Issue 53 - May 29, 2009

A Brave New Road to Recovery

The US Economy and those around the world are no longer experiencing the dramatic, free falling declines that were pervasive this past fall and winter. However, it is only the pace of the decline which has slowed; not the direction. Job losses are continuing to climb across industries even before the major car companies suffer the full effects of bankruptcy. The downstream impact of their restructurings will be felt across all of North America. Potential dislocations resulting from the looming commercial real estate refinancing tsunami were highlighted in the recent bank stress tests. Further intervention by the Federal Reserve will be required to provide sufficient liquidity and financing channels in order to find the combination of bank capital and investors for some $300-500 billion of orphaned debt coming due over the next three years. This is clearly not your “Father’s Recession” and as such it will not be his standard recovery. It is critical that we understand what lies in front of us in the coming years and so that we may invest accordingly.

Vehicle Choice

While there is endless debate surrounding the precise timing of recovery, more valuable discussions would focus on the characteristics of the new economy that lies over the horizon.

Historically, a period of slowing comes about as a function of high interest rates and or restrictive credit. Accordingly, interest rates are lowered to stimulate spending and risk taking and a recovery ensues. But in this time, the problem was not the lack of borrowing but rather quite the opposite. Just as a drunken man can not drink his way to sobriety, an over leveraged society will take time to readjust to prudence.

Perhaps most importantly, the over leverage was masking poor business models across numerous industries. As credit was withdrawn, those businesses failed and we now have to admit and contend with the fact that many tried and true blue chips of the 20th century are no longer viable in the 21st. This is the crux of the matter. The road in front of us is fundamentally different than the road we just left and the right investment vehicle choices depend upon our understanding of what lies ahead.

Speed Limits

To a large extent, our economic growth is simply a function of employment. A job allows a consumer to spend and save and to have access to credit. The absence of that job is the absence of that productive contribution. Since the beginning of 2008, the US has lost approximately 5.7 million jobs. In addition, we have a material part of the population working either part time or full time in positions for which they are overqualified. Recent estimates put the total figure of unemployed plus underemployed at 16%. In terms of repairing the situation, standard estimates suggest that it takes GDP growth of at least 2.5% just to keep employment stable and therefore something like 3% growth would be required to make a meaningful dent in the problem. While many pundits repeat the slogan – “employment is a backward looking data point”, in today’s world, unemployment will be very much a current phenomenon.

Consider the type of job losses we have experienced. Not only have businesses of all shapes and stripes cut back in response to the slowdown; we have had wholesale failures of 20th century industries. Newspapers, auto manufacturers, finance and lending, retailing, hospitality and travel have all seen their traditional business models fail. Quite simply, many of the jobs lost in those industries are gone just as those who manufactured button hook fasteners, typewriter erasers, and buggy whips.

Our society is changing its habits in response to and as part of a feedback loop predicated on the removal of credit and leverage. As we saw last summer with $4 gasoline, people will drive less and alter their new auto purchase plans. Now with job loses and the removal of credit from the system, the way we conduct the day to day activities of our lives is evolving. Currently we have no normal, we simply have constant change. Over time however, these new norms will become more predictable and better understood, and capital will flow to those business opportunities which best compete under a new set of rules.

This transformative period in our history has and will continue to have certain dominant characteristics: weak employment, excess capacity, and contracting leverage. The combination of these factors will lead us to slower growth (sub 2% GDP) and keep a tight lid on inflationary pressures. In other words – our economic speed limit is coming down. The combination of these factors becomes self reinforcing and as such they will likely make this period last much longer than pundits currently predict. Investing successfully through this time will require a critical eye and heavy emphasis on the highest quality and liquidity risk-adjusted opportunities.

Deflation, not inflation is the preeminent risk in an economy with as much slack as ours. It is not just the US economy; we invest in a global economy which has even more slack than we have at home. Credit infrastructure is being successfully rebuilt, but even a fully functioning system will not begin to lend at the speed or volume to which we had become dependent. This period of time will play to the heavy advantage of the strongest business models and balance sheets. We will have clear winners and many losers. And while it may currently be attractive to consider lower quality investments and their eye popping potential returns, we must be mindful of their illiquidity in another potential relapse and the fact that this period of subdued economic activity might last far longer that the models suggest. Real Estate and other traditionally leverage investments will suffer from lower gearing and even their optimistic projections will be dialed down.

We need to get through this transition and it may last a number of years not months. Now more than ever – quality, liquidity, and income will be the primary drivers of return.

• A Brave New Road to Recovery
• Vehicle Choice
• Speed Limits