Sense on Cents

The developments in our global economy are so large in scale that it is of paramount importance to develop a macro view. David Swensen, Yale’s head of investments and widely regarded as the top portfolio manager within college and university endowments worldwide, says as much in an interview reported by Bloomberg:

“The crisis forces you to think top-down in ways that would, I think, be unproductive in normal circumstances, or absolutely necessary in the midst of a crisis,” Swensen said. “You have to think about the functioning of the credit system. You have to think about the potential impact of monetary policy on markets over the next five or 10 or 15 years.”

I concur. In that spirit, let’s look back at my outlook from last October so that we can more clearly look forward as we navigate the economic landscape.

Excerpts, with current commentary, from The Economy – What Lies Ahead (originally published October 14, 2008):

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. 

I still maintain this premise. The move down in the economy last Fall led to an initial move lower in rates on government bonds. Our central bank and other central banks have subsequently supported the economy via quantitative easing (central bank purchasing of government and mortgage-related assets). That said, we are now entering the stage where the global demand for credit is swamping investors’ and central banks’ ability to provide it and rates are moving higher. I believe this move to higher rates, especially in the government and mortgage sectors, will continue. Rates for municipal and corporate bonds should also be forced higher although not as much.

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.

I continue to believe we will experience stagflation. Comments by Bill Gross of Pimco highlighting the potential likelihood of the United States losing its implied AAA credit rating adds fuel to this fire.

Individuals, corporations, and governments still need to delever (pay down debts) and will be forced to sell assets in the process. As such, while I think selected sectors of the equity market may hold up, I remain concerned about the overall market. I think the U.S. dollar and other currencies of overlevered (big fiscal deficits) nations will suffer. These developments are inflationary. To defend one’s portfolio from inflation, gaining exposure to TIPS (Treasury Inflation Protected Securities) is prudent. Mr Swensen addresses this point in the aforementioned interview.

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.

While rates on CDs and other short term deposits have come down, I still believe it is prudent to remain defensively positioned at this juncture. As the liquidity needs increase – and they are – opportunities will develop in a wide array of markets. While it may be prudent to buy short term bonds of highly rated companies, I still think people should keep plenty of dry powder. Within equities, companies with pricing power (ability to increase prices in an inflationary environment) will outperform.

4. Other Highlights . . .

If the government accedes to the pressure being applied to suspend the mark to market accounting principle, I would expect 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.”

I very much believe this and maintain this viewpoint.

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.

I also maintain this premise. I believe we will experience double digit unemployment this year given the problems in the automotive (production, parts, and dealers), and municipal sectors (forced cuts as tax revenues plummet. California is the poster child!!). Retail sales will remain low keeping domestic production and imports also depressed.

Please share your thoughts and opinions. Each and everyday is a microcosm, but we need to maintain the macro view as we navigate the economic landscape!!

LD