First Quarter 2009

The decline in the economy is now the most severe in postwar history. We believe that 2009 real GDP could decline in the U.S. by as much as 3.5% in 2009, and that unemployment, now 8.5%, could hit 10-11% by year end. The first quarter of 2009 is likely to be the sharpest GDP decline, with the second and third quarter demonstrating continued softness, albeit at a slower rate. The good news, however, is that classic leading economic indicators appear to be bottoming at multi-decade lows. The U.S. ISM manufacturing index has been stable now for three months, as have equivalent manufacturing indices in China, the U.K., and in Europe. Expectation levels are now so low, and have been so fully rebased downward, that we may have reached the point of maximum pain in the stock market, which is down some 50% from its 2007 highs. While we have experienced a sharp rally in March, the risk is still that we do not experience a “V” shaped recovery (which is very rare), but rather a “W” shaped recovery (plunge, rebound, and then another plunge).

The Federal Reserve’s policy of “quantitative easing” has provided lower long term interest rates through the purchase of long term bonds. The economic effect of this is the equivalent of a negative interest rate. As government bond yields have gone down, however, corporate bond yields have risen in the first quarter, demonstrating that a much hoped for boost in corporate credit has not yet taken place. In fact, while the Fed has been pumping unprecedented levels of liquidity into the market, the Obama administration’s stimulus package has still not really taken effect yet. What is more important for now is the Geithner bank recovery plan. Since last year, the Fed’s balance sheet has increased by 200%, which means that the monetary base has increased with bank reserves. The U.S. government and the Federal Reserve have spent, lent or committed $12.8 trillion, an amount just shy of the entire U.S. GDP.

What effects in the real economy has this flooding of money had so far? On the one hand, it prevented the banking system from complete collapse. On the other hand, the reserves which have injected in the banking system are not yet being deployed as loans. To demonstrate this, consider “M1”, the narrow definition of money supply (currency) whose growth (+19.8%) has been massive over the past 12 months, while bank lending has remained flat over the same period. When bank lending picks up again, the Fed’s measures will start to become more effective in the real economy. An economic rebound will also depend upon households and businesses starting to spend and invest once again. In the fourth quarter of 2008, personal consumption expenditures fell dramatically, by 4.3% on an annualized basis. In January and February this figure grew by 1% and 0.2% respectively, demonstrating that the worst consumer confidence may be behind us.

We have more cause for optimism by noting extremely low stock valuations combined with a reasonable probability that economic stimulus efforts in the US, China and Europe will have a significant effect, albeit lagged, on the economic and thus corporate profit outlook for 2010 and beyond. Leading economic indicators appear to have stabilized, and recently commodity prices and indices have been on the rise. It should be noted that institutional investors remain heavily underweight in equities vs. benchmarks even after this initial rally, with potential buying pressure thus building. A reduction in consumer debt is happening quickly and saving rates are increasing sharply as consumers decrease spending, refinance their mortgages at a lower rate, and face lower energy costs. On the pessimistic side, we face further bank write downs of toxic assets, GM bankruptcy, and ramping unemployment. Commercial real estate is showing serious weakness as rent prices fall and soaring vacancies have caused delinquencies to double since last year. Residential housing prices are still dropping, and mortgage delinquencies are at record highs (7.88% of all mortgage loans outstanding for one-to-four unit residential properties) in the fourth quarter of last year.

There is a strong likelihood, longer term, of another boom/bust cycle engendered by the overly stimulative response to this crisis by the Fed. Inflation is likely, unless the Fed drains money on a rapid and timely basis if and when the crisis abates. For this reason, we continue to advocate holding gold, TIPS (Treasury Inflation Protected Securities), and any other investments sensitive to a rise in commodity prices.

For the first quarter of 2009, the Dow was down 13.3%, the S&P 500 declined 11.7%, and the Nasdaq fell 3.1 %

Grant Rogers Elizabeth Allen

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