing financial meltdown.

There are some similarities in just how quickly and unexpectedly events spiraled out of control. An East German official, when asked about when modifications to travel restrictions would become effective, was reported to reply that as far as he knew, immediately. German Chancellor Helmut Kohl was so unprepared for one of the most significant events in a generation that he was out of the country. Bear Stearns Chairman and CEO was so unprepared for the dismantling of his firm that he was playing in a bridge tournament in Detroit when the events unfolded that ultimately led JP Morgan to snatch up the remaining Bear Stearns assets for a few dollars.

While not present for the fall of the Berlin Wall, I was present during the ensuing German reunification less than two years later. While a significant and exciting historical event, the euphoria present during November 1989 had faded. The government’s official stance was supportive and celebratory. The average West German’s position, however, was more grounded in the reality of economic uncertainty. Sure, it was a wonderful occurrence to be reunited with our countrymen, but how was this integration going to be paid for? An immense transfer of wealth from West to East was imminent.

The road forward would be difficult for both East and West Germans, and depending on the specific experience of any individual, could be more or less onerous than the average. The road for the global economy will be difficult and there are likely to be relative gainers and relative losers.

We use this month’s commentary to reflect on the major themes and economic assessments discussed in this forum over the course of a very tumultuous 2009. Broadly speaking, our economic assessments focused on three underlying themes: 1) Investors will seek better returns than low yielding U.S. Treasuries, 2) Neither inflation nor deflation will win the day and 3) Take the long view and maintain reasonable expectations.

Seeking better alternatives than U.S. Treasuries

When the financial markets come under duress, global investors flock to the traditional safe haven of U.S. Treasuries, commonly referred to as the “flight to quality”. When demand for Treasuries increases, the yield declines as investors are willing to trade lower income for relative safety. Eventually, however, and over the long-term, investors may require higher yields than offered through low risk investments. When yields fell to essentially 0% last December, we commented that investors eventually would seek better investment alternatives. (Fig. 1.) We examined three areas for monitoring investor preferences: the tendency of equities to lead out of recessions, tightening yield spreads and market perceptions.

Equities lead out

We commented in January that the equity and fixed income markets typically anticipate turns in the economy and on average, the stock market advances three to four months before the economy, but not always with precision. This was written in January, prior to the S&P 500 declining an additional 27% to begin the year. The Fed had already slashed the federal funds target rate to a range between 0% and 0.25%. We noted in January that “a result of the Fed’s decision to cut the federal funds target rate to near zero is to make it so utterly unpalatable to hold Treasury debt that investors will begin to look for alternatives to earn a better return.” Recognizing that the equity markets tend to lead recessions out, and after three consecutive down months, nervous investors and economic observers were left to ponder just how long the recession might last. While ultimately proven correct, it sure did not feel that way for the first three months of the year.

Yield spreads

In seeking signs of any potential economic recovery, we suggested that any tightening of historically high credit spreads may signal improvements in the underlying economic data. The difference in yields (spread) between below investment grade corporate bonds and U.S. Treasuries had widened to levels not seen in the past 50 years. These high spreads were indicative of widespread economic uncertainty, and even severe economic distress. Spread compression, or the declining of corporate yields relative to U.S. Treasuries, gained traction beginning in March 2009, the same time the equity markets hit their lows. (Fig. 2.)

By April we strongly encouraged investors and market observers not to turn away, “however tenuous the present circumstances seem, turning one’s back from the fight can be reckless with regard to one’s long-term financial interests. By definition, one cannot advance if one retreats.” In other words, do not sell into the bottom of a major market meltdown. Investors who faced the challenge saw risky assets lead extremely oversold markets higher; high yield bonds, high beta equities (smaller companies and technology) and emerging markets.

Perceptions

In April we commented that positive perceptions concurrent with improvements in fundamental data can be a powerful force coming off depressed market levels. While not the only metric, we noted that home prices can serve as a useful gauge of market perceptions, “home prices, however, do not have to again rise by double digits on an annualized basis or get back to previous levels for the economy to become healthier. The market has only to perceive that prices can once again rise. This applies not just to housing prices but all investment assets, especially those assets with risk premiums relative to U.S. Treasuries.”

As it turns out, quite coincidently of course, home prices bottomed in April, helping to support and sustain the rally in risk assets that began in March. As the Case-Shiller Home Price Index shows, when measured by directional trends and not the absolute asset prices for homes, a minor positive adjustment can instill health in the marketplace, particularly for investor and consumer confidence. (Fig. 3 .)

We have maintained that improvement in economic data accompanied by improvement in economic sentiment and expectations will help to heal and eventually revive our economic markets, albeit at a more moderate pace than experienced in the run up to the current recession.

Inflation vs. deflation

During this current quarter, the debate over inflation or deflation came back into prominence when two well known market pundits debated one another through media channels on the appropriate levels for commodities.¹ The renewed debate over whether the price of gold can double over the next 10 years (inflationary) suggests that economic data continues to provide little evidence of either an extreme inflationary or deflationary outcome occurring.

In February of last year, we suggested that investors should not overly concern themselves with inflationary forces, “should investors be concerned about inflationary influences? Yes, to a certain degree and in due time. Inflation itself is usually not the challenge, but rather unanticipated inflation that historically hurts portfolios and economic prospects.”

We believed that deleveraging was creating enough deflationary pressures to ward off any serious threat of inflation. In fact, we posed that deflation may be a more realistic and potentially dangerous outcome. When the equity markets took a breather from mid June through mid July, fears of future inflation were mentioned in media stories as a contributing factor. Those fears were quickly neutralized when the Consumer Price Index Year over Year report came in at -2.1%, the lowest reading since January 1950.

Another way to assess the outlook for inflation is through the market’s pricing of inflation expectations. We noted in February that the break even between the implied inflation rate and the 10-Year U.S. Treasury is

attractive on a historical basis. As the market at the time was pricing one extreme deflation scenario, recognizing this relationship may provide investors with an attractive opportunity should inflation expectations reach a more normal breakeven level, we concluded that “For all the torment over the inflation-deflation debate, neither may end up a significant concern this year.”

The market’s expectations for inflation did in fact increase significantly from depressed levels, and only in November did the market’s forward expectations match the 10-year average of forward expectations. (Fig. 4.) In other words, from February through the end of November, neither inflation nor deflation dominated the marketplace. In fact, as of the time of this writing, the debate is intensifying among high profile economic strategists and commentators.

Oil is up over 120% from its December 2008 lows and commodity prices globally are trending higher. This “headline” inflation could be met by jumpy markets with expectations of higher inflation and the need to unwind stimulus. So far, as expressed through the inflation breakeven rates, the market’s expectations of inflation have been moderate and stable. With unemployment exceeding 10% and enormous slack in terms of capacity, deflation arguably remains a bigger threat today than inflation.

Take the long view and maintain reasonable expectations

Throughout the year we have encouraged investors to take a long-term view and maintain reasonable expectations in the face of short-term economic releases and publications of widely disparate economic viewpoints. In May we wrote, “While it may be difficult to foresee the return of economic normalcy given the backdrop of 2008 and 2009, we encourage investors to take the long view. A more moderate economic environment will return, although perhaps not this year….Just like an aggregate debt decline toward equilibrium is probable, so is a movement up toward housing and auto demand equilibrium.”

We were somewhat overcautious then as, by most accounts, the recession in the U.S. has ended, and certainly as a result of the massive policy stimulus.

Stimulus and monetary policy

The fiscal stimulus alone cannot mend the economy. We commented in March that “in conjunction with the Fed’s monetary easing and the U.S. Treasury’s bank rescue plan, a more positive economic environment may be within sight…the stimulus bill is likely to provide a boost to quarterly GDP.”

In response to improved economic data and expectations among most economic observers, we mentioned in September that there is likely to be a cyclical rebound over the next few quarters driven by factors that do not require early consumer participation, including inventory restocking, manufacturing production and the continued impact of government stimulus and monetary policy.

The “cash for clunkers” program boosted spending on autos by 56% and contributed significantly to the third quarter’s 3.5% annualized GDP figure. However, beyond a short-term rebound the consumer will have to step in to help sustain the recovery. As Figure 5 shows, auto sales have been responsible for driving retail sales higher. There is widespread debate on whether the consumer can accomplish this, and we are too early in the cycle to really know for sure.

If the stimulus is responsible for improvements in the economy, by definition, most of what helped cause the recession still needs to be sorted out, mainly excessive leverage.

Deleveraging

Deleveraging will continue to be a headwind toward economic growth. The most critical areas of balance sheet repairs concern household and financial sector debt. (Fig. 6.) We pointed that investors should shift focus from the elevated levels assets reached prior to the recession, and instead focus on a more realistic, even muted, set of economic expectations in a deleveraging environment. In past recessions, healthy recoveries were supported by healthy growth in credit. The challenge coming out of this stress period will be moving the economy forward in the face of tighter credit than in recent recovery periods.

Expectations

We have attempted to check sentiment against concurrent and leading indicators and encourage investors and economic observers to continue to maintain reasonable expectations going forward. The global and U.S. economies are showing signs of improvement and we already experienced positive GDP growth in the third quarter. But the global economy is still fragile, and we have argued consistently that the road back to a more stable economic state will be protracted and jagged. Whatever the outcome, it is important for investors to have a framework grounded in reality and to take action based on where the economy and markets stand, and not solely on economic forecasts. Being grounded in actual outcomes increases the likelihood that investors can accept whatever happens next, even if they are unfavorably disposed to the outcome. As individuals, we cannot prevent future shocks, but maintaining reasonable expectations can lessen the impact and surprise factor.

While a rapid return to sustainable growth is not impossible, there are a number of factors that may reduce the probability of it occurring, including but not limited to, unemployment, consumer spending, a weak housing market and continued deleveraging among households and corporations. Growth could be positive for a sustained period, but at the same time advance below long-run trends.

Where are we headed?

One of our underlying themes throughout the year, and indeed throughout our ongoing monthly publications, is to favor monitoring directional trends over absolute readings of economic data. Absolute readings are subject to volatility, seasonality, and most importantly, misinterpretation. We do not feel confident in making economic assessments or forecasts based off of a single economic reading, nor do we think there is any value in attempting to do so.

In hindsight, our monthly “Where are we headed” section virtually wrote itself. It wasn’t that we got a lot of the assessments correct. Instead, the global economic and asset declines were so severe that there was hardly any room to make an assessment of further deterioration. Given the massive amounts of monetary and fiscal stimulus injected into the financial system, a recovery from such a deep recession was perhaps the only option with which to make an assessment.

The equity market rally since the Mar. 9 lows predicted the turnaround in economic data. But just as the fall of the Berlin Wall did not suddenly elevate the East German economy, nor does the exit out of recession fix what ails the global economy today. Credit flow remains constrained, economic activity, while reversing the waterfall slide, is still weak, and unemployment is at highs not seen since the early 1980s. The easy money has been made through the equity rally and we are now entering an environment of more uncertainty.

For many economic watchers, entering 2009 there appeared only two scenarios: the economy either continues toward financial obliteration or it stops just short and enters into a prolonged economic super-recession. The doom scenario has been averted, and is no longer a serious consideration entering 2010.

While the probability of the severe prolonged recession is significantly diminished, it cannot be altogether thrown out.

In the Federal Open Market Committee’s November statement, the Committee indicated that it expects exceptionally low levels of the federal funds rate for an extended period. This will permit the continued restructuring of corporate balance sheets, allow banks to earn their way out of the weak balance sheet positions they held in 2008 and lessen the pain of the necessary consumer deleveraging.

When and under what circumstances the Fed tightens monetary policy will be critical to the sustainability of the economic recovery, and perhaps more importantly, to the market’s perceptions of that sustainability. We will monitor these developments closely in commentaries throughout next year.

The construction of the Berlin Wall, and the communist regimes it represented, was such a traumatic event that it had longstanding impact on the behavior and economic perspective for generations of East Berliners. In the 20 years since the fall of the Wall, while there is still economic separation between the former West and East Germany, by most accounts, the glass is no longer half-empty but today is half-full.

The global economy is experiencing a similar state of dislocation heading into 2010. There is still a large degree of economic separation from pre-recession levels. But like the former communist regimes, the economic foundation underlying the easy credit era was simply unsustainable over the long-term. Now it is time to rebuild.