Crescenzi: My Top 10 Investment Themes for '09
If you haven’t been able to tell by now, I like to write. Look no further than my three books for proof, in particular to my 1,200 page revision to Stigum’s Money Market.
What I don’t like is pontificating. I seek instead to raise awareness of important issues, always trying to strike themes that investors can act on. I do this from a macro perspective, from the top-down, which is the subject of my latest book, Investing from the Top Down, which includes 40 major top-down indicators. Having wrote the book and given my penchant for macro-style investing, I thought I’d initiate — in part as a good exercise to start each year — an annual top-10 list of top-down bankable themes for the New Year.
Here are the top 10 top-down themes for 2009:
1) The U.S. will retain its reserve currency status: This theme is paramount because it answers the question of our age: If the U.S. is backing its financial system, who is backing the U.S.?
The question is critically important because the U.S. needs massive amounts of money to finance its efforts to restore stability to its economy and its financial system. If the support exists, the effort will work. If not, financial and economic Armageddon. Thus far, support has been superfluous, as evidenced by the low level of Treasury yields, continued sufficient bid/cover ratios for Treasury auctions, and 2008’s rebound in the U.S. dollar. The reason I am siding with the view that the U.S. will get the money it needs and retain its reserve currency status is because the U.S. remains the world’s preeminent power economically, politically, and militarily. Moreover, the currencies of rising powers such as China are not yet ready to absorb the $7 trillion in reserve assets the world holds, particularly because their bond markets are immature and can’t house reserves as U.S. markets can.
2) The overhang of unsold homes will fall and alter the dynamic on home prices: The massive overhang of unsold homes has already fallen, with the supply of new homes close to levels considered normal by historical standards. This is because home builders have substantially curtailed the construction homes whilst the population continues to grow. The inventory theme is a bankable one because as with many reliable top-down themes it relates to a basic necessity in life: shelter.
The U.S. population is growing by 3 million per year, which results in 1.2 million new households (household formation slows during recessions but it is a delay in the inevitable). If builders are constructing just 700k or so new homes, the net increase in the housing stock is only about 500k or so, because some of the tally represents the reconstruction of homes from storm damage and such, and as a result of teardowns. Given the basic need for shelter, people have to go somewhere. People are born short a roof over their head and they are forced to cover, whether through the purchase of a roof or renting one.
Bank credit and emerging markets...
3) Bank credit will expand: The Federal Reserve has injected massive sums of money into the U.S. banking system yet credit growth has slowed materially, harming the U.S. economy. In 2009, this situation is likely to change as a result of many factors, in particular because the Federal Reserve is likely to find the right number with respect to how much money is enough money to jumpstart lending.
The Fed has already expanded its balance sheet by about $1.5 trillion to $2.3 trillion, and excess bank reserves have increased from near zero to about $700 billion, bringing cash assets at commercial banks to over $1 trillion for the first time, yet it has not been enough. At some point the Fed will find the right number, as was the case with the LIBOR problem, and the money multiplier will increase and result in new money supply (remember, only banks can expand the money supply). Also likely to boost bank credit in 2009 will be broadening recognition by bankers of the disparity between returns on securities holdings versus those that could be earned from net interest margins (the difference between what a bank pays for money versus what it earns on loans). Banks keep about 25% of assets in securities, which these days are earning far less than can be earned on loans (net interest margins for loans are typically between 3.5 and 4.0 percentage points, data from the FDIC show).
4) Foundations for the second leg of the secular bull-run in the emerging markets will be set: I said in the Spring that with investors loaded up on one side of the market in commodity-related investments that the U.S. dollar would be the main beneficiary of a decline in commodity prices. Investors were long commodities outright, as well as the stocks, bonds, and currencies of countries benefiting from higher commodity prices. Investors were also long the stocks, bonds, and currencies of countries that were indirect beneficiaries of the commodity run; for example, Eastern Europe was on the receiving end of cross-border deposits from monies sent from throughout the world, in particular OPEC. The massive unwinding of commodity-linked trades caused major dislocations in the emerging markets, where many countries have learned valuable lessons, just as was the case in Asia following its financial crisis in the late 1990s. For example, Eastern Europe is sure to take actions that mitigate the effects of any future changes in cross-border flows. China will reduce its dependency on exports and boost domestic consumption, possibly by increasing its social safety net, which is a chief cause of its high savings rate (the lack of equivalents to the U.S. system on social security and Medicare is strong motivation to save in China). Emerging markets countries that prospered before the financial crisis will basically look in the mirror, identifying areas of weakness exposed by the crisis, exiting it with a stronger foundation for future growth built upon solid fundamentals, such as Brazil’s with its relatively young population—a median age of about 28 years compared to 37 years in the U.S. and 44 years in Japan, data from the Central Intelligence Agency show.
Consumer confidence, corporate bonds...
5) Consumer confidence will rebound: Amid many strains, in particular rising unemployment, consumer confidence will rebound. It is already beginning to follow a pattern that dates back to the early about 40 years whereby consumer confidence levels increase around the time of a presidential election and into the inauguration period and beyond. Confidence levels are often correlated with presidential approval ratings, which for Barack Obama are sure to be higher in his early days than his predecessor, whose numbers have been in the 20s for quite some time. This represents a substantial change. Putting policies aside, Barack Obama is the type of man that exudes confidence, just as Ronald Reagan did (many gasp at the inclusion of Obama and Reagan in the same sentence when I do so, but for many in America the comparisons ring true). Confidence levels are not normally as important as they are today, but it is a lack of confidence that is feeding the economic and financial crisis and its recovery will be a crucial ingredient in ending the crisis.
6) Investment-grade corporate bonds will gain favor: Lured by returns that are comparable to the historical returns earned on corporate equities, and their higher place on the corporate structure, investors will move increasingly into investment-grade corporate bonds. Investors on November 25th began their first major foray out the risk spectrum, moving into agency securities and agency mortgage-backed securities, doing so in response to an announcement by the Federal Reserve of a plan to purchase $100 billion of agencies and $500 billion of agency MBS. Investors will feel compelled to move further out the risk spectrum if yields stay low in the mortgage realm, not only because of the allure of higher returns elsewhere but also because of the beneficial effects that improvements in the mortgage realm will have for both the economy and the financial system. A major move in corporate bonds will not occur until investors can more clearly discern the depth and duration of the recession. For this to happen economic data need not improve much, they merely need stop getting worse. When this happens, corporate equities are likely to gain, too—corporate bonds and corporate equities gain on the same premise: the promise of improved cash flows.
7) The money market will remain stable: Crucial to any end to the financial and economic crisis is stability in the money market. Without it the banking system will not function in ways that get money to people and entities that need it. The money market became dysfunctional early in the financial crisis in the summer of 2007 and in recent times was again at the epicenter of the crisis. A recovery has been underway for several months now, thanks to actions taken by the Federal Reserve, in particular the establishment of its Commercial Paper Funding Facility and its swap arrangements with foreign central banks (the Fed in October offered to supply unlimited amounts of dollars to foreign banks needing dollars). The recovery of the money market is most apparent in the downtrend in LIBOR, which is collapsing and is set to collapse further based in part on simple interest rate theory which states that long-term rates are a bet on where short-term rates will be in the future. For 3-month LIBOR, which is hovering around 1.45%, there should hence be some convergence with the 1-month rate of about 0.45%, since the 3-month rate is simply a bet on where the 1-month rate will be 3 times. Adding to the favorable backdrop is the excess amount of dollars in the financial system, which is apparent in the commercial banking sector’s $1 trillion of cash balances (versus the usual $300 billion), and excess bank reserves, which at $700 billion are about $700 billion above normal (the increase in cash balances and reserves reflect the same condition).
Success for Fed & Treasury, techs and Obama...
8) The Fed and the Treasury will succeed in reviving the asset-backed securities market, spurring an expansion of credit extended for automobile loans, credit cards, equipment leasing, and such. On November 25th, the Federal Reserve announced the creation of the Term Asset-Backed Securities Loan Facility (TALF), a facility the Fed said would “help market participants meet the credit needs of households and small businesses by supporting the issuance of asset-backed securities collateralized by student loans, auto loans, and loans guaranteed by the Small Business Administration.” The Fed will lend up to $200 billion to investors for the purchase of asset-backed securities. The facility will become operational in February 2009. The $200 billion facility is large enough to normalize the market for credit card and auto loans. For example, for revolving credit, which stood at $976 billion in October, monthly growth averaged about $3 billion per month over the past 10 years, a growth rate that could easily be met by the TALF. Non-revolving credit, which stood at $1.6 trillion in October and consists of loans for automobiles, mobile homes, education, boats, and trailers, grew $6.5 billion per month over the past 10 years, an amount that can also be met by the TALF. The Treasury Department will provide $20 billion of credit protection to the Fed in connection with the TALF. The Treasury’s commitment to reviving the asset-backed market was shown again in December with its investment in General Motors Acceptance Corp (GMAC), which put GMAC under the government’s “umbrella,” which is to say in a place likely to stay protected until the sun shines again.
9) Seven “C’s” will help keep the tech sector afloat and enable its recovery: Cost reduction initiatives (the purchase of equipment and software can boost productivity); Competitive forces (in order to maintain competitive advantages, companies can’t risk falling behind investing in the best equipment and software); Capital depreciation (the depreciation rate for information-processing equipment is much faster than for other types of machinery, which will tend to sustain investment in technology equipment); Controlling inventory (businesses recognize that having the best technology in place helps them to keep inventories from increasing undesirably, a risk in an economic downturn); Capital deepening (businesses recognize that their return on capital is generally good on spending on equipment and software); Cyclical forces (the technology boom that began in the mid-1990s is secular, which means it will rebound when the economy does; Cultural fabric (consumers and businesses simply love new technology: have you ever walked into an Apple store?).
10) Barack Obama’s strategies to end the financial and economic crisis will prove creative and effective, boosting the electorate and pleasing investors. Obama will maintain a high approval rating throughout 2009: The first nine themes I discussed set a foundation for Obama to be successful, and theme #1 is the main reason Obama will be successful: U.S. hegemony was built on its illustrious history, and Obama is showing early signs that he has the ability to lead the nation back to prosperity.
Infrastructure, fine art and clean water...
Among other themes:
Infrastructure, which is likely to benefit from the next U.S. fiscal stimulus plan and from ongoing and new initiatives throughout the world, such as in China, which plans to boost infrastructure spending on a large scale. Investors need be careful as this could become a crowded trade despite the positive outlook for actual spending levels.
The art market, which in the 50 years ended 2000 saw returns similar to that of the S&P 500 but which tends to be far less volatile (and hence, lacking correlation to corporate equities) is likely to continue to show itself as an asset class with substantial diversification benefits.
A persistent theme for years to come is the water industry, particularly companies that purify, desalinate, disinfect, and distribute water. Demands upon the global water supply are far greater than most think. Estimates from the United Nations show that around 1.2 billion people live in areas where the limits of sustainable water use have already been breached.
U.N. Secretary-General Ban Ki-moon, speaking at the World Economic Forum in Davos, Switzerland in January 2008 noted that “A recent report by International Alert identified 46 countries, home to 2.7 billion people, where climate change and water-related crises create a high risk of violent conflict. A further 56 countries, representing another 1.2 billion people, are at high risk of political instability. That’s more than half the world.” Ki-moon noted that the conflict in Dafur began because of factors related to a drought there.
Strains on the world’s water supply have increased also because of the production of ethanol and other biofuels, which require a massive amount of water to produce. For example, by one estimate, the amount of water needed to produce biofuels for a tank of an SUV equals the amount of water needed to feed one person on grains for a full year. In light of these and other factors and given that water is a basic necessity in life, the water industry looks likely to see strong growth for years to come.
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