I like to write, but I don't like pontificating. I seek instead to raise awareness of important issues and 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."
Having written the book, I thought I'd initiate an annual top-10 list of top-down bankable themes for the New Year. Here it is:
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
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 while 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.
3) Bank credit will expand
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 to jumpstart lending. The
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%age points, data from the FDIC show).
4) Emerging markets will be set for a second leg of the secular bull run
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 sent from throughout the world, in particular OPEC. The massive unwinding of commodity-linked trades caused major dislocations in 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. Social Security and Medicare systems is a strong motivation to save in China). Emerging markets countries that prospered before the financial crisis will basically look in the mirror, identify areas of weakness exposed by the crisis and exit them with a stronger foundation for future growth built upon solid fundamentals. A good example is Brazil, 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.
5) Consumer confidence will rebound
Amid many strains, in particular rising unemployment, consumer confidence will rebound. It is already beginning to follow an established pattern 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 low for quite some time. This represents a substantial change. Putting policies aside, Barack Obama is the type of man who exudes confidence, just as Ronald Reagan did (many gasp when I include Obama and Reagan in the same sentence, but for many in America the comparison rings 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. Recovering confidence 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, investors will move increasingly into investment-grade corporate bonds. Investors on November 25th began their first major foray out of 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 to 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 for 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 the people and entities that need it. The money market became dysfunctional early in the financial crisis during the summer of 2007, and in recent times it 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 drop 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 therefore be some convergence with the 1-month rate of about 0.45%. 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).
8) The asset-backed securities market will revive
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) 7 C's will help keep the tech sector afloat
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
10) Obama's strategies to end the crisis will prove creative and effective
The first nine themes I discussed set a foundation for Obama to be successful, and theme #1 is the main reason: 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. Among other themes is infrastructure, which is likely to benefit from the next U.S. fiscal stimulus plan plus 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. A persistent theme for years to come will be 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 Darfur 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 need 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.
To see Tony Crescenzi's daily breakdown of all that is going on in the economy and market, check out his regular stuff on RealMoney.com.
Tony Crescenzi is the chief bond market strategist at Miller Tabak + Co., LLC, and advises many of the nation's top institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board's Livingston Survey of economic forecasters. He is also the author of the revised investment classic,
The Money Market
, first published in 1978 by Marcia Stigum, and
The Strategic Bond Investor
. At the time of publication, Crescenzi or Miller Tabak had no positions in the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Crescenzi also is the founder of Bondtalk.com, a popular Web site covering the bond market and the economy. Crescenzi appreciates your feedback;
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