Imagine a scenario in which one country, or a group of countries, had a slowing/struggling economy, their banking system was being forced to lower rates while across the oceans things were steaming full speed ahead, growth was strong and the banking system was tightening to slow the expansion. Because we live in a global economy, the weaker economy was being buoyed by the stronger to the point where it may have been its only saving grace. Clearly, we would imagine the weaker of the two economic systems had a currency that was faltering and public perception was that things were going to be bad for quite some time.
As you may have guessed I am describing the US versus the European economies, but I am describing the scenario that existed a decade ago when the Euro was first introduced and promptly dropped to less than 0.90 versus the US Dollar, while the US was propelled forward by the tech bubble and unprecedented productivity gains. The point is, these things are cyclical. Today the shoe is on the other foot but the US economy will not be weak indefinitely and the dollar will not slip into obsolescence. Our relatively weak currency and expansion outside our boarders are buoying the US economy and will likely be the driving forces averting an all out US recession.
There is no doubt there are still problems, some of them systemic, with the US economy related to the subprime contagion. The latest reports from Deutche Bank (DB) and Moody’s (MCO) suggest that there is somewhere around 250 billion dollars of high risk subprime debt that may need to be written down. That’s on a base of about 2.5 trillion dollars of subprime debt. Further uncertainty is likely to cause investor angst relating to home prices where a predicted 10% drop in home values would evaporate over 2 trillion dollars of net worth. Although that number is staggering, try to put it in perspective; according to the Wall Street Journal, nearly 7 trillion dollars of market capitalization was evaporated during the tech sell of the last bear market. And although there are plenty of consumers who will suffer from the reduction in home prices, keep in mind that the vast majority of homeowners are relatively long-term compared to those who invested in the volatile tech sector of the late 90s, so even though there may be short-term weakness in the US housing market the majority of homeowners will not be materially impacted.
The situation with subprime CDOs is spreading to high quality paper as well. Fearful investors are beginning to discount quality paper in an attempt to get a handle on risk. The Markit Group quotes indexes that track the tradable value of the riskiest CDO debt which is now at an all time low of 17.4 cents on the dollar, over 50% lower than earlier this summer when the troubles first began. Normally, quality CDO paper trades above 95 cents on the dollar, but today it is trading as low as 79 cents on the dollar. At least some of the weakness can be attributed to the uncertainties of the nearly 300 billion dollars of outstanding debt held by off-balance sheet vehicles known as SIVs. In the next couple weeks the 100 billion dollar bail out fund for the SIVs should be completed and provide a cushion for their valuations, hopefully placing a floor under investor uncertainty.
These factors seem to pointing to some important conclusions. It is likely that the choppy markets that we have been seeing since the summer are probably not over. With earnings season winding down, it looks as if management teams for the financial stocks tried what is known as the “kitchen sink” approach to reporting, meaning they wrote down everything in the house so that they might only get hit once. Although this probably seemed like a good idea at the time, it has led to a few high level job losses and skeptical investors continuing to pound the stocks for fear that it might not be the last right down. The sectors with the most exposure continue to be financials, builders, and consumer discretionary, all of which have relatively low valuations by historical standards and compared to the rest of the market. Although these sectors probably stand the most to gain, cautious investors will probably wait and see how the next couple quarters shake out before any kind of real buying returns to them. Meanwhile most other sectors of the economy remain relatively robust. Our quantitative work suggests that Industrials and Energy will continue to be areas that should be overweight.