Tuesday, 23 December 2008

Revision momentum still points downwards

It has for many years been a tradition in the stock market to monitor the analysts following a given company. If the company is going through a rough patch, it is taken as a positive indicator once analysts begin to turn their own forecasts more positive. Thus, following the pattern – the momentum in earnings upgrades - in what supposedly more informed folk say about the company, the less informed investor can gauge when it would be time to turn more positive. Admittedly, this observation is rarely taken to be a sufficiently strong indicator about when to buy.

This "methodology" could equally well be applied to the overall economy. Over the past weeks a number of studies and forecasts have been released by various economic research institutions. Approaching the various reports in the way described above does not exactly provide for a lot of optimism leading into the new year.

So far, particularly in the stock markets, one economic statement has gained almost mantra-like status: The economy will improve in Q3 of 2009. Recently it has been updated to: the economy will improve in second half of 2009. When examining the various forecasts, it appears that there is successively less evidence to support this optimism.

In November, IMF reduced the 2009 growth forecasts from 3 percent growth to 2.2 per cent. The industrialised countries are expected to see a negative growth of 0.9 per cent, so the positive economic growth is coming from the developing countries.

In December, the World Bank published a revised estimate of a global economic growth of only 0.9 per cent, but remains optimistic about the outlook for 2009.

In the US, a host of institutions make forecasts and in general they are still revising their forecasts downward. The Energy Information Administration wrote on December 9 that "The current global economic slowdown is now projected to be more severe and longer than in last month's Outlook".

Members of the Securities Industry and Financial Markets Association's Economic Advisory Roundtable – sort of consensus for the financial industry - in December expected the current U.S. recession to continue into mid-2009, with subdued growth thereafter through the end of the year. -1.0% growth in 2009.

In Germany, the Kiel-based institute IfW released a very negative forecast of a negative growth of no less than -2.7 per cent in 2009 and a near-zero growth in 2010. This forecast easily beat the otherwise negative forecasts published by Bundesbank (-0.9%), Institut fur Wirtschaftsforschung (-1.9%), RWI (-2.0%) and ifo (-2.2%).

France's INSEE reported last week that there will be negative growth in the first two quarters of 2009 and that after that, only a very small recovery is likely. Economic periodical The Economist expects France's GDP to contract by 1.3 per cent in 2009.

Italy is the same story: all institutions, Banca d'Italia, OECD, IMF, and a host of private forecasts have since November been moved down from somewhat positive to an expected minus of -1.5%.

Reading through the accompanying notes reveals an interesting fact, namely that the recent downward revisions mainly affect the first half of 2009. Compared to the situation a couple of months ago, it is now expected that the downturn is faster and deeper in the first half of the year and then suddenly things get better in the second half. Personally, I believe it will prove an illusion. I do not understand how it is possible to predict a sharper downturn in the first two quarters of the year without it spilling into the last two quarters.

My guess is therefore that as the next round of revisions comes in February/March of 2009 they will likely postpone the recovery.

All of this looks pretty grim, to say the least. Economic forecasts are always by nature, made under a set of assumptions regarding the future. One typical assumption is the economic policy. Policy makers have the possibility of adding more fiscal stimulus if the economic forecasts look to bad, thereby invalidating the forecasts.

It is typical to use assume that the economic policy (public spending, investment, taxes and the like) will in fact be implemented as they are planned at the moment the forecast is made. At this moment, this is probably the largest source of uncertainty to this very negative outlook.

Across the world, various policy packages have been implemented in order to get the economy going (different from the ongoing initiatives of getting the credit markets going again). Apart from what the Chinese government is doing, so far nothing impressive has been put in place. EU has presented a package of 1.75-2.0 per cent of GDP but a lot of it was already existing policy plans. UK has cut TVA temporarily, which is likely to miss the target as people will not spend the extra cash, but use it to draw down debt. Rumours from the Obama transition team is revised almost weekly in regard to the magnitude of the fiscal stimulus package.

My guess is that as the downwards momentum accelerates in the coming months, more fiscal stimulus may be added as well as a further easing of monetary policy worldwide. If that happens in time, there is still a possibility that the global downturn will bottom out towards the end of 2009. There are, however, far too many ifs and buts behind the various forecasts.

Wednesday, 17 December 2008

Fed pulls out all the stops and stock markets get it right

Federal Reserve's statement yesterday was no less than historic. For the first time, Fed commits to use "all available tools" to fight the downturn. It looks like a Japanese-style Zero rate policy, but it is a good deal more. In fact, Fed allows itself to inflate its balance sheets through unlimited asset swap transactions and no questions will be asked about the quality of the collateral for an extended period of time. By making funds available to the banks at an interest rate of zero, the banks can make money on lending even at a couple of per cent. Nonetheless, this move is largely symbolical compared the continued expansion of the asset swap program.

Given that the banks have so far reduced credits instead of granting new ones, the asset swap program partially bypasses the banking sector by offering the possibility for Fed to grant collateralised loans directly to non-financial institutions or at least to non-bank organisations. All well and good, and there is now no doubt that Fed is applying plan C in targeted and consistent way. I has already had the desired effect on the longer term yields with 10-year treasury yields heading towards 2 per cent and mortgage rates falling in parallel.

What may not be so positive is the background for this move. The US economy is still deteriorating. Not one single economic indicator is pointing even to a stabilisation. One element of a recession, namely an increase in the corporate default rate is only at the beginning. Even if the savings rate has jumped sharply – sober estimates say to 2.5% of disposable income – in a matter of months, it is still anybody's guess when the US households will finally feel that they have reduced their debts enough in order to resume normal spending. Car sales are still dead in the water and credit card companies are reining in debt instead of expanding it. The only shimmer of light comes from the weekly refinancing activity, where an increase is an indication that US home owners are in fact restructuring their debt by taking longer term loans at the currently attractive rates. All of these factors are unknowns that make it very difficult to time when the US economy may hit rock bottom and begin to rebound.

We have seen some powerful rallies in the stock markets recently. They are built on the assumption that with all the good work by Fed and Obama signalling ever-growing economic stimulus once he has moved into the oval office. It makes sense that with so much power and determination being poured into the project of getting the economy going, it will eventually happen. The only question is when this will happen.

I earlier subscribed to a point of view that 3rd quarter of 2009 would be the time when the US economy could have seen the bulk of the contraction and it would be possible to imagine a rebound. I am not so sure it will happen that fast. The mainline scenarios for growth now appears to have settled on a contraction of about 2 per cent for the US economy in 2009 after an almost flat/slightly negative growth in 2008.

At the same time estimates for the "necessary contraction" required in order to re-establish the savings rate to healthy levels have ranged between four and seven per cent accumulated over the duration of the downturn. Even if we stay at the comfortable end of this range, the current mainline growth estimations for 2008 and 2009 only sums up to half of that. So either the negative growth will continue into 2010 or the downturn in the economy will be a good deal more severe than the current consensus estimates.

Which brings us back to the stock markets. While the stock market perennially prides itself of being able to predict events that will happen 6-9 months time, this ability appears somewhat impaired recently. And the stock market needs an economic rebound to see an earnings rebound. What if the rebound only comes well into 2010 because the debt overhang is still too heavy? Obviously it would lead to another downturn in the market. I simply refuse to believe that the average of the stock market operate without being able to take into account this possibility. Yet we have seen a healthy recovery in the stock markets recently.

If looking for an alternative explanation, it might be useful simply to think as follows: the market suffers from a total "lack of visibility". This is analyst-speech for "we don't know what will happen" – which appears a rather sensible thing to admit. So we all act on the basis of perceived probabilities instead. With each of the initiatives coming from the US and even from Europe over the past weeks, the perceived probability of a rebound in 3rd quarter of 2009 has clearly increased. That makes the case for maintaining short positions less attractive. So it could indeed be that the main driver of the recent rallies have been short covering, punctuated by selling from those who still have to liquidate positions (read: hedge funds being hit by redemptions). Judging by the relatively low volume of turnover in the stock markets, this could indeed be the case. While this is not exactly a strong basis for a sustained rally, it at least gives some legs to a continued rebound, which will last as long as the market perceives that the probability of a rebound within 6-9 months is increasing.

Wednesday, 10 December 2008

Happy days waiting around the corner?

Over the past week or so, it appears that the level of confidence in the financial markets has improved several notches. Trying to summarise why, one arrives at a situation more or less as follows:

  • Led by the Federal Reserve, the world's central banks are doing what is necessary in order to improve the situation in the financial sector, and even to bypass it if necessary. Fed has even begun to monetise the public sector deficit – known as printing money – and bypass the financial sector in creating credit
  • Across the world, with China as the leaders, political leaders are putting in place fiscal stimulus in order to get the economies going
  • Long term interest rates are plunging
  • Commodities and in particular crude oil have fallen so much in price that it will stimulate the economies
  • Stock prices are almost at a giveaway level
  • By third quarter of 2009 we will have seen the worst of the downturn and we will be on our way back to better times.

I would like to be able to join in that happy chorus. I am also slightly more positive about the future economic developments than I was six weeks ago, mainly because it appears that politicians across the world are ready to scrap the traditional way of thinking. By this I mean the conventional wisdom of economic policy as it has been understood more or less since the Reagan-Thatcher era.

However, I have quite some difficulty in joining the optimists. Let us try and take each of the arguments above and look at it.

Central banks are certainly doing a lot. Two weeks ago Federal Reserve began monetising the debt and introducing several instruments allowing for a closer control of the conditions in the money market. It was announced that Fed would be interventionist regarding the yield curve and that financial assets of a highly troubled nature could serve as collateral for facilities with the Fed. The effect has been a predictable fall in US yields along the curve, and direct intervention in the mortgage market has led to a narrowing spread for MBS over government bond yields. The effects of this have spread to Europe, where the central banks have cut interest rates to unprecedented levels. European central banks have not yet, however, begun a process of quantitative easing. I consider this to be all positive, as the Fed has reacted quickly and fully in line with what is necessary. Fears of this leading to inflation are overdone, as the Fed can easily mop up the excess liquidity once the situation is better.

In Europe, the banks are in general in a much better state (with the UK as the possible exception). The current "credit freeze" may be more severe than what is completely normal in a period of economic downturn, but there are good reasons to believe that the governments will let their voices be heard clearly in their capacity of part-owners of many banks, pushing for less strict credit conditions. If that should not work, there are several more instruments left, most notably in the repo-area, where the central banks can accept progressively worse assets as collateral for liquidity.

Governments are working overtime in order to stimulate the economies. Or are they, really? So far US lawmakers have done nothing, understandable given the limbo period before the swearing in of the Obama administration. He has, on the other hand promised rapid action after 20 January. So far he has been talking of packages to the tune of 2.5 percent of the GDP. Not half enough to stave off a deep recession, as it lurks behind the horizon. Given the need of US households to consolidate their balance sheets, the recession will be deep or it will be a medium recession followed by a long period of sluggish recovery.

China presented an impressive package, supposed to be worth more than $500bn of government stimulus. Upon closer inspection, a significant part of this happened to be infrastructure spending which was already planned in advance. So the overall short term impact will be much smaller than announced.

Across Europe, the governments are presenting each a package of their own. According to the estimations of the EU commission, the overall effect will be some 1.5 per cent of EU GDP. Some of the initiatives were in place before the crisis hit and some are brought forward. Net new initiatives are likely to be somewhat less than 1 per cent of GDP. Some will work very well (announced infrastructure projects in Denmark, France and Germany) but will be slow in the coming. Some will not work as desired (temporary tax reductions or VAT cuts). Summarising it all, the effective stimulus in Europe will be significantly smaller and slower than most people are meant to believe.

Long term interest rates have been plunging. Bond markets have been reacting absolutely rationally to the change in the US monetary policy and the world is profiting from it. In particular it will be positive for troubled home owners, who will be helped to refinance with long term loans at low rates. And companies in need of long term finance should find it easier to issue bonds. Whether anybody will buy them is still anybody's guess. Some – including myself – are worried about the long-term effect on inflation and hence, on the long bond yields. It is not a relevant issue right now, and will be addressed when the governments or central banks find it appropriate to tighten monetary policy.

Commodities and oil have fallen considerably, offering an impetus to the markets. Quite correct, but the prices have fallen from speculative levels and are likely to have undershot meaningfully on the way down. After all, commodities and oil have to be priced at least at levels where they can finance the search for new sources as the existing mines/oil fields dry up. That may not be the case for several items right now and they will begin to move back. And nobody could take the 84% fall in Baltic Dry rates seriously. Anyway, the world did not enter a recession because of high commodities and energy prices. So yes, the current low level of commodities prices are a plus, but unlikely in itself to pull us out of the recession.

Stocks are cheap. Oh, really? Yes, if you compare to the peak of valuation in the summer of 2007. And of course if you assume that companies will return to the same level of profitability seen in the first half of 2007. And provided that valuations improve.

What will happen if they do not get back to the same profitability levels? My guess is that they will not anytime soon revert to those happy days. The banking sector will be hobbled for decades to come, as regulators de facto will tighten reserve requirements visibly and for an extended period of time, introduce limitations to the bank's activities.

It will reverberate into other sectors because credit will be less readily available and in particular, financing M&A activities will be hurt. Venture funds and private equity funds, who have been important players in the "grey" credit creation, are likely to be regulated in a rather more strict way.

In order to return to profitability, companies in all sectors will depend critically on a return to sustainable economic growth. Eventually, economic growth will return. But for a span of years, it is likely to be slower than seen in the past 10 or 15 years. There are two reasons for that. A good deal of the growth was credit financed, a driver which will be off the table for an extended period of time. Secondly, we are not only looking at a situation where new credits will be limited, we are looking at one where existing credits will have to be reduced. The size of this debt overhang in the US is significant enough that it will take years to work it down. In that period US consumption will grow slower than before and be a drag on the world economy.

With growth below par, and finance for M&A drying up, the case for a rapid return to profitability is weak. Unless the Asian consumers suddenly turn themselves from being excess savers into excess consumers.

Even if stock markets return to profitability, there is no guarantee that valuations will begin to pick up either – exactly for the reasons mentioned above.

By Q3 2009 we have seen the worst. Stock markets still celebrate themselves for being able to predict turns in the economy 6-9 months ahead. Yet they did not see the current recession coming, so the predictive ability of the stock market appears rather jaded.

But still, things will turn in late 2009? I hope so, but am not too optimistic. The fiscal stimulus packages appear too small and too late in the coming. There is a new wave of resets on 'Alt-A' loans coming in the first months of 2009. We have still not seen the full impact of the Credit Default Swaps. The economic downturn has become sharper in recent months, but we have not yet seen the traditional surge in corporate defaults. Once that happens, we will find out how bad the situation is in the CDS market. I am afraid that it may not be a pretty sight.

So all in all, while too much pessimism is not good for the markets, I still have some difficulties in letting myself be swept away by any wave of optimism..

Friday, 5 December 2008

Strong increase in US jobless claims

US Labor Department announced today that nonfarm payroll employment fell sharply in November, as 533,000 jobs were lost. The official unemployment rate increased by 0.2% to 6.7% From October to November. At the same time the Nonfarm Payroll number for October was revised for the worse, from an initial reading of 240,000 to 320,000. Not exactly a trivial revision either. Consensus estimates for the November number stood at 350,000 lost jobs.

Since the start of the recession, the economy has lost 1.9 million jobs, the number of unemployed people increased by 2.7 million and the jobless rate rose by 1.7 percentage points.

Not entirely surprising, the stock markets reacted negatively to the publication of such bad numbers. In the tug-of-war between the forces claiming that now it cannot get much worse and those stating that this is only the beginning, the latter scored a hands down victory.

No doubt, the US economic situation is bad enough, and there we will continue to be showered in nasty-looking economic indicators for quite a while to come.

But before panicking over the Nonfarm Payroll statistics as they were released Friday, one has to remember that employment numbers are not an indicator of things to come. They are what in economist-speak is called a lagging indicator. Employment statistics are an indication of how employers were thinking about the future some months ago – before they set in motion the actions that led to the laying off of their employees.

Similarly, do not expect to find the employment statistics to give an early indication of the turn for the better – whenever that may be. When unemployment begins to fall, it will be several months, maybe more than a year after the bottom of the recession.

Hiring or firing on a large scale is in the vast majority of cases expensive business and is usually not undertaken until it really is necessary. There may be various obstacles depending on the jurisdiction, Europe being a case in point. What makes it expensive is, however, not the compensation paid to the leavers. Instead, it is the loss of human capital from the company. An overwhelming majority of jobs require particular skills paired with good dose of experience. Firing on a large scale means that a company waves goodbye to a lot of knowledge, and the laid off employees may not be available next time an upturn comes around.

Similarly, once the economy gets better, many companies will have similar reservations hiring on a large scale. New employees have to be trained for the jobs, and that is often a huge expense, so the companies will prefer to run at capacity or above for as long as possible. Germany is a case in point, where employment still continued to increase in October – as if German companies had not realised what was going on in the rest of the world.

The German unemployment has been steadily falling over the past three years or so. But well before that, in 2004 and 2005 many German companies began to improve their profitability in a meaningful way after a serious wave of restructurings. That in turn led to new hirings from late 2005 and onwards, and it is only now that this trend is likely to be broken.

So why would the market react so strongly to the US nonfarm payrolls. Probably because it is not readily known that it is a lagging indicator. On top of that it appears that the depth of the recession is only now beginning to dawn on a large segment of market participants.

Wednesday, 3 December 2008

Some good news for investors in mortgage bonds – and for the rest of us

Under some hype, the US Federal Reserve announced an extra $800bn facility, which was allegedly being "pumped" into the markets. This new initiative as not passed by congress for the rather simple reason that this was a conceptually simple extension of Fed's normal lending facilities. Yet another letter combination joined the fray, the TALF , short for Term Asset-Backed Securities Loan Facility, which will lend up to $200 billion to holders of AAA-rated ABS backed by newly and recently originated consumer and small business loans. The Fed also will purchase up to $100 billion in debt from the Fannie Mae and Freddie Mac, and up to $500 billion in GSE-backed mortgage-backed bonds.

At the same time it has been visible in the market that Federal Reserve is buying Treasury bonds all along the yield curve. Fed Chairman Ben Bernanke has even stated that Fed has "obviously limited" room for lowering short term interest rates further and that other, less used policies, may be used. Such as buying Treasury bonds.

There are several implications of these moves. Most importantly, the conjunction of the two indicates that Fed is acting very actively in order to make sure that the T-bond yield curve keeps flattening, and secondly, that the huge risk premium in the mortgage segment will be forced down. The reason is that the US government is under heavy pressure to "do something" about the slowly unfolding disaster going on in the US mortgage market. One of the elements of "doing something" is to create conditions under which some homeowners now under pressure from high refinancing rates in the short end of the market can be offered a debt restructuring to a less volatile segment of the market and thereby lower their financing rates significantly. Federal Reserve is working to create the background for a "bail-out" of home-owners. Of course the concrete form of that will be determined by the new Administration in the US.

Overall that $500bn in the TALF would be enough to purchase more than half of all new issues in the GSE backed mortgage segment, and hence enough to take a lot of the troubled assets out of the market. It appears that finally the cornerstone is being laid for switching into mortgage bonds instead of treasuries: falling T-bond yields along the curve PLUS a narrowing spread. This is likely to spread all over the world, were mortgage spreads have remained stubbornly high, despite lack of convincing signs that conditions are just half as bad as in the US.

But the more important message is that by buying bonds along the T-bond yield curve, Fed is simply monetising (part of) the government deficit. Printing money and pouring it directly into the economy instead of putting money into the banking system which remains frozen, anyway. For more than 30 years it has been the credo of all responsible economists that central banks should not monetise the debt of the public sector, but doing so right now is a definite step in the right direction. It means that the dysfunctional banking system is partly bypassed and fresh money is handed down where it is needed, primarily to the mortgage lenders.

In the good old days – some months ago – this would have been considered sacrilege and likened to putting out the inflationary fire with kerosene. Now, with inflation plummeting and the d-word back in fashion again, printing money is not any longer one of the seven deadly sins of a central banker. Deflation is still far away, but dis-inflation is certainly back. So now there is leeway to increase the monetary stimulus. Fed Chief Ben Bernanke was ridiculed in 2002 for suggesting that printing money in a recession might help if everything else failed. He was even nicknamed Helicopter Ben because the economists' standard parable is to throw money down from a helicopter.

Pretty much everything else has failed, and with increasing paralysis of policymakers in the dying days of the Bush Administration, the Fed has made a very significant move in the right direction.

Whether it is enough, is still an open question. Remember that the next segment in the US mortgage market to have massive resets of the introductory "teaser rates" is the "Alt-A", one notch up from the "Sub-Prime". They will have massive resets in March and April 2009. Maybe a plan will be in place to help them avoid a wave of foreclosures. Maybe not. The stock market appears convinced that the latter is the case.

Oh yes, and if you have exposure to dollar assets, here is a small teaser - of a different nature. If US short term interest rates are on their way towards zero, and if Fed is printing money - what will happen to the dollar?

NBER drives home the message: This is BAD

Forgive me for being a little bit confused. For years, friends and colleagues working in the financial sector have told me that what happened yesterday is of no importance to the stock markets. What counts is what happens NOW and what is expected to happen in the (near) future.

Monday, nevertheless, the stock markets sold off on news that a group of economists had decided that the US economic recession began in December 2007. Why, one could ask, is it suddenly so important now. Particularly since everybody has understood that we are in a recession.

National Bureau of Economic research, NBER, is a privately funded group of economists, but its board has won the privilege of officially stating when recessions begin (and end). Being professional economists, they use a wider set of economic indicators than the rest of us (you have probably heard of the definition: two consecutive quarters of negative GDP growth), employment, manufacturing, industrial production, retail sales, and income.

Their role has never been that of "playing politics", meaning that their definitions were meant for use when designing economic policy. Instead it is a rather academic exercise, aimed at academic economists and analysts looking at the really long trends. NBER established that the previous recession ended in October 2001 and the US had 73 months of growth. But then employment peaked in December 2007, Personal Income in the same month, while manufacturing and retail sales had peaked in June 2008. Industrial production peaked in January 2008.

Maybe it has to do with perceptions of the recession. Some pundits were already getting into the futile game of guessing the "shape" of the recession. Would it be V-shaped (short and sharp) or U-shaped (taking a little bit longer to recover from)?

Then this bunch of economists tell us that the recession has already lasted for 11 months. The longest recessions of the post war era were both 16 months long (73-74 and 81-82). Worse, there are absolutely no signs of this recession abating. If anything, the downturn is still accelerating. Car sales continue to collapse, employment is falling, retail sales are still falling. Repossessions of residential property is accelerating, so are defaults on home loans. And we have still not seen the commercial property sector give in despite rumours, and there have still not been any marked increase in corporate defaults.

NBER's statements made it clear to even the most starry-eyed optimist that this recession is at least going to be longer than anything we have seen this side of WW2. It has also the hallmarks of being deeper than anything seen since the '30s.

There you have it. The combination of NBERs statements and the continued flow of really bad news drove home the message to everybody: the point of reference for this downturn is not any longer any recent recession, but the depression. Understandably, the stock market took cover and the oil prices resumed their fall.

Then in a twist of brilliant irony, the markets began to rally again. Now the arguments were turned on their heads again: now we know it is so much worse than what we believed last Friday. So now we cannot be surprised badly any more. So let us go and buy some stocks.

Suddenly, yesterday began to look so – yesterday. I have argued earlier that this recession is going to become deep because of the debt overhand, compounded by the banks' various follies in the derivatives markets. I am afraid I have still seen nothing that will make it likely that the stock markets could not become negatively surprised again.