What do you think?

October 5, 2008

“The only thing we have to fear is fear itself – nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance.”

These words were spoken by Franklin Roosevelt at his first inaugural address on March 4, 1933. The economy had experienced a cumulative decline of 27% and US equities had dropped about 80%. From then on and in short order, the economy grew a total of 10.8% by 1934, 36% by 1936, and a 63% by 1940!!!

At this point in today’s crisis, we should consider these words very carefully. Fear has ground the normal functioning of money markets to a virtual halt. As an example, the commercial paper market has shrunk by $200 billion in the course of 3 weeks and credit spreads as measured by the TED spread (Libor rates less Treasury bill rates) are the widest on record. Fear has reduced the tolerance for counterparty risk to a single day, as evidenced by overnight repurchase agreements becoming the instrument of choice. Fear has led to heightened market volatility with measures of equity risk such as the VIX at records highs since the index began in 1990. Fear has led some of the largest and most successful companies in the US such as Microsoft, General Electric, Caterpillar, and Verizon to reach out to Washington to express their need for prompt government action in the face of the current crisis. Fear was further exacerbated by the House’s display of election year politics when it failed to initially pass the Treasury’s rescue package on September 29th; a perfect example of what we have referred to as policy mistakes that could aggravate the current credit crisis. These fears are real and to a certain extent justified. However, what is NOT justified is the fear that we are on an economic path similar to the Great Depression.

It is Darkest Before the Dawn

Let’s begin by reviewing the significant structural differences that exist today:

—First and foremost, we have several institutions, themselves the result of Roosevelt’s New Deal, that serve as economic stabilizers. The FDIC, established in 1933, is of utmost importance in backstopping customer deposits, thereby mitigating runs on banks. FDIC insurance was just increased by 2.5 times from $100,000 to $250,000 to improve confidence in the financial system. The Social Security system, enacted in 1935, now provides unemployment benefits to lessen the impact of an increase in the unemployment rate. In fact, the House just passed a bill last Friday to extend the period of unemployment benefits coverage. However, it remains to be seen if the Senate will also pass this bill. The Exchange Rate Stabilization Fund, established in 1934, recently made insurance available to money market funds in order to stem the outflow of assets. This insurance program is critical to money market mutual funds at this time, as it restores confidence and alleviates the fear of these funds “breaking the buck.”1

—Secondly, the Treasury and the Federal Reserve have been much more pro-active compared to anything that was done prior to Roosevelt’s New Deal (which occurred nearly four years into the crisis) and to Japan’s policy responses (nearly nine years into their crisis). The conservatorship of Fannie Mae and Freddie Mac is critical to the ongoing liquidity of the mortgage market, as this eliminates the fear that they will be unable to issue debt and/or continue to buy home mortgages. In addition, the Federal Reserve’s interest rate response has been much more aggressive, as Federal Funds rate now stands at 2% and long bond real rates are at -1.8% versus +14% in the early 1930s.

In fact, our view is that the Federal Reserve will likely ease policy again, lowering the Federal Funds rate by as much as 1% over the next several months. Synchronized policy action from other central banks is also likely. Already, countries like Germany, Ireland and Greece have insured their bank deposits and European governments are instituting their own versions of “conservatorship.”

In addition to these actions, the Federal Reserve, in its role as “lender of last resort” has introduced numerous liquidity measures currently totaling about $1.5 trillion. The Fed has further announced increases in the size and types of accepted collateral in these facilities, in order to deal with the continuing lack of confidence among counterparties.2

–Thirdly, we now have the 442 page version of TARP, the Emergency Economic Stabilization Act of 2008, which has been signed into law. The most important aspects of the initial Troubled Asset Relief Program are intact. The Treasury, effective immediately, can start to purchase up to $250 billion of securities, with the next $100 billion available if the President certifies the need to Congress, and the final $350 billion available unless both the Senate and the House pass a joint resolution of disapproval. The whole array of residential and commercial mortgage-related securities is eligible. Some additions to the bill, such as allowing the Federal Reserve to pay interest on bank reserves starting October 1, 2008 and the increase in FDIC insurance mentioned above, are all beneficial. The former provides some incremental income to the banks and the latter improves confidence in commercial banks’ deposits. The most immediate benefit of the new legislation will be some price discovery, some liquidity and some fresh capital.

The passed plan is not without issues, however. We do worry that provisions such as limits to executive compensation and requiring a taxpayer equity stake in participating financial institutions may, at the margin, discourage stronger firms from partaking in the program. The requirement that calls for oversight from two boards including an independent Congressional panel was humorously described by Representative Barney Frank as “having Groucho, Harpo, and Chico watching over Zeppo.”

Additional provisions in the Act, such as providing tax relief to 22 million Americans by altering the alternative minimum tax, are a small version of a fiscal stimulus package…and how can we argue with fiscal stimulus, however small, at this time. Additional fiscal stimulus is expected next year, including spending on infrastructure.

–Finally, we are in an environment where corporations, such as the ones mentioned above, have low levels of debt and high levels of cash. Microsoft, as the best example, has a low debt to equity ratio of roughly 1x and a cash hoard of $24 billion. Sovereign wealth funds have an estimated $3.5 trillion of dry powder and many opportunistic investors are sitting with cash waiting for an opportune time to invest. Oil prices have declined 36% from their peak. The dollar, in spite of its recent 16% rally relative to the Euro and 11.5% rally on a trade weighted basis, is still relatively cheap and supportive of continued improvement in the trade deficit.

The obvious question you might be asking, then, is why haven’t these extensive government measures stopped the vicious downward spiral? Over the course of last week, US equities fell by 9.4% for a cumulative decline of 30% since October 9th, 2007. Developed equity markets outside the US fell by 10.9% and emerging market equities fell by 14.2% for a cumulative decline of 38% and 45%, respectively. And corporate high yield debt yields increased by 2.2% to a total incremental yield over 5-year Treasuries of 11%.

Obviously, the delay in passing TARP undermined the psychological benefit of swift and decisive action. The endless volume of criticism and alternative proposals from both well-informed and ill-informed commentators over the course of a week also eroded confidence in the efficacy of the plan. Needless to say, as we mentioned in our September 28th piece, delays and policy mistakes are not desirable at this time. Hopefully, the consequent 777 point decline in the Dow Jones Industrial Average should reduce the likelihood of further US policy mistakes. Market participants are also unsure of the impact of the various government measures and thus remain concerned about how quickly the credit markets will thaw and when confidence will be restored in the financial system.

The economic data released over the last week has also been disappointing. The Case-Shiller Home Price Index decreased 16.3% on a year-on-year basis. However, the rate of decline has slowed in recent months from its worst levels at the beginning of the year. The ISM manufacturing index dropped to 43.5, which is close to recessionary levels. Labor market indicators are also deteriorating; initial jobless claims, which are a leading economic indicator, rose to 497,000 and non-farm payrolls fell 159,000. Both these measures indicate that the economy is close to, if not already in, a recession. In addition to a poor macroeconomic backdrop, those who look at technical charts have been waiting for the S&P 500 to reach levels around 1075, as this is seen as a key support level.

Our Outlook

We have no doubt that the bursting of the real estate bubble–not just in the US, but in the UK, Spain, Dubai, Mumbai, and Shanghai–and the ensuing global credit crisis and ongoing deleveraging, will take a significant toll on the US and other economies. A recent IMF economic outlook report shows that downturns that have been preceded by periods of financial stress result in deeper recessions than when they are not preceded by financial stress.3 The length and depth of this credit crisis has prompted us to adjust our economic outlook accordingly. We expect 3-4 quarters of negative growth in the US with a cumulative decline of about 5%. In all likelihood, the next two quarters will be in the negative 2% range. Unemployment in the US will exceed 7%, maybe even reach 8%. However, looking past mid-2009, we think the economy will slowly recover, as the combination of government measures–both monetary and fiscal–will reverse the economic downdraft sometime in the next 12 months. We also assume that we will not have to contend with any geopolitical shocks–“October Surprises”4–such as an attack on Iran. As the Honorable Ashton Carter discussed on our client call on July 23, 2008, he expects the odds of that to be negligible.

We expect S&P 500 operating earnings growth in 2008 to decrease between 10-12% which is more negative than our prior estimate of a decline of 5.5%. Furthermore, looking at earnings industry by industry, we continue to think that 2009 earnings growth will be flat to negative, troughing sometime in late 2009. Nevertheless, we also believe in the discounting mechanism of the markets, which will be focused on when the fundamentals will trough. Given that equity markets consistently rally 6-12 months ahead of a turn in the fundamentals, we are optimistic that the S&P will approach 1300 in the next 6-8 months and reach 1400 by the end of 2009. Low inflation should also be supportive of equities.

In such an environment, we recommend clients incrementally add to their equity positions. We understand that the prospect of further declines is worrisome to all, but as we have said before, scaling in slowly and maintaining a well-diversified portfolio is appropriate at this time. We are reminded of Sir John Templeton’s advice to the typical investor: “the only investors who should not diversify are those who are right 100% of the time”. We have to brace ourselves for continued volatility–both on the upside and the downside–and believe the best protection for a portfolio in the long run is diversification that allows you to withstand the downdrafts but also be as opportunistic as Warren Buffet during times of turmoil.

Sources: Investment Strategy Group, Goldman Sachs Global Investment Research, Global Insight, Datastream, Bloomberg, Lehman Live, Robert Shiller, US Bureau of Economic Analysis, US Department of the Treasury, Federal Reserve, US Congress, International Monetary Fund

1 Under the program, the Treasury will prevent any participating money market fund’s net asset value from falling below $0.995. The program will exist for an initial three month term, with the option for the Treasury Secretary to renew the program until September 2009.

2 Examples of the Federal Reserve’s liquidity measures include the Term Auction Facility, 28-Day Term Repurchase Agreements, the Term Securities Lending Facility (and related auctions), Primary Dealer Credit Facility, and the Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility.

3 International Monetary Fund. World Economic Outlook (October 2008). Chapter 4: “Financial Stress and Economic Downturns.”

4 “October Surprises” refer to news events that could influence the outcome of an election, particularly a presidential election, the following month. Historical examples include Secretary of State Henry Kissinger announcing that “peace was at hand” in Vietnam less than a month before the 1972 presidential election between Richard Nixon and George McGovern.