Global Warming....Economically, Not Ecologically

Eric Linser, CFA | June 15, 2009

With the markets on the right trajectory as of recent, it seems safe to come out of our bunkers again. The rocky start to the year has revealed an almost unprecedented opportunity for investors -- a chance for a fresh start to 2009. After an abysmal start in January and February, March, April and May have rewarded investors with a nice sustained 3-month rally which has brought us back to being flat to up for the year. Just as the motto for 2008 may have been "cash is king" when a flat return was the best return, 2009 optimistically could be called "the return to normalcy".

From the early March lows through June 1^st, broad stock indices are up between 40% (S&P 500) and 65% (MSCI Emerging Markets index). The price of oil has doubled from its 1^st quarter bottom (now at $73 per barrel), and yields on high yield, or junk, bonds have nearly been cut in half (conversely, prices have risen). The predominant worry has shifted from a debt deflation trap to a government-sponsored inflation problem. Investors have steadily renounced their extreme risk aversion and demand for safety. Equity, commodity, and credit markets are unequivocally acting as though the credit crisis is over, and a new global economic recovery is on the way.

Apart from the typically strong initial rebound from a bear market bottom, two factors would seem to account for the extraordinary shift in the investment landscape over the past 3 months. First, the fear of financial and economic apocalypse was more intense than the vast majority of investors had ever before experienced. Since markets are a reflection of mass psychology, this led to a situation where sentiment became so negative and investment postures so defensive that financial assets had nowhere to go but up. Second, we have the exceptional circumstance of the greatest fiscal and monetary stimulus in history, and it is certainly working to revive global economic activity and asset prices. Fed Chairman Ben Bernanke famously stated in 2002 that deflation is always reversible under by the government printing more money (akin to throwing money out of a helicopter to all below). The surprise is not that he has been proven right, but that so many rejected his premise in the dark days of late last year through early March of this year. Few observers today doubt the ability of the Treasury and the Fed to create inflation by widening the federal deficit and expanding the monetary base in such an unprecedented fashion.

Now that we have had the powerful thrust off the lows, what happens next? Financial assets, especially in "high beta" asset classes like emerging markets and natural resource stocks, look pretty overbought presently. But a lot of investors, professional and the layperson alike, are still sitting on too much cash, and the pressure to get money invested in an environment where cash pays next to nothing, asset prices are moving up, and inflation expectations are rising, is intense. While this bull market should be given the benefit of the doubt, the risk/return profile of stocks over the next couple of months appear neutral at best, especially in asset classes that have run up the most. It is still a very uncertain world, and there will undoubtedly be plenty of volatility in the months ahead, as opposed to the nearly straight line up that has occurred thus far.

In the wake of the financial crisis, the "decoupling" theory - that emerging markets could continue to grow with developed economies in the grip of severe recession was dismissed. Now, with the MSCI Emerging Markets Index up an impressive 38% year-to-date, versus single digits for the S&P 500 or the Dow Jones or the MSCI EAFE Index (foreign developed markets), and certain emerging stock markets (China) back up to levels prior to the collapse of Wall Street last September, the "decoupling" theory is back in vogue. There is an obvious element of trust to the theory, given the more favorable growth and demographic characteristics of key emerging markets, but clearly these economies are intertwined with the global economy, including the developed markets that still comprise a majority of global GDP. The recent strength of their stock markets suggests that the global economy is in recovery.

Equity and commodity markets have recently confirmed that the depression is over, and credit markets have shown steady improvement since the 4^th quarter of 2008, when the Fed began to apply its unprecedented support measures. Short-term commercial paper and inter-bank lending markets were the first to recover. 3-month US dollar LIBOR (the inter-bank lending rate) is at a post-crisis low of 0.65%, after having been as high as 4.8% last October. Corporate borrowing rates have declined steadily since late 2008, when the yields on corporate bonds rated BBB (the lower end of investment grade) implied default rates worse than those during the Great Depression. In the past 6 months, the spread between long-term Treasury bonds and long-term BBB-rated corporate bonds has narrowed from over 5.5% to 3.5%, a level that is more typical of a merely recessionary environment, rather than a depression. Municipal bond yields have shown a similar improvement, and are back to more normal relationships to federal government bond yields after that market essentially collapsed last year when the Lehman Brothers bankruptcy sent the market into a tailspin.

As a result of the 40% to 65% (depending on the index) gains we have seen off the lows, stocks have moved from nearly dirt cheap levels 3 months ago to valuations that seem appropriate to mildly undervalued given the economic environment and the yields available in fixed income markets.

The economy is clearly beginning to recover, but the strength and durability of the rebound remains to be seen. After this initial bounce from government stimulus and pent-up demand runs its course, the economy may be vulnerable to a "rolling recession" type of environment as a result of private sector balance sheet rehabilitation, which will involve a multi-year process of higher savings and debt reduction.

Emerging markets stocks, which have delivered 15% per annum returns over the past five years (versus returns of minus 1.9% per annum for the S&P 500) are the most expensive of the major equity segments—relative to their history. Of the three broadest global equity segments—US stocks, foreign developed markets stocks, and emerging markets stocks—emerging markets stocks are the only asset class whose price/book multiple is close to its historic average. This seems appropriate when one considers the relative economic positions of emerging markets versus developed markets in the context of the past 15 years.

Long-term US Treasury bonds were the top-performing asset class in 2008, but they have been the worst-performing investment in 2009. The 10-year Treasury bond yield has increased from 2.25% at year-end to ~ 4.0%, and has jumped from 2.8% to 4.0% since mid-March, when the Fed announced its intention to purchase Treasury bonds to hold down interest rates. It seems the "bond vigilantes" are back. This is a term used to describe Treasury bond investors who can enforce some discipline on a government that is potentially behaving very irresponsibly with respect to fiscal and monetary easing, and courting serious inflation risks.

A dramatic rebound in inflation expectations accounts for nearly the entire rise in nominal Treasury yields in 2009. In the past six months, the spread between the 10-year Treasury yield and the 10-year TIPS yield (which represents the market's expectation of the annual Consumer Price Inflation, CPI, rate over the next 10 years), has jumped from under 0.5% to nearly 2.0%. Treasury investors are clearly becoming concerned about the $10 trillion in projected federal budget deficits over the next 10 years, and the ability of markets to absorb this supply. Hopefully, the recent jump in Treasury yields has delivered a warning shot to the government to restrain its spending excesses now that the financial crisis has largely been resolved.

Outside of conventional Treasuries, 2009 has been a rewarding year for investors in a number of fixed income categories, including corporates (especially high yield), emerging markets, municipals, and TIPs.

Commodities, natural resources stocks, and foreign real estate stocks all enjoyed strong gains in May. Like stocks, commodities are benefiting from economic optimism. Commodities are also benefiting from the "reflation trade," where rising inflation expectations stimulate the purchases of "anti-dollar" asset classes such as commodities, gold, resource/materials stocks, and foreign stocks. The US dollar index dropped 4.9% in May, and, along with Treasury Bonds, has been one of the weakest asset classes in 2009. The US Dollar Index is approaching key support levels in the 76-78 range (versus a current value of ~ 80).

Accordingly, I would be surprised if the US dollar had much additional downside risk relative to most other major currencies with respect to either the short- or the intermediate-term. The US Dollar Index did spend nearly six months below the 76 level between March and September of 2008, but that period coincided with an extreme "blow-off" move in the price of oil, which exerted extraordinary downward pressure on the US dollar. A rebound in the US dollar would likely coincide with a pullback in commodity-oriented investments, foreign stocks and bonds, and "risk assets" generally.

Following the recent rebound in real estate investment trusts (REIT) prices, and also owing to dividend cuts and dilution from new stock sales, the yield on the NAREIT All-REIT index has dropped to 7.4%, only 1% above the long-term average. This level of yield is uninspiring, given the negative fundamentals of the asset class. Other areas of the equity markets are more attractively valued, which argues for an underweight allocation to US REITs.

THE DRAW-BACKS (what could go wrong?)

Could things still go wrong? Absolutely. Foreclosures and credit card defaults are both still rising, as are interest rates. North Korea is saber-rattling. State budgets are a mess. And the US economy cannot withstand another shock to the system. Nevertheless, when you consider both the change in the economic data and the fact that the worst-case scenario has been avoided, it's hard not to feel more optimistic now versus a few months ago.

Despite many positive aspects in the economy taking hold (popularly referred to as "green shoots",) we're not out of the woods; quite the contrary. More people have lost jobs each and every month for the past year than were hired. The economy is very fragile and is continuing to contract. General Motor's bankruptcy could be messy. Any recovery is likely to be slow and drawn out, making many people feel like the US is still in a recession. The recovery could take hold and be accompanied by lingering high unemployment, something akin to a "jobless recovery."

Employment is still falling sharply in the US and other economies. Indeed, in advanced economies, the unemployment rate will be above 10% by 2010. This will be bad news for consumption and the size of bank losses. Take May's unemployment results released June 5^th, one more in a series of lousy employment reports. Another 345,000 jobs were gone from the economy. The Department of Labor stated the U-3 unemployment rate jumped to 9.4%. Worse, a better government statistic of unemployment, the U-6 number, rose to 16.4% ( if those workers who have either given up seeking work or have taken a part-time job as a substitute for full-time work were included in the unemployment figures), up from 15.8% in April. U-6 unemployment was at 9.4% at this time a year ago. Since December 2007, the US workforce has lost jobs every month.

Since last fall, we have been hearing, "not since the Great Depression ..." at the start of many sentences. In fact, by almost all metrics, this has been the worst US economic crisis since the 1930s. We have blown through all previous comparisons except the big one. So what would it mean if it were to get as bad now as it was then? The worst case result is based on percentage declines from the top. If the decline were to match that of the Depression, the Dow Jones Industrial Average would be around 2,000; the S&P 500 stock index would be around 200. Could this happen? It is not probable. Such levels don't consider the current interest rate and inflation environment, and they completely ignore government actions that have been taken to restore the vitality of the economy.

Optimists who spoke last year of a soft landing or a mild recession or an average length (10 months) recession were proven wrong, while those who argued that this would be a longer and more severe, 24-month recession were correct. (So far, the domestic recession is already in its 18 month). The crucial issue, however, is not when the global economy will bottom out, but whether the global recovery, whenever it comes, will be robust or weak over the medium term. One cannot rule out a couple of quarters of sharp GDP growth as the inventory cycle and the massive and unprecedented monetary and fiscal stimulus boosts lead to a short-term revival.

Green shoots of stabilization may be replaced by yellow weeds of stagnation if several medium-term factors constrain the global economy's ability to return to sustained growth - recent data on employment, retail sales, industrial production, and housing in the US remain very weak; Europe's first quarter GDP growth data is dismal; Japan's economy is still comatose; and even China, which is recovering, has very weak exports. Thus, the consensus view that the global economy will soon bottom out has proven, possibly, to be overly optimistic. There are calls that the current recession will end by September-December of this year, but even if the recession is officially called over at that time, it will still mean that unemployment will rise even through 2010 and the pace of recovery will be anemic for a few more years.

After the collapse of Lehman Brothers in September 2008, the global financial system nearly melted down and the world economy went into freefall. Indeed, the rate of economic contraction in the 4th quarter of 2008 and the 1st quarter of 2009 reached near-depression levels. At that point, global policymakers got religion and started to use most of the weapons in their arsenal: vast fiscal policy easing; conventional and unconventional monetary expansion; trillions of dollars in liquidity support, recapitalization, guarantees, and insurance to stem the liquidity and credit crunch; and finally, massive support to emerging market economies. The policy equivalent of shock and awe sets the stage for most economies to bottom out early next year.

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