|
Risky Business A U.S. and Bermuda Under 40s (Re)Insurance Collaboration Winter 2010 |
|
The Economic Year in Review By Andrew Baron, CFA
What a difference a year (and a bit) makes! In May of 2008 I did an interview with the Bermuda Captive industry magazine in which I stated an opinion, which many others held, that following the Fed/Treasury led rescue of Bear Stearns in March 2008, the US economy was headed for a “relatively mild” recession. That seems an eternity ago now and what has followed has turned out to be a truly remarkable period in the financial markets. The credit crisis that we were in the middle of in June 2008 morphed into a global economic recession, with the US at the epicenter. As we write, we are in the 22nd month of the US recession, widely acknowledged to be the worst in the post-Depression era, despite a recent GDP recovery into positive territory. Fed Chairman Bernanke, himself a renowned expert on the global policy errors of the Great Depression, made it quite clear when he articulated that his goal during the worst of the crisis was to “avoid another Depression”. As it was, we still managed to witness a spectacular Government policy failure with the Lehman bankruptcy in September 2008, with the fallout resonating through the financial world. Crucially, this failure exacerbated the already precarious situation on both Wall Street and Main Street, something that has not truly coincided since the 1930’s. Books will be written on this collision of poor Government policy in future. If that wasn’t enough “history” being created, the US also elected its first African American President, and a near bullet-proof Democratic majority in both houses of Congress. Policy judgments aside, the first 10 months of the Obama Administration have seen a fiscal profligacy not seen since the New Deal and that isn’t even taking into consideration a proposed overhaul of the US healthcare system. The Federal Reserve has kept the Funds Rate at zero for 11 months and this zero interest policy is due to last throughout the remainder of 2009 and likely much of 2010. In addition to this quite rare event in monetary policy, the Fed also embarked on a very large program (well over $1.5 Trillion) of Quantitative Easing, meaning outright purchases of Treasury, Agency and Agency Mortgage-Backed securities. The stated purpose of this program was to support credit markets and guide consumer lending rates lower. This has increased the size of the Fed’s balance sheet to an enormous two trillion Dollars, double what it was a year ago. The effect that this program has had on consumer mortgage rates, however, has been negligible. Historically low short-term interest rates drove the yield on the 2 year US Treasury from approximately 2.6% to under-1% and cash yields on virtually all short-term debt remain close to zero. Despite the quantitative easing program from the Fed, who is now the buyer of first AND last resort in the market, both the Treasury market and the US Dollar are in a precarious position. A large re-allocation of cash back to risky assets as the markets have stabilized, combined with nervous investors looking at the size of the fiscal deficit and the mountain of Treasury debt issuance to come, may make for difficult conditions. This is to say nothing of what happens when the Fed attempts it’s “exit strategy” and actually ceases to be the life support for financial markets. We all know how strongly the equity markets have rebounded over the last 6 months, but there is quite a lot of good news priced into that market and little room for disappointment. Outlook & Strategy For the last two years, I have consistently said that the headwinds facing consumers were overwhelming, beginning with the negative wealth effect from the housing crash and the stock market decline (no I did not predict the breadth and depth of either decline!) and that further retrenchment in spending was not only likely, but the only rational choice. Over the last year a new threat has been added to the trillions of dollars in devastation of net worth – a very high (and rising) unemployment rate. Unemployment stands at 9.8% nationally and numbers of so-called “marginally attached” and involuntary part-time workers are at a record high of 17%. The duration of unemployment is longer than it has ever been, the average workweek and earnings are falling and there are a record number of workers, 5.4 million at last count, who have been without a job for over 6 months. Consumers have acted rationally, scaled back consumption and saved what small fiscal stimulus has come their way, leading to a rise in the national savings rate. There is also a worrying underlying demographic trend at play – the Baby Boom Generation is approaching retirement, a natural period of lower consumption, at the same time as a record destruction of household net worth. This generation will be licking its wounds as the worst affected portion of the population for some time to come. These headwinds for the consumer sector, that represents 70% of GDP, lead me to firmly believe that fundamental weakness in the US economy will continue, not at the highly destructive pace that we saw in the fourth quarter of 08 or the first quarter of 09, but nonetheless more of an “L-Shaped” recovery. The Fed’s dual mandate for supporting trend growth and containing inflation will lead it to keep rates low for some time to come, as core and headline inflation are still falling – the threat of deflation is still higher than that of inflation. It will not always be thus, however, rapid inflation is a longer-term worry as opposed to an imminent threat. The market fears inflation will eventually rear its ugly head in response to a combination of the Fed over-stimulating the economy (likely) and the fiscal picture deteriorating (also likely). Over the last year, indeed as recently as 6 months ago, investment grade and high yield corporate credit yields were at multiple standard deviation highs (100 year storm territory for those of you in reinsurance) and trading at levels that were pricing in a severe Depression scenario. As we have seen recovery in the stock markets since the low on March 9, so too has the corporate bond market recovered. Not to dwell too heavily on the performance of corporate debt or credit spreads, in particular, but it is an important indicator to measure the breadth of recovery in financial markets – much more important to the overall health of markets than a particular level of the Dow or S&P 500. The coordinated recovery in the outlook for the credit markets removes an important impediment to the resumption of lending by financial institutions to both individuals and businesses. This is a necessary, but not sufficient condition for recovery; we must also see a sustainable upturn in demand for credit, something I have grave doubts about for reasons articulated above. At present, consumer credit outstanding is still shrinking at a near-record pace. Overall, one must be careful not to equate a market correction from oversold conditions with a strong economic or corporate recovery. We have seen (a very recent) move away from the brink of financial and economic Armageddon, but the US still faces a long road to sustainable recovery to trend or above-trend growth.
About the Author: Andy Baron, CFA, is the Head of Fixed Income at Butterfield Asset Management in Bermuda. If you have any queries you can contact him on +441 298 4836 or Andrew.Baron@bm.butterfieldgroup.com. |
