Issue 55 - August 4, 2009

A Transformation is not a “Recovery”

As the global economy begins to regain its footing, the discussion has quickly shifted from how to best avoid systemic risks and failures to talks of an imminent “Recovery”. This, by definition, implies a return to something of the past and a return to something known. Beyond semantics, looking for a return to a 20th century economy is to dismiss numerous, fundamental changes in consumer habits, employment trends and credit availability. When pundits see “green shoots” in measures of sentiment and optimism, they miss the forest for the trees. It sets the stage for future disappointment and, more importantly, it can mislead investors into inappropriate allocations and missed current opportunities.

The global economy is undergoing a generational transformation which touches many of the ways we conduct business and our lives. Whether or not we are plus or minus a recessionary reading makes very little difference in a practical sense. The Federal Reserve has recently stated that they expect the US Economy to take five to seven years to fully absorb the excess capacity in the system. This implies a slower and more gradual trajectory in growth rates than we had enjoyed most recently. It recognizes that the credit infrastructure has been impaired and that unemployment will face a long and inconsistent journey back to traditional levels. These are not insurmountable challenges, but to expect a return to what we may have understood as “normalcy” misreads the situation. We have already witnessed a major rebound in many of our riskiest asset classes which is a welcome development. However, many of these strategies are now priced for perfection and an imminent, robust recovery. Reality unfortunately will intrude.

Amid continuing calls for increased capital and updated regulation, bank credit continues to contract. Thirteen of the top fifteen commercial lenders contracted their loan books in the second quarter. As we have argued in previous notes – credit is the lifeblood of commerce. Many are looking for an inventory replenishment cycle to add a boost to the economy in the balance of the year, but financing will be a limiting factor. Couple this with the fact that commercial real estate and private equity loans are now entering the first stages of impairment, and it will be increasingly difficult for lesser credits with lesser collateral to find willing lenders to work them out of their overleveraged positions.

The path to the “New Normal” as many call it will provide ample investment opportunities provided that we look for them in the right places

Not All Economic Data is Created Equal

Measurable economic data should not be confused with surveys of opinions. The 7 million people currently looking for work would not have the same view of the economy as those with a stable job enjoying good retail deals. Unemployment has traditionally been a lagging indicator but the spike we have seen in the past 12 months where the rate has popped from 5.6% to 9.5% speaks to something more fundamental than a garden variety recession. Our most recent 20th century economy did not staff for 1970s style manufacturing booms and busts. Yet employment is behaving eerily so.



What is so different now? The answer lies in the additional deluge of layoffs resulting from the near simultaneous failure of several 20th century business models. Those who find themselves displaced by the demise of print newspaper for instance are now forced to compete for a position in a new industry requiring perhaps new skills against many who have been laid off from surviving businesses in search of further efficiencies. Consider further the impact of 79 million baby boomers who have seemingly all suddenly decided to save money. That is 1/3 of the US population and arguably the biggest spenders of all who are materially changing their spending and savings habits. Even strong, viable businesses are now forced to plan with a high degree of uncertainty which further inhibits hiring.

This is perhaps the most fundamental point in favor of understanding the coming years as a transition and transformation rather than a recovery. We have to find employment homes for millions of people in new work. This begs the question: “Where do jobs come from and in particular, how long will it take to create several million of them?”

According to the Small Business Administration, small businesses employ one half of all private sector employees, pay 45% of all US payroll taxes and are responsible for 60 to 80% of all new net hires over the past decade. Small business is the engine of job growth. The cavalier discussions with regards to income taxes do nothing to encourage hiring within this constituency for the simple reason that all of these enterprises pay tax at the individual rate. This seems to be a fact which is not well understood and certainly not discussed by the popular media.

Just as we see competing forces within the banking complex – desires for higher capital versus demands for more lending – we can not expect prolific job growth to come from its most reliable source if we are simultaneously extracting higher levies. This is not to say that this economic tug of war is either inappropriate or even unexpected, but it is to say these will absolutely be substantial headwinds and will add meaningful amounts of time to the process.

Smallest, Lowest, “Shortest”

The best performing assets in 2009 have been those with smaller capitalizations, the lowest credit ratings and the highest level of short interest. In a global economy which now hugely favors those businesses with the strongest balance sheets and business models, investors have flocked to junk. Go figure. The psychology which brought us negative real interest rates on US Treasury Bills at year end has now decided for the moment that the coast is clear enough to reach way, way, way out on the credit spectrum. This is not so much an investment thesis as an opportunistic, albeit highly risky, trade. Buying something for 50 cents works out well if it can be sold quickly for 60 and it is a reflection of how truly oversold many assets had become. However absent a “V” shaped immediate recovery, it is hard to see where there is any further upside to be had in this arena while it is quite easy to imagine the opposite given the facts facing the real economy. Meanwhile, quality stocks and bonds have performed well, but have lagged their lesser brethren. Therefore, opportunities remain in the highest grade securities. Markets have moved dramatically and to a large extent, we have wrung out much of the oversold conditions that resulted from liquidity driven selling in the fall and winter. Recent earnings announcements have been hailed for beating much diminished expectations however the majority of those who have reported missed their equally diminished revenue targets.

We are all anxious to declare an end to what has been a remarkably painful chapter in our history. The official end of this recession will be a welcome and necessary point in time. But while it is necessary, it is simply not sufficient. Growth is the next ingredient. The numerous uncertainties surrounding spending, saving, credit, taxes, and employment will take time to work through and we continue to favor those investments which are best suited to persevere in a low growth environment.

Patsy and Jen

• A Transformation is not a Recovery
• Not All Economic Data is Created Equal
• Smallest, Lowest, “Shortest”