Issue 52 - April 07, 2009

The Things We Know

The first quarter of 2009, while far from a positive period was a reprieve from the frenetic pace of 2008. The liquidity issues and downstream consequences of the credit crisis and institutional bankruptcies are now understood and a variety of powerful programs have been launched to address each with promising initial results. The pace of the economic decline has become more orderly which is sadly only cold comfort to those most affected.

Refurbishing the entire credit complex will take time but we should take note of those steps which are currently underway and working. Those homeowners who are in a position to refinance conforming mortgages have led the way with increasing volumes at historically low rates. In addition, the major initiatives of the Treasury and Federal Reserve have been launched. Aimed at cleansing the “legacy” loans (former known as toxic) from the banks and restarting the securitization of consumer credit, these two plans are the heart of the revitalization.

The Things We Don't Know

While the credit markets are just coming back on line, market participants are going to have to contend with several more monumental challenges in the coming months: the likelihood of one if not two major auto company bankruptcy filings and the refinancing vacuum facing a tidal wave of commercial mortgages. All of this will be imposed upon a background of continuing job losses.

The job picture is difficult as there are numerous layers of losses. We have losses related to any recessionary period where businesses make modest cutbacks to reflect slackening in demand. However in this time we are seeing wholesale job losses as those enterprises which were dependant on leverage simply unwind and those with more modest credit needs are cutting to the quick in order to make it day to day. Even the nature of the losses is evolving as companies are cutting back on hours rather than eliminating positions altogether giving rise to a new category of those who are underemployed. Finally, we have losses associated with the change in trends and habits. Consumers and businesses have at least for the immediate term significantly adjusted their travel and shopping habits. How long lasting these changes will persist is anybody’s guess but just as we saw driving habits react to $4 per gallon gasoline, it is fair to assume that the US consumer is making some permanent adjustments.

Savings and Sensibility

It now seems clear that the US Economy is undergoing a major (and painful) remodel. What began as a problem in poorly underwritten home loans has led to a process of redefining many of the most successful 20th century business models.

The Federal Reserve and the US Treasury are providing incredible liquidity and flexibility but they can not sort out the business case for every industry. The catch 22 of this recovery is that consumers and banks are now acting exactly as we had wished they had behaved previously. The savings rate for the US Consumer has abruptly returned to a prudent 5%+ after turning negative as recently as last summer. Banks now require down payments and hefty credit scores for the best terms which are precisely what they didn’t do in the credit bubble run up.

Just like the old yarn – “You can lead a horse to water but you can’t make it drink”, prudent consumers and businesses are responding cautiously to the ultra low rates at a time when the financial system could really benefit from the best credits going on a real borrowing spree. Conversely, those most indebted borrowers who could really use a low interest loan go begging.

This backdrop of evolving business models, sensibly lending standards and prudent savings is inherently a long term positive for the US Economy. The difficulty is getting from here to there. Some pundits have been fanning the concerns of inflation given the amount of stimulus provided. Inflation could ultimately prove to be a significant issue down the road when our remodeled economy begins to hit its new stride. But the more immediate problem is further job contractions and deflation. The Federal Reserve and Treasury have been adamant in their commitment to do whatever it takes to keep rates low and stimulative until such time as it works. While these efforts are clearly helping to stabilize the economy, the recovery is simply out of their hands. The business case for every industry is under review and we are likely to see further divergence in the results of similar firms.

While this is certainly a challenging time for any investor, there continue to be substantial opportunities as a result of the wholesale sell off of 2008. Municipal bonds continue to offer terrific value which simply can not persist indefinitely. Yields on essential service offerings remain at levels in excess of US Treasuries and are at attractive absolute levels as well. On the equity side, the market has seen a multi decade upward move recovering from the lows posted in early March; a testament to the futility of market timing. Patient investors, with appropriate liquidity and risk allocations can use this time to adjust allocations to their advantage.

• The Things We Know
• The Things We Don't Know
• Savings and Sensibility