AMERICAN ECONOMY ABOUT TO HIT BOTTOM, THE TURN IN THE CYCLE

As history goes investors, analysts and the general public tend to show a misleading unanimity at the end of every major cycle and trend. This is no exception. Human nature is such that at times of intense pressure from current events, foresight and opportunities are obscured by risk aversion, just as euphoria blinds to impending risks at major market tops.

Indeed we have witnessed the largest financial dislocation followed by the sharpest economic rout in the living memory of market participants. The turn will surprise most. At the tail end of utter devastation commensurate opportunity looms.

Recent figures show the largest back to back retreat in US personal consumption since the Great Depression. The American consumer has been the engine of demand in the long winded economic expansion of the last generation. At the tail end of the cycle the consumer was carrying unprecedented debt and has been hit by the combined impact of the collapse in property and equity values, a major negative wealth effect. To this is added massive job destruction roiling incomes at a time when savings ratios are being rebuilt.

GDP figures for Q308 and Q408 have reflected this sharp retrenchment in consumption. We expect that Q109 will exhibit economic contraction of similar proportions to Q408 (-3.5% to -4.5%) but for different reasons. The main culprit in Q109 will be massive de-stocking as output belatedly but swiftly adjusts to the shrunken levels of consumer demand seen in H208. The sharp retreat in output necessary to evacuate stocks will be the main driver in the economic contraction of this winter as the downshift in consumption will decelerate. The sharp fall in oil and commodity prices combined with weak demand is currently reducing inflation drastically and will lead to temporary negative inflation in the first half of 2009. This will be a major countervailing influence shoring up the purchasing power of the consumer. As anticipated major destocking hits the first quarter of 2009, the American economy will reach spring in a broadly rebalanced state, just as the first fiscal stimuli of the major countercyclical package rammed through Congress by the new Administration will be starting its way into taxpayers’ pockets.

Spring will mark the end of the economic contraction.

The housing crisis will also hit bottom by mid-spring or early summer, soon after measures to reduce foreclosures, combined with the steep reduction in construction help starting to clear the still bloated inventory of unsold property.
Housing affordability, as portrayed by lower prices and cheaper mortgages, is already starting to show anecdotal evidence of a rally in pending home sales. A pick up in demand will gradually emerge to stabilize the situation although the necessity to clear the stock of unsold homes will keep a lid on new construction probably until the late part of the year.

Signs of a gradual de-icing of credit markets will stop the collapse in the money multiplier and will finally start to offer traction to the massive efforts shown by the Fed to arrest the implosion seen in the second half of 2008. Official guarantees, Fed purchasing programs, efforts to recapitalize the banking system and the projected ‘Bad Bank’ that will siphon off toxic assets roiling the normal pricing mechanisms of assets and liabilities are already producing some results.

Segments of the market, most markedly commercial paper and agency (guaranteed) debt are witnessing a strong revival of issuance which forestalls risks of a major surge in insolvencies. Money supply is surging at 10% a year, credit spreads are narrowing from critical levels as show by the shrinking of 3 month libor-IOS and Ted spreads.

True most of the huge amounts of liquidity created by the Fed at still sterilized in bank deposits at the central bank but the massive increase in cash in balance sheets is offering only derisory income and as conditions and confidence stabilize a potentially massive amount of funds will find its way into more productive allocations that will jump start the money multiplier and reduce spreads considerably further towards historically more normal levels.

Cash levels at institutional investors current make up close to 90% of the total market capitalization of the Wilshire 5000 index. A potential tsunami of liquidity stands on hold to create an explosive recovery in equity markets. We anticipate that equity prices will rise by a minimum of 30% and possibly 50% from the current cyclical bottom in the course of this year.

Recent levels of 2.0% in 10 year Treasuries also reflect unsustainably low returns fostered by mesmerized risk aversion. A share of the capital that sought refuge in the security of Treasury instruments will also soon start diversifying from uncompetitive yields into the substantially higher returns offered by investment grade and high grade private debt as well as the equity universe.

Prudence is a virtue in the face of daunting risk but a wealth of historical opportunity is now shaping.
To the daring will go the spoils.

A. Ferreira
February 4th 2009