Outlook Jan 21 2009 - 2009 Economic Outlook
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Outlook Jan 21 2009 - 2009 Economic Outlook
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Outlook Jan 21 2009 - 2009 Economic Outlook
- 1. Winter 2009 Economic Outlook: Recession and Recovery Estate Planning Council of Abbotsford January 2009 Presented by: Allan Seychuk, Economist Phillips, Hager & North Investment Management Limited Est. 1964
- 2. Global Equity Markets Struggle to Find Bottom Major Markets Since January 2008 (local currency terms) 110 Lehman Bros Fails 100 Index, Jan. 1, 2008 = 100 90 80 70 S&P 500 S&P/TSX 60 MSCI EAFE MSCI Emerging 50 40 Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jul-08 Aug-08 Sep-08 Oct-08 Source: Datastream
- 4. Challenging Times Slowly Setting the Stage for Next Bull Market 2009 to be extremely challenging for the US economy Recession Canada’s buffers against US spillovers will diminish Risk of deflation and market disappointment remains elevated Recovery Why we’re optimistic about 2010, and beyond Signs we’re looking for the recovery is underway What obstacles still stand in the way of true recovery? Obstacles Have we indeed entered a new era, with new behaviour? How much should today’s bailouts / stimulus worry us?
- 5. Financial Market Stress is Easing CBOE Volatility Index (VIX) U.S. Dollar LIBOR 80 5.5 70 5.0 60 4.5 4.0 50 Index 3.5 40 % 3.0 30 2.5 20 2.0 10 1.5 0 1.0 06 06 06 07 07 07 08 08 08 Jan- May- Sep- Jan- May- Sep- Jan- May- Sep- Jan- 09 -07 -08 ar- 08 -08 ul-08 -08 ov-0 8 -0 9 Nov Jan M May J S ep N Jan Source: Chicago Board Options Exchange Source: U.S. Federal Reserve, Bank of England CDX Credit Default Swap Index U.S. Financial Commercial Paper Outstanding 300 900 275 850 250 800 225 US$ billions 200 750 175 Index 700 150 125 650 100 600 75 550 50 25 500 0 450 Ju 8 Ju 7 Ja 6 Ja 7 08 M 7 M 8 M 7 M 8 Se 7 Se 8 No 6 No 7 No 8 M -03 M -04 M -05 M -06 M -07 08 De -04 De -05 De -06 De -07 De -08 J u -04 Ju -05 Ju -07 J u - 08 Ju -06 Se -04 Se -05 Se -06 Se -07 Se -08 -0 -0 0 0 -0 -0 0 0 l-0 l-0 0 0 0 v- v- v- n- n- p- p- p- c- ay ay ar ar c c c c c p p p p p ar ar ar ar ar n n n n n De Se Source: Bloomberg Source: Federal Reserve
- 6. Not Your Garden Variety Recession U.S. Median Resale House Prices U.S. Light Vehicle Sales 20 20.0 0.20 Million units, annualized Year-over-year % change 15 17.5 Sales per worker 10 0.15 15.0 5 0 12.5 0.10 -5 Single-family homes 10.0 Total new vehicle sales -10 New vehicle sales per worker -15 7.5 0.05 64 67 70 73 76 79 82 85 88 91 94 97 00 03 06 81 83 85 87 89 91 93 95 97 99 01 03 05 07 Source: National Association of Realtors Source: Autodata, US Census Bureau, PH&N U.S. Household Net Worth Year-over-year Change US Household Net New Borrowing (% of GDP) 8,000 10 Borrowing, % of GDP 6,000 8 4 per. Mov. Avg. (Borrowing, % of GDP) 4,000 $ billions % of GDP 6 2,000 - 4 -2,000 2 -4,000 0 -6,000 -8,000 -2 1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Source: U.S. Federal Reserve, Merrill Lynch Source: U.S. Flow of Funds, TD Newcrest
- 7. Current Conditions Continue To Deteriorate Job Losses Accelerating U.S. Real Consumer Spending 0 10 8 -100 -82,000/month 6 -200 Thousand 4 -300 % 2 0 -400 -2 -500 -484,000/month -4 -600 First 8 months Latest 3 months -6 of recession of recession 70 73 76 79 82 85 88 91 94 97 00 03 06 09 Source: BLS, Economic Policy Institute Source: U.S. BEA
- 8. Leading Indicators Signal Deep Downturn Leading Economic Indicators: OECD & Selected Non-OECD 20 OECD Non-OECD* 6-month rate of % change 15 10 5 0 -5 -10 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 * Trade-weighted average of China, India, Brazil, Russia, Indonesia & South Africa Source: Organization for Economic Cooperation & Development, PH&N
- 9. Japan’s Recession Expected To Deepen Japanese Exports Industrial Production & Machinery Orders 30 20 Industrial production 20 15 Domestic machinery orders 10 10 % Year-over-year 5 0 % 0 -10 -5 -20 To the US -10 To Western Europe -30 To China -15 -40 -20 6 6 6 7 7 7 8 8 8 9 07 07 07 07 08 08 08 08 09 -0 r-0 l-06 t-0 n-0 r-0 l-07 t-0 n-0 r-0 l-08 t-0 n-0 Jan- Apr- Jul- Oct- Jan- Apr- Jul- Oct- Jan- n Ja Ap Ju Oc Ja Ap Ju Oc Ja Ap Ju Oc Ja Source: Ministry of Finance Source: Ministry of Industry & Commerce
- 10. Remarkable Deterioration in China, Asia China Merchandise Trade Industrial Production 60 25 Year-over-year % change, 3 mth avg. 50 Exports 15 Imports 40 5 % year-over-year 30 -5 20 -15 10 Taiwan 0 -25 Korea Thailand Singapore -10 -35 Apr-07 Apr-08 Jul-07 Jul-08 Jan-09 Jan-07 Jan-08 Oct-08 Oct-07 -20 97 00 02 03 05 06 07 98 99 01 04 08 Source: National Bureau of Statistics of China Source: National Statistical Agencies
- 11. Canada’s Recession Just Getting Started U.S. in the worst shape of any major economy and Canada is the country the most exposed to the U.S. Canada also exposed to global economic conditions via global demand for commodities (which has crumbled) Why should we expect Canada to hold up well in this environment? Expect: job losses, lower national income, falling nominal GDP, more weakness in factories, housing and retail sales Monetary stimulus to be joined by further fiscal stimulus Positives: lower fuel prices, room for more government spending, somewhat better household fundamentals, less reliance on home equity for spending money
- 12. Canada Playing Catch-Up in Key Sectors Existing House Prices New Light Vehicle Sales 20 120 15 110 Annual % change, 3 mth avg Index, Jan 2006 = 100 10 100 5 90 0 80 U.S. 70 -5 U.S. Canada Canada -10 60 -15 50 Apr-06 Jul-06 Jul-07 Jul-08 Apr-07 Apr-08 Oct-06 Oct-07 Oct-08 Jan-06 Jan-07 Jan-08 2003 2006 2007 2004 2005 2008 Source: Can. Real Estate Assoc., National Assoc. Source: Merrill Lynch, StatsCan, of Realtors US Dept. of Commerce
- 13. Canadian Consumer Not Really So Different Household Debt, % of Personal Disp. Income Growth in Household Net Worth 150 20 140 Canada 15 U.S. 130 U.S. Year-over-year % change 120 Canada 10 110 5 100 % 90 0 80 -5 70 -10 60 50 -15 1961 1965 1985 2009 1969 1973 1977 1981 1989 1993 1997 2001 2005 1998 2006 2008 1990 1992 1994 1996 2000 2002 2004 Source: Federal Reserve, Statistics Canada, PH&N
- 14. Extended Period of Low Interest Rates Ahead Central Bank Policy Interest Rates 6 Bank of Canada Projection 5 U.S. Federal Reserve 4 % 3 2 1 0 2003 2004 2005 2006 2007 2008 2009 2010
- 15. Issues, Obstacles and Risks: Resolution of auto sector’s troubles still uncertain, confusion regarding bailout, TARP, etc. More housing trouble ahead in Alt-A, Option ARMs Need for looser credit conditions and strong financial sector: conflict U.S. household financial conditions still a long way from good Deleveraging: how much is enough? How fast can global GDP grow? Can China generate sufficient growth internally? “Frugal future”, or a temporary setback? Has behaviour really changed? How much to worry about the long term implications of bailout, deficits?
- 16. US Deficit Set To Soar United States: Deficit and Debt 25 80 Debt to GDP Ratio will rise Financial balance (left) 20 Net debt (right) 64 sharply 15 48 No strong correlation 10 32 between deficits and bond yields 5 16 Higher private sector 0 0 savings will offset public -5 -16 sector dissaving -10 -32 Business cycle will 1986 1988 1992 2000 2002 2004 1980 1982 1984 1990 1994 1996 1998 2006 2008 2010 2012 dominate issuance cycle Source: Finance Canada, OECD Economic Outlook No. 83, June 2008. Data is general government, national accounts basis.
- 17. U.S. Dollar Has Bottomed – For Now U.S. Dollar Trade-Weighted Index 150 140 130 120 Index 110 100 90 80 70 Major currency index 60 1979 1985 1994 1997 2000 2003 2009 1973 1976 1982 1988 1991 2006 Source: U.S. Federal Reserve
- 18. From Conspicuous Consumption to Thrift? US Household Debt Relative to Disposable Income 150 Household deleveraging 130 will be a drawn-out process 110 % 90 70 50 30 1960 1968 1976 1984 1992 2004 1952 1956 1964 1972 1980 1988 1996 2000 Source: U.S. Federal Reserve Flow of Funds
- 19. For How Many Years Will Spending Shrink? U.S. Real Per Capita Personal Consumption 15 10 5 % 0 -5 -10 1889 1899 1909 1919 1929 1939 1949 1959 1969 1979 1989 1999 2009 Source: Robert Shiller, www.econ.yale.edu/~shiller/data.htm
- 20. Summary: Near-term gloom, hope for the future Economic indicators still deteriorating and will not bottom until much later in 2009 – true recovery is a 2010 story Credit will remain tight until house prices stop falling and more people are finding jobs than losing them Economic and market outlook must be reconciled with magnitude of loss of wealth, jobs, income and confidence Canada is very negatively positioned in this environment Eventually, tremendous monetary and fiscal stimulus will have an impact Markets are forward-looking and have now priced in a sharp recession Eventually, central banks will have to mop up today’s flood of liquidity
- 21. Early Cyclical Stocks Rallying While Bond Yields Plummet TSX Sectors Since January 2007 Canadian Treasury Bond Yields Since Jan. 2007 175 5.0 Energy 4.5 Materials 150 Financials 4.0 Index, Jan.1 = 100 3.5 125 % 3.0 100 2.5 2-year 2.0 10-year 75 1.5 50 1.0 May-07 Nov-07 May-08 Nov-08 Mar-07 Mar-08 Jul-07 Jan-07 Jul-08 Jan-09 Jan-08 Nov-07 Nov-08 Sep-07 Jul-07 Jul-08 Sep-08 Jan-07 Jan-08 Jan-09 May-07 May-08 Mar-07 Mar-08 Sep-07 Sep-08 Source: Datastream Source: Bank of Canada
- 22. 2008 – Optimal Asset Allocation Strategy 60% Ghana Stocks (+66%) 40% US Long Bonds (+30%) Total Return: 52% plus currency!
- 23. Asset Mix Strategy – Patiently Await Opportunity to Add to Stocks Cash levels close to minimums as short-term yields plunge. Overweight bonds – at maximum corporate bond focused on high quality as credit cycle plays out No rush to further add to stocks as bottoming process could be prolonged – epic credit cycle continues as consumers and financial system deleverage while the contours of the global downturn remain unknown
- 24. Stocks Bottom In Advance of Earnings/Economy Equity Markets, Earnings and Recessions 120 115 Equity Performance (DJIA) 110 DJIA Reported Earnings Index, 4 week average ISM Index 105 100 95 Reported earnings bottom ~ 2 DJIA bottoms ~ 5 years after end of recession 90 months before end of recession 85 ISM bottoms ~ 4 80 months before end of recession 75 Recession 70 -12-10 -8 -6 -4 -2 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34
- 25. Searching for Signs of a Market Bottom Extended period with no more nasty surprises!! (ie financial system continues to regain normal functionality, systemic stress eases) US housing market stabilization: housing starts bottom, defaults/foreclosures peak, ARM resets peak, monthly house price declines slow, inventories stabilize Other leading economic indicators stabilize: sentiment, orders, retail sales, Chinese & Japanese exports Commodity prices and oil prices stop falling and stabilize Low interest rates begin to spur demand for loans and banks actually lend Technicals: stocks climb on rising volume, mountain of cash begins to move from sidelines Markets rise on bad news
- 26. Credit Markets TED Spread Signals Increasing Risk Appetite 3-Month T-Bill Eurodollar Spread (TED Spread) 500 450 The TED spread is a leading indicator of liquidity 400 conditions and credit risk. T-bills are risk free while eurodollar deposits reflect borrowing 350 conditions in the short-term corporate credit Basis points market. A widening spread indicates rising risk 300 aversion. 250 200 150 100 50 0 1994 1996 1998 2000 2002 2004 2006 2008 Eurodollars are US dollar deposits in banks outside the USA. The eurodollar rate reflects the cost of US dollar funds for large non-US financial institutions. Source: Datastream
- 27. Sentiment Cash A Safe Haven Amidst Credit Crisis U.S. Money Market Mutual Fund Assets 4,000 Dec 2008 = $3.36 3,500 trillion 3,000 2,500 $ Billions 2,000 1,500 1,000 500 0 1983 1986 1989 1992 1995 1998 2001 2004 2007 Source: Federal Reserve Bank of St. Louis
- 28. Valuation A 45 P/E on Bonds – Model Says Buy Stocks Fed Model - United States 45 40 S&P500* US Treasury Bond** 35 30 P/E 25 20 15 10 5 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 * Based on expected EPS for the S&P 500. ** Based on the interest income of a 10-year U.S. Treasury Bond.
- 29. Canadian Equity – Outlook Mean Reversion Works Both Ways S&P 500 10-Yr Rolling Return (1929-2008) S&P/TSX 10-Yr Rolling Return (1929-2008) 400% 350% 350% Average: 86% Average: 103% 300% 300% 250% 250% 200% 200% 150% 150% 100% 100% 50% 50% 36% 0% 0% -1% -50% -25% -24% -50% -65% -65% -100% -100% Dec-29 Dec-34 Dec-44 Dec-39 Dec-49 Dec-54 Dec-59 Dec-64 Dec-69 Dec-74 Dec-79 Dec-84 Dec-89 Dec-94 Dec-99 Dec-04 Dec-09 Dec-59 Dec-74 Dec-79 Dec-84 Dec-89 Dec-29 Dec-34 Dec-39 Dec-44 Dec-49 Dec-54 Dec-64 Dec-69 Dec-94 Dec-99 Dec-04 Dec-09 Source: Scotia Capital
- 30. Canadian Equity – Outlook The Worse the Headlines…The Better the Return S&P 500 Performance 12-Month after ISM-survey (since 1950) 12M fwd S&P 500 performance Average Probability of ISM* <0% 0-10% 10-20% +20% Gain Positive return Return > 10% <40 5 6 26 27% 100% 86% # of occurrences 40-50 40 32 42 59 11% 77% 58% 50-60 109 85 102 73 8% 71% 47% 60+ 42 42 21 9 2% 63% 26% * The Institute for Supply Management (ISM) publishes a monthly purchasing managers survey Source: Scotia Capital, Bloomberg
- 31. Canadian Equity – Outlook Looking Across the Valley Phase 1: De-leveraging Phase 2: Markets Normalize Phase 3: Recovery 2009-2010? Equity markets in Markets bottoming as Strong rally in Equity Index freefall credit begins to thaw anticipation of Good & bad stocks Short/sharp bear earnings recovery fall sharply rallies Volatility normalizes Valuation metrics Gradually improving Fundamentals matter Fundamentals don’t apply! confidence in again! Earnings estimates in fundamentals Cost cuts magnify freefall Earnings finally margin expansion Macro events drive reflect trough & Sharp earnings markets begin to stabilize recovery Survival of the fittest Market leaders take Pricing power/margin Companies Weak companies share and drive out expansion become distressed efficiencies Operating leverage (GM) Weak competitors magnifies EPS forced to exit/get growth for survivors acquired
- 32. Canadian Equity - Strategy Financials & Consumer Discretionary Lead in S&P/TSX Recoveries First Year of New Bull Market 1957 – 2008 Consumer Disc. 87.5% Financials 87.5% Industrials 62.5% Consumer Staples 37.5% Consumer Staples is a likely Utilities 37.5% funding source to re-position for early cycle leverage Energy 37.5% Materials Key Overweights 25.0% Key Underweights Telecom Services 12.5% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Source: BMO Capital Markets
- 33. Canadian Equity – Strategy Canadian Banks Capital, Profitability, Valuation Dashboard Bank Capital Strength – Nearly Double 1990s Crisis Canadian Banks ROEs – Q4/08 Overweight - Current Tier 1 Underweight - Current Tier 1 30% Operating ROE 1990 Tier 1 Ratios Reported ROE 10.4% 10.5% 25% 9.8% 10.1% 9.8% 9.3% 9.2% 21% 20% 20% 20% 18% 17% 16% 16% 6.5% 15% 15% 14%15% 13% 13% 5.5% 5.3% 5.3% 4.7% 5.0% 5.0% 10% 6% 5% 5% 0% BMO BNS CM NA RY TD BNK BMO BNS CM NA RY TD BNK Less Cyclical & Higher Recurring Revenue Streams Price to Book Multiple for Canadian Banks 3.5 10-year Average P/B: 1.9x 10-year Average 80% Non-Interest Income % of Total Revenue Current P/B: 1.5x Current P/B: 1.5x 3.0 60% 55% 50% 2.5 40% 31% 2.0 19% 20% 1.5 0% 1980 1990 2000 Q4-2008 1.0 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-98 Dec-00 Dec-01 Dec-02 Dec-04 Dec-05 Dec-06 Dec-08 Dec-97 Dec-99 Dec-03 Dec-07 Source: Bloomberg, company reports and Scotia Capital
- 34. Canadian Equity – Strategy Commodity Stocks are Late Cycle Performers! CRB Index 525 475 425 375 325 275 225 175 125 75 Dec-86 Dec-88 Dec-08 Dec-70 Dec-72 Dec-74 Dec-76 Dec-78 Dec-80 Dec-82 Dec-84 Dec-90 Dec-92 Dec-94 Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 Shaded areas highlight U.S. recession Source: Bloomberg
- 35. Investment Implications of Global Economic Trends Infrastructure Governments will support infrastructure investments Developed world infrastructure is crumbling Developing world needs to build infrastructure Outsourcing Companies will look for ways to turn fixed costs into variable costs. Look for beneficiaries Organic Growth Most businesses have no pricing power. Look for those that have organic or unit volume growth: driven by demographics, life cycle of industry, changes in consumer behavior, long-term secular trends. Market Leadership Leaders will become stronger weaker companies fail
- 36. Fixed Income Opportunities: Corporates Corporate Bond Yields Less Gov’t of Canada Bond Yields* 4.4% 4.5 4.0 3.5 Yield Spread (%) 3.0 2.5 2.0 1.5 1.0 0.5 0.0 Dec-96 Dec-97 Dec-02 Dec-04 Dec-90 Dec-91 Dec-92 Dec-93 Dec-94 Dec-95 Dec-98 Dec-99 Dec-00 Dec-01 Dec-03 Dec-05 Dec-06 Dec-07 Dec-08 Source: DEX Mid Term Bond Index
- 37. Fixed Income Opportunities: Liquidity Spreads Canada Housing Trust (CHT) Yield Spreads vs Similar Term Canadas 1.0 These bonds are guaranteed by the 0.9 Government of Canada. The wider spreads 0.8 represent the nervousness of investors and the “price of liquidity”. 0.7 Spread (%) 0.6 +0.54% 0.5 CHT Five Year Term 0.4 0.3 0.2 0.1 0.0 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Dec-06 Dec-03 Dec-04 Dec-05 Dec-07 Dec-08 Source: creditCHT spreads (5 yr chart) 1/2//09
- 38. Evolution of Asset Mix Strategy: Benchmark Sep/07 Dec/07 Mar/07 Jun/08 Sep/08 Dec/08 % % % % % % % Cash 5.0 10.1 10.9 7.1 7.1 3.0 1.2 Bonds 35.0 32.1 33.7 35.2 35.0 36.9 38.3 Canadian 35.0 30.5 29.7 31.5 33.5 32.4 31.9 U.S. 12.5 14.7 13.3 12.7 12.4 16.7 17.6 International 12.5 12.6 12.4 13.5 12.0 11.0 11.0 Equities 60.0 57.8 55.4 57.7 57.9 60.1 60.5
- 39. Why Be Optimistic? Governments Globalization Greed Extremely low interest Well underway and Businesses will rates, innovative irreversible continue to try to sell monetary policy more actions, banking Increased trade has led system recapitalization to rising living Investors will standards globally continue to look for Tremendous fiscal gains stimulus and more to Rise of Asian come; Fed printing consumer is inevitable Fear will recede over money time Eases recession and Capitalism is not lays groundwork for dead recovery
- 40. Key Points The equity market decline has been unprecedented in severity and speed, and has been accompanied by extreme strains in credit markets We are positioned for an eventual narrowing of credit spreads and are benefiting from higher yields of corporate bonds Economic recoveries in the U.S. and beyond will be determined by bottoming in housing and wringing out of credit crunch fears, likely not until later in 2009 Equity markets tend to bounce before the economy
- 41. Thank You
- 42. U.S. Deflation To Be Short-Lived U.S. CPI Projection 7 July 2008 5 3 % 1 -1 Monthly CPI % change, headline -3 Year-over-year % change, headline Year-over-year % change, core CPI July 2009 -5 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
- 43. Valuation Reasonable Based on Long-Term Metrics U.S. Price-Earnings Ratio Since 1881 50 Shiller P/E Ratio 45 One std deviation above 40 Mean One std deviation below 35 30 Ratio 25 20 15 10 5 0 1881 1891 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 Source: Robert Shiller, www.econ.yale.edu/~shiller/data.htm
Notas del editor
- Global equity markets have bounced back sharply since mid March led by the commodity heavy TSX. The exception is the Chinese stock market where stocks have plunged 50% from recent unsustainably high levels. It would appear that the bounce in stocks may be a bear market rally – expectations for earnings remain too optimistic in all major markets. Downward revisions may set the stage for further equity market weakness amidst an uncertain macro economic environment.
- The crisis in financial markets turned what might have been a moderate US recession into a severe global one. Since November, the crisis appears to be abating. Among the indicators we follow, volatility is down from November’s peak level, interbank lending rates continue to decline, the cost of corporate bond default protection as measured by the CDX index is no longer climbing to new highs. By and large most credit market stress indicators have returned to levels last seen in September, pre-freeze-up. Encouragingly, commercial paper issuance has picked up again thanks in no small part to government intervention and guarantees. Financial markets seem to be regaining a measure of normal functioning, which is encouraging.
- However, the financial crisis has become an economic crisis. Indicators of the current situation in the US range from tremendously bad to unprecedented. The decline in median house prices has been the worst in the post War era by a long shot; Vehicle sales are collapsing: level is the worst since the 1980s recession, but when scaled by population or by number of workers, sales levels are worst in post-War era; Household balance sheets are under tremendous stress as wealth evaporates; and households are deleveraging at a pace never before seen. In the absence of anything else, the wealth effect alone (equal to 5 cents per dollar of wealth change) suggests spending decline of $400 billion in 2009, enough to bring real consumer spending growth to zero. This does not even include the effects of deleveraging, and we can see by panel 4 that HH new borrowing has turned negative for first time in many decades. Debt paydown will exacerbate the effects of the negative wealth effect.
- Households are also facing the largest loss of jobs of any recession since the mid-1970s. 2.6 million jobs have been eliminated since the start of the recession in December 2007, and the pace of layoffs is accelerating (left panel). The implication is that we expect to see a big drop in consumer spending in the 4 th quarter of 2008, and for 2009 as a whole (right panel), as job losses combine with deleveraging and the large negative wealth effect.
- As recently as early Fall Japan could probably have escaped the worst of the effects of the US recession. Japan’s banks were in decent shape, Japan is not an overleveraged society and they have increasingly tied their trade sector to booming Chinese markets. However, the deepening global recession caught up to Japan via its dependence on exports for growth. Although Japanese exports to the US have been shrinking since mid-2007, this has been offset by growth in exports to Europe. As exports to Europe began to contract in mid-2008, exports to China picked up the slack, becoming by late 2008 Japan’s largest export market. Then, very recently, exports to China began to shrink as China’s manufacturing sector slowed abruptly. Now, Japan’s three key export markets are all contracting simultaneously. In this environment, Japanese industrial production and factory sector investment spending have begun to rapidly contract on a year-over-year basis. This highlights the risk of competitive devaluation: if yen remains elevated while won falls and yuan holds steady, Japan will want to take measures to protect exports. Intervention in foreign exchange markets? With rates at zero and little appetite/ability to undertake fiscal stimulus in any meaningful way, stimulating the trade sector seems to be the only option.
- … and nowhere is this more true than in Canada.
- Despite the lower deflation risk in Canada, the Bank of Canada is still expected to cut rates again by 50 basis points in early January, bringing the overnight rate to 1.00% where we expect it to stay for the balance of 2009 and much of 2010. The interest rate profile should be similar in the US, with rates remaining in the 0-0.25% range for much of the next 24 months.
- At this point the outlook remains very murky. There are still several huge obstacles to recovery in the near term, no the least of which pertains to the auto sector and the risk of Ch. 11 filings. This risk is easing but has not been eliminated. Moreover, there is still a lot of uncertainty as to how much more funding will become available under the Troubled Asset Relief Program and how it will be used. Further fiscal stimulus is on the way, but once the announcement effect is out of the way there is room for disappointment as markets realize that fiscal stimulus and bailouts will have little impact on real consumer spending in the near term. There is risk of a later, second peak in foreclosures related to Option ARMs– some estimates peg that issue as one for 2011, highlighting the fact that the housing bust will have long-term implications on markets. There is a near-term conflict that needs to be sorted out between the need for banks to boost credit availability and the need for banks to shore up balance sheets and appear to have adequate capital hoards. More broadly, rebuilding the financial conditions of US households is a long process that implies weak consumer spending growth for several years. How much debt reduction is enough? That depends on how loose credit conditions become down the road. If a large debt reduction is needed before financing become freely available again, it will be tough for global GDP to return to the 3.5%-5% range seen in the past few years given how central the US consumer was to the global economy. We still don’t really know if consumer behaviour has permanently changed and whether households will see this increase in savings as temporary or permanent.
- PCroft : The global economic outlook is challenged by the ongoing volatility in the price of oil and significant movements in global currencies. In addition, while most central banks have moved to the sidelines with the exception of the Fed, short-term interest rates have moved off recent lows. Importantly we do not foresee a global recession. China and the US should continue to grow at above-trend rates.
- Despite the fact that the economy, and earnings growth, may remain muted for much of 2009, the stock market is a forward-looking mechanism and will begin to reflect the recovery well in advance of when we begin to see actual economic evidence. This chart attempts to highlight the fact that as far as we have data, markets bottom before earnings.
- We have noted that we expect an eventual recovery in the economy and that markets rebound before the economic indicators. Okay, so what are we watching to determine when it might be a good time to more to a more aggressive stance? The slide shows a list of many indicators that are used to assess when markets have put in a durable bottom and are in the process of staging a durable recovery.
- The TED spread is a further indicator of risk – the spread has narrowed sharply from the Lehman high of 464 bps, now back down to 100 bps. However, this is still above the longer-term norm of 25 to 50 bps.
- A further indicator of sentiment is shown here – holdings of US money market mutual funds – now at a record high despite zero interest rates. This represents 41% of US equity market cap, a record high. For the first time since 1993, the assets held in money market mutual funds exceeds the dollar value of assets held in US equity mutual funds. While this source of liquidity is potentially positive for stocks, cash could be sidelined for some time owing to the uncertainties associated with the depth and duration of the recession and deleveraging process.
- The Fed model is a screaming buy for stocks with the P/E on bonds at over 40% versus the S&P P/E at less than 10%.
- Government action will prevent the recession from spiralling out of control and will lay the groundwork for eventual recovery Regarding globalization, the bottom line is that incomes and living standards will continue to steadily rise, the world economy will continue to grow and markets will eventually resume their advances Greed is not necessarily bad. The desire to make money has not disappeared. Eventually, people will find ways to improve on existing conditions, and will be rewarded for this.
- Regarding deflation, it’s coming to the US in the very near future, given the path already taken by monthly CPI inflation rates. However, deflation is expected to be short-lived and confined to the headline rate, driven by falling prices for food and fuel. We do not expect to see falling core CPI prices as the price for core services continues to rise at a moderate pace. Nor do we expect to see a downward spiral in wages as was the case during the deflationary 1930s. We expect to see inflation return to positive territory by 2010, as year-on-year comparisons to $150 oil drop out and $40 oil moves steadily in to the equation.
- This chart looks at valuation back to 1881 using trailing real ten year earnings. Valuation on equities has improved considerably in this cycle.