Oct 06, 2009

Short Term Optimism: Longer-Term Fear

Every August I organize two Friday luncheon discussions for serious investors who spend their summer weekends in Eastern Long Island.  We focus on the major issues which will influence the world economy and its financial markets during the coming year.  It is a broad constituency which includes more than a handful of billionaires, chief executives of public companies, private equity leaders, hedge fund managers and former government officials.  There are about twenty five at each session.  Called the “Benchmark Lunches”, they represent an opportunity to reflect on what is likely to happen with a group of successful and hopefully knowledgeable people.  Since I write up the discussions, each participant can look back and assess whether the group was able to see future events clearly.  As you might expect, their skill in doing this is not notable for its accuracy.
 
At the beginning of each session I reviewed the discussions of 2008 and criticized the group for not anticipating major change.  They were gradualists in a period of convulsion.  Did anyone in the group see the major events of the past quarter–century before they happened?  The end of Communism in Russia represented a profound change, the technology revolution of the 1990’s was significant, the terrorist attacks of 2001 made us all feel vulnerable.  While the lunches last year took place less than a month before Lehman Brothers went bankrupt, Merrill Lynch was folded into Bank of America and American International Group required an enormous cash infusion to survive, nobody in the group thought anything of that magnitude was about to happen.
 
In fact, last year a few people in the group thought the recession we were in was likely to end in the near future.  Most thought we were in for a year of lackluster economic growth but that the market would be modestly higher (1300 to 1400 for the Standard & Poor’s 500) when we met again in 2009.  They believed the presidential election would be close (Obama had a tough August) and the price of oil would stay in triple digits.  The major investment conclusion was that credit instruments would outperform equities over the coming year and they were right about that.  They thought that the dollar would be strong because of problems abroad.  Concern about Iran’s possible nuclear capability and terrorism in general would cause geopolitical factors to have a major influence on the financial markets.  While there has been substantial turbulence around the world over the past year, I would argue that it has been primarily financial rather than political.  The group was worried about liquidity problems constraining businesses and financial institutions, but with the crisis that developed last September central banks around the world tried to take care of that.
 
This year the group seemed preoccupied with the long term economic problems resulting from the financial crisis, both for the United States and the rest of the world.  Short term, over the next year, there was a fair degree of optimism.  A majority thought the S&P 500 would be at least 10% higher a year from now with many thinking it might be 20% above present level.  A meaningful minority thought the market would be at least 10% lower because of slow economic growth and financial strains coming out of last year’s meltdown.  On the economy, however, few thought we would see strong quarters for real Gross Domestic Product any time soon.  We were only starting housing units at a rate of 500,000 with four million on the market so it would be a while before homebuilding would pick up again.  Auto production was below ten million units and while the “cash for clunkers” program might provide a temporary boost for sales, production was likely to drop off after the incentive expired.  With housing and autos problematic and the consumer famously over-leveraged, it seemed unlikely that there were going to be any upside surprises in the economy.  Retailers have no pricing power and it is difficult for individuals and non-public companies to borrow.  Some in the group thought the shape of the recovery might resemble a square root sign with a surge near term, coming off the down-turn, and then flat economic performance afterwards.  There was concern that if the economy lost momentum because consumers paid down debt or increased savings rather than spending, then a second stimulus might be necessary to avoid slipping back into recession.  That might cause a retest of the market lows of last fall or this spring.  A number of people were worried that the financial markets were stronger than the economy and that might result in a decline in the stock indexes as investors woke up to reality.  
 
In this uncertain environment most expected the unemployment rate to reach 10% and stay there for a while.  Consumers, worried about job security, will increase their savings.  Retailers, anticipating a weak Christmas, will maintain inventories at low levels.  About a quarter of the group was more optimistic than the consensus and believed jobs would be created in technology, healthcare and export-oriented industries.  The Federal Reserve would keep interest rates low, and as business conditions improved, companies would start borrowing again, assuming banks would start lending.  One concern was that the excessive leverage built up earlier in the decade would change consumer spending patterns for a generation, but over the near term monetary policy and fiscal stimulus will make the economy strong.  If the unemployment rate stays near 10% and the savings rate rises, the economy could be in for another period of weakness later on.
 
One participant said that the spread between rich countries and poor countries was widening just as it was between the rich and poor within countries and this was a potentially destabilizing force.  Another was concerned that the problems associated with the financial crisis had caused us to put the looming challenges represented by pension and healthcare liabilities on the back burner, but these obligations will be with us sooner than we realize both at the corporate and government level.  As a result corporate earnings are overstated and government deficits are understated.  If taxes are raised to deal with deficits, entrepreneurial incentives to innovate and invest will be stifled.  
 
One foreign investor in the group said that the United States is a great place to live but he doesn’t want to be taxed here, so his principal place of residence is in a more investor-friendly country.  With the Internet and jet transportation, he can live anywhere and invest anywhere.  The tax policies of the United States are discouraging the modern international investor and London is catering to them, although there have been negative rumblings there recently.  While the United States was still the most important economy in the world, there was a recognition that a significant amount of the world’s wealth was outside the United States.  America’s higher education system was still the best in the world, but we are losing some of the brightest students as they returned to the countries where they were born to seek opportunities there.  We have not made enough progress in improving our primary and secondary education and that is a major long term problem.  In contrast to last year, almost everyone expected a continued period of dollar weakness.  America is running enormous trade and budget deficits, losing two wars in Asia and the only reason it maintains its reserve currency status is that there is no other viable alternative.  A number of countries wish there were one because they have lost a great deal of confidence in the United States and its future.
 
Some of the participants were fearful about the implications of a rise in populism.  The outrage against Wall Street compensation was a good example.  Anti-business sentiment was likely to lead to legislation which would add to the problems associated with a business recovery that was trying to get going while leverage was being reduced and financial institutions were trying to dispose of the remaining toxic assets on their balance sheets.  One participant who has testified frequently in front of Congressional committees said he is discouraged by the lack of financial sophistication of many of our elected officials.  They also seem to be uncomfortable with situations involving analyzing numerical models in order to understand what changes in policy might be desirable.  This is particularly true in matters relating to derivatives like credit default swaps where more transparency and control is clearly needed.
 
One bear said he observed that in 2006 43% of S&P 500 earnings came from the financial sector.  Much of that was illusory, he believed, and, in any case, it was unlikely that those institutions would earn anything like what they had booked in the middle of the decade.  Nobody expected a return of inflation; everyone thought oil prices would remain restrained.  There was a fair amount of worry that the economic difficulties countries were experiencing would lead to protectionism which everyone agreed was a negative that was not in the market.  
 
Although there were mixed views on the economic prospects for the United States, few were optimistic about Europe or Japan.  Europe made less of an inventory adjustment than the United States so the economies there are not likely to have the same rebound potential.  Russia would be interesting if the price of oil stays high, but the political risk discouraged many from putting serious money there.  Many were enthusiastic about prospects in India and China in spite of the fact that the markets there had a strong recovery in 2009.  The bears on China questioned the lending standards of the banking system.  They also said that while there was a great deal of integrity among the officials in Beijing, there were problems with corruption at the local level throughout the country.  Some thought Chinese accounting practices needed considerable upgrading.  While the government had spent a lot of money improving infrastructure, some thought the quality of construction was poor and would have to be reworked.  Many had questions of whether the rule of law prevailed.  This was in sharp contrast to Brazil where there was confidence in the legal system and many business opportunities.  
 
The participants thought housing might have a modest further decline but the worst was over.  There was more optimism than I would have expected about commercial real estate.  Rents and occupancy have dropped significantly but there was a feeling among those participants who are major factors in that industry that the situation wouldn’t get much worse.  Prices of major office buildings were below replacement costs.  Retail space was a major problem throughout the country, however.  Stores that rented for $1000 a square foot in 2006 and 2007 were on the market for $600 with no takers.  Net leases for office space that were $70 a square foot a few years ago have dropped to $40, but from here capitalization rates are likely to improve.
 
There was a discussion of the Iran nuclear threat.  Several felt Israel would not tolerate a nuclear bomb in a country so hostile to it.  Others believed that the political balance in Iran was shifting toward more accommodation of Western views since the uproar over the election, but it was too soon to tell if this mood of moderation was real or if it would last.  The majority of the population is weary of the repression in Iran but the clerics are still in control.
 
At the end of each session I asked the participants what they were doing with their own money.  The responses were wide-ranging.  They included Treasury Inflation Protected Securities, long-term municipals for the benefit of not-for-profit institutions, Chinese companies listed on American exchanges, leveraged loans and bank debt of all kinds, real estate from commercial  to vacant land, adult education, nutritional improvement (70% of health problems in the U.S. are weight-related), venture capital, solar energy, biotechnology and smart telephones.  
 
At the end of the two sessions I was left with an uneasy feeling.  The world financial markets had gone through an upheaval and survived.  The net worth of everyone around the table had suffered but their lifestyle remained pretty much the way it was before the crisis began.  That gave everyone the feeling that we had prevailed over adversity and could focus on rebuilding our wealth by taking advantage of the opportunities that had been created over the past year.  The impact of the big problems like excessive government debt, instability in the Middle East, terrorism, swine flu, global warming, world poverty, the falling dollar, possibly rising inflation and interest rates among others was hard to quantify and assess, but that doesn’t make these issues less real.  Last year we were unprepared for Lehman and AIG.  I wonder what major event we’re unprepared for this year.  I realize something major doesn’t happen every year, but you have to be on the lookout.