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The Economy–What Lies Ahead

Posted by Larry Doyle on October 14, 2008 10:03 AM |

I share these opinions with you given the historic nature of the events currently going on in our global financial markets and economy. I hope that you find them of interest. I would be very interested in your thoughts as well. Much like that scene in the movie “Trading Places” when the wealthy tycoon “turn those machines back on,” I view this bailout package as nothing more than the best of a litany of very bad alternatives. Without being overly pessimistic, though, if you want to reduce this package to layman’s terms this package is the equivalent of a massive injection of capital/liquidity into a Ponzi scheme that was being played (whether they knew were playing it or not) by certain large financial institutions.

The systemic risk was so massive that something had to be done. That said, this injection of capital will not necessarily fully flow through to the economy.The banking system here in the U.S. likely has $1 trillion in embedded losses. This plan is trying to buy time for the system to recognize those losses. The recognition of those losses will curtail future growth for the banking system and the economy as a whole. The U.S. followed Europe’s lead and specifically Great Britains’ in making the direct capital injections into banks. If the U.S. did not there would likely have been a significant capital flight to Europe. However, while the U.S. is injecting 250mm (i.e., billion) as part of the 700mm package, Europe has injected 10 times that figure. We may still see a flight in capital away from our economy. Not that other economies are necessarily stronger, because they are not, but merely due to the fact that the level of nationalization of deposits is actually deeper. How do all these programs, both here in the U.S. and around the world get funded? What are the implications for the markets?

In my opinion, I see the following:

1. Global Increase in Long Term Interest Rates –the massive amount of debt that will need to be issued will cause rates worldwide to rise even in the face of a likely significant economic slowdown. …….

  • 10yr U.S. Treasury rate is up 50bps in the last week even with the Fed having cut the fed Funds rate by 50bps…
  • IBM issued debt last week in the midst of this tsunami….they borrowed for 5yrs at app 6.75% and 10yr money at app 7.75% ( a full 400bps over Treasurys for one of the strongest global companies!!!!!!)
  • 3 mo Libor is only down to 4.63% this morning from 4.75% at the end of last week…hardly a resounding vote of confidence
  • markets are now appreciating where REAL money will care to invest not the highly levered and speculative money that was the lifeblood of Wall St. and hedge funds for the last 8 yrs.

2. Financial asset deflation while hard goods and asset inflation. Why??

  • I can already hear the printing presses at work churning out currencies worldwide. The rise in interest rates will depress bond values. With slower worldwide economic growth and increasing unemployment GDP prospects are not pretty for the foreseeable future. I think there is a very strong chance that we will see “stagflation”.
  • While financial assets have limited upside growth potential and significant downside even from here, hard commodities and assets will likely increase in value or perhaps I should write will hold their value as financial currencies and financial assets lose value.

3. Where do you put your money??

  • take what the market is giving you, and right now they are giving you security and guarantees in deposits in large money center banks,…this also provides flexibility to provide liquidity for those in desperate need and you will see more and more of that occur both at a personal level and a corporate level…. BE PATIENT…..
  • buy QUALITY…..this market is very quickly separating the wheat from the chaff…well managed institutions will gain market share and it will be reflected in the value of their stocks and bonds….one has to fully understand an entity’s ability to generate cash flow to meet their debt service and to grow their enterprise…..

4. Other Highlights…

  • if the government accedes to the pressure being applied to suspend the mark to market accounting principle, I would expect that that move would only prolong the underperformance of the economy….I view a suspension of the mark to market as the equivalent of an agreement to officially allow one to “cook their books”…
  • SELL RALLIES…….while financial institutions have been feeling the pain of overleverage for the last 12 to 18 months that pain is just now coming to bear on the consumer…given that the consumer represents app 70% of our GDP, the expected precipitous drop in consumption across a wide array of products and industries will be very painful….you will see a litany of corporations announcing layoffs on a regular basis…Pepsi did just that this morning…

Not trying to be a gloom and doom guy here but I think we are in for a very rough ride. Granted this is just my opinion and you know what they say about opinions…

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