Adam Matthew Waitzman : Northwestern Mutual - Economic Commentary - January 2009 : Article: Economic Commentary

Economic Commentary - January 2009

Christopher Bremer

Senior Investment Consultant

CONSENSUS WAS WRONG

The historical 2008 election vaulting Senator Barack Obama into the White House marked the 60th anniversary of the re-election of President Harry Truman over Governor Thomas Dewey. While there have been numerous historical accounts of newspapers incorrectly reporting presidential election results, the Chicago Tribune’s “Dewey Defeats Truman” headline is generally regarded as the most infamous.

What does the 1948 presidential election have to do with the current state of economic affairs? In both cases, the consensus of experts was wrong.

After conceding the election, Dewey told reporters, “I was just as surprised as you are, and I gather that is shared by everybody in the room, as I read your stories before the election.” In fact, polling data published just before the election was actually taken weeks before. Also, historians have suggested that insufficient analysis, old data and wishful thinking were prevalent among the consensus, in this case, reporters.

Despite mounting evidence to the contrary, economic strategists entered 2008 with a high degree of optimism. Massive write-offs among bellwether financial firms in the fourth quarter of 2007 did not appear to influence GDP estimates. According to Bloomberg, in December 2007, the consensus analyst estimate for 2008 GDP growth was 2.3 percent. Even in the aftermath of the Bear Stearns near collapse in March 2008, consensus estimates put the odds of a recession in the second half of 2008 at about 50 percent.

As the markets tend to lead going into recessions, the fact that the S&P 500 had declined by almost 16 percent from October 2007 to March 2008 made the consensus GDP forecasts all the more peculiar. Despite a freefall in housing prices, the near collapse of Bear Stearns, downward pressures on the equity markets and a continuous onslaught of Wall Street write-downs, consensus estimates for 2008 GDP in April 2008 were still 1.3 percent, low by historical comparisons but not recessionary.

Economic analysts are not the only means of assessing consensus expectations. Market prices and trends reflect real investor expectations, and perhaps there is no better illustration of how the consensus got it wrong than the chart comparing the price of financial companies to the price of oil. (Figure 1.) In the first half of 2008, the consensus view was that the sub-prime mortgage crisis that began in 2007 would dramatically harm the health of large financial institutions with exposure to the sub-prime market. The global growth theme, however, was expected to remain in tact, as reflected in the strong surge in oil over $140 a barrel. The consensus never anticipated the severity of the spillover affects into the global economy. As oil had become the proxy for the global growth story, the violent reversal in July represented a strong signal that the global economy was in serious trouble.

A combination of all these factors contributed to the current recession and one of the worst bear markets. No single event, Federal Reserve policy, or stimulus package will restore economic health. It will take a combination of factors to emerge out of recession, and overcoming three specific challenges will determine when and how well we come out of the crisis: 1) suppressing deflationary pressures, 2) stimulating economic growth and 3) improving credit markets.

Deflationary Pressures

Fed Chairman Ben Bernanke defined deflation in a 2002 speech: “in almost all cases a side effect of a collapse of aggregate demand – a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers. Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending – namely, recession, rising unemployment and financial stress.”

In mid-December, the Fed cut policy rates to 0.25 percent, the dollar dropped over 10 percent in a week, and OPEC drastically cut oil production. All are bullish for oil prices, and yet oil continued to drop, a powerful indication that oil demand has materially subsided. In its December statement, the Fed stated it “expects inflation to moderate further in coming quarters,” which translated means that the Fed is worried about deflation.

Compare this with the statement of June 25, in which the Fed states, “The committee expects inflation to moderate later this year and next year. However, in light of the continued increases in the prices of energy and some other commodities, and the elevated state of some indicators of inflation expectations, uncertainty about the inflation outlook remains high.”

The complete reversal of focus on inflationary to deflationary pressures speaks to the magnitude of financial panic and the daunting challenges facing global policymakers. The global disinflation trends and deleveraging cycle caught even monetary policy makers off guard. While the Fed began its easing cycle early in 2008, the European Central Bank (ECB) actually raised rates in July, putting Europe even further behind the curve. (Figure 2.)

Falling commodities A plunge in commodity prices is one indication of deflationary pressures. (Figure 3.) In July, oil touched $145 dollars. In December, oil had dropped below $40. The Consumer Price Index (CPI) fell 1.68 percent in November, with a 17 percent drop in the energy component leading the decline. The decline in the CPI index was the most since 1947, and yet again, far exceeded analyst expectations.

Weak housing On an annualized basis, housing starts fell to the lowest level since 1946. (Figure 4.) The pace of decline through November actually increased. The sharp drop in housing starts and permits suggests

residential investment will continue to be a substantial drag on the economy and employment through the summer. On the other hand, the magnitude of deceleration may actually be a positive for the housing markets and the economy, by moving the housing market closer to a bottoming process. (Figure 5.) The combination of reduced supply and lower mortgage rates is necessary to provide some much needed stabilization for homeowners. In fact, in closing out the year, mortgage rates hit their lowest level since 1971, which may provide a boost to cash-strapped home owners and help start a bottoming process in housing values.

Economic Growth

Employment The ISM Index, a survey of national manufacturing conditions, turned in the worst reading since 1982, plummeting well under the line dividing expansion and contraction. Employers cut fourth quarter payrolls at the fastest pace in 34 years and unemployment continued to advance higher toward 7 percent. Actual reported employment numbers were materially worse than estimates, further evidence that the economic experts still did not fully grasp the severity of the economic situation.

In December, more than 4 million Americans received government unemployment checks, the most since 1982. At the same time, weekly jobless claims are holding above a half million. (Figure 6.) As of the second week of December, initial jobless claims fell 21,000 to 554,000, close to expectations of -23,000, although the prior week was revised up by 2,000. Continuing claims fell by 47,000 to 4.384 million. Nevertheless, the 8-week average of claims and insured unemployment hit their highest levels since January 1983. But claims could rise further in the coming weeks, led by the automakers. For upcoming payroll employment releases, we see the unemployment rate climbing to 7 percent and potential heading toward 9 percent. Clearly the rate of decline in economic activity and the anxiousness on the part of businesses to retain and hire workers has led to labor market conditions that are consistent with a severe recession.

Consumer Having experienced first-hand that house prices do not go up forever, many Americans may now commit to saving in the future, which could prolong the recession and depress real estate prices further. (Figure 7.) The inherent conflict is that during recessions, governments want people to spend, not save. Governments then resort to loosening fiscal policy as a way of encouraging the populace to spend.

The sharp downturn in personal consumption contributed to the downturn in GDP. Consumption of final goods and services by households accounts for approximately 70 percent of GDP when measured by the expenditures approach. Higher unemployment, frozen credit markets and low consumer confidence will drive GDP lower unless offset in other areas, primarily government spending and net exports. The dollar’s strong rally from July through early December resulted in a strong headwind for U.S. exporters.

According to the National Bureau of Economic Research, the U.S. economy entered a recession in December 2007, which would make the current recession the longest since 1982. All told, real GDP is probably down -6.0 percent in the fourth quarter.

The good news is that by the end of the fourth quarter 2008, with news on the economy getting worse by the week, the markets shook off negative reports and rebounded 20 percent from the November lows.

Credit Markets

Willingness to lend Just a year ago, companies that horded cash were pursued aggressively by activist investors and hedge funds to obtain better returns on cash. When the overnight commercial paper market froze in September, companies with cash were no longer viewed with suspicion, but regarded with envy. The corporate hording of cash, including by large banks, is the equivalent of a run on a bank by individuals. This is symptomatic of a global economy that has been turned completely on its head. The desire for safekeeping cash was so strong in December that investors were willing to pay the United States Government for holding their money.

Corporate spreads Credit is essential for buying homes, running small businesses, managing big businesses and investing for the future. The spread (yield difference) on Baa corporate bonds relative to U.S. Treasuries is higher than any time over the last 50 years. (Figure 8.)

High corporate spreads are indicative of economic uncertainty and a larger risk premium required by investors. The spreads reached in the fourth quarter of 2008 reflect not just uncertainty, but severe economic distress.

The market dislocations of October and November were characterized by “risk aversion” and a “flight to quality”. Risk aversion simply means the unwillingness on the part of investors to hold risky assets, which could be any asset with the potential to decline in price. This results in a flight to quality, a shift into safer assets such as U.S. Treasuries.

An unfreezing in the credit markets Within the credit markets, the TED Spread often provides an indication of the health of the inter-bank lending market. The TED Spread is the difference between the three-month Treasury bill interest rate and three-month London Inter Bank Offered Rate (LIBOR). (Figure 9.) The spread is a measure of liquidity and shows the degree to which banks are willing to lend money to one another. After reaching a high of 460 basis points in October 2008, the Fed’s 75 basis point rate cut in December freed up the LIBOR rates from stubbornly high levels, reducing the TED Spread to 150 basis points. For perspective, the 10 year average spread prior to the financial crisis was 40 basis points.

A result of the Federal Reserve’s decision to cut the federal funds target rate to near-zero is to make it so utterly unpalatable to hold Treasury debt that investors will begin to look for alternatives to earn a better return. (Figure 10.) Beginning with Treasury Bills and money markets instruments and working its way out along the yield curve, it is likely that most spreads should narrow further in the coming weeks.

In December, the Federal Reserve reduced the federal funds rate to a targeted range between 0 and 0.25 percent. It was the 10th reduction in this easing cycle that began last September to the lowest level ever. Moreover, the last time the Federal Reserve used a range was in 1989 when it began targeting the funds rate. This range will be in effect “for some time.” The central bank also reduced the discount rate by 75 basis points to 0.50 percent, the lowest rate since April 1946.

The Federal Reserve is pulling out all the stops to get the economy moving again and to avoid deflation. It “will employ all available tools” to achieve this objective. That means quantitative easing. With the funds rate slashed to near-zero, monetary policymakers will now focus on buying large quantities of agency debt and mortgage backed securities and is considering purchases of long-term Treasuries. When the central bank indicated that it would buy government bonds, Treasuries, predictably, rallied driving yields on 10-year Treasuries to their lowest level since the 1950s. Going forward, that means we can expect narrower yield spreads between mortgages and corporate bonds relative to Treasuries.

Early in 2009, the Federal Reserve will implement the Term Asset-Backed Securities Loan Facility for households and small businesses. The size of its balance sheet will continue to increase to a previous unthinkably high level; which will be a near term stimulus for the economy. The message has to be to expect an aggressive Federal Reserve until a bottom is put in the economy. Lastly, it is encouraging that the Federal Reserve has been the global policymaker most committed to a full-throttle approach and will likely be joined by the Obama economic team in early 2009 in a coordinated effort to promote economic growth.

What to watch for

Investors and observers can monitor the progress of the deflation, economic and credit market challenges by keeping a watchful eye on key economic and sentiment metrics.

On the deflation front, while the price of oil is the most commonly tracked inflationary component, look at all the Consumer Price Index (CPI) components, including health care and other core items. While a material decline in energy prices can exert downward pressure on the CPI, “Core CPI” excludes the effects of energy. A level around or below the Feds 2 percent target for the Core CPI would indicate the deflationary pressures are contained within the energy component. (Figure 11.)

Overall economic and market sentiment can also be gauged by the CBOE Volatility Index (VIX). (Figure 12.) The VIX is a key measure of market expectations of near-

term volatility conveyed by S&P 500 Index option prices. Typically, the index spikes in proportion to the level of uncertainty and risk aversion in the markets. The historical average for the index is around 20, and previous extreme spikes in market anxiety elevated the VIX to 40. Twice in the fourth quarter the VIX closed above 80, concurrent with massive deleveraging by banks, institutions, mutual funds, hedge funds and individual investors. Such measurements of market anxiety and sentiment have reached such unprecedented levels that the scales of measurement and perspective may have to be adjusted for years to come. While the volatility index level has come off its highs, the VIX will likely remain at elevated levels during this period of lingering mistrust. Forty is the new twenty.

Where are we headed?

It may be that the best signs of economic recovery will be tightening of corporate bond yield spreads and sustainable gains in the equity markets. The equity and fixed income markets typically anticipate turns in the economy – although not precisely. The adage that bear market declines have predicted 9 out of the last 5 recessions (or to be more accurate: 11 out of the 7 recessions) is perhaps less than directionally correct. Interestingly, the markets have had a far better track record in signaling upturns.

Every new domestic economic expansion since post-WWII came on the heels of a major equity market rally. On average, the stock market advances three to four months before the economy. Based on the 10 recessions since 1945, there has been a tendency for the S&P 500 to anticipate slowdowns by declining into the start of the recession, continuing to decline over the next five to six months, and then recovering in anticipation of the recession’s end. This time around, given the massive de-leveraging and extraordinary events that have unfolded, it is likely to take longer than normal to bounce back. Nevertheless, in all 10 cases, the market’s recession low turned out to be a bear market bottom. And following those lows, the market’s performance has been exceptional, with the S&P 500 up by a mean of 16 percent three months later, 24 percent six months later, and 32 percent a year later (according to Ned Davis Research).

Likewise, the most powerful elixir for a recession is aggressive easing of monetary policy. In most bear markets, economic and earnings uncertainties weigh down equities but also encourage monetary policymakers to cut rates. History confirms that once the Federal Reserve begins to “prime-the-pump”, it is only a matter of time before an economic recovery begins. The bond market is usually first to respond with a steeper Treasury yield curve and declining corporate bond yield spreads. Shortly thereafter, equities typically follow and rally an average of three fiscal quarters after the central bank has cut rates. Economic indicators tend to turn around a quarter following an equity rebound. Finally, corporate earnings bring up the rear, on average, a quarter later. Usually by the time the stock market starts responding to signs of life in the economic outlook, the Federal Reserve is still playing it safe by continuing to ease. In fact, in 10 of the 11 bear markets associated with easing cycles since 1953, the stock market bottomed before the Federal Reserve finished easing, doing so by a median of seven months.

Historical averages are just that – averages of a lot of numbers that can vary widely. And, the past year has been anything but average. As Americans, we live in a changed world. One in which trust and optimism on the part of investors and the general public seems to have given way to fear and despondency. One does not have to look any farther than the recent uncovering of an alleged $50 billion Ponzi investment scheme which has destroyed the wealth and financial security for countless individuals and charitable institutions. So while it may appear we are living in a new reality, what will never change is our resolve to conquer any challenge. As Warren Buffet has often stated, “There is nothing dumber than betting against America. It hasn’t worked since 1776.”