Monday, August 10, 2009

The Appropriate Sports Metaphor for the State of the US Economy

How many times have you heard the question about what inning we are in when it comes to certain aspects of the financial crisis? The question can apply to the housing bust, stock market correction, consumer de-leveraging cycle or anything that ostensibly has an identifiable beginning and end. While I am a baseball fan, I don’t think the baseball comparison fits quite right. See, there is no halftime in baseball. Between innings and during the seventh inning stretch there is some time for players and fans to catch their collective breaths, but these are short breaks that don’t allow for substantial rest and reflection. This is why I think a football analogy works much better. So, in an attempt to provide some lighter commentary than usual, the following is my analysis of the first half, the half time speech by the coaches, and what the second half may have in store for the US economy.

The First Half

Well, what can I say? The first half of the crisis was pretty ugly. I am going to arbitrarily deem the beginning of “the game” as June 2007 when the two Bear Stearns hedge funds that were heavily invested in subprime securities started to waver. Of course, this was just the tip of the iceberg but when they eventually failed it was kind of like when the other team returns the opening kickoff for a touchdown. It is immediately demoralizing to be down 7-0 in the first minute but you know there is a lot of time left in the game so you don’t get overly worried. Unfortunately, the rest of the first half was no better and included the following trends and debacles (in no particular chronological or importance-based order):

  1. The failure of Freddie Mac and Fannie Mae that required them to be taken over by the government; an event that added significant and seemingly ever-growing liabilities to the US’s balance sheet
  2. Bear Stearns looking as if it would be forced to file for bankruptcy until the Fed and JP Morgan (JPM) stepped in to rescue the firm. This proved to be the first of many major government supported takeovers
  3. The decision to allow the failure of Lehman Brothers that caused the commercial paper markets and money market funds to just about collapse. This led to an extreme dislocation in the global capital markets and signaled the end of non-bank holding company investment banks
  4. The rescue of AIG by the government in an attempt to protect against a total market meltdown and save AIG’s counterparties from being mortally wounded
  5. Major FDIC action when it came to banks such as Washington Mutual, IndyMac, Bank United, National City, and Wachovia (just to name a few) that caused the insurance fund to decline dramatically
  6. Massive redemptions at hedge funds that resulted in forced selling of any and all assets and helped lead assets that were deemed to be uncorrelated to move in the same direction
  7. Increased consumer deleveraging that has precipitated higher savings rates and diminished consumption that have both had a tremendous impact on corporate revenues and earnings
  8. Significant housing price declines caused by a full blown foreclosure crisis, massive over supply, limited amounts of mortgage credit and previous extreme price increases in bubble markets
  9. The Fed being forced to buy US Treasuries and mortgage backed securities in an attempt to provide liquidity to a market that had been crippled by the destruction of the shadow banking system. As a result, interest rates have fallen to near historical lows
  10. The US government’s backstopping of everything from money market funds to the dodgy assets of investment banks (as well as increased FDIC deposit insurance limits) in an attempt to stop modern day banks runs from happening
  11. A peak to trough decline (at least so far) of the US stock market from October 2007 to March 2009 of over 57% (1565 to 666 on the S&P) that coincided with unemployment reaching as high as 9.5% (so far)
  12. A crash in oil and other commodity prices that sent stock markets in export-dependent countries tumbling and led to a drop in world trade that mirrored some of the worst declines last seen in the Great Depression
  13. The bankruptcy of GM and Chrysler as well as a number of well known retailers, with many more filings expected before this crisis is over

Just like those seen ESPN, these highlights just give you a sense of how the game has unfolded. There are probably another 25 things I could list, but I thought 13 was an appropriately unlucky number and believe that the above list encompasses most of the dominant events and themes of the past 2 years.

So, if that was the first half, then where are we now? This is where I am going to provide my two cents and make some prognostications that will inevitably have some elements that are right and some that are wrong. But the purpose of this exercise is to help people think about what the near term effects of the ongoing crisis could be. Accordingly, the answer to the above question is that we are currently in the locker room at half time. Just before the end of the half, we were able to score a touchdown to make the game just a little closer. We are still down by 3 touchdowns but there is some optimism in the air. Specifically, there have been a number of seemingly positive factors that indicate that things may be turning in our favor:

  1. The remarkable recovery in world stock markets and the tightening of bond spreads for everything from high yield bonds to AAA credits
  2. The increase in commodity prices and the (somewhat muted) return of global trade
  3. Fed expansion of its balance sheet that has helped keep interest rates low, stimulate the economy, and induce mortgage refinancing
  4. A cessation in the free fall in housing prices and a potential bottoming in housing starts
  5. A slight recent downtick in the unemployment rate and decelerating job losses

The Second Half

After a very inspiring halftime speech by our coaches (Bernanke and Obama), it is now time to run back onto the field for the second half. As a country we have seen what the abyss looks likes and have been at least temporarily pulled backed from it. Halftime has given us the opportunity to reflect on the events of the past few years and this reprieve has allowed us to get our second wind. Many of us are understandably more optimistic than we were previously as it appears that due to the fact that we are going to receive the forthcoming kickoff, the ball is literally and figuratively in our hands. But, my concern is that there is not going to be a Gatorade shower in our near future. At least not in this version of the game. When it comes to the economy I have deep fears that there are some necessary structural changes that must occur before we see a sustainable recovery. I plan to detail those more explicitly in an upcoming post. But for now, let me list some near term, second half themes that I think are likely to play out. Some are favorable and others are not. Some are new and others are continuing storylines. But on balance I am afraid that they will all combine to limit productivity increases, positive GDP growth and further appreciation of stock markets (13 more for good measure).

  1. Losses on commercial real estate loans and commercial mortgage backed securities will put increasing pressure on property values and bank balance sheets and lead to more turmoil in the financial system
  2. Unemployment will continue to rise but U3 (the headline rate) will not reflect the true rate. Instead, U6 (the rate that reflects under-employment) will be the one to pay attention to while keeping in mind that people will also be dropping out of the job market due to the difficulty in finding a job and thus may not be counted in headline statistics
  3. The impact of unemployment will lead to even higher default rates on consumer credit and mortgages, especially as the impact of the stimulus wears off. This will require continually higher provisions and loss recognition at banks and only exacerbate the lack of credit in the market as banks continue to cut consumer and business credit lines
  4. The household savings rate will continue to rise as people forego consumption and focus on rebuilding their balance sheets. Debt paydown will also be a priority, which, in combination with higher savings, will lead to lasting drop in demand for the goods and services that companies offer and consequently limit revenue and earnings growth
  5. After a free fall in inventories that lasted into Q2, inventories will slowly get rebuilt as cautious companies dip their toes back into the water. As a result, this component of GDP will stop being such a drag and may be a positive in the coming quarters
  6. Measures such as Cash for Clunkers and an inevitable increase in auto production off of a low base will help boost GDP temporarily
  7. After foreclosure moratoriums have ended and banks are no longer able to forestall recognizing losses and meaningful mortgage resets re-appear, there will be more pressure on housing prices and bank balance sheets that is likely not currently reflected in the stock prices of homebuilders and regional banks. In the meantime however, housing prices may hit a temporary bottom and housing starts will unfortunately start to rise irrespective of the existing inventory glut
  8. If the Fed is serious about winding down its purchases of securities and US Treasuries, it is my belief that it will not find private buyers to pick up the slack and will be forced to continue buying these assets to keep interest rates from rising enough to hamper a recovery
  9. China’s ability to pump up its real estate and stock markets through stimulus will likely run its course and even if the bubble does not pop in a dramatic fashion, slowing Chinese growth will put downward pressure on commodities and perceptions of the strength of the global economy
  10. The problems of Eastern Europe and Central Europe could come to a head, events that could cause significant problems for European banks and the Euro Zone as a whole
  11. Deflation will remain the concern of the day, as prices (potentially excluding gas and food but not necessarily if the reflation trade dies and commodities fall in price) continue to see downward pressure
  12. Seeing that job losses have not stopped and that the lack of credit continues to prevent a recovery, talks of additional stimulus will reach a fever pitch but fears of the increased deficit may inhibit the implementation of further stimulus
  13. The risk of a major event such as a severe outbreak of swine flu, a sovereign default, or another seizure in the financial markets will be ever present and force people to temper their currently unbridled optimism

The End of the Game?

Although there are some new players in this portion of the game, this hypothetical second half sure doesn’t look too different from the first half, does it? Despite the fact that we were able to score a late touchdown and had the ball first in the second half, it looks like there are a lot of reasons why we are likely to fumble away our opportunity and go back to being down by 4 TDs. Of course the previous list of items is not all encompassing. There are an infinite number of permutations when it comes to how this will all play out. But when you list out these potential outcomes, I think it becomes clear that cautious optimism is more appropriate than blind bullishness. Especially, when it comes to US equity markets, we must all be aware of the potential downside as a result of any number of the above mentioned items.

Finally, I want to end with another question. What does the end of the game look like and what does losing imply? Fortunately, this is where the applicability of the football analogy ends. Luckily for the US economy there is no final whistle. We can drag this game along for many years and there is always the possibility that we have seen the worst of the downturn on every level. Accordingly, I don’t think there is any realistic way for the US to lose per se. But, what I would like to avoid is a prolonged downturn in which investors are suckered into the equity markets as a result of the current bullishness (the halftime speech) and then are crushed when the markets turn around. While that may provide a great opportunity for value investors, I would hate to see further damage to people’s 401k’s because in the long run these are the people who will have to be financial sound if this economy is to recover.

So, while my continual suggestion to approach the markets with extreme caution has proven to be terrible advice so far, with the S&P over 1000 I implore you to start taking stock of the headwinds facing and tailwinds potentially buffeting the US economy and US companies as you look at potential investment opportunities. In that vein, I hope this discussion has helped identify logical and plausible outcomes that could occur as a result of what we have witnessed so far (during the first half).

Stay tuned for the follow up to this piece that will focus on the longer term trends that could have an impact on this game. This will include my take on what the new normal may look like. It may not be as pessimistic as you would expect coming from me, but my guess is that it won’t include a return to business as usual or to bubble-like times for most companies and consumers.

(Picture courtesy of (no joke))