Garnett Keith's February Update

Garnett Keith is my boss at SeaBridge Investment Advisors, below is an update he wrote to some friends in Europe...

February 2009 Update

A year ago we were worrying about sub-prime mortgages. Then larger problems in SIVs and financial institution leverage rose to the top of the worry list. Libor soared and the banking community ossified. Then Lehman, FNMA, AIG, Countrywide, WAMU and Wachovia focused our attention on failures of specific institutions. Falling markets, massive withdrawals from mutual funds, and hedge fund forced selling made September through November extraordinarily painful. December had a hopeful rally, and then January dashed hopes. So where are we today? Are we not ready for a rebound in the equity markets?

Through the confusion and all this pain, the “how we got there” is becoming clear. The world’s structural financial problems shifted from two decades of emerging market borrowing crises to a decade plus of huge emerging market savings. The savings were recycled to the U.S., and interest rates were substantially suppressed. This liquidity flow and low interest rates sent the U.S. consumer on a borrowing binge; a libertarian government supplied too much credit and too little supervision; investment banks enjoyed massive increases in leverage; plentiful liquidity meant rising securities prices and casual attitudes about risk; and commercial banks became intoxicated with their new merchant banking and “originate and sell on” capabilities.

In this litany, there are a lot of problems to be fixed. I doubt we are entering a sustainable bull market until more of the fundamental problems have been fixed. What is the progress report?

• The Bush team stabilized the major banks and pushed the auto industry debacle forward to March 2009
• The Obama $787 billion Economic Stimulus package will cut middle class taxes, reduce hardship by extending unemployment benefits; will fix the Alternative Minimum tax problem; and will unleash other spending programs.
• The housing support package (Foreclosure Prevention Act), approved by the Senate this week attempts to slow the decline of house prices; gives cities money to purchase foreclosed homes, restores the depleted reserves of FNMA and Freddie Mac; and slow the eviction of defaulting homeowners by allowing the adjustment of mortgage terms.
• Secretary Geithner’s plan for restoring the financial sector is still under development. Reports are that it will encourage and finance private sector efforts to lift bad assets out of the banks, probably providing some ceiling on losses on purchased assets.

The problem with this combination of efforts is that they do not seem to be adequate to solve the problems in 2009. It appears that many of the problems will have to be worked out by debt reduction via defaults over time.

• At the head of the list of unsolved problems is the global imbalance. World trade is collapsing and domestic demand in the surplus countries will take years to offset the consumption swing in the U.S. Essentially, no consumer has been found to replace the tapped-out U.S. shopper and keep world production at its 2006-2007 level.
• The capital destruction numbers are grim. Jeremy Grantham calculates that 2008-09 losses of 50% on equities, 35% on housing, 35% on commercial real estate, destroy about $20 trillion of wealth from a starting number of $50 trillion. This compares to a $13 trillion economy and $25 trillion of corporate and individual private debt. As a result banks are rapidly trying to get more collateral and guarantees behind their loans. At elevated lending standards banks would like to reduce the $25 trillion of debt to $15 trillion. The pressure to reduce the other $10 trillion of debt is a major depressant on the economy.
• As U.S. spending falls, excess capacity and inventory cause layoffs, rising unemployment and a downward cycle of consumer confidence in the world-wide supply chain.
• With demand for both consumer and capital goods falling fast, export powers like China, Japan, and Germany are finding their economies falling far faster than anticipated.
• The second and third round multiplier effects of the global contraction will be moving through the global markets throughout 2009.

High level analyses being circulated from academe and think tanks, arrive at worrying conclusions that the proposals of governments, so far, provide much less stimulation than the negative forces being unleashed by a world wide contraction. For example, announced reductions in corporate capital spending plans exceed all currently discussed government stimulation plans. This means more and more pressure on global employment. In the consuming countries, unemployment puts heavy pressure on bank assets – defaulting credit card and prime mortgages in the U.S. and heavy losses on their Eastern European assets in European banks.

The most interesting statistics I have seen lately is from a paper from Wynne Godley at the Levy Institute (Prospects for the U.S. Economy and the World, December 2008.) It concludes that to restore balance, U.S. private sector debt needs to be reduced from 174% of GDP to roughly 130% of GDP between 2008 and 2013. This requires a savings shift from borrowing roughly 10-15% of GDP at the peak to saving roughly 5% of GDP for 5 years, 2009-2013. This equals roughly a $2 trillion a year savings increase on a $14 trillion economy ($10 trillion of consumption) for several years. A 20% U.S. consumption swing on a sustain basis requires a new world order or a global recession of large magnitude.

The Obama Economic Stimulus Act, even if one assumes it is 100% effective, is roughly $787 billion spread over two or more years. So the scale is mismatched in favor of continuing deflationary forces.

Debate now seems to be moving toward nationalizing major banks. This would allow an immediate “lift out” of bad assets (The Swedish solution) This probably has the best odds of fixing the banking system within 12 months. However, U.S. opinion still recoils from nationalization of anything, so there is a good chance we will apply the Japanese solution – banks struggle on for years – rather than the Swedish solution.

All these forces lead to major institutions ranging from Warren Buffett to Yale University to shift away from equities toward debt – especially investment grade debt until the problems are worked out. That thinking, of course, leads to lows in equity markets and very good equity values for those willing to look across the problems to an eventual recovery.

Equity commentators vary in their assessment of the odds for a sharp bear market rally. The composite scorecard looks something like:

Pluses:

1. There is huge liquidity on the sidelines which could push equities substantially higher if confidence were restored.

2. The Fed is making progress in fixing the capital markets and investment grade bonds have moved up significantly since November

3. The Baltic Dry Index has turned sharply higher signaling the beginning of recovery in China

4. There has been a huge increase of liquidity in China and the Shanghai market is moving higher.

5. Manufacturing orders around the world are declining at a less rapid rate.

6. Money supply in the U.S. has been growing rapidly, offsetting the fall in money velocity

Minuses

1. Bank profits will be negative in 2009 and industrial profit forecasts are still being downgraded

2. Industrial production, tech orders, and orders for durable goods are still falling

3. While optimistic earnings forecasts put P/E’s in the range of past bear market lows, there is very low confidence on what the E’s will be in a global recession of this magnitude. Pessimistic earnings forecasts show the S&P at over 25 times 2009 earnings

4. With $2 trillion of Government borrowing on the horizon, 10 year Treasury rates have moved significantly off their lows. The fear of stagflation is growing.

5. With the rebound in Treasury rates, the spike in mortgage refinancing – providing liquidity to the system – has collapsed again

6. The debate over nationalizing the banks and the auto companies will be very divisive

7. Unemployment will likely rise from 7.6% to 9% during the course of 2009. While a lagging indicator, this will weigh on confidence.

8. Until there is a credible plan to fix the banks, money will stay on the sidelines.

Within the Yield Growth portfolios we continue to increase our focus on “reliable income streams.” These include significant positions in MLP’s, in Government Guaranteed mortgage REITS, and in corporate bond funds – especially closed end funds trading at a discount. We have begun buying some individual investment grade corporate bonds in the PIM Yield Growth SICAV where bond fund holdings are limited. With more and more fixed income, portfolio yields are at highs.