From the December-January 2009 issue of Treasury & Risk magazine

Dark, Stormy, Murky...That's the Good News

Economists Stephen Stanley of RBS Greenwich Capital Markets, M. Cary Leahey of Decision Economics and Keith Wade of Schroders peer into the future.

How Deep is the Spending Valley? By Stephen Stanley

The current economic environment is without question the worst in at least a quarter century. The abrupt tightening in credit conditions has helped to bring about an awful set of economic fundamentals. Moreover, the series of financial market events seen in September and October has spooked business and households, leading to a sharp falloff in discretionary spending. As a result, the near-term outlook for capital spending is quite gloomy. The main question is whether business spending will continue to contract well into next year or rebound quickly. Business capital spending is broken into two main components within the official GDP data: outlays for equipment and software and nonresidential construction. The trajectories of the two often diverge radically. In the most recent recovery, spending for equipment and software bottomed out in early 2003 and posted solid gains from the spring of 2003 through late 2006, as businesses reloaded after sharply curtailing outlays in the wake of the late 1990s tech bubble. Meanwhile, nonresidential construction tends to lag the economy significantly. In fact, it is often the last sector to turn in an economic cycle, and recent experience was no exception. This category was essentially flat from 2003 through 2005, finally beginning to grow in 2006 and was still going strong through the summer of 2008, as builders worked through what had been a huge pipeline of projects even as their order books dried up.

In the final quarter of 2008, both equipment spending and nonresidential construction may have contracted together for the first time in nearly five years. On the equipment side, firms have gotten very careful with their budgets, and any outlays for non-essential equipment was likely put on hold. As a result, the period could rival the spring of 2001 as the worst quarter since 1980. Nonresidential construction appears to be in the process of turning drastically. Not only are developers finding it incredibly difficult to obtain financing, but with the economy contracting, the supply of office, retail and industrial space suddenly appears excessive. Thus, capital-building activity may have declined in the fourth quarter after 12 consecutive increases.

Unfortunately, it appears that capital spending will remain weak for most of 2009. Demand for equipment will not revive until two things happen. First, the financial environment has to begin to loosen up, so that high-quality businesses feel confident in their ability to raise money at reasonable expense. Second, and more importantly, firms will need to foresee stronger demand prospects for their products and services. Corporate decision-makers are, of course, forward-looking, so that they do not necessarily need to see the whites of the eyes of a recovery in consumer demand to generate renewed optimism, but there has to at least be a light at the end of the tunnel, and this may still be at least six months away. Thus, we look for business spending on equipment and software to continue to slide through next summer before finally stabilizing late in 2009. That would mark seven straight quarterly declines (beginning in early 2008), which would constitute the longest such streak since World War II.

The good news on the nonresidential construction side is that there was not as much overbuilding in the most recent expansion as in most prior cycles (as mentioned above, the sector only started to expand robustly in 2006). The bad news is that the tightening in credit in the commercial mortgage space has been calamitous in recent months. Between the severity of the economic cycle and of the credit cycle, this sector may contract sharply for much of 2009. Indeed, we expect declines in construction of business structures to persist into early 2010.

In short, the severity of the economic downturn suggests that capital spending will take a while to recover. By late next year, businesses may just be regaining enough optimism to act on plans that will have been on hold for an extended period. It will probably be 2010 before firms begin to expand their activity in a meaningful way and even later before the peak levels of 2007 to 2008 are revisited.

Help Wanted: Aggresive Recovery Strategies By M. Cary Leahey

It's shocking, but not hyperbole, to say that we face the worst economic conditions in at least 30 years and the worst financial market conditions since 1933, during the height of the Great Depression. Notably, the slump in U.S. and global manufacturing sectors has been rapid, recent and deep. Considering the monumental economic upheaval around the globe, public and private sector officials must cooperate internationally to implement aggressive recovery strategies. And they must come together quickly. Only then will the myriad of challenges be met.

There has been no shortage of talk since the financial universe began spinning out of control, but follow-through has been limited. Though most major economies have announced stimulus packages, the details are often sketchy and the implementation slow. That can't continue. A massive, coordinated series of country-specific stimulus packages must be adopted quickly to provide aid to distressed households, companies and local governments. These programs must be targeted, timely and temporary, so they do not extend budget deficits. Countries with large budgetary and trade surpluses should spend more at home and push through larger packages.

China is spending the most; more than 15 percent of its GDP. In other countries, packages of 1 percent to 2 percent appear to be the norm. In late November, the incoming administration of Barack Obama was mulling a U.S. package as large as 5 percent of the GDP.

In emerging markets, where upheaval has been especially dire, bigger and stronger countries must step in to provide assistance. The International Monetary Fund (IMF) and The World Bank already are leading financial aid programs, which must grow. And the Federal Reserve has announced currency swap arrangements with Mexico and other emerging countries.

To succeed, the best rescue plans will require a blend of capital injections and/or toxic asset guarantees and bank debt loan guarantees. The costs will be extraordinary, potentially requiring a contingent liability of as much as $8 trillion. The actual "losses," however, will likely be a small fraction of that. When implemented effectively, these plans will go a long way toward restoring confidence in private capital markets, which fundamentally depend on trust.

Morevoer, in the U.S. and other countries where housing markets are especially weak, policymakers should be finding ways to reduce delinquencies in an effort to stop home prices from falling further. The mortgage meltdown, after all, has been the root of U.S. economic problems, and an economic recovery depends on a housing recovery. Piecemeal approaches are not working fast enough; large-scale measures must be adopted. If necessary, U.S. bankruptcy courts should be allowed to restructure mortgages, which would require new legislation.

The crisis won't be averted, however, until financial services firms fulfill their traditional roles as credit intermediaries. The public sector has pumped enormous liquidity into the financial sector. But success is stymied if the "rescued" institutions do not use the proceeds to aid mortgage holders. It's especially critical that banks take the lead, because non-bank intermediation, in many cases, has dried up. Financial firms should remember that good loans can be made in bad times. Lending to creditworthy borrowers is more profitable than sitting on cash and it will help the global economy overall. What is good for a bank's bottom line is good for the economy.

Finally, nonfinancial firms must be ready to follow-up on profitable opportunities, despite the poor near-term economic environment.

But none of these global objectives will be achieved if policymakers abandon much discussed but long-overdue budget and economic reforms. In the U.S., president-elect Obama should follow-up on his promises to restructure the health care system and rebuild the public infrastructure. The next administration must finally find ways to reduce the medium- and longer-term budget gaps by cutting public health care and retirement spending. There is no time to waste.

Seeking the Bottom of the Downturn By Keith Wade

At some point in every downturn investors gain enough confidence to look beyond the immediate financial horrors to a brighter day. But with widening credit spreads and the worst equity market declines since World II, that prospect appears to be some way off. In the past, the conversion from cynicism to hope usually came at the moment of maximum gloom.

Traditionally, this moment has been a signpost pointing to economic renewal. Schroders' research shows that in nine of 10 downturns since 1900, market turnarounds have preceded economic turnarounds--pointing to a comforting trend. We found an average lag of 11 months between the trough in the Standard & Poor's 500 and the trough in earnings. The one exception was when the 2003 economic turnaround led the market by five months, but that was attributed to unique circumstances, including the tension created by the build-up to the Iraq war.

In this cycle, however, there have been so many potential points of maximum gloom, each of which has been superseded by another, that it's difficult to say when, or if, pessimism will bottom out.

It didn't occur in March when Bear Stearns collapsed, or in September, when Lehman Brothers fell, or, more recently, when the government bailed out Citigroup. The moment of maximum gloom will only become clear in hindsight.

So, ordinarily, we might look to another indicator to provide a degree of comfort--a compass to guide us out of the dark. For most of the last 100 years, markets have bet on monetary policy doing its job. The problem in the current cycle is that monetary policy is struggling for traction. The central banks have their policy rates such as the Fed funds in the United States, but there has been little impact on the economy because banks are not passing on rate cuts to their customers. Had they done so, we would have seen the first signs of recovery in September 2008.

Clearly, the usual indicators have failed. The transmission mechanism is not working and the cost of capital is out of control. After more than $900 billion of write-offs, banks in the United States and Europe are focused on conserving capital and rebuilding their balance sheets. To do this they are looking to increase their margins and raise the quality of their assets rather than expand the loan book. They have rediscovered risk, but such action is offsetting the efforts of the central banks to reduce the cost of borrowing.

This dislocation is borne out by fluctuations in Schroders' panic index (see chart), which captures the stress in money and credit markets as well as volatility across equity and fixed income. Having eased a little recently, the index is now heading back toward the levels experienced in the wake of Lehman's bankruptcy. Although no single factor can be identified as the cause, the U.S. Treasury's decision to not follow through on plans to acquire troubled assets from the banks has been a blow.

From a macro perspective the panic index signals that the cost of capital to companies and households remains high. Since the market sets the price for a range of loans, we know that the cost of all credit remains tight, a view confirmed by surveys of bank lending from the Federal Reserve, European Central Bank and Bank of England.

In effect, the central banks have lost control of the cost of capital, rendering monetary policy ineffective. Investors should look out for more dramatic attempts to kick-start lending. In the meantime, fiscal policy is being rolled out, but the consequence is that more than a year since interest rates started to tumble, investors are still peering into the abyss.


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