Friday, January 02, 2009

2009 Forecast: That bad huh?

For most of my career, with an exception here and there, there have been two persistent trends. One is that in the debt markets, the fundamental outlook has generally been good. You had persistently low inflation, mostly low volatility, and a growing economy. Sure, some bonds went bad, but for the most part, the fundamental picture was good. The problem was always valuation. You'd look at a corporate bond and see a whopping 100bps spread or something and it would seem like all downside, no upside risk. But of course, you had to buy something, so you'd hold your nose and buy it.

Now its just the opposite. The fundamental outlook is piss poor, but the valuations look extremely cheap across all risk sectors.

Risk assets are pricing in Armageddon. As long as no one spies any horsemen running around, those risk assets ought to pay off well for investors in the very long term. But that's the real trick isn't it? When to jump in?

I think the key to bond investing in 2009 is two fold.

1) Protect your liquidity. Professional investors, whether leveraged or not, never know when their clients will need cash. And the cost of turning bonds into cash has never been higher than now. Non-pros tend to underestimate the probability of needing cash, and frankly, non-pros don't have as many resources for producing liquidity in bonds. No offense, but its true.

I believe that liquidity has probably bottomed, or put another way, that liquidity won't get any worse than it is now. But when I say probably I mean like 65%. There is still a decent chance of another blow-up causing another spate of deep illiquidity.

That being said, bid/ask levels are going to remain very wide, probably for the next several years. We've seen improved liquidity in high-quality sectors, like agencies and munis, but even there, I expect liquidity to wax and wane with buyer demand. Remember that dealers used to be the guardians of liquidity. That's gone and it ain't coming back.

2) Buy what you can hold. This isn't to say you can't put money into a bond as a trade, but given how wide bid/ask is, and given that you don't know when bids are going to suddenly disappear, you can't assume you can flip a position. So when buying a bond, ask yourself: would I hold this bond for the next year? Two years? To maturity? Is this credit strong enough that, if I had to, I'd hold this bond indefinitely?

I argue that you shouldn't buy anything in 2009 where you can't answer that question with a confident yes.

So with all that being said, here is my basic economic forecast for 2009. I'll follow this post up with thoughts on some of the major bond sectors. As always, I'll discuss a most likely scenario along with a less likely but possible scenario.

Most Likely: Sharply negative real growth in 4Q 2008, continuing (at a less severe pace) at least through 1H 2009. 2H 2009 likely near zero. Meaningful recovery doesn't start until 2Q 2010.

Less Likely: Government fumbles stimulus, and growth is negative through 2010 and possibly into 2011, with a deeper trough.

I think the immediate period after the Lehman/AIG/GSE/WaMu/Wachovia failures resulted in a massive pull back in economic activity. We saw it in Existing Home Sales in October/November, in auto sales activity, bank lending, everything.

That took what was already going to be a recession and turned it into something much worse. I had thought that mortgage foreclosures could bottom in mid-2009, because that seemed like long enough for the bad loans to burn out. But the sharp contraction in 4Q 2008 will result in much higher unemployment, I suspect around 10% by the end of 2009, and thus the foreclosure party will continue on.

And it will take a slowdown in foreclosures for housing prices to bottom. I suspect it will be government intervention that is the catalyst for this. We've already seen the government move to lower mortgage rates, which really should give us pretty good affordability. And while part of the initial problem with housing was over-building, but that ship has sailed. Housing starts have plummeted, and now all starts are pretty much multi-family or made to order.

Anyway, you need demand to outstrip supply in order for prices to start rising. As long as foreclosures are rising, that means supply is rising. Demand is going to be tepid until the employment picture improves. Rising supply and unchanged demand equals falling prices.

So I see home prices falling throughout 2009, absent direct government intervention either buying foreclosed properties or subsidizing banks to prevent foreclosures. Obama & Co. may actually take these steps, but I'd say it'll take several months for such a thing to pass Congress, then several more months to actually be implemented. So we're still looking at late 2009 at best.

GDP growth will probably be worst in 4Q 2008, then more modestly negative in 1Q and 2Q 2009. Beyond that is difficult to say. My base case is for 2H 2009 to be about zero real GDP growth, with a meaningful but tepid recovery in beginning in 2Q 2010.

The risk to this forecast is that the government bungles the bailout attempts, most likely by letting another financial institution fail. It currently doesn't look like that's their strategy, but then again, after Bear Stearns it didn't seem like they wanted to let another institution fail. But then came Lehman.

Another risk to this forecast is...

Most Likely: Inflation? What inflation? The Fed will spend most of 2009 fighting deflation, although by 3Q or 4Q it will be apparent that the Fed will indeed win the battle. Headline CPI will print negative multiple times in 1H 2009, predominantly on falling food and energy prices.

Less Likely: We fall deeper into deflation, most likely because the less likely growth scenario comes to pass.

I've written a few times on deflation, which is truly the primary concern of the Fed right now. The Fed has plenty of tools to fight it, and Ben Bernanke is the right man for the job, having spent his academic life studying how the Fed blew it in the 1930's.

I don't see Japanese-style deflation taking hold, at least not for the same reasons as it took hold in Japan. The Bank of Japan maintained a ZIRP policy for many years to no avail. They still suffered from deflation. Why? Because you can't get consumer inflation without consumer spending. I argued this multiple times when energy prices were rapidly rising. Energy doesn't "create" inflation, rising money supply does.

But even in the face of rapidly rising money can't create inflation unless consumers are spending. Right now, money is contracting and consumers are pulling back. In fact, those two things are usually correlated. But in the case of Japan in the 1990's, consumers refused to spend despite massive fiscal and monetary stimulus.

But here is where I think the U.S. differs from Japan. The Japanese are fundamentally savers. Americans are fundamentally spenders.

Unemployment is going to be bad in 2009, heading toward 10%. But the other 90% of Americans will keep spending their income. Now they won't be able to spend their home equity, as in the past, but basically we're a nation of spenders. Once the American stimuli take hold, consumer spending will advance anew. That's not to mention the fact that the U.S. Fed has been far more aggressive far earlier than the BoJ ever was.

Eventually this leads to some inflation problems, probably not till 2H 2010. To suggest that the Fed will provide just enough stimulus to avoid deflation but not create a significant inflation problem down the road is ridiculous.

Key to the Fed's success is the progress on quantitative easing. The TALF is the quintessential example of QE, where the Fed targets interest rates away from overnight bank lending rates. There will be no limit as to how far the Fed goes to fight deflation. They could buy corporate bonds, municipal bonds, commercial mortgages, anything. Beware what you short!

However, if we get another big leg downward in economic growth, resulting in even tighter consumer lending conditions, then the deflation fight becomes more difficult. I'd still see the Fed eventually winning, but such an outcome would result in a much longer period of ZIRP and eventually much bigger inflation spike.

In the next couple days, I'll be discussing my investment strategy around this forecast.


Unknown said...

AI said.."Energy (prices)doesn't "create" inflation, rising money supply does. But even in the face of rapidly rising money (supply) can't create inflation unless consumers are spending.""

OK, then what's more important in your opinion, the rising money supply or the velocity of money?

BT said...

I think you've given some very wise advice here. But I also wonder if you are being optimistic in some places. The popular refrain is to say that we started with a financial crisis that has now affected the real economy, as if everything that is happening now is just a footnote to Lehman. But there are massive structural issues with our economy that have yet to play themselves out, I think, and this would have happened regardless of how Lehman was dealt with.

dave in sv said...

Great post, I look forward to your thoughts on where the opportunities are tomorrow. I am not an economist, but the ISM data today sure seemed bad (seems like Brad Sester thought so too). When I see data that says new orders from the ISM were at levels last seen in 1949, I think, "maybe this time it is different". And the fact that the rest of the world seems to be rapidly slowing down also seems like this recession will be longer than expected. While I think your point that Americans are spenders is true, if home values keep dropping, and if people are afraid of losing their jobs and if the stock market fails to significantly rally, then perhaps the American consumer's willingness to spend will be very slow to come back. We live in interesting times!

housam said...

While I can understand your line of reasoning when it comes to the feds attempts at stamping out deflation by any means necissary,I do disagree with you on your assumption that americans are spenders and therefore inflation will take hold.The last stimulus the government gave out illustrates my point .Most americans recieved the 600-1200$ checks in july and 85% of that money was either saved or used to pay down debt.This was before the calamity that unfolded in september and things now only look worse.To be honest I am a little bit scared when I hear comments comparing the feds action in the great depression to their actions now,simply because there is not solid evidence to suggest that if the current actions where taken back in the 30's,things would have been better.The boom in infastructure spending in the 50's where monumental and yet there is no evidence to suggest it made the subsequent recessions any less severe.

pepster said...

I agree with housam. Americans have indeed been a nation of big spenders for the last 20 years or so, but with unemployment rising, wages stagnant for those lucky enough to still have jobs, mortgages that are upside down and massive credit card bills among other things, I don't think that Americans will resume spending any time soon.

Besides reduced spending, another reason why I think inflation will not take hold is stagnant wages, as I touched on above. My understanding of inflation is that it requires a wage-price spiral, but I don't see the average worker being able to get raises for the forseeable future.

Michael H said...

America is a nation of spenders...

So, when do you expect that the Boomers will make the shift from spending to savings?

Waking from Lever-Lever Land

Accrued Interest said...

Ginger: I'm being a little sloppy by saying "money growth" when I really mean both the supply and velocity. I'd say that the Fed is going to try to compensate for a rapidly declining velocity with a rapidly increasing supply.

BT: It isn't that its all a footnote to Lehman, but Lehman changed the severity of what was already underway. After Lehman, a CP-oriented funding strategy is dead. Hell, an unsecured debt strategy might be dead. Surely the Prime Brokerage as funding strategy is dead. Before Lehman it wasn't that bad.

Now we have a much bigger transition to make in the world economy, and that will mean a much deeper and longer recession.

Accrued Interest said...

On Americans being fundamentally spenders, not savers, you are taking my claim to an extreme. Clearly Americans will be forced to save more than in the past. I think this will particularly manifest itself in people delaying retirement.

But conversely, I'd argue that people who can still afford to spend are still spending at a similar pace. And I'd further argue that people who have recently lost their jobs will resume spending once they find work.

This is in contrast with Japan, where the BoJ couldn't spark spending no matter what it did.

So my spender/saver argument was all about the long-term deflation arguement, not a claim that spending isn't about to decline.

capital beacon said...

I think implicit in your assumptions is that housing inventory will have to come down. I have seen various estimates of excess inventory generally in the 1.5 million area. The NAR (Natioanl Association of Realtors) estimates that we have about 11.2 months of supply as of December. I would guess that number is higher considering NAR's agenda(s).

I also think that marked growth in the economy cannot be acheived without a recapitalization of our banking system. In particular, community and smaller regional banks will have to get more capital investment as commercial real estate and C&I (commercial & industrial) loans starts to worsen.

lineup32 said...

Thanks for the interesting post. Will be looking forward for your investment outlook going forward.
Unemployment levels will be the key going forward as job security real and imagined will impact most workers outlook in this regard.

Accrued Interest said...

Real supply of housing has to fall, and I think it will take a decline in the pace of foreclosures. We've heard reports that some CA districts are seeing 70% of sales come from foreclosures.

Activity of that kind is not condusive to good price discovery.

There has been anedotal evidence that home buyers are being enticed into the market. That's great, but as long as foreclosures remain high new demand isn't actually getting us anywhere is it?

Credit Cruncher said...

I think that in this sort of environment, it is worth noting that corporate bonds also need to be valued in an absolute return sense, as well as a spread over extremely low government rates.

If you hold a long term bond, 10 or 20 year maturity, and you think that above target inflation is going to get created by policy actions, your bond return might be more "normal" than it seems, rather than some incredible deal, as wide spreads might have indicated in the past.

Maybe its just theoretical for those of us that live in the bond world, and have to invest there. Or maybe it means that shorter maturities should b more attractive on a relative basis.

Or maybe inflation is just a myth from a bygone era...

Lockstep said...

AI, thanks for the post. Great summary.

It is a nice view from a traders perspective. But I think you are a little short sighted on your economic analysis.

I live in So Cal and I am familiar with most of the markets. You can rest assured that despite the pain there is another two years of decline left at the current 15% rate of decline.

Countrywide still employs 40,000 people, yet makes 1/3 of the revenue on loans as compared to previous years. My point is there is a lot of pain to come, still.

So Cal is not the center of the world, but it is significant and a leading indicator on whether or not a housing recovery is in the offing anytime soon.

Moreover, house wealth destruction is choking off the consumer. Thus consumer spending will not come back until this pain shakes out and the consumer is recapitalized.

qadi said...

All people have stopped spending. Even wealthier folks have stopped buying as much: the fear is deep.

Interest car auction data I got: an Audi A8L, 2007 with 13k miles, sold for $25k last week. This car was $85k about two years ago.

The book used for "book value" has been tossed out the window!

Accrued Interest said...

Lock and Gadi:

In terms of spending, I'm thinking 1-2 years down the road, and I'm not thinking that spending occurs at the same pace, but that the decline (again, 1-2 years from now) will be modest. Or put another way, the decline will be modest enough that a tepid recovery is possible 2 years from now, without a deflationary spiral.

Christopher Wheeler said...

I liked your comment on liquidity, but I think you need to generalize that from bond trading to personal finance situations across the economy. We all need more liquidity, although that is normally called having an emergency fund. In an uncertain economic environment, more people are holding onto their cash.

The drive to increase liquidity will tamp down spending and increase saving until the jobs outlook begins to look more certain. The tactic of using a HELOC to gain liquidity will probably be retired for at least a generation, until the bankers who are living through the nightmare retire.

~~~~~ Preftrader ~~~~~ said...

On the Canadian side, specifically perpetual preferreds

Nice summary, Accrued . . . all that I might add for any Canadian readers, is that some kind of gift from the heavens was dropped on the perpie market just about 12 noon Christmas eve. After months, actually 2 years, of tortuous selling, and endless flooding of this market by the banks with new issues, for some totally unexplained reason (not even the HIMI experts have a clue), buyers came to the market and ran up Canadian perps by a good 20% across the board. Oddly, the newly invented rate resets were not bestowed this uptick, just the perps. This trend seems to be pretty much over now, with the bid slowly vanishing, the banks continuing their flooding ways, and the institutional sellers renewing their selling bias. This has been a great opportunity to unload what has become one of the scankiest investment vehicles of all time, and although I do not know who is responible for this gift, all I can say is . . . thank you.

Anonymous_1 said...

"But when I say probably I mean like 65%"...

So a 35% chance that we head into a deflationary spiral that makes the New Deal look like Ann Rand Capitalism!

The recent 2.6->3.1 30-yr yield stopped me out of TLT, and now I've got three coins that say "Inflation", "Deflation", and "Stagflation". I've been flipping them for 2 days and have yet to come to a conclusion.

~~~~~ Preftrader ~~~~~ said...

Jeff Lacker on inflation

Accrued, this is what the Richmond Fed President said today; he believes inflation is clearly still a threat to be dealt with . . . by raising interest rates maybe sooner than later. Is he just brain-dead?

" REUTERS Fed's Lacker-Fed cash flood poses inflation risks [JHYXWGX]

LINTHICUM, Md., Jan 9 (Reuters) - The Federal Reserve's
dramatic dumping of money into the economy poses inflation
risks down the road, and the central bank may need to raise
interest rates before credit markets have completely recovered,
Richmond Fed President Jeffrey Lacker said on Friday.

"While at the present time, credit programs do not conflict
with our monetary policy strategy, there could well be a time
at which monetary stimulus needs to be withdrawn to prevent a
resurgence in inflation, even though credit markets are not
deemed fully healed," he told the Maryland Bankers
(Reporting by Mark Felsenthal, Editing by Chizu Nomiyama) "