The State of Financial Markets and U.S. Dollar in 2009, Part II

Includes: AMGN, IBB, UUP, XBI
by: Amit Chokshi, CFA

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While credit conditions are easing, banks are still insolvent and commercial real estate will pose further strains on capital markets in 2009. Although one can’t predict the actions of any government, on the surface commercial real estate does not appear to be as strong a “bailout” candidate as residential real estate and banks. In 2009, commercial REITs, specifically what some believe is the safe apartment sector, could be at risk. Some apartment REITs are located in areas where housing has experienced major corrections. With home prices falling significantly and mortgage rates continuing to decline, home sales could be set to moderate from the severe declines experienced over the past 18-24 months. Simply stated, owning a home in certain previous bubble territories is getting cheaper while some apartment REITs expanded capacity during 2004-2007. These apartment REITs borrowed considerably on the assumption of high rental rates. However, in 2009, with so many homes on the market that are becoming increasingly attractively priced, a supply/demand imbalance in certain markets has arisen where homes, now priced to move, and apartments, are in tight competition. This matters because apartment REITs have considerable debt loads based on the assumption of high rental rates which will come under pressure as vacancies rise due to economic strains and also competition from the glut of homes available in certain markets.

So despite a major drop across REIT share prices, apartment REITs could face significantly more downside in 2009. Life insurance companies, especially those with commercial real estate exposure, may also not be out of the woods in 2009. Life insurance companies were aggressive buyers of commercial real estate and while the broader markets have appeared a bit more stable and the assumption that this is now “old news” may perpetuate, if commercial real estate experiences difficulty as the recession increases in severity in 2009, more pressure could be exerted on life insurance companies. This sector is also facing similar dynamics to those companies that maintain defined benefit obligations. Life insurance companies have long offered guaranteed annuities, essentially promises to pay 5-8% annually. With markets down substantially and lack of transparency surrounding the broader portfolios of life insurance companies, this sector may experience difficulty in making good on those payments. Life insurers that face a shortfall in funding these annuities may need to issue stock, diluting existing holders, or they may seek government assistance, presenting a political risk as taxpayer capital would be used to pay out annuity holders. So while shorting everything in the financial sector may not be the slam dunk it was in 2008, certain REITs and life insurance companies could present shorting opportunities with substantial upside in 2009.

That said, individual and institutional investors should still recognize that the financial sector could provide long opportunities in 2009. As previously stated, some areas in corporate, investment grade bonds could offer solid risk adjusted returns where coupons are stable and the bonds are priced at a significant discount. As markets ease, holders of these bonds would experience attractive total returns with the combination of the coupon and increasing values for bonds. High yield could start to offer opportunities later in 2009 once defaults really start setting in. Individual and institutional investors could both benefit from backing analysts and funds that have the credit abilities to successfully navigate these markets. Last, banks will struggle to lend but this could present a huge opportunity for institutional investors. The notion that banks will continue to struggle may sound as a major contradiction to the initial statement that financial markets will stabilize. Banks will lend to solid credits. Despite the difficult economic conditions, there are companies that are sound credit risks that banks will lend to but in many cases banks and their executives have all been swimming naked such that nobody really has confidence about where the next hole in the balance sheet will arise. Each hole is expensive and this is what some people struggle to understand.

I’ve been asked by some friends about why banks have not stabilized despite all of the money poured into them. The main reason is to simply understand that banks can maintain $8-$12 in assets against $1 in equity. To make things simple, if a bank has $10 in assets and $1 in equity and $1 of those assets are bad, the bank is in major trouble. Some of these banks maintained far more leverage than that, meaning it takes even fewer bad apples to wipe out a bank. So while equity markets are forward looking, banks are still facing problems “on the ground” because the recession is picking up steam and defaults will increase. Banks and taxpayers went through hell with recapitalizations for the problems in the residential mortgage market and the derivatives tied to those, but problems in commercial real estate, consumer credit (credit card), and corporate lending could all start to rise significantly, making banks nervous about using any capital received by the government to lend. A bank could nervously be sitting on a set of loans tied to commercial real estate that it is marked at a slight discount to par but internally they expect the loan to be a non-performer. Given information asymmetry, bank executives have no intention of coming clean but the knowledge internally that there are many more problems with their assets would make them less willing to lend out any of the capital received by the government since they may very well need that money to plug future holes in their balance sheet. This is also why hyperinflation, as some predict, should not be a problem. The issue for a bank knowing it has more problems on the horizon as defaults creep up should help people realize that a lot of this government funded capital is going into a vortex and being vaporized as soon as it goes into some of these banks as it’s set to be used for very certain, upcoming defaults and not for lending and expanding the money supply.

However, while banks will struggle, institutional investors may be able to benefit from the formation of origination funds. Rather than back funds that invest solely in the secondary fixed income market, institutional investors could benefit from investing in funds formed that focus solely on origination. Since banks will be far more selective with lending in 2009, pricing will favor those that have the ability to lend. This could be a step up from the traditional mezzanine fund whereby funds raised for lending in 2009 could lend across the capital structure, senior and subordinate, and due to the financial market constraints, could procure equity kickers such that blended returns could range from 15-20+%. Institutional investors on the hook for commitments to large leverage buyout firms that plan to free themselves from those commitments may find better risk adjusted returns by investing in these types of funds.

Respect for the USD?

Some people expect that US monetary policy will prompt the risk of hyperinflation, resulting in a USD that will basically be toast. Over the long-term, the USD and many fiat currencies could be toast but the point is if the USD is trash, other currencies will be even worse at this point. I expect the USD to maintain strength in 2009 due to interest rate differentials and growing problems in some other previously favored sectors. The EUR was viewed as a “better” currency because the European Central Bank (ECB) had a single mandate of controlling inflation. Inflation is not a risk, deflation is the real risk, and that will spur the ECB to cut rates more than most expect.

Second, one would not be surprised to see the ECB alter its mandate of solely inflation fighting. This is due to the inclusion of more emerging, Eastern European countries to the EU. These countries have different economic and financial needs than mature western economies and in some cases maintain significant current account deficits. Focusing solely on inflation could place significant strain on these younger, emerging economies that maintain these deficits. As for other currencies, the GBP is tied to a country that is experiencing a credit-induced hangover worse than the US, so there’s little reason to expect the GBP to strengthen against the USD. China’s GDP growth is expected to be in the 6% range when in recent years, GDP was 10+%. Given China’s reliance on exports, it has every incentive – political and economic – to maintain a cheap Yuan. Many Chinese citizens were pulled from poverty over the years due to its massive growth in exports and as the US consumer retrenches, China will want to make its exports as affordable as possible to the world to avoid any social or political backlash as manufacturers go out of business and Chinese citizens face the prospect of major economic hardship.

With the US at a Zero Interest Rate Policy (ZIRP), it’s only a matter of time for other central banks to do the same and get to what is a practicable policy in those regions. Eventually, when the economy does turn, the US may be in a position to raise rates first. The combination of these aspects could work to maintain a stronger USD longer than most expect.

Some Additional Ideas

There are a few additional, less developed ideas investors should consider. Treasury yields are considered unsustainable with yields virtually at zero and the general consensus is that investors should short Treasuries. Yields may have been artificially depressed by banks which received federal money through the Troubled Assets Relief Program (TARP). In these instances, banks may have purchased 3-Month Treasuries when they received TARP aid, depressing yields. However, as credit conditions ease, banks may unwind some of their Treasuries holdings, resulting in higher yields.

Another area investors may want to consider is biotech. I recall a recent report on Bloomberg television discussing the capital constraints of many small biotech companies. I can’t recall the precise numbers but I believe the stated number was that of 370 publicly traded biotechs, 120 are expected to burn through their cash balances in the coming six months. This may sound like a sector to short but the dynamic of the industry presents a possible attractive long opportunity. Many small biotechs with cash and liquidity issues could have promising drugs in mid-stage development but lack the financial resources to carry out the testing to the final stages.

In contrast, mature pharmaceutical companies have liquidity but patents facing expiration. To bridge that gap, pharmaceuticals need to bolster their drug pipelines which would lead them to considering biotechs with promising ideas. Even mature biotechs like Amgen (NASDAQ:AMGN) can gain from purchasing some of these smaller biotechs. For investors that don’t have the competency to select individual biotechs or are not invested with biotech fund managers, ETFs likeXBI and IBB can allow them to participate in a possible uptrend in the industry.

Parting Thoughts

While I’m not optimistic on broader equity markets, it appears that they now present a more tradable environment than in previous months. However, the euphoria tied to stimulus programs and the initial inclination for many fund managers to not want to miss out on an upswing in the early part of 2009 and lag the market may subside by Q2 09. It’s important to note that disappointing earnings are what drive bear markets and while the general consensus is that markets will recover in H2 09, this could prove optimistic. Couple this with the fact that the more seasoned investment professionals came of age during the strongest bull market in history from 1982-2000 and suffered just a mild recession in 2001, there’s little real experience or tangible “feel” to what a serious downturn is like. Nonetheless, there are some securities with sound capital structures, solid cash flows, and most importantly attractive valuations that can offer investors some upside. Stocks that offer these characteristics along with attractive dividend yields could be a good addition to investor portfolios but investors would also benefit from seeking out some sort of equity hedge component to insure against market reversals.