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.
27 February, 2009
19 February, 2009
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.
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.
15 February, 2009
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.
06 February, 2009
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.
30 January, 2009
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!
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!
23 January, 2009
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.
13 January, 2009
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!
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!
05 January, 2009
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.
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.
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