Happy New Year! Really!?!?

This piece below is not my handiwork - it was completely
conceived/written by my friend, Vivin Oberoi who is an
economist by training and is now a Portfolio Manager.
It's a long and cerebral read, so I suggest you print
it, sit down and read it...then ruminate and see why it
makes sense.

- aLV

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1/1/09 Outlook 1H 2009: Happy New Year or is it?

1) The United States is in the midst of the worst economic
recession in decades (the ROW is in a recession as well):
The economy fell off the cliff in Q4 08. This is reflected
in economic stats such as survey data in G7+Australia (worst
readings since inception of data in a lot of cases). The
speed of deterioration of activity in retail and durable
goods and falling employment is ample support for the survey
data. Our baseline is for the economy to trough at the end of
2009. Moreover, the recovery is likely to arrive in fits and
starts (induced by multiple fiscal stimulus packages) and
NOT in the usual private sector debt financed spending.

2) The banking system has gone bankrupt in a number of countries
but has been recapitalized by the government. Good news is that
the authorities will do whatever is necessary to keep the banks
capitalized.

3) Stock markets have lost ~ 40%. This, however, does not make
them a screaming value.

4) Fixed income yields have plummeted. Yields on the short end
are zero in US, Japan, Switzerland and HK. They are close to
getting there in Canada and followed by UK.

5) Credit (like equities) “looks cheap.” The Federal Reserve
and the treasury are inducing the private sector to buy
credit – by buying themselves. Markets that the Fed/Treas are
buying are rallying. Other types of risky assets are not.

6) However, the outlook for the economy now built into the
markets is really bad. More so in treasuries than in stocks.

7) Is the worst over? Markets are showing signs of reacting
positively to any statistics that come in above the already
lowered expectations. For example, US/UK consumer confidence
and a couple of regional manufacturing surveys in the US. Take
these for what they are – temporary rebounds in expectations
of the massive stimulus working. We would like to offer
anecdotal evidence of what we are saying – the Univ of Mich
consumer confidence rebounded and the markets cheered.
Econometric evidence points toward falling gas prices and
a stock market that has stopped falling as a cause. The
more reliable conference board measure of shows that
consumer confidence is still falling as a result of rapidly
deteriorating employment. What is likely to be the dominant
factor, we ask ourselves, falling gas prices or rising
unemployment. Hence, temporary bounces in economic statistics
should be scrutinized with care. There are numerous sources
of noise, both technical and economic, overlaid on the trend
of deteriorating economy. Another example is the
misinterpretation of smaller falls in house prices (Case
Shiller index) over the summer – it was merely seasonal.
It is now becoming clear that the housing market is still
in free fall and the credit squeeze is making it a lot worse.
We could (and should) get short term rallies in credit and
equities (second half of Dec). The failure of commodities
to confirm is a sign that underlying fundamentals are not
improving.

8) Deflation vs. ZIRP

Demand destruction vs. Bailouts:

Our best guess for the short term is that economic activity
is unlikely to free fall as it did in Q4. In other words,
the speed of descent will slow down. However, that does
not mean it is about to turn around. Deflation and demand
destruction are likely to remain with us for a good while
longer. The debt that has been accumulated over decades is
not about to disappear. As we outlined in our Oct outlook,
the first stop on the way to economic rebalancing is for
the US consumer to cut back consumption to the point where
our borrowing needs are manageable. Let us put some numbers
on the problem. The US was borrowing about 6% of GDP. The
private sector consumption is likely to contract by 10% or
about 6-7% of GDP. In previous cases of crises of this
nature, the borrowing goes down to zero as the tap of lending
is shut off. In the case of US, that is likely to be true as
well for the private consumption. The public sector will
offset the pain of the sudden rebalancing where the need is
most acute. In our opinion, the government should provide
support where the patient needs life support. Unemployment
benefits should be extended and states helped on that front.
On the other hand, the support for GM to provide 0% 72 month
financing to subprime borrowers for new cars is an example
of perpetuating the kind of consumption that has gotten us
in the first place.

9) We are going to play a hard game of cat and mouse in the
markets which will rally on “News that is awful but expected”
and sell off on “News that clarifies the real value in risky
assets.” In other words, earnings reports, bankruptcies.
Overlaid on top will be fiscal stimulus and bail outs.

10) The housing market will not find a bottom anytime soon. The
summer stabilization in house prices has fizzled out. The house
prices in the US need to fall by 35-45% peak to trough. This
has largely been accomplished in areas such as California etc.
The clear sign of price adjustment having taken place is that
housing market volumes are picking up. However, regions like
the North East are still in fantasy land. As a clear sign of
things to come, real estate rental rates are falling fast in
New York City. However, the price of real estate has not
fallen much. In other words, the earnings produced by the asset
are falling without the value having fallen much. As a result,
the PE of real estate is rising while the industry insiders
proclaim the paltry sub 10% fall from peak as having already
produced the necessary adjustment. Further adjustment in real
estate prices will hit the banks further as prime mortgages
falter as a result of falling employment. Financial shocks
such as these will combine with corporate bankruptcies and
worse than expected earnings news to produce down legs in
the equity markets.

11) In fixed income markets (govies), the target rate is 0%+
in US, Japan, Switzerland and HK. It will get there fast in
UK and Canada. ECB and Australia will resist going to ZIRP
(mostly because they do not see the benefits of zirp).

ZIRP countries:

a. 2yr rates ~ 0.5% in ZIRP countries as it can’t get too far
away. Very hard to short the short end. Gains will be limited
as we are almost there. Sell offs should be bought. We are
going to be in ZIRP land for a long time.

b. Yield Curve: 100bps ≤ 2-10Yr ≤ 200bps IMPLIES 1.5% ≤ 10Y ≤ 3%
NON ZIRP countries:

c. 1% ≤ 2Yr ≤ 2%

d. 2% ≤ 10Y ≤ 4%

Non-ZIRP countries will outperform in the govies.

12) In the FX Markets, the combination of de leveraging, carry
trade unwinding and imploding growth will keep Yen/USD (and
CHF to a lesser extent) on an uptrend. Commodity currencies
will suffer the most as will deficit emerging markets. Reflation
rallies may reverse the above action temporarily. In terms of
levels, EUR/USD should trend toward 1.05 to 1.15.

13) Equity markets could easily fall another 20% as earnings
expectations are ratcheted down. However, we look for this to
happen in a much more orderly fashion than in Q4. Surely, there
are bound to be some Walmarts and McDonalds in the world that
will benefit from a sliding economy. However, they will not
be able to prevent corporate bankruptcies from hitting the
wider market.

14) We said it in October- watch the dollar. The dollar and
the commodity price action in July and August were early
indications of falling economic growth. We will continue to
watch for clues and confirmation in these markets of changes
in our baseline for economic growth.

Policy Framework:

Trading in the 4Q has confirmed how “in tune” with policy
changes one needs to be in order to negotiate these markets.
We wanted to put down on paper what the markets will be looking
for in policies going forward.

1) ZIRP works by building expectations of prolonged timer
period of low and stable rates. Any buildup of expectations
the central bank may hike will lead banks and private lenders
to scale back estimates of future profits and not lend in
difficult times. For eg, in 2000, the BOJ action to end ZIRP
and hike hit the economy. The Fed in the US has already
taken the correct steps of making it clear their policy of
keeping rates very low for an extended period of time and
possibly buying longer dated government paper. The credit
markets have benefited. Forward rates will come down further
as expectations of no hikes build and inflation expectations
go down further. There has been good progress on this front
in the US and the same is happening in UK etc.

2) Transparency and consistency are vital for private sector
to start lending. If agents believe firms could go bankrupt,
they will not lend. Associated is the need to convince
private agents that banks and firms are not hiding losses
and therefore will likely stay solvent. Any likelihood of
further losses or potential bankruptcies will prevent lending
from happening. This was the biggest problem in Japan and is
happening now in the US and other countries. Banks have
been backstopped. If more losses pile up in real estate,
credit cards, car loans, commercial loans, etc, the govt.
will put in more capital into banks. Another problem in Japan
was inconsistency. Japan suffered a lot due to erratic and
ever changing plans (much like here in the US with the
Bear/Lehman/AIG trifecta). The case of non financial firms
needs to be solved. The auto bailout will set the precedent
in this regard. This is the next frontier in policy action.

3) Central banks the lenders of last resort - intervention
will only work if the price is right. Buying risky assets
will not work if the price is too high. The govt. can not prop
up markets. Key question is whether markets have fallen
enough? Will future price falls in houses etc lead to more
than expected bankruptcies? For example, in prime mortgages.
The evidence is not convincing on this front. The non-prime
mortgage securities “seem to have fallen enough.” The prime
housing market, commercial real estate and other securitized
credit markets may have further to fall.

4) Fiscal policy – the spenders of last resort - Life support
for the economy – The new administration will take care of
this in the US. It is less clear whether Europe needs more
stimulus and if it will get it fast enough. Another is that
emerging markets experience hard landings and are unable to
stimulate due to already burgeoning fiscal deficits (India)
or unable to sustain foreign lending (eastern Europe)
necessitating IMF/World Bank action.