The Dollar Surge

I guess it is fair to say that most of us got caught by surprise with the reversal in direction in the dollar since the beginning of December. Dollar bears were citing a ballooning US deficit, remaining toxic waste and weak consumer demand as prime reasons to clobber the dollar. But then, around the beginning of December, something fundamental changed. People began to realize that Europe was not any better, neither fiscally (huge deficits and a growing risk of defaults for certain countries) nor in terms of consumption and the tides began to turn. Further support for the dollar also came in the form of employment statistics that were overall better than what the market was expecting. So there you go, the U.S. economy is not doing as bad as what we were led to believe, on a relative basis of course! I should also point out that emerging markets are not plagued by the deficit problems of developed markets and therefore their currencies should rightfully appreciate against the dollar. This is especially applicable to commodity rich countries such as Australia.

Mind you, these are long term trends that I expect. As everyone knows, the short term is notoriously difficult to forecast, especially regarding currencies that contain a lot of noise.

Another black swan?

The Dubai government's announcement that it would postpone debt repayments in its holding company sent markets roiling across the globe, triggering a sharp spike in the cost of insuring debt from a growing number of emerging and even non emerging markets including the likes of Brazil, Turkey, Hungary and Greece. The crisis, which began in the second half of 2007 with the collapse of the subprime mortgage market (as delinquencies soared), spread like wildfire into the highly leveraged banking sector, triggering a severe credit crunch which in turn prompted governments across the developed markets to instigate an unprecedented scale of intervention with an immediate aim of assuaging markets that were on the verge of complete collapse.

Until Dubai disclosed its problems, the general belief was that emerging markets had "emerged" out of the crisis relatively unscathed mainly, it was thought, as a result of the limited exposure they had to the subprime toxic waste. What pundits (once again) apparently failed to heed attention to were the implications of tighter credit standards to debt laden countries in the wake of the crisis. It basically meant that the "unscathed" emerging markets were having increasing difficulty in servicing the huge amount of sovereign debt that had been accumulated during the booming years preceding the crisis. It is difficult at this stage to asses exactly how serious the problem is, markets were certainly not expecting such a gloomy announcement from Dubai. If there is any certainty, however, it is that the crisis is still with us and probably for some time to come.

Paving the way for inflation?

It would seem a bit farfetched to expect a surge in inflation any time soon, especially given the dire economic conditions that continue to plague mainly the more developed countries. But then again it is when you least expect something to occur that it actually does materialize. Nothing could be truer in this regard than inflation expectations. The Federal Reserve or any central bank for that matter, has a dismal record when it comes to anticipating inflation. That is why most central banks actually shy away from overtly publishing their expectations.

A surge in inflation typically occurs when demand for goods and services outrun supply. Several indicators can provide a good idea of the risk of inflation in a given economy. One such example is the employment rate whereby the closer unemployment is to its "natural" rate, the greater is the probability that prices may surge (given that labor is the single most costly input in production). Another is capacity utilization which measures manufacturing ouput is to its full capacity. As with employment, the closer it is to its limit, the greater the risk of a surge in price. The problem with these measures are that they dont tell us much on their own (they need to be assessed in conjunction with other indicators) and also that they are not "forward" looking enough.

As for recent economic releases, one that drew my attention is business inventories with the latest figure signaling yet another drop, bringing stockpiles to their lowest levels since November 2005 (see chart). What this means is that if demand were to suddenly surge (unlikely if you ask me), U.S. businesses would be caught swimming naked and would have no other option than to jack up prices until enough capacity is restored to build inventory. It is indeed an inflation "red flag" but unfortunately doesnt tell us much in terms of probability of occurrence.

Emerging signs of a long period of anemic growth?

The various high octane government actions/interventions over the past two years have clearly had an impact on the global economy, namely by putting a stop on the market freefall, the worst of which occurred in 2008. Those very same markets are now pricing a very high degree of optimism regarding the future, almost as if someone had pressed on a reset button to give the economies of the world a new lease of life, as if the crisis itself was nothing more than a bad dream! Certainly there is significant variation in the health of the economies across the globe, with those of developed countries looking far more sickly than those that belong to the emerging league. No wonder, considering that most of the financial mess was not only concocted in first world countries but was also largely consumed by them. Emerging markets, on the other hand, emerge from the mess relatively unscathed with far less leverage and in a much better shape structurally than at any time in the past. So now that we know which horse to bet on, can the dizzying ascent of the global stock markets be justified in any way? It is the developed markets that worry me and although there have been a flurry of upbeat figures over the past couple of months that would suggest the worst is behind us, more recent figures on housing and prices are less comforting as they increasingly suggest that we are entering a period of anemic growth.

An economy on life support...

There are currently an increasing number of so called key economic releases and market indicators that are showing a marked improvement in trends from where they were only a couple of months ago. We can, for example, confidently state that the severe liquidity crunch that almost froze the economy roughly a year ago (triggered by Lehman's collapse) is a thing of the past. The oft used TED spread indicator (differential between risk free treasuries and libor) is now around 17 basis points which is even lower than the levels it was at in the first half of 2007, before the crisis began.

Even more interesting is the housing market which is, after all, at the center of what led to this unprecedented crisis. The most recent home price figures (see graph above) for the United States are actually indicating a recovery. In other words, if the figures are to be believed (and there is frankly no reason why we shouldn't) we are witnessing a recovery which means that the deceleration and bottoming out phases that were mentioned in previous blogs have already occurred! It is indeed very encouraging news if we are to take the figures at face value. If we dwell a bit deeper, however, a completely different picture emerges. More specifically, the role that the government has played in stabilizing the economy has arguably been as unprecedented as the scale of the crisis itself, all one has to do is take a closer look at the figures:

-80% of the new mortgage loans this year benefitted from some form of government support

-the government now effectively owns Fannie and Freddie and their combined $5.4 trillion in loan portfolios

-the Fed has purchased $836 billion of mortgage backed securities issued by Fannie, Freddie and Ginnie, pushing down mortgage rates guaranteed by the firms

- it also buys up to $30 billion in mortgage securities every week

-the government is on track to purchasing $1.5 trillion in mortgage debt and $300 billion in treasuries

With the massive and ongoing injection of capital into the markets it is no wonder that the housing market has more than stabilized. The caveat, however, is that it is happening thanks to the government intervention and, just like with the analogy of an ICU patient hooked to a ventilator, if the government withdraws its support, the housing price freefall will most probably resume.

I am making this point to highlight the fact that one should not just rely on figures to get a reading on the health of the economy. The rebound in its current form is unsustainable as the government coffers are not unlimited and come at a cost which seems to be rising every day.

Trust...

It can be argued that the single most significant casualty of the current crisis has been trust. Confidence in the system was substantially eroded as a result of the gross mismanagement of risk by large financial institutions that were blinded by their pursuit for profit in an environment of declining return on investment and a series of high profile fraud cases that have, in some instances, destroyed lives. Although governments across the globe have gone a long way along the path of regaining that trust (so critical for the proper functioning of the financial system), there still remains much to be done. As in the 1930's, new regulation is likely to play a key role in improving things but it will have to be done in a careful manner so as not to be an impediment to innovation. Hedge funds, for example, are likely to become subject to some degree of regulation.
Even if the regulation does not go far enough to restore confidence, however, clients will put pressure by increasingly favoring institutions that adhere to higher ethical standards. On the other hand, the additional regulation and more rigorous standards will not in themselves guarantee a fraud free environment, the con artists of our industry are very cunning and resourceful and will always find new ways to fool the system.

Has the recession bottomed?

Yesterday's stellar new home sales figures, a whopping 11% month on month increase, took everyone by surprise, and was further emboldened by the Case/Shiller Home Price Index which, for the first time since 2006, showed an actual gain in prices, adding further weight to the view that a recovery is really taking hold. This comes on the back of a series of more encouraging news on the global economic front such as continued deceleration in U.S. jobless claims, robust GDP figures in China and better than expected earnings figures for the majority of the companies that figure in the DJ Stoxx 600. The positive momentum is captured by the equity markets that have resumed their ascent, with the MSCI All Country World Index now up an impressive almost 42% since the March lows.
As mentioned in previous blogs, however, the problems that plague the world economy are far from being resolved and although a recovery at this stage is possible, it is probably going to be a sluggish one that will most likely last a very long time. The government led stimulus infusions into the various economies have helped avert a complete bloodbath, but they are temporary fixes that come at a price(soaring budget deficits). Businesses face large debts, a significant chunk of which matures soon. With sagging sales and difficulty in obtaining credit, the unemployment rate is likely to continue rising. In this type of environment, it is difficult to see how consumption, whether it is for housing or for other goods and services can rebound in a manner that will make a difference.

Exploiting black swans

One of the main reasons why asset managers lost so much money in this crisis was because their risk metrics in most cases failed to account for extreme events, and in those few cases where they did, the probability of occurrence they attached to it was too small to have any significance on their strategy (i.e. the gaussian tails where way too thin and therefore distorted reality).

If the standardized risk measures adopted by our industry fail to take appropriate account of extreme events and if black swan events occur more frequently than expected, their destructive impact should come as no surprise. The challenge remains, however, that even if we are aware and accept that black swan events do occur, how do we integrate them into our strategy? A good analogy may be drawn from past military strategy with the example of the "Maginot" line whereby a series of concrete fortifications were built by the French along its border with Germany during the inter war period. The idea was to dissuade Germany from attacking or invading France, and although in the end it did work, it did not stops the Germans from invading France as they simply circumvented the line by invading Belgium first and then proceeding to cross the border into France. The example shows us that planning for an extreme event such as an invasion does not guarantee success. In portfolio strategy, it may not suffice to protect against large moves in the market. In an environment of great uncertainty, we need to take into account other extreme events such as hyperinflation, no matter how unlikely the probability of occurrence may be.

Inflation and other worries...

Markets have been heading south over most of the week in response mainly to the growing complacency that there may be too much stimulus out there. The most visible confirmation of this came from the G8 meeting over the weekend in which leaders hinted that they may ease on their stimulus plans in light of growing confidence that the economic downturn may not be as bad as it seems.
It is indeed true that shortly after the Fed entered into the liquidity trap territory after bringing the target rate down close to zero, market worries started to focus on the future inflation implications of the overwhelming stimulus package. This worry grew more recently as economic indicators started to reveal a marked deceleration from the accelerating freefall of early weeks and months and as banks now seem to be in much better shape than just a couple of months back.
Trouble is that it is very difficult to predict if the economies of the world are indeed close to taking off again or if the slump is here to last for a while more. Although it is true that a deceleration in the negative statistics could imply that the worst may be behind us, it is a whole different thing than a bottoming out or, even better, an acceleration in the opposite direction. By taking action to reduce the stimulus firepower out there, authorities risk prolonging the recession significantly, as was the case with the great depression of the 1930's or, more recently, Japan's deflationary slump of the 1990's.
As mentioned in the previous blog, unless there is some yet to be accounted for event occurring, the anticipated correction should bring markets to a level above the low that was reached in March of this year.

Green shoots, take 2

Markets continue to defy gravity with the MSCI ACWI index within arms length of a 40% return since mid March, prompting a growing number of investors to wonder whether the economy may be gently pulling itself out of the crisis. After all, a look at the economic releases (most recently the jobs report) continues to show signs of improvement. As mentioned in a previous post, the optimism is based on the fact that although most of the economic figures continue to worsen, they do so at a decelerating pace. Granted, that in itself is indeed good news because it signals that the economy is stabilizing and that things are more or less in control. As such, it would justify the first leg of this rally. It is its sustained pace which is most troubling as optimism is steadily replaced by euphoria brought about probably by those investors that lost big time earlier on in the crisis and are now playing catch up to at least partially cover what has become a gaping hole in their nest eggs. To that I would add another class of investors who probably think that the recession is at its last throes.

In conclusion, we should be prepared for a sharp correction, although I would add that we are unlikely to come down to the levels that existed in the middle of March since there is genuine improvement going on. The worst may indeed be behind us but that certainly does not mean that we are out of the woods. A cursory look at fundamentals suggest that a protracted recession is still the most likely scenario going forward. I would also pay attention to growing inflation risk considering all the stimulus fire power out there.

It's what you don't know that matters...

According to recent behavioral studies, humans have a very hard time coping with uncertainty. Although it is true that the economic crisis that has swept across the globe has left many households significantly poorer than they were less than two years ago, it is apparently not the reason behind the sharp drop in all kinds of "health and well being" indexes. Instead, the culprit seems to be the significant amount of uncertainty regarding the way the economy is likely to unfold over the next couple of months or years. Studies show, for example, that we tend to derive greater comfort and cope better with the certainty of bad news than with not knowing if results will be good or bad. This has something to do with the concept of "synthetic happiness" which was thought up by Harvard professor Daniel Gilbert. According to the theory, we end up being less happy when we are given a choice than when something is imposed on us. This concept was demonstrated with students that were broken into two groups. The first group were asked to rank a series of Monnet paintings in terms of attractiveness and given the chance to select the one they liked most to take with them. The second group were asked to do exactly the same thing with the exception that they were allowed to exchange their painting for another one in a week's time. At the end of a week it was discovered that the first group (who could not exchange their painting) where generally much more satisfied with their choice than the second group who had the option of exchanging it for another. In other words, choice, it seems brews dissatisfaction just as uncertainty leads to anxiety.

Is this rally for real?

Since around the 10th of March, the stock market has been rallying, generating an impressive performance of around 30% for the MSCI All Country World Index and, in the process, wiping out all the losses that had been accrued until now. The burning thought in most investors minds is if the bull run is a signal that the economy is out of the woods or if it is just another bear market rally, similar to the 5 that preceded it since the crisis began.

If we dig deeper by looking at sector performances, the markets seem to be suggesting that the recession may be entering its final phase. So far this year, the cyclical sectors, such as materials, consumer discretionary and information technology have significantly outperformed typically defensive sectors such as consumer staples, healthcare and utilities. It should be mentioned that the stock market is far from perfect as a leading indicator of the economy and that the current rally may just be reflecting a growing sense of optimism due to economic releases that are showing signs of improvement. Improvement does not necessarily mean that things are getting better, however. In the current context, it simply means that the deterioration is occurring at a slower pace. As a result, I would advise caution against the complacency that seems to be building up.

The re-emergence of the headline/core debate...

Just last year, as commodity prices were soaring to record levels, there was intense debate going on amongst financial pundits as to whether the importance the fed attached to core inflation was warranted. The measure of core inflation came about in the 1970's, during a period where there was a tremendous amount of volatility in commodity prices. The volatility was such that it rendered the broader headline inflation measure (which includes both food and energy) almost useless.

More recently, in the age of globalization, volatility in commodities seemed to have subsided markedly, and a steady upward trend in food and oil prices were observed over a relatively long period. This change in price behavior is what prompted the debate on the usefulness of core inflation, given that with steady prices, headline inflation measures were considered to be superior as a leading indicator of inflation trends. Just as pundits were getting comfortable with the idea of ditching core inflation, a financial crisis erupted, sparking a huge revival in volatility and sending commodity prices on a tailspin. At its most recent results, headline inflation has plummeted dramatically and is now well below the core measure. The core measure has remained relatively steady which is somewhat reassuring but not entirely so given that the current crisis still has some distance to run its course. Although central banks have injected a tremendous amount of liquidity into the markets doubts still linger as to whether it is enough to eliminate the risk of a deflationary spiral taking hold. If the household mindset begins to shift towards expectations of future price drops, we may very well see a gradual decline in the core inflation measure. Once that sets in, the past suggests that it will be very difficult to reverse.

The death of diversification?

Whilst it is true that at a broad asset class level, in 2008 almost every investment generated negative returns, and therefore one could question the validity of diversification in portfolio strategy, there were other, more subtle changes that took place that were probably missed out by a majority of investors.
Studies on historical returns show us, for example, that almost all performance returns are generated by the weights that are given to the various asset classes. In other words, the investment choice within an asset class contributes to only a small fraction of total portfolio return. Choosing investment A instead of investment B should not materially affect the overall performance outcome as historical data shows us that the divergence in performance of investments within the same asset class tend to be small.
The big change with this ongoing crisis is the contradiction of this observation. 2008 in fact showed us that what mattered most was the choice of investment as the divergence in performance within the same asset class widened significantly. This was most clearly observed in the hedge fund universe where the divergence in performance was so dramatic; it was difficult to believe that the investments belonged to the same asset class!
The 2008 experience begs the question as to whether what we have witnessed is just a one off or an actual paradigm shift. If it is indeed the latter, it will require a revision of modern portfolio theory.

The Fed in overdrive...

The Fed has markedly changed strategies with its announcement earlier this week that it would be committing $300 billion into treasuries and another $750 billion into mortgage backed securities. By doing so, it hopes to bring down longer term interest rates, thereby providing businesses and homeowners with much needed cheaper credit. The strategy seems to be working as long bonds have been rallying ever since the announcement was made. It also risks sparking inflation into the future, however, as the markets also seem to be signaling with the swift drop in the dollar and the sharp rally in both the value of gold and TIPS. The market is also indicating that it is not confident the Fed will succeed in tackling the perceived inflation threat.

The move which is meant to provide additional stimulus into the economy essentially diminishes the independence of the Federal Reserve as it sort of becomes an agent of the Treasury (effectively providing the government with cheaper credit). On the other hand the scale of the current crisis is unprecedented which in a way justifies the use of extreme measures to tackle it.

Some M&A activity in pharmaceuticals...

The dire economic environment seems to have triggered a series of mergers and acquisitions in the pharmaceutical industry that show no signs of ebbing. In January, for example, Pfizer made a $68 billion bid for Wyeth which was soon after followed by Roche's announcement that it was pursuing a full acquisition of Genentech. Most recently, Merck disclosed its intention to buy Schering-Plough in a $41.1 billion deal and there is now talk that the next potential target drug maker could be Bristol-Myers Squibb.
There are several reasons behind the consolidations. The ongoing stock market correction has depressed equity market prices substantially, making them increasingly attractive buys. Pharmaceutical firms are much less debt ridden and, unlike other sectors of the economy, can easily raise cash. Last but not least, companies like Merck are facing important drug patent expirations with few alternatives in the pipeline.
Acquiring or merging with a rival should ensure greater revenue stability through product diversification. On the other hand we can expect layoffs to occur over the short term as a result of the consolidations. Over the longer term, having fewer large firms in the industry may lead to complacency through diminished competition which might prompt firms to cutback in R&D investments. That in itself would be bad for society.

A flurry of dire economic releases...

In the last couple of days we have observed a number of economic releases that seem to highlight the severity of this downturn. GDP figures in the U.S. have been released most recently for the fourth quarter of 2008. Although an estimate, at -6.2% (annualized), it is significantly worse than expectations and according to the data, the second quarter of contraction for the economy. January durable goods orders which measures household consumption of goods defined as lasting at least 3 years or more was more than twice as negative than expected. More telling, however, is the fact that this is the 6th consecutive drop in durable goods orders! A similar pattern has also been observed for a number of other critical indicators such as jobless claims which not only has been systematically worse than expectations but also adds to a consecutive series of negative results.
It should be noted that the U.S. is no exception and that dire figures are sprouting out almost everywhere. In Japan, for example, the latest industrial production figures indicate a drop of a whopping 10%, making it the largest monthly drop since records began more than half a century ago. It is also the 4th consecutive month in which a drop has been recorded. This comes on the back of a contraction of 46% in exports.

Yet another transmission failure...

Part of the dilemma facing authorities across the globe, and more specifically in the U.S., is to find a way to get consumers to start spending again. After all, consumption represents something in the region of 70% of GDP and therefore is central to any plan attempting to revive the economy.
Unfortunately, the household spending stimulation plan seems to be suffering from a similar ailment to that of monetary policy, namely a total breakdown in the transmission system.
To resume, monetary policy, especially in the U.S., has become completely impotent, not only because of the "liquidity trap" phenomenon in which room to maneuver disappears once interest rates come close to zero, but also because widespread distrust and lack of confidence in the marketplace meant that even when rates were not close to zero and were being cut aggressively, the various participants preferred to stay on the sidelines.
And now, it can be argued, we are observing a similar phenomenon in the household space. Part of the government stimulus plan is to revive household consumption that has been rapidly retrenching on spending. It is highly unlikely that they will succeed in this mainly because the largest spending segment of the population are made up of the so called baby boomers. This segment of the population are reaching retirement age and the economic crisis has erased a large chunk of their accumulated wealth, forcing many of those that were hoping to retire to get back into the workforce. Unfortunately jobs are scarce right now and are expected to become more so in coming months. So even if money is handed to them just as they were to the banks, it is unlikely they will be spending any of it. With rampant negative savings amongst households, it is more likely that they will be using the extra cash to rebuild their savings, just like in the case of banks where the money they received to revive lending was instead used to build reserves against their bad debts.
This begs the question as to how the authorities can possibly hope to revive the economy in light of these structural breakdowns? There is no doubt that the cycle will eventually reverse itself as the environment normalizes but to expect a revival in the next couple of months, I think, is just wishful thinking.

Investing in times of uncertainty...

The combined size of investment losses over the past year and a half and the growing uncertainty on the length of the current economic crisis has prompted an increasing number of investors to bail out of their investments and seek the relative safety of cash. Pundits that have been drawing parallels with the great depression of the 1930's point out that an eventual recovery of the stock market did not occur until 4 years after the crash! 

The recession is likely to deepen further, as the impact of the ongoing credit crunch spreads into the wider economy.  This will happen despite the robust government efforts to revive the economy given that there is still considerable debate as to what the correct policy response should be. Current economic measures also seem to be indicating that although government action to date may have succeeded in slowing or even stopping the "hemorrhage", the "patient" is still in intensive care as the antidote has yet to be administered. Trouble is that nobody seems to know what the correct antidote is, given that the crisis has no reference point in the past to draw lessons from!

In conclusion, given continued uncertainty, there is still a strong probability that assets decline further. For stocks, not having reached the bottom would mean that it is still too early to switch from defensive to cyclical sectors. Some asset classes seem more attractive than others, however. Take the bond market as an example. Treasuries have clearly been overbought (a result of the ongoing fear factor). If we compare their yields with the other end of the bond market spectrum (i.e. junk bonds), it is almost as if the "higher risk" spreads are pricing the equivalent of a world war (see graph). This makes them extremely attractive from a potential capital gains perspective. At the same time, however, it needs to be made clear that, as in the stock market, the yields are forward looking and, in this case, seem to be anticipating a much higher default rate, a scenario that could very well materialize the longer the recession drags on. 

Many corporate bonds that were issued some 10 years ago, for example, are maturing this year. Given that financing costs have literally exploded, many of the firms that opt for refinancing are going to find themselves in dire economic hardship, raising the probability of bankruptcy. So although non treasury bond yields look attractive, the risk of default should clearly be factored into the investment decision making process to limit damage in the event that the recession turns out to be a protracted one.

Where are we heading?

The graph above is of the seasonally adjusted month on month change in the U.S. Consumer Price Index. The 1.7% plunge in November 2008 has raised some red flags.

In our most recent newsletter entitled "The Great Deflation", we discussed the dire economic consequences of a deflationary spiral. Today the world faces a real risk of entering a deflationary spiral with grave repercussions as it has the potential of turning what is at the moment a benign recession into a full fledged economic depression. It is therefore not surprising that in light of this threat, nervous policymakers have been very active in trying to reinvigorate the economy. This is especially noticeable in the U.S. where the target interest rates has been brought down to zero and where billions (with a promise of more to come) are being spent on bailing out a growing number of institutions.

As consumers, we may perceive deflation, which is a general and sustained drop in the price of goods and services, as something that is desirable considering that it tends to improve our purchasing power. The problem, however, is when deflation continues over a sufficiently long period of time that it starts influencing expectations of future prices. If households believe that the drop in prices are likely to continue into the future, they will postpone purchases until a later date. Producers will also adapt to these changes by cutting back on capital expenditure as they see their return on investment drop.

With these developments the consumer may well end up worse off because although deflation will improve their purchasing power, they may end up being worse off as their standard of living could suffer if firms lay off more workers to counter the drop in sales.

How best to ride the gloom and doom...

Now that most of the world is experiencing the effects of an economic contraction and considering that most of the more recent economic data are strongly suggesting that the recession will probably last beyond 2009, the question that comes to mind is how best to structure one's portfolio in order to most effectively ride the gloomy patch?

Taking a portfolio structured along three core asset classes (fixed income, equities and alternatives) and beginning with fixed income, my first suggestion would be to make sure that the exposure is diversified. This is in sharp contrast to last year's risk laden environment of "across the board" market corrections where the most effective strategy for fixed income turned out to be concentration in a single subset of the asset class, namely "treasury" type securities. The dramatic increase in risk averseness last year effectively punished all fixed income instruments outside those issued by governments. This means that today we observe spreads in other categories such as corporates, high yields and emerging market debt that are at levels comparable to those seen couple of years ago. Add to this that treasury type debt are probably not only overpriced (reflecting the acute risk averseness) but that we need to factor in all the additional supply that is likely to hit the markets in order to pay for the present and future "bailouts" and it quickly becomes clearer why maintaining a concentrated portfolio would be perceived as a highly risky proposition.
For equities a "sector rotation" approach is in order. Whereas a "defensive" play was most suitable for last year's "we are entering a recession" environment, and is probably still the case for at least part of this year, an eventual rotation back to "cyclicals" probably towards the end of the year would seem logical. Obviously this would depend on how the economy unfolds but we have to remember and factor in the "forward looking" nature of stock markets (a market rebound typically precedes that of the economy sometimes by several quarters).
As for alternatives, lots of caution would be advised in the hedge fund space. This is a segment that is likely to experience a high degree of consolidation as the less talented players are squeezed out, and as it becomes increasingly difficult for event the better ones to secure operating income. Private equity may also experience consolidation for similar reasons. The real estate market could, on the other hand, become attractive again, albeit in a highly selective way. Let us not forget commodities (a cyclical play) which should continue to provide excellent long term opportunities, especially after the huge correction.
Finally, we need to consider the aftermath repercussions of the stimulus plans that are being implemented pretty much across the globe. At this stage it is difficult to say whether they are potent enough to eventually trigger inflation. It will depend on many factors such as if the monetary authorities will react early enough or how much further housing prices need to drop before we reach a bottom. It is nevertheless prudent to provide some sort of hedge against the risk of both inflation and deflation. Exposure into such things as Treasury Inflation Protected Securities (TIPS) or gold (gold also being a good hedge against a weakening dollar) would help on the inflation side. Maintaining some exposure into treasuries would ensure at least some protection in the event of deflation.
One last word of advice would be to avoid looking too frequently at the markets, there is so much noise out there that it would serve no other purpose than to confuse and that is the last thing you need right now!

A hazy outlook...

The equity market hemorrhage, it seems, has spilled over into the new year with losses observed pretty much across the board. Sector wise, the hardest hit continues to be financials, followed by industrials as a distant second. Amongst the least affected are the traditional defensive sectors including healthcare and consumer staples but other cyclical sectors such as consumer discretionary are not too far behind! In other words sector rotation doesn't seem to be paying off in this instance as markets seem to be giving mixed signals about the extent and severity of the recession. In all fairness, the period (less than a month) is just too short to give a clear indication. If we add this years performances to those of last year, things look very different, with a clear demarcation between defensive and cyclical.

                                    

What about the bailout scheme? With the amount of money that has been pumped into the system we should be anticipating an eventual rebound, and the "forward looking" nature of the stock market should make it amongst the frontrunners in signaling a change in the cycle. But nothing like that is happening, at least for now because the money that is being thrown to banks is not it seems being used for lending purposes but rather to improve their sickly balance sheets. The TED spread, or the spread between LIBOR and U.S. Treasuries, although having narrowed significantly since right after Lehman's bankruptcy still remains too high to factor in a recovery. Just as in previous cycles, the downturn was driven by a financial sector that lost control of the complex derivative instruments that it unleashed into the markets, and just like in previous recoveries, a change in the business cycle will take place once the banks find themselves in a more solid footing, financially speaking. We don't see that happening anytime soon as it requires that banks fix their balance sheet problem (forget earnings) which will take a tad more than just receiving money from the government. 

Managing bonds...

A couple of blogs back I mentioned that treasuries as a subset of the fixed income asset class was one of the rare investments to generate a positive return in 2008. With the crisis in full swing, correlations among asset classes shot up, dragging almost all investments into deep negative territory. The unprecedented rally in treasuries was a sort of a knee jerk reaction to the perception of greater risk in the markets. Panicked and distraught investors sought the safety of the federal government to protect what was left of their rapidly diminishing wealth.
As mentioned in our recent Review & Outlook publication, our fixed income strategy, which was implemented in mid 2007 involved overweighting treasuries and other government securities at the expense of others such as corporates, emerging market, high yield etc. This decision resulted from the observation at the time that spreads in other fixed income markets were just too tight to justify the "greater" risk. Corporate bonds, for example, although generating higher yields, were just not worth the additional risk. This strategy of ours remained pretty much intact throughout 2008, with the exception of a few minor changes such as shortening durations and reducing corporate bond exposure further.
As a result of this strategy, the fixed income segment of our portfolio generated a stellar total return of 7.7% for 2008. This return is adjusted for costs including currency hedging operations. With hindsight, the positive return provided yet another example of the importance of diversification, helping to absorb some of the losses in the other asset classes. It also showed how a sound strategy combined with a disciplined approach can pay off over time.
What we didn't really expect, however, was how much better our fixed income strategy performance would turn out to be when compared to a peer group. We tapped into Bloomberg's database to generate a peer group of funds with the same characteristics and constraints as our bond strategy. The filter generated a list of 8 funds by various institutions with performances that ranged from -5.94 to 4.62%. These results put our bond strategy performance at the 100 percentile, with a 308 basis points outperformance to the best performer in the peer group.
The results also highlights an important point that was made by El-Erian, CEO and Co-CIO of PIMCO, which was that 2008 has shown us that product selection may be as important, if not more important, then the weight attributed to the asset class. Food for thought!

What to expect in 2009?

Stabilizing the economy will be the main priority of government policy in the first half of 2009. Both monetary and fiscal tools will continue to be employed aiming at restoring a sense of normalcy. New and effective strategies will have to be devised to replace those such as interest rate policy that have run their course as the Fed takes on a more “activist” role. Jumpstarting the economy will also require careful maneuvering given the unprecedented and uncertain nature of the crisis. Irrespective of the attempts towards stabilization, certain key factors such as the decline in housing prices will need to show signs of bottoming out before improvements can be hoped for.
2009 will be a challenging year for government institutions as they sort out a strategy to deal with the structural changes in their balance sheets and the quasi nationalization of the banking sector (risk taking has effectively been transferred from the investment community to government institutions). They will have to keep a close eye and tackle further disruption in the system as the crisis spreads to other areas such as commercial mortgages, auto and credit card loans and sectors that have yet to manifest themselves.
Confidence having suffered the most during this downturn will take plenty of time to heal as the full extent of the damage becomes apparent and government policy works its way through the system. Although there is still a long way to go, there are signs that confidence may be returning as mortgage yields begin to decline and the TED spread narrows.
A global recession which begun last year is likely to last throughout this year and possibly beyond as households cut back on consumption and business postpone capital expenditures. On the other hand, 2009 could turn out to be a transformational year, as a new administration with a penchant towards increased regulation takes over the helm of the U.S. government. Regulation in itself should not be viewed negatively (we have certainly witnessed the effects of the opposite extreme) as long as it is carried out in a manner that doesn’t hinder productivity or growth.
In this context, with the combined effects of having all the “bad news” out in the open, signs of bottoming out for various key indicators, the prospects of a large stimulus package passing through and continued vigorous government attempts to turn things round, we may see a strong rebound in the stock market sometime towards the second half of the year. The vigorous attempts to jump start the economy will, however, bring new threats in the form of inflationary pressure which means that governments will have to be extra careful not to miss the early warning signs and react before it is too late.
We expect 2009 to be a challenging year but for different reasons than those that defined 2008.