For most of my career, with an exception here and there, there have been two persistent trends. One is that in the debt markets, the fundamental outlook has generally been good. You had persistently low inflation, mostly low volatility, and a growing economy. Sure, some bonds went bad, but for the most part, the fundamental picture was good. The problem was always valuation. You’d look at a corporate bond and see a whopping 100bps spread or something and it would seem like all downside, no upside risk. But of course, you had to buy something, so you’d hold your nose and buy it.
Now its just the opposite. The fundamental outlook is piss poor, but the valuations look extremely cheap across all risk sectors.
Risk assets are pricing in Armageddon. As long as no one spies any horsemen running around, those risk assets ought to pay off well for investors in the very long term. But that’s the real trick isn’t it? When to jump in?
I think the key to bond investing in 2009 is two fold.
1) Protect your liquidity. Professional investors, whether leveraged or not, never know when their clients will need cash. And the cost of turning bonds into cash has never been higher than now. Non-pros tend to underestimate the probability of needing cash, and frankly, non-pros don’t have as many resources for producing liquidity in bonds. No offense, but its true.
I believe that liquidity has probably bottomed, or put another way, that liquidity won’t get any worse than it is now. But when I say probably I mean like 65%. There is still a decent chance of another blow-up causing another spate of deep illiquidity.
That being said, bid/ask levels are going to remain very wide, probably for the next several years. We’ve seen improved liquidity in high-quality sectors, like agencies and munis, but even there, I expect liquidity to wax and wane with buyer demand. Remember that dealers used to be the guardians of liquidity. That’s gone and it ain’t coming back.
2) Buy what you can hold. This isn’t to say you can’t put money into a bond as a trade, but given how wide bid/ask is, and given that you don’t know when bids are going to suddenly disappear, you can’t assume you can flip a position. So when buying a bond, ask yourself: would I hold this bond for the next year? Two years? To maturity? Is this credit strong enough that, if I had to, I’d hold this bond indefinitely?
I argue that you shouldn’t buy anything in 2009 where you can’t answer that question with a confident yes.
So with all that being said, here is my basic economic forecast for 2009. I’ll follow this post up with thoughts on some of the major bond sectors. As always, I’ll discuss a most likely scenario along with a less likely but possible scenario.
Most Likely: Sharply negative real growth in 4Q 2008, continuing (at a less severe pace) at least through 1H 2009. 2H 2009 likely near zero. Meaningful recovery doesn’t start until 2Q 2010.
Less Likely: Government fumbles stimulus, and growth is negative through 2010 and possibly into 2011, with a deeper trough.
I think the immediate period after the Lehman/AIG/GSE/WaMu/Wachovia failures resulted in a massive pull back in economic activity. We saw it in Existing Home Sales in October/November, in auto sales activity, bank lending, everything.
That took what was already going to be a recession and turned it into something much worse. I had thought that mortgage foreclosures could bottom in mid-2009, because that seemed like long enough for the bad loans to burn out. But the sharp contraction in 4Q 2008 will result in much higher unemployment, I suspect around 10% by the end of 2009, and thus the foreclosure party will continue on.
And it will take a slowdown in foreclosures for housing prices to bottom. I suspect it will be government intervention that is the catalyst for this. We’ve already seen the government move to lower mortgage rates, which really should give us pretty good affordability. And while part of the initial problem with housing was over-building, but that ship has sailed. Housing starts have plummeted, and now all starts are pretty much multi-family or made to order.
Anyway, you need demand to outstrip supply in order for prices to start rising. As long as foreclosures are rising, that means supply is rising. Demand is going to be tepid until the employment picture improves. Rising supply and unchanged demand equals falling prices.
So I see home prices falling throughout 2009, absent direct government intervention either buying foreclosed properties or subsidizing banks to prevent foreclosures. Obama & Co. may actually take these steps, but I’d say it’ll take several months for such a thing to pass Congress, then several more months to actually be implemented. So we’re still looking at late 2009 at best.
GDP growth will probably be worst in 4Q 2008, then more modestly negative in 1Q and 2Q 2009. Beyond that is difficult to say. My base case is for 2H 2009 to be about zero real GDP growth, with a meaningful but tepid recovery in beginning in 2Q 2010.
The risk to this forecast is that the government bungles the bailout attempts, most likely by letting another financial institution fail. It currently doesn’t look like that’s their strategy, but then again, after Bear Stearns it didn’t seem like they wanted to let another institution fail. But then came Lehman.
Another risk to this forecast is…
Most Likely: Inflation? What inflation? The Fed will spend most of 2009 fighting deflation, although by 3Q or 4Q it will be apparent that the Fed will indeed win the battle. Headline CPI will print negative multiple times in 1H 2009, predominantly on falling food and energy prices.
Less Likely: We fall deeper into deflation, most likely because the less likely growth scenario comes to pass.
I’ve written a few times on deflation, which is truly the primary concern of the Fed right now. The Fed has plenty of tools to fight it, and Ben Bernanke is the right man for the job, having spent his academic life studying how the Fed blew it in the 1930’s.
I don’t see Japanese-style deflation taking hold, at least not for the same reasons as it took hold in Japan. The Bank of Japan maintained a ZIRP policy for many years to no avail. They still suffered from deflation. Why? Because you can’t get consumer inflation without consumer spending. I argued this multiple times when energy prices were rapidly rising. Energy doesn’t “create” inflation, rising money supply does.
But even in the face of rapidly rising money can’t create inflation unless consumers are spending. Right now, money is contracting and consumers are pulling back. In fact, those two things are usually correlated. But in the case of Japan in the 1990’s, consumers refused to spend despite massive fiscal and monetary stimulus.
But here is where I think the U.S. differs from Japan. The Japanese are fundamentally savers. Americans are fundamentally spenders.
Unemployment is going to be bad in 2009, heading toward 10%. But the other 90% of Americans will keep spending their income. Now they won’t be able to spend their home equity, as in the past, but basically we’re a nation of spenders. Once the American stimuli take hold, consumer spending will advance anew. That’s not to mention the fact that the U.S. Fed has been far more aggressive far earlier than the BoJ ever was.
Eventually this leads to some inflation problems, probably not till 2H 2010. To suggest that the Fed will provide just enough stimulus to avoid deflation but not create a significant inflation problem down the road is ridiculous.
Key to the Fed’s success is the progress on quantitative easing. The TALF is the quintessential example of QE, where the Fed targets interest rates away from overnight bank lending rates. There will be no limit as to how far the Fed goes to fight deflation. They could buy corporate bonds, municipal bonds, commercial mortgages, anything. Beware what you short!
However, if we get another big leg downward in economic growth, resulting in even tighter consumer lending conditions, then the deflation fight becomes more difficult. I’d still see the Fed eventually winning, but such an outcome would result in a much longer period of ZIRP and eventually much bigger inflation spike.
In the next couple days, I’ll be discussing my investment strategy around this forecast.