New Baseline from The Baseline Scanario

“Testimony to the Senate Budget Committee hearing on The Global Economy: Outlook, Risks, and the Implications for Policy, January 29, 2009.  Submitted by Simon Johnson, Ronald Kurtz Professor of Entrepreneurship, MIT Sloan School of Management; Senior Fellow, Peterson Institute for International Economics; and co-founder of http://BaselineScenario.com (a widely cited source for daily policy analysis on the global crisis.)”

Keep reading for Johnson’s 9-point summary, but the really quick summary is: Global Japan Scenario!  “There will be some episodes of incipient recovery, as there were in Japan during the 1990s, but this will prove very hard to sustain.”  (Follow the link above for the whole 12-pages of Senate testimony.  Also, look at past entries under the Japan Scenario category for background.)

Worthwhile Words of Caution

I posted yesterday that it is too soon to be too critical of the stimulus plan, but David Brooks has some good words of caution today.  Politics is a messy game and compromises are often required.  But, as critical as the stimulus package is, burdening it with Democratic agenda items that have been desired but unfunded for many years is not helpful to the task at hand – no matter how worthy they may be.

The world leaders assembled at Davos are also concerned about the inflationary impacts of a bill bloated with spending that is not exclusively stimulus in nature.  While deflation is the serious near-term threat, high inflation and US dollar devaluation remain longer term concerns.  World leaders, and David Brooks in his column, are worried that there is no clear exit strategy in the current spending plan.

Exclamation Point

Today put an exclamation point on the end of a week of really bad economic news.   Q4 08 GDP was the worst in 26 years.  Obama characterized the economy as a “continuing disaster”.  The WaPo headline was Economic Signs Turn From Grim to Worse.  The NYT headline read Steep Slide in U.S. Economy, but Not as Dire as Forecast.

As noted in the WSJ, the only reason that it was not as dire as forecast is because manufacturers were able to ship a bunch of products to stores and count that as revenue, even though the products are just sitting on store shelves.  With no sales, the stores will now cancel orders for new products and Q1 09 will see the GDP hit.

Manager Call Notes

As I have mentioned before, I am a fan of a small group of mutual funds categorized by Morningstar as “world allocation funds” and by Lipper as “global flexible portfolio funds”.  These funds allow the manager to essentially invest anywhere in anything, subject to some risk boundaries.  They let smart teams manage.

Today I participated in a call with the management team of a fund that is top-rated by both Lipper and Morningstar.  It was down -20.87% in 2008, but still handily beat the S&P 500 by approximately 16%.  Morningstar claims that over the past 10 years this fund has had average annual returns of 12.32% versus the S&P 500 at -1.38%.  So, it has an excellent track record.

The fund remains mostly invested in global equities, 77%, with the rest in cash (US and foreign), fixed income, and gold.

While I use this fund extensively, this is a much more aggressive allocation than I would recommend most clients have overall.  I am much less favorable to equities right now, but the fund clearly has an enviable track record so I listen to them closely.  Here’s the summary of their commentary:

• While 2008 was an extremely difficult year, they are confident that losses they incurred are temporary, not permanent.  They have avoided companies who have already failed or whose prospects are dim (e.g., financials and those that are over-leveraged).  They claim to be investors in companies with stable, defensible, global franchises, so asset values are depressed, not permanently destroyed.
• Equity prices are currently low enough globally to offer selectively attractive buying opportunities for long-term investors (meaning those willing to hold for at least 5 years).  The future is unpredictable over the more near term.  They are hopeful, however, that current US government stimulus activities will provide a bottom for the economy later this year.  No prediction was offered on when equity markets will bottom or recover (its “unpredictable”).
• While there are exceptions, fixed income is not a better buy than equities overall right now.  Defaults may hit the high end of the range implied in fixed income prices.
• Gold and foreign currencies remain a valuable hedge against “unmanageable, unintended outcomes” of US government actions.  Examples include inflation spikes and US dollar collapse.  Current gold prices, however, are inflated by historical standards and this is now expensive insurance.  (Commentary: their allocation to this asset class would seem to me to be too small to be an effective insurance policy.)

Drum Beat of Protectionism

In Davos world leaders are lining up to criticize the US for leading the world into global recession.  Frankly, they have a point.  Yesterday it was the president of Malaysia, today is was China and Russia.  Even Tony Blair spoke about the lack of morals in our current form of capitalism.

Add to that the displeasure in the EU with the “Buy American” provisions in the House version of the stimulus bill and the ugly face of protectionism is starting to be seen more clearly.  International investing now has a new set of risks.

WSJ: As the global economy struggles with the steepest recession since World War II, business and political leaders gathered here warned that a rising wave of protectionism could make things even worse.

Highlights

Not surprisingly, the markets were back down today after a short bit of enthusiasm yesterday on the emerging “bad bank” plan.  While this plan is helpful, the overwhelming drum beat of poor economic news continues.  Ford had the worst year ever in 2008, new-homes sales hit a record low, jobless claims saw a new high, business orders declined, more layoffs, further earnings downgrades, etc., all show that the economy continues to slide, making recovery this year less and less likely.

At this point, our near term prospects are governed mostly by two governmental programs: recapitalizing the financial system and stimulating the economy.  Progress is being made on both fronts, but plans are still being created.

There is plenty to criticize in both draft plans.  It looks like the bad bank plan will pay too much for the bad assets, further burdening taxpayers, and keep the same management in place that got us in the mess to being with.  The stimulus plan has some stimulus in it, along with plenty of Democrat and Republican sacred cows.

But, it’s too early to be too critical.  Something needs to be done and every available option has a host of problems associated with it.

IMF Sees Lowest Growth in 60 Years

This post’s title comes from the Financial Times, a similar story is in today’s WSJ.

FT: The International Monetary Fund slashed its forecasts for the world economy on Wednesday, saying that global growth would come almost to a standstill and that losses from US financial assets would top $2,000bn. (Note: that’s $2T in American English.)

The IMF cut its 2009 global growth projection to just 0.5 per cent, a huge downward revision from its previous 2.2 per cent forecast made in November.

WSJ: “A sustained economic recovery will not be possible until the financial sector’s functionality is restored and credit markets are unclogged,” the fund said in its update to its semi-annual World Economic Outlook.

The IMF called for new policies to force the recognition of losses and “sort” firms based on their chances of survival over the medium term. Governments should intervene to help viable institutions with capital injections, while resolving insolvent firms and carving out bad assets either through a “bad bank” approach or some other method, it said.

More Pain in Housing

WSJ: Banks and Investors Face ‘Jumbo’ Threat.  It turns out that the default rate is shooting up in a part of the mortgage market that was considered safe: affluent homeowners with prime jumbo loans.  The culprit: layoffs.

That means trouble for banks that made those loans when times were good and investors who snapped up jumbo loans packaged into mortgage-backed securities. Defaults on jumbo mortgages tend to result in especially steep losses for lenders, because pricier homes are tough to sell in the current market.

“There is more pain to come,” says Herb Blecher, vice president of analytics at LPS.

Daily Dose: Nationalize the Too Big to Fail Banks?

Today’s entry comes from the Washington Post.  Similar to the NY Times article of the other day, the WaPo covers the choices (all bad) and reinforces the sense of urgency to solve the problem inside the Obama administration.  As has been stated here before, the worst for the financial sector could still be in front of us.  That being said, news of some progress on this front is is being widely credited with today’s market rally.

Dr. Doom Strikes Again

Readers of this blog have heard this before from Nouriel Roubini, but he’s giving interviews at the Davos Forum.

Roubini said the U.S. government should nationalize the biggest banks because losses will exceed assets, threatening to push them into bankruptcy. The banks could be privatized again in two or three years, Roubini said. The professor reiterated his prediction that U.S. financial losses will more than triple to $3.6 trillion and that global equities will fall 20 percent this year from current levels.