Opportunities in These Uncertain Times

Perspective - Fourth Quarter, 2009

► The bank panic of 2007-08 has caused a recession
► China and India will cushion the impact of the global slowdown
► Governments and central banks will use all their tools to reflate economies
► Central banks focusing on deflation
► Stocks have priced in a deep recession
► Valuations are becoming compelling
► Opportunities in high quality corporate bonds, high-dividend global stocks

We have been anticipating a global economic slowdown since 2005. We obviously did not expect this global financial crisis, its extent or the recession it precipitated. However, we did have our clients’ portfolios conservatively positioned. We also avoided the major failures in the financial sector by adhering to our investment disciplines.

Although stock markets ended the year down over 35%, our clients’ diversified portfolios were down about 15%. Our slight underweight in total equities; regional diversification across Canada, U.S. and International markets; emphasis on high-dividend paying companies; and our diversified bond portfolio all combined to cushion the overall impact of the markets.

In addition to enhancing our dividend equity strategy with additional layers of protection in response to the current environment, we plan to take advantage of opportunities presented by high-quality Canadian and U.S. corporate bonds.

Paving the Way for Recovery

While much has already been written about possible causes and effects, it is worth highlighting that credit and liquidity issues precipitated the current economic and financial crisis. Therefore, it will be a solution to both issues that will pave the way to eventual recovery.
 
Governments and their monetary authorities saved the global banking system in 2008, supplying colossal amounts of money in the form of recapitalizations for banks, rescue packages for corporations, direct purchases of toxic securities, and guarantees for debt.
 
The next stage of the process is for participants to want to lend to those who want to borrow. Although financial markets have hardly returned to normal, there are signs of thawing. Interbank lending rates have fallen from crisis levels. The London Interbank Borrowing Rate (LIBOR) has fallen 3.4% to 1.4% in recent weeks. This indicates banks once again are becoming somewhat willing to lend to each other.
 
The headwinds facing U.S. consumers remain a significant concern. Unemployment could rise to 10% by the time the recession is over. The Obama administration is looking at extending the duration of benefits for those who lose their jobs. Without a return to stability in the job markets, home prices cannot stabilize and give banks confidence that the value of their assets can be maintained. Without that greater confidence, banks won’t be inspired to lend, and homeowners, worried about their jobs and the shrinking value of their homes, will be less inclined to spend with earned or borrowed money.
 

Response Package Still Expanding

So, where will recovery come from? Given the problems facing the corporate sector today, it appears that only governments have the answer. In this regard, the U.S. Federal Reserve and the Obama administration have grasped the lessons learned from earlier crises and the Great Depression—and they have demonstrated the will to do what is necessary to unfreeze the financial system and stimulate economic recovery.
 
Barack Obama will take on Franklin Delano Roosevelt’s 1933 ‘New Deal’ mantle. The New Deal was based on the assumption that the power of the federal government was needed to get the country out of the depression. Obama has told us to expect trillion dollar deficits for years to come. He wants an extra $825 billion  

$825 billion in his 2009 stimulus package, in addition to the $350 billion in Troubled Asset Relief Program (TARP) monies.  Obama  has  earmarked  infrastructure projects as targets for increased spending and job creation. He is also proposing $300 billion in tax cuts.

Meanwhile, Fed chairman Ben Bernanke is living up to his nickname of “Helicopter Ben”. He earned the moniker in 2002 when he implied that deflation could be fought by dumping money out of helicopters. Bernanke has fired up the chopper: Early in 2009, the Fed will extend credit to households and small businesses, effectively by-passing banks and putting dollars directly into the economy. Already in 2008, the monetary base in the U.S. had risen by more than 70% from levels a year earlier.

The Fed has lots more fire power if credit conditions do not improve. It doubled the size of its balance sheet in 2008 to $1.2-trillion and, for the first time ever, will use this money to buy hundreds of billions of  dollars  of  mortgage-backed securities and agency debt, helping to pull short and long-term interest rates down and opening up more room in the private sector for additional lending and mortgage refinancing at record-low interest rates.

With deep interest rate cuts and fiscal stimulus efforts underway in most of the world's major economies, global growth could find a footing in the second half of 2009. However, because of the severity of the recession, a recovery will probably not feel like one–it will be slow and deliberate as the excesses of the financial crisis continue to unwind.

Stocks Price in Deep Recession

The stock market generally leads the economy by six months. Long before the global recession was confirmed, the markets assumed that it was and discounted, or priced in, potential economic negatives. The path of the market reinforces our view that 2000 was the modern day 1929 and 2008 is more like 1937 [Chart 2]. As the chart shows, market bottoms are a process and they take time. It is likely that the S&P 500 and other markets will retest their lows in the spring of 2009 as the recession touches its deepest point.

The coming year could resemble the late-2002/early-2003 period when stocks began to look past the economic weakness; in essence, a year where earnings are terrible, but where valuation multiples begin to normalize in anticipation of an eventual recovery in the economy.  Valuations are becoming compelling. At the market bottom in October, the 5-year or ‘normalized’ Price/Earnings ratio was 11.7x. Historically, the P/E has been 10x at the end of bear cycles.

Inflation Gives Way to Deflation

Among the many firsts we saw in 2008, was the near evaporation of inflation as commodity prices corrected. Concern shifted to potential deflation because of the downward spiral in prices and the collapse in consumer spending.

Over the short term, deflation in the U.S. will be the order of the day as the struggling economy continues to pull prices and wages temporarily lower. In the longer term, the trillions of dollars in reflationary economic stimulus entering the global economy will add to inflation pressures–but for now, there is no alternative.

Central bankers will, however, move quickly to  mop up excess liquidity once the stimulus has done its work and the world economy is growing again.