Global Investing Economic Outlook for 2009

In Chekhov's The Seagull, the fatuous writer Trigorin calls the attention of his callow admirer to "a cloud which looks like a grand piano". As I ponder the outlook for 2009, I am not sure if what we face is a cloud which will blow away, or a piano which is about to fall on our heads and crush us in a jangle of jangling strings and smashed wood. I fear it is the latter.

Much as I would like to believe we are only facing a temporary non-fatal setback in our economy and markets, this is hardly a certainty. Is the risk of deflation really gone from the scene now? Let me try to make the optimistic case.

Once the close of the year is done with, once the new Administration is in office, the pile-up of year-end catastrophes will draw to a close. Window-dressing will cease and investment funds will find something more exciting than zero-coupon T-bills to put their money into. Year-end tax selling will have finished. Bonus-deprived Wall Streeters and famished hedge funds (and their investors) will stop selling anything that still has some life left in it. The repercussions of Madoff and Bear Stearns and Lehman and AIG will be off the headlines. De-stocking will have gotten rid of the inventory overhang. Deleveraging will have cut risks. Savings will have been boosted enough so the animal spirits will start to spur new risk-taking. Banks, having rebuilt their rainy day reserves a bit, will start lending out money again. Mutual fund investors will stop selling their positions for cash, The worst of the disasters will have been taken into account by the markets and banks will trust each other again.

Once you have declared bankruptcy or defaulted on your mortgage or lost your job, there is not much point in doing it all over again. Panics can never last. With the famous January effect, new years tend to be good for stocks. Although, after a bloodbath it is not certain that the effect will turn up on schedule.

New administrations generate optimism but they also tend to want to get the bad news over with fast so as to blame the former lot. But the proposed further stimulus measures being plotted by the Obamites should generate at least some bounce in the economy as a whole, in corporate profits, and ultimately in stock market prices.

You can even argue that enough stimulus is already in the pipeline to generate a relatively rapid U.S. recovery, in Q1 or Q2 2009. These things, we are told by economists, take time to work themselves through the system.

And yet, and yet.

I know I am supposed to wait for the J-curve to kick in before judging the validity of the rescue packages, but I cannot see much evidence that they are doing what they are supposed to do: unblock the drains of the international financial system to produce credit, interbank loans, trade finance, commercial paper... to say nothing of merger funding, new issues, all that stuff which the market hasn't seen for months.

The trouble is that so much stimulus in 2008 did not work yet, like the tax cuts which are now long in the tooth. Deficit spending is deficit spending, if takes the form of a free-market pinata for everyone or a bunch of infrastructure projects for the pols. It may not work better in 2009 than 2008..

So short term, I expect the market will test the October 10 lows. What we have had since then, particularly in the pre-Christmas run-up in stock prices when the Fed started its near zero interest rate pricing (ZIRP) is a head fake, a bear market blow off.

Stock markets are discounting mechanisms. They always run ahead of the real economy. But if there are serious setbacks in the corporate sector in early 2009, the stock market will fall back again. We have not yet seen a major non-financial bankruptcy, but that is in the cards. And lousy earnings will be showing up virtually across the board. Our bear market rally will be tested.

Too much official tapping of the lines of credit out there, either domestic or international, ultimately risks crowding out less solvent borrowers who might be the ones to invest in productive enterprises, creating jobs, making goods the world will buy. It is not the government's job to control the credit system, except in a crisis. I remain skeptical as to whether we are in the type of crisis throwing taxpayer money at can resolve.

As for the Fed, there is a standard remark that cutting interest rates to achieve growth is "like pushing on a string." I am not sure if quantitative easing and ZIRP than tax cuts or deficit spending. QE and ZIRP were tried by the Japanese Central Bank without much success, maybe because they were only half-heartedly in favor of these tactics. But maybe because they don't work.

Washington clearly will continue expansionary policies if other countries do not go along. That's the rub. Germany is already derailing the EU attempts to match Washington and London's stimulus measures. The ECB head, Bernard Trichet, has made it clear that he is halfway on the Germans' side.

If the U.S. and Britain continue to throw money at the financial sector and the money winds up flowing across the Rhine, they will reconsider the free-spending policy. The fact that these countries will be run by ostensibly left-wingers makes it harder to sustain the fiction that this is a prudent and sensible way to get out of the crisis. Don't forget that Labour and Democrats are vulnerable to accusations that they are "tax and spend" types.

If only a bunch of currencies are engaged in money creation in a noble mission to bail out the world, those currencies will collapse against the others. Trying to forecast pegged and manipulated exchange rates is tough; look at the ludicrous and improbable recent strength of the U.S currency which rose to the clouds or the grand piano all by itself while the Treasury bill auction produced zero or even negative yields. Who could have predicted that? Then the dollar came back down, but it is still high.

However, if eventually all currencies are debased, or your currency is (that's the Greenback, folks), you want to own gold. Should you trust Angela Merkel to join the circus and throw Germany new Autobahns? Will Italy boost its deficit to spend even more? Will the Dutch build new dikes and windmills to stimulate their economy? Will the European Central Bank broaden its mandate to act to produce growth rather than stick to fighting inflation? Heck, no. The weight of law and custom will keep these continental countries from printing money along with us.

Our major transatlantic buddy country is Britain which essentially has gone into the printing-press game with even more zeal than the U.S. Britain is gaining a competitive advantage from this. Sterling lost 25% of its value against the dollar in 2008 and nearly as much against the euro.

Some other countries, like France, are also susceptible to the fight-deflation siren song from Bernanke et al. Japan, having barely emerged from a decade-long deflation, now is getting ready for more of the same. So the developed industrial world is on two different tracks over the policy to pursue.

I think our British international stocks will actually gain from the beaten-down pound. Converting profits generated in other currencies into sterling will enhance the share price and the dividend-paying capacity of British multinational corporations. I particularly like defensive stocks like Glaxo (GSK) or Tesco (TSCDY.PK) which should be immune to slowdown, and which will rise as their non-sterling earnings go up.

International repercussions are what doomed the post-1929 economy to a further decade and a half of depression. Recall the Smoot-Hawley Tariffs. The U.S. decision to raise tariffs to "beggar my neighbor" made it impossible for the small number of key countries to cooperate in the 1930s (and Hitler's rise to power did not make it easier). Competitive tariffs kept the half dozen countries which mattered in the 1930s from getting their act together and kept the crisis going longer than it should have.

Now the number of key players is much larger. China alone can start the 21st century beggar-my-neighbor game all by itself, with a competitive devaluation. The Chinese tried this with a market intervention in December. Such kind of export-bolstering measure can easily be adopted by other countries. And there we go again.

The fact that the Doha Round is already in disarray about further cuts in tariffs and quotas is the background for worrying about trade policy. Farm subsidies, obstacles to direct investment, issues of intellectual property have already caused international disarray. A Beijing-generated yuan devaluation would trigger a rush to copy that move. So let us all pray to Buddha that the Chinese see reason.

But actually I don't trust Pres. Obama's free-trade credentials either, to judge from what he said during the campaign. We are supposed to think he was only cozying up to the unions in his talk of renegotiating protection of workers in NAFTA, and in his nasty attitude toward a free trade deal with Colombia. But maybe he really believes in managed trade and export subsidies, despite the historic risks. I also don't trust Ben Bernanke's commitment to a strong dollar because in the next few months this will be incompatible with his anti-deflation policy. You cannot defend the currency while dropping it from a helicopter.

The whole notion of a Detroit bailout, however bi-partisan, is another lump of protectionism. Since only U.S. owned car companies are being considered for loans, not foreign-owned carmakers with U.S. Plants. So too are the multilateral efforts to help banks. Each regulatory move or bailout is purely national in scope at a time when banking is global.

The price of oil is not set by the market, and plenty of other commodities are equally suspect. Oil is priced by a sloppy cartel with lots of cheating members, thanks to Saudi Arabia acting to shut in surpluses. Other commodities are priced by contract, like iron ore pellets.

And some things we own, like dry bulk carriers, are rented through a self-reinforcing index. Participants have to confront not just earlier deals, but an army of vicious stock-shorters among their rivals.

In a resumption of inflation, such as I anticipate sometime in the next 12 to 18 months, the prices of all these goods will rise when denominated in U.S. dollars.

Worried about the international repercussions, I cannot believe in a new boom in the U.S. economy or in stocks. The best you can expect is a reversal of the bear market, such as we saw late in 2008. Some people say it was just a dead cat bounce.

There are several important lessons from my musings about pianos and clouds.

1. Don't be a buy and hold owner. Trade away. And take your time playing your money. Scale in. I am not sure there won't be a new testing of the lows of October in early 2009.
2. The stocks you pick are the key. Look for neglected small caps with a niche and few or no competitors. Big is not best once credit starts moving again.
3. Dividends can be a support of stock prices if they are based on real earnings. The risk is that they are cut. This is the main reason why I am not including any financial stocks in my list this year. Key Bank (KEY) is the key. What was done to the coupon clippers of Cleveland will be done to those of Santander (SBP) and Scotland (RBS), Bangalore and Blimey. Invest defensively.
4. My favorite sector right now is drug research where you will find a lot of ideas below. It is defensive but also an area of potential growth given global demographic trends. We are all getting older.
5. Inflation-indexed bonds are a future protection against price rises after the economy is brought out of deflation. And it will be brought out of deflation and then the inflation spiral with begin. TIPS are the only kinds of Treasuries to buy now.
6. Asia infrastructure is a no-brainer. Yes, you want construction companies, real estate funds with office/commercial portfolios. You want builders of homes for sale. The Hindustan Times on Dec. 17 ran an article that there are 100 applicants for every New Delhi Development Authority home put on the market. Even if mortgage rates remain high in India (as they must, because banks pay a lot for deposits) I think the country may adopt a direct subsidy for home-buyers. China already has done so along with offering a tax cut. XIN, Xinjiang real estate is the winner.

   Unlike our home-grown subprime borrowers and some of the speculators who have crashed in Shenzhen and Hong Kong, the typical homebuyer in the rest of Asia has no other major debt; he pays as much as he can in cash; and he wants to buy a better life-style. His aspirations will pay off for the government, which is why he is being encouraged.

7. Own gold or gold ETFs. I do not think our rulers are so perverse that your gold will be confiscated as in the 1930s. So I don't think you need to hold physical gold. My colleague James Di Georgia would disagree and at least one Washington reader also expects Uncle Sam to confiscate private holdings of gold again.
   But I think every portfolio needs an inflation hedge in a period of unbridled monetary easing and pump priming. Mining stocks are a specialist's business. You need to have a guide to which companies have reserves to develop; which have cash at hand; and which are selling their future output forward to finance new mines. I buy ETFs now but obviously if talk of confiscation arises, I can buy physical gold (like jewelry or coins or even an ingot).
8. Closely watch stocks priced for perfection where an anvil chorus of simple-minded analysts is telling you to buy. You don't have to sell these shares; you have to watch them if you keep them.

   A current example would be Teva (TEVA), which is supposed to finance my retirement. I am not selling; but I would not now buy more along with the Citigroup (C) and JP Morgan (JPM) customers who have only just been told about the charms of the Israeli generic drug-maker; we have been pounding the table for this share for years.

9. Diversification between domestic asset classes has proven useless. Real estate hits stocks which undermine commodities which zap hedge funds which hurts private equity. There is no hiding place.
10. International diversification has a longer history of working. It will resume its worth going forward.
11. The odds are that the dollar is going to fall further than the less expansionary euro. I can't tell you when. I can tell you what. So buy foreign stocks. Britain should gain from what amounts to a competitive devaluation and looks attractive. Except of course for its financial shares.
12. China is a tough one to call, first of all because Chinese statistics are Madoff-ian. The Beijing Regime is widely believed inside China to publish made-up numbers on inflation and growth for political reasons. And growth prospects are hard to figure out because the degree to which China depends on export markets is shifting.

Disclosure: I own 1400 shares of Teva in my IRA. I own 500 shares of DRYS. I own 300 shares of Tesco and 600 shares of GSK and 300 of XIN.

Comments

[sr9web:]

What did you pay for the DRYS?

2008 Dec 21 04:59 PM

[John Lounsbury:]

Global Investing Editor - - -

What October 10 low are you referring to? The DJIA, S&P 500 and NASDAQ all bottomed (so far) on November 20. Making the October 10 statement without explaining why you pick that date damages your credability.

That being said, some of your thoughts seem to have some merit, but I, for one, would like more detailed analysis shown. Maybe less breadth and more depth would be more useful. Don't let my criticism stop your posting - please try to take it as constructive.

2008 Dec 21 07:57 PM

[PastTense:]

When you see articles like this on DRYS to me it looks like a stock to stay away from no matter what its price:
seekingalpha.com/artic...

2008 Dec 21 11:15 PM

[ewr:]

how can a comment, which actually appears sensible, be taken seriously, if the author cannot spell credibly ?


On Dec 21 07:57 PM John Lounsbury wrote:

> Global Investing Editor - - -
>
> What October 10 low are you referring to? The DJIA, S&P 500 and
> NASDAQ all bottomed (so far) on November 20. Making the October 10
> statement without explaining why you pick that date damages your
> credability.
>
> That being said, some of your thoughts seem to have some merit, but
> I, for one, would like more detailed analysis shown. Maybe less breadth
> and more depth would be more useful. Don't let my criticism stop
> your posting - please try to take it as constructive.

2008 Dec 22 01:50 AM

[A simpler Way:]

I like this article. It gives me a more clearer view of the global economy from a non pro or con point of view. I can take it or leave it but it offers me a good springboard to go look further.

As a side note, I have a learning disorder (but not disabling) which effects my reading but I must say "I like the way you write".

2008 Dec 22 11:01 AM

[OldLimey:]

"Our major transatlantic buddy country is Britain which essentially has gone into the printing-press game with even more zeal than the U.S. Britain is gaining a competitive advantage from this. Sterling lost 25% of its value against the dollar in 2008 and nearly as much against the euro."

Your buddy would be doing a whole lolt better out of this sterling devaluation if it actually made more 'stuff' that people overseas could buy (assuming they have the money). Trouble is, the manufacturing sector has been hollowed out and there's very little sign of life in exports despite sterling's death-dive. As for service exports, the expressions 'City of London' and 'busted flush' come to mind.

"I particularly like defensive stocks like Glaxo (GSK) or Tesco (TESO) which should be immune to slowdown, and which will rise as their non-sterling earnings go up."

Be careful about Tesco. First, it's predominantly UK-driven. Second, it has relied heavily in the recent past on growth in non-food sales, which are of course taking a caning. Third, its vast land-bank makes it a quasi-property company - and land values have nowhere near done falling. Personally, I'd see its bonds as a better bet than equity at the moment (disclosure: talking my own book).

"Britain should gain from what amounts to a competitive devaluation and looks attractive."

From this side of the Pond that seems like a bold contrarian call right now. Not necessarily wrong, but perhaps a tad early. Maybe quite a big tad.

2008 Dec 22 02:02 PM