What do you see as the likely scenario for the economy?
First, a Great Depression of the 1930s is not in the cards. The world will not suddenly lose its color and turn black and white (the colors that come to mind when we think about 1929 Great Depression, as there were not color cinemas then). No, we won’t have food lines, our kids will not start playing with bricks and sticks instead of toys and they will not be wearing handed down clothes several sizes their senior. Their collection of toys rotting in the attic may shrink and - I have to warn you – you may still see kids wearing torn jeans with holes that are too big for them. But don’t blame the economy, blame the latest fad. Our economy is stronger, more diversified, and far more developed than in the 1930s. It is unlikely our government will repeat the mistakes it made then. We also have a system of social nets, such as unemployment insurance (which will probably be extended, like it was in 2001 and 2002) and welfare.
I see three possible scenarios for the economy: (1) a Great Recession (2); a (semi-normal) recession; and (3) a quick recession leading to growth.
Our problems today stem from two sources (here I am oversimplifying a bit): an abundance of bad debt and a loss of trust in the financial system. Banks don’t trust their current or potential customers; investors and depositors don’t trust banks; and banks don’t trust each other. The government is trying to restore this circle of trust. Two months ago, socializing the financial system would have seemed preposterous. Now there is no way around this, at least temporarily. The Fed and Treasury are trying to restore trust by shoring up banks’ balance sheets and by stamping government guarantees on otherwise risky loans, and they will likely succeed.
The next step is dealing with the bad debt. Some of it will be socialized (paid for by the taxpayers). Some of the bailout programs will cost money, and some won’t. Warren Buffett says the government will make money on the CDO auction program, but I think this will depend on the price the government will pay for this debt.
The possibility of a Great Recession (which would be a steep decline in GDP growth and a sharp rise in unemployment, lasting a long time) is higher than in the past. The only reason a Great Depression would happen is if the “circle of trust: not restored.
The bottom line is, if the Fed is successful at restoring the circle of trust, a Great Recession is avoided.
We are very likely to be in a semi-normal recession. How long and deep will the recession be? We really don’t have a good benchmark to forecast the level of unemployment, nor the level of growth or decline in GDP, nor the duration of the recession. This is a consumer-driven recession and the consumer is two thirds of the economy. The last recession of 2001 was led by corporate slowdown; the 1991 recession was a consumer recession, but it was very different from current one. Housing prices did not decline nationwide; the consumer was not as leveraged and the global economy was in different shape. And yes, we are in a recession, no matter if it fits into traditional definitions. Growth is down and unemployment is up. The definition of a recession doesn’t matter.
A possibility of the third scenario – a quick and shallow recession leading to growth – is not high but it is there. For this scenario to play out the bulk of losses in financial sector need to be behind us.
What is your forecast for other world economies?
In looking at the external consequences of a global recession, I prefer to divide the world into four broad categories of countries: the US, Europe (and other developed countries), emerging markets, and commodity exporting nations (Russia and the Mideast).
As I mentioned before, the US will fare the best on a relative scale, because we are diversified. Despite the socialism which has transpired through the various bailout initiatives, we are still a capitalistic economy. Our capitalistic DNA will be only slightly (and hopefully only temporarily) diluted with socialism.
Europe is in a very interesting situation, one which will test the stability of the European Union (EU) and the long-term survivability of the euro. The EU consists of countries with strikingly different histories. Some have experienced runaway inflation and, for this reason, countries like Germany are very cautious about increasing monetary supply. To fight today’s financial crisis some countries will want to increase the money supply, and this will pit countries against one another. This also makes me less bullish on the euro.
Russia and the Middle East benefited from high commodity prices. If you look at Russia, for instance, the return on capital in oil- and commodity-related industries was much higher than in any other industry. This siphoned capital from other industries, which caused investments in these industries to decline. To make things worse, the rise of commodity exports drove up the Russian currency, making non-commodity industries even less competitive in the world market. Once you take high commodity prices away, Russia is worse off than it was before. On top of this, when Russia did well, it acceded to pressures to increase social programs. (In case of Middle East, they embarked on ambitious construction projects, like building a brand new city with a zero carbon footprint in the United Arab Emirates). Russia has created a stabilization fund (a super savings account), but I am not sure how long this fund will last. Russia is strong on a balance sheet basis, but that is a reflection of the past. The future, as reflected in its future income statements, looks horrible. To some degree it is almost a mirror image of the US – our balance sheet is weaker but our earnings power is strong.
The Middle East is a very similar story to Russia - with a twist. It benefited from oil prices and spent a lot on infrastructure, like building out new cities. My concern is that terrorism came mostly from the Middle East, and I am unsure what will happen when poverty levels go up in these countries.
Are there any foreign markets that look attractive now?
It comes down to stock selection. For example, we are concerned about Europe, but we own a British liquor company that has better fundamentals, a lower valuation and higher yield than its American counterparts. It is likely to do better in this environment. Our biggest concern is the “stuff” stocks (industrials, energy, and materials). They were responsible for a good chunk of excess in corporate profit margins. The analysts’ earnings assumptions are way too optimistic. The only question about the recession is how big it will be and how long it will last.
As I mentioned before, it is a stock picker’s environment. We don’t know how long this drama will last, and thus we are not trying to be heroes.
1 comment:
Some very interesting posts.
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