Q3 Commentary (2008)
“The worst is likely to be behind us. There’s no doubt that things feel better today, by a lot, than they did in March.”
Treasury Secretary Henry Paulson, May 7, 2008
Our economic commentaries over much of the last 3 years had cautioned that beneath the veneer of a strong economy were the inevitable seeds of its own demise. Much of our economic growth over the prior 15 years had been fueled by asset inflation and the increased use of leverage to enhance spending and corporate profits. Combined with collapsing house prices, rising consumer debt levels were the harbinger in early 2006 of an impending and pronounced consumer slowdown. In late 2007, these concerns spiraled towards the credit markets. Inadequate risk assumptions by rating agencies on mortgage and asset backed securities and their derivatives held on the balance sheets of many financial firms were soon exposed amid tumbling prices. This in turn placed increased strains on capital ratios leading to rising credit spreads, tightening lending standards and threatening first liquidity and then even solvency concerns. At the core sat the viability of our entire financial system.
Even with a healthy respect for the infestation of over-leveraged derivative securities and the interdependency of Wall Street, Main Street and indeed, the rest of the globe, the events of the last 2 months have been frightening. Credit stress initially eased in the months following the fall of Bear Stearns and the creation of various credit facilities available to support our financial system. However, ongoing price weakness in housing and the corresponding declines in the securities tied to these markets facilitated a far greater and quicker deterioration in the balance sheets of our major investment and commercial banks. With the collective pressure to de-lever via sales of these assets, no willing buyers, and collective fears of toxic balance sheets, credit lines in our financial system effectively froze. Within 14 days we witnessed the nationalization of Fannie Mae and Freddie Mac; the fall of Lehman Brothers and Washington Mutual; the shotgun wedding of Merrill Lynch and Bank of America; an $85B infusion to save AIG; the status change of Goldman Sachs and Morgan Stanley into bank holding companies and the folding of Wachovia into Wells Fargo.
While global central banks can be accused of drastic underestimation of this financial crisis (see above), the enormity of the coordinated recent response may successfully eliminate the fat tail risk of a financial market meltdown. After the major policy blunder of allowing Lehman Brothers to fail amid a tangled web of over $400B in derivatives, the Treasury has since backed money markets funds, raised the FDIC limit to $250K (and maybe higher), and authored a $700B Emergency Economic Stabilization Act (EESA). This unprecedented rescue package is being used to directly infuse capital ($250B) into our major commercial and custodial banks and set up an auction facility to target purchases of mortgage-backed securities.
We are now witness to a financial landscape that has been permanently altered by the collapse of the debt bubble. The notion of free markets and the Invisible Hand are being replaced by handouts. Does capitalism need regulation to control itself? Does human behavior inherently vacillate between excessive risk taking or aversion when facing intense competition such as borne on Wall Street? While many of these answers may be yes, our government cannot avoid much of the responsibility of how we got here.
From the 1999 repeal of Glass-Steagall reuniting banking and Wall Street and rendering risk management impossible; to the 2000 act excluding the oversight and exchange-trading of credit default swaps from the CFTC or SEC; to maintaining 1% interest rates for over a year; to abrogation of their supervisory responsibility over mortgage lenders; to the 2004 waiving by the SEC of its leverage rules requiring debt-to net capital ratios of 12:1 for 5 investment banks (Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Stearns, Lehman Brothers), government was complicit in allowing this to go on.
The Wall Street impact has been swift. There are no more investment banks. Open an account at Goldman Sachs and one might be able to negotiate a toaster. Leverage is being reduced throughout the system as we face a radically different banking model of slimmer, lower risk balance sheets and lower return on equities. This will slow down longer term growth and increase the possibility of stagflation as the system is flooded with money. We may also see the shakeout of the hedge fund industry as leverage and funding disappear.
The Main Street impact may be greater and last longer. Historically high consumer debt levels and low savings rates did not get here overnight. It will take a long time of increasing savings and paying down debt to repair the balance sheets. This will be a longer term positive but will have negative growth impact for the intermediate term. We have postulated that we are in a consumer-led recession for the entire year. The continued pressure on the consumer of declining assets has been manifested in reports on Consumer Net Worth that indicate a record decline of 9% in the 3Q of 2008 and an estimate of a greater decline of over 13% in the 4th quarter. Consumer credit witnessed the first outright decline in August of over $7B as both challenged access to credit and the need to pay down debt will cause real consumer spending to turn in the first contraction in the 3Q since 1991. The 4th quarter does not look better. Our previous estimate of unemployment exceeding 6% was conservative and we now see an increase in the jobless rate to as much as 7.5%.
Gross Domestic Product has remained surprisingly resilient (2Q GDP of 2.8%) as a weak dollar and strong foreign demand allowed trade to offset declining consumer spending and residential construction. The contagion of the financial issues and declining US imports has now dramatically and swiftly spread across the globe. We posited in our 2Q commentary that the IMF estimate of global GDP growth of 4.5% would move closer to 2%. We maintain that estimate and are now looking for an outright contraction in US GDP in both the 4th quarter of 2008 and the 1st quarter of 2009. We fear it will not be mild and may be as much as 2%-4% but are optimistic that it may represent the bottom of the cycle as there clearly are some positives on the horizon.
Inflation threw most economists and policy makers a major curveball as it peaked at about 5.8% year/year and seemingly distracted the focus away from declining economies. It is now dropping precipitously as oil prices are now down from $145 per barrel to just above $80 taking the national price of gas from over $4.20 towards $3 and less. Recessions and de-levering by definition are deflationary and we would not be surprised for overall CPI to drop to 1% over the next year. Interest rates are coming down globally and mortgage rates should continue to make housing more affordable. Global, coordinated policy responses will have a strong yet lagged impact and there is a lot of money in the system in corporate cash (at very high levels to market cap) and Sovereign Wealth Funds (SWFs). The inclusion of additional fiscal stimulus and a plan targeted at the heart of the issues, mortgage foreclosures, are additional measures we hope to see enacted.
Our expectation on S&P 500 earnings for 2008 was a decline to below $80 significantly below consensus of over $95. We were optimistic as it now appears to be closer to $75. We now project an additional decline for 2009 towards $65 again below consensus. As the credit crisis has paralyzed markets turning bulls into bears, we have witnessed a dramatic decline into the early 4th quarter with the S&P 500 down over 40% from the highs experienced just last October. At current levels, we are finding valuations to be the most attractive since the early 1990’s with a market P/E of between 14X-15X what we expect to be trough earnings in 2009. Additionally, we are now looking at an index dividend yield of over 3% a level last broached in 1993.
The markets are inexpensively valued for one reason. We are facing the most challenging global economy in our generation. The last 2 recessions in the U.S. (1990 and 2001) were relatively benign as the consumer was in excellent shape. Currently, we are facing the worst financial crisis since the 1930’s at a time when the stress on the individuals has never been greater. We have confidence now that the actions of the global policy makers will return the blood flow to the patient (credit markets). It may be a slow process; however the markets are finally priced to give patient, long-term investors a very reasonable risk/reward. Strong, long-term returns are made in bear markets not bull markets.
