People who know me regard me as a naturally positive person, in that I typically view the proverbial glass as being half full rather than half empty. I am however also a realist who relies on empirical evidence to form opinions. These two different factions within me co-exist in an uneasy state of potential conflict. Obviously the current financial and economic crisis has put both my positive and realist states on an inevitable collision path.
Nowhere is this more apparent than when I meet up with clients or have to speak at seminars to share my views on the market. While I would love to go out and tell investors what most of them would like to hear, namely that things will be alright and that financial markets will recover sooner rather than later, the realist side of me has been more domineering, as I lay out all the brutal facts as to why we believe it will take several years to undo the mess we find ourselves in today. Doing this however makes me feel like I am the harbinger of doom, as clients go away feeling more depressed. So before I continue, here is a quick warning to readers who just want to read about the positive side of things - skip the next few pages and just concentrate on the last paragraph!
Economy in the doldrums
The outlook for the global economy continues to be shrouded in uncertainty as governments grapple with how best to tackle the financial crisis, which has morphed into arguably the deepest recession since the Great Depression. The IMF has recently warned that global growth would slow to +0.5% this year, well below the +2.5% typically used to define a global recession. In addition, the International Labor Office recently forecast in its annual report that 51 million jobs are likely to disappear by the end of 2009 as a result of the economic slowdown, pushing the global unemployment rate up to 6.5% by the end of the year. In fact, the US unemployment rate is already higher than this figure, having risen to 7.6% in January, the highest level since 1992. The latest jobs report also showed that payrolls plunged almost 600,000 for the month, bringing the total number of jobs lost over the last 13 months to a whopping 3.6 million, the biggest slump in the postwar period.
It is not surprising then that Americans are cutting back on consumption, scaling back on spending for the sixth month in a row in December as their savings rate rose to 3.6%. This represented a reduction in spending amounting to US$102.4 billion, or 1% less than the month before. While cutting back on spending and reducing debt levels is definitely a prudent step in the right direction for these over-leveraged consumers, these reductions are severely hurting businesses, forcing companies to scale back on orders and trim workforce. All this is having a detrimental effect on the earnings of companies, many of which have already announced sharp reductions in earnings for the last quarter and are preparing the market for similarly bad numbers in the quarters ahead.
Unfreezing the financial markets
One of the key issues that needs to be resolved urgently is a plan to unfreeze capital markets, so that banks can and will start lending again and provide much needed liquidity to the system. In this regard, the market was waiting with much anticipation for US Treasury Secretary Timothy Geithner to outline a comprehensive plan to solve the problem once and for all. In the end, they were sorely disappointed with the US$1.5 trillion rescue plan that he finally unveiled.
At the heart of the plan is the creation of a public-private partnership fund amounting to at least US$500 billion to recapitalize the banks, and another US$1 trillion to support consumer and business lending. The government also intends to subject major US banks to a rigorous stress test to determine if they can survive the economic downturn - essentially weeding out the institutions that are worth saving from those that should just be closed down. The Treasury and the Federal Reserve obviously believe that these measures will be sufficient to stabilize the financial system.
Unfortunately the markets did not share this confidence, as equity indices all suffered a sharp sell off following the announcement. Many commentators were unsatisfied with the lack of details provided, seeing this as a sign that the authorities themselves were unsure about how to solve the problem. We understand that one reason why the plan took its current form was to satisfy different factions with differing priorities - one group wanted to focus on how to free banks from their toxic loans, while the other wanted to announce punishments for senior bankers and to impose punitive measures on bank shareholders. The problem with this is that these two objectives are mutually exclusive: you cannot punish the banks and restructure the banks at the same time. In seeking a compromise, the government ended up with a plan that arguably lacked enough bite to truly satisfy either objective.
While it remains to be seen if the announced measures will be sufficient to unfreeze the financial markets, it does seem that the same problems that plagued the TARP are still unresolved, key among which is how to find a mechanism for pricing the toxic assets on banks' balance sheets. As such, the government may find themselves forced to take much firmer action sometime down the road.
Protectionism raising its ugly head
To make things worse, there is now a growing threat of protectionism as governments naturally adopt policies to help their local industries and citizens. At the recently concluded World Economic Forum in Davos, politicians were united in agreeing that protectionism was the biggest danger facing the global economy. The US is seen as a major culprit in this regard, as seen by the recent bailout of the American auto industry and the "Buy American" provisions in the current economic stimulus bill, which favours US steel producers. The risk here is that other countries may impose similar protectionist policies, causing a repeat of the 1930's when nations raised tariffs to protect their own industries, thus affecting global trade and damaging the world economy.
To his credit, President Barack Obama realized the potential implications of this stance and acted quickly, saying he would alter the "Buy American" language in the economic stimulus bill. However, his political will is going to be stretched to the limit as his fellow politicians are pressured to help their local communities. Another disturbing development is the fact that some Senators have already taken this "Buy American" mantra to the next level, proposing a "Hire American" proviso for banks that receive government bailouts. The US is by no means alone in gravitating to these policies. The Spanish government has offered to pay foreign labourers to return to their home countries, and the Singapore government has come out with a jobs credit scheme that helps preserve employment for Singaporeans and permanent residents.
Over-reliant on government intervention
All these unresolved problems are contributing to the uncertainty in the marketplace. Hopefully a lot of this uncertainty will be removed in the months ahead with the implementation of the various government initiatives. We however expect a rocky road ahead, as politicians continue to debate the best approach to address the problems. With the Republicans already putting up stiff opposition to the economic stimulus package, imagine the kind of resistance Timothy Geithner will face with his bank bailout proposal.
It is always disconcerting to have your fate lie in the hands of a bunch of politicians, but this is the uncomfortable position we find ourselves in right now. Optimistic investors who are banking on a quick turnaround in asset prices are relying on these politicians to act decisively and quickly in coming out with the right policies to solve the economy's problems. However, the reality is that there is no quick or easy solution to the current mess we find ourselves in.
Structural downturn may lead to a decade of lost returns
All the above problems suggest the current recession may be a structural downturn that will take far longer to recover from than the usual cyclical downturn. This sparked us to go back in history to find similar “abnormal” periods where financial market returns were negative or flat over a prolonged period of time. We identified three such abnormal periods – namely the Great Depression of the 1930s, the Stagflation period in the 1970s, and the Japanese Deflation “lost decade” of the 1990s. The common observation from all these periods was that investors failed to get positive real returns over a five- to ten-year time horizon.
The risk of a similar abnormal period repeating itself over the next five to ten years prompted a review of our investment strategies, particularly for our clients who have a shorter time horizon and who need to drawdown on their investments during this period. As a result of our analysis, we decided that we have to tweak our investment strategy and introduce a new set of portfolios (and management style) to cater to clients who have a shorter time horizon.
So far this article has been dominated by the realist side of me, laying out all the brutal facts above, preparing you for the tough times ahead. The optimistic side of me however wants to end this on a positive note. While we are facing challenging times, there are attractive investment opportunities for long-term investors who can ride through volatility. I have absolute confidence in the strength of the human spirit to withstand adversity. After a period of cleansing and clearing out the excesses, the economy will undoubtedly continue on its former growth path and asset prices will inevitably recover. It may take a little more time and the journey will likely be a bumpy one, but we will be rewarded for our perseverance. -- Daryl Liew
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