GDP Contraction in Q4

GDP contracted in the fourth quarter at a 3.8% annualized rate. The silver lining of this very dark cloud is that the GDP figure beat the consensus estimate, which forecasted GDP contraction at 5.4% for the quarter. GDP saw most of its contribution come from a combination of built up inventories and continued strength in exports. This should be of little comfort as both of these contributors are likely to be decimated in 2009 as consumer demand continues to plummet and the dollar strengthens amid continued monetary easing on a worldwide basis. The moral of the story is we can expect further declines in economic activity in 2009 as the culture of de-leveraging continues in America and abroad.

Good Read

Article from December issue of Portfolio.com by Michael Lewis

"It Will Get Worse Before It Gets Better"

While on business travel I enjoy watching the local news in the morning to get a sense of what issues are important to people in the viewing area I happen to be visiting. This morning in Fort Walton Beach, FL the top story was the cold front that might bring snow to the Tennessee valley later in the week. What was not the top story but was included in the broadcast was the fact that this county in Florida has an unemployment rate of 9.3%. I am guessing that the producers realize that reminding people of the economic reality around them will not exactly give them a lift to start their day.

Just as people here in Fort Walton Beach no longer want to hear about the economic troubles that face this nation, it looks as though Wall Street might becoming slightly immune to bad news. On a day where California announced its unemployment rate was getting very close to 10% and 6 major companies announced they would be laying off a combined 68,000 employees, the markets didn't sell off but actually managed to hold onto some positive ground.

Some economists are hoping that the onslaught of negative news will make it easier to pin point when the economy bottoms out. Just as quickly as the recession came, it can turn around in a period of just a few months and we will then start hearing about companies re-hiring many of the same people that had to lay off during this downturn and at that point we will know it is over.

Obama, Optimism, and Equities - A Rational Viewpoint

There is no doubt a feeling of unbridled optimism among many U.S. citizens who feel that President Obama will undoubtedly bring "change" to the United States. If we are to take yesterday's mass euphoria as an indicator of this coming "change" it will likely result in 0% unemployment, 10% GDP growth, and the re-emergence of a pre-ABS financial system (excuse the sarcasm).

While I feel that our new President will surely take the actions he sees necessary to stimulate economic activity it seems almost inevitable that the results will fall short of expectations. This is especially true when we look at the latest iteration of a fiscal stimulus package based on ineffective government spending and tax cuts aimed at a consumer whos marginal propensity to consume is at its lowest level in over 60 years. This ill-planned and undersized fiscal stimulus package coupled with the limitations now facing monetary policy (as we are up against the zero bound) equates to a long road to economic recovery.

As the realization that Obama will not be able to wave a magic wand and return the United States to economic prosperity in the blink of an eye results in a drastic reassesment of people's expectaitions we can expect further and increased contraction in economic activity (i.e. decreased consumer demand, capital investment, etc.), and as a result further downward pressure on the equity markets as we work our way through 2009.

International ETFs

The “BRIC” Countries (Brazil, Russia, India, and China) are the 4 developing nations likely to continue to have strong domestic growth over the next decade and beyond. These countries have rapidly growing middleclass’ that will prevent their economies from topping out anytime soon. The easiest method to get exposure to the economies of these countries is through ETFs. Risk adverse investors have crushed these ETFs over the past 6 months and after a huge pull back from 52 week highs these international ETFs could have huge upside potential. The question is which one? I would immediately knock off any ETF tied to the Russian indices. The Russian economy is tied to energy prices and there is currently a lot of political instability in the area. I would also take India off my list. Much of India’s growth was a result of companies from the US and Europe outsourcing to India. As the US and Europe go through a downturn, the growth of those jobs will slow and put pressure on the fledging middle class that relies on them in India. Which leaves Brazil and China. The two ETFs I would look at are EWZ (iShares MSCI Brazil Index ETF) and FXI (iShares FTSE/Xinhua 25 China ETF). See comparison charts below:

The performance of these ETFs is almost identical. However, the sector weighting of each ETF is very different. (see charts below).

52% of EZW is in Energy and Materials and 40% of FXI is in financial services. Knowing this makes the decision easier. If you believe energy and material prices will rebound, EZW is the best pick, but if you think Chinese banks will be stimulated by government assistance FXI is a buy. To hard to make a decision? There are also ETFs that have exposure to each of the BRIC countries.

Q408 Asset Class Performance: The Worst Quarter in 20 Years

The following chart depicts asset class performance (based on major indices) for Q408. As expected, returns for the final quarter are quite dismal, even following a year-end rally in most markets in December. The following is of particular interest:

• Investment grade bonds recovered following the October decline ending up 5% for the quarter
• Commodities (on the aggregate), which had a stellar H108 and then plummeted, ended up for Q408
• TIPS returned a -3% during Q408 as deflation expectations weighed on investment decisions
• High Yield (as noted in a previous post) saw yield blown wide open, depressing prices considerably for the quarter and presenting attractive investment opportunities toward the second half of December
• Equity markets saw their worst quarter in 20 years, with emerging market's taking the biggest hit as risk aversion dominated the period
• Real estate, which lead the economic decline still rippling through the global economy, was down another 37% in Q4. It should fall further!

Trade Deficit Narrows

The Census Bureau is reporting that the US trade deficit fell by approximately 28% M-O-M in November; representing a $40.4b deficit (markedly better than the $50.1b estimate).

A majority of the decline can be attributed to a fall in the price of oil imports, although there was an overall widespread pull-back in the demand for most foreign goods (12.0% M-O-M decrease). It is likely that this downward pressure on oil prices will persist, and continue to be a significant factor in the trade balance, as global adverse economic conditions result in further decreases in demand, which have thus far outpaced a reactionary pull back in supply (as I previously argued this dynamic is likely to persist in the near term).

Accompanying the decrease in imports was a 5.0% M-O-M decrease in exports (long gone are the days of H12008 where strong exports provided a significant boost to GDP). We can certainly expect to see continued weakness in the demand for exports as all indicators point towards pro-longed economic weakness abroad accompanied by a continued easing of monetary policy resulting in further increases in the value of the USD.

Source: US Census Bureau

Employment Situation Summary Report: Another Step Toward Double Digit Unemployment

Nonfarm payroll employment declined sharply in December, and the unemployment rate (U-3) rose from 6.8% to 7.2% , the Bureau of Labor Statistics of the U.S. Department of Labor reported today. Payroll employment fell by 524,000 over the month and by 1.9 million over the last 4 months of 2008. In December, job losses were large and widespread across most major industry sectors.

Other takeaways from the report?

• U-6 is now at 13.5% and rising
• Although many reported that initial claims for state unemployment insurance benefits fell 24,000 to a seasonally adjusted 467,000 in the week ended Jan. 3, coming well below market expectations for 540,000 new claims, the perception that this news is positive is flawed (as were the estimates themselves). Intial claims may have come in below expectations, but that fails to consider those that delayed making such claims in light of the holidays.

Unemployment will continue to march toward double digits.

Unprecedented Underperformance: A Bottom for Bonds?

The table above outlines the excess returns by sectors of the bond marketplace over the last 10 years relative to the risk free (treasuries) rate. Not surprisingly, 2008 marked the single worst year of the period, with Q408 (un-annualized) and 2007, marking the second and third worst years respectively for most sectors. With spreads blown this wide, prices are markedly depressed, and I have little doubt that high yield spreads will move downward, equating to price appreciation of bonds in this category. The spread this wide anticipates massive defaults, and although some may occur, diversification in this sector should net some solid gains. Coupled with our orthodox sentiment that debt markets should lead the recovery, look to see Abnormal Return move out of 100% cash in the coming days, and into high yield ETFs.

Fiscal Stimulus - A Long-Term Perspective

The Congressional Budget Office estimates the federal government's budget deficit will grow to $1.2 trillion for the current fiscal year. It is expected that this figure will be revised upward after the enactment of President-elect Obama's enormous economic recovery package (now estimated at $775 billion).

With these extreme levels of debt it is becoming increasingly important that the fiscal measures employed in the stimulus package are capable of providing the economy with not only short-term stimulus, but also long-term social benefits.

The package can hypothetically be structured to increase any of the four sources of demand; consumption, investment, government and exports. Thus far, a significant portion of the package has been allocated to tax cuts ($300 billion over 2 years), which predominantly aims to increase private consumption, as well as capital expenditures (albeit to a lesser degree) in the short to medium term. The jury is still out on whether these tax cuts will be an effective consumption stimulus. My opinion is they will have a moderate effect given the extreme sense of pessimism and risk aversion in the private sector.

With the possibility of increasing exports out of the question (global economic weakness, widespread monetary easing, etc) the remainder of the stimulus package should be focused on government spending on, and investment in, resources and projects that have long-term benefits to the economy and society as a whole. This includes spending and investment incentives directed toward education (and as a result human capital), infrastructure, and alternative energy. Such an initiative would provide the economy with additional short-term support (e.g. increased employment), and more importantly long-term social benefits to the nation. At some point we need to revert back to proper fiscal responsibility and this may be our last hoorah. We need to make it count and in turn be able to realize benefits that reach beyond short-term stimulus and transcend the current economic cycle.

US Residential Housing: Further to Fall

Simple data aggregation coupled with modest assumptions suggest that aggregate US residential housing prices have to fall another ~15% over the next two years before they reach historical median values. This reality alone will place more stress on the household balance sheet and curtail spending for the foreseeable future, but in my opinion we are likely to see prices decline more than to this historical value (measured as median price/median income).

First, a simple example outlines a major demand concern:

Assuming a 5.0% 30-year fixed loan with 20% down, the median household faces:

• $180,000 median house
• $36,000 cash down payment
• 1.44 * $550 PI = $792/mo. * 12 = $9,504
• 1.5% * $180,000 Property Taxes = $2,700 (almost no tax benefit since PIT ~= two-earner standard deduction)
• 2% * $180,000 Insurance and Maintenance = $3,600
• Total yearly outlay: $15,804

This $15,804 annual outlay as a percentage of median income ($53,500), means the cost of ownership on an annual basis is 30% of total income. In other words, the median house is now barely affordable by the median household. Furthermore, this example depends upon both a 5.0% mortgage rate and a $36,000 down payment; a best-case, and highly unlikely scenario. Real homebuyers earning the median income most likely face much higher mortgage rates, have under 10% down payments available, and face additional fees and expenses in the form of insurance penalties.

In a supply environment of record inventory, with this demand enviroment (decline incomes, unemployment, etc.) it is quite likely overshooting such that prices decline much more than 15% from today's levels. As you can see in the following charts, previous downturns almost always resulted in declines below the historical average, and there is certainly no indication that this environment is likely to prevent such an occurance.

Oil is Back

Good news for people who bought hybrids during the days of $100+ per barrel oil prices. The escalating war in the middle east between Isreal and Hamas, growing tensions between Russia and Ukraine and OPECs production cuts have pushed oil prices back over $50 per barrel. The political tensions are prompting buyers to pick up oil at depressed levels as they worry about future supply issues that could result. The market will now have to determine just how high oil should be priced as they weigh the new supply concerns against the economic slowdown that cut worldwide demand.