Batten Down the Hatches

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BATTEN DOWN THE HATCHES

The Economic Outlook: Kathleen Stephansen, Credit Suisse

Last week I attended an investment conference at Credit Suisse and heard a presentation by Kathleen Stephansen, Director of Global Economic Research, which I believe was one of the most cogent and convincing discussions of the current economy that I have heard.

I thought I would pass it on to my clients and friends. I am subscribing to the conclusions and the view presented therein.

In very short summation: On the economic side, jobs and employment are headed lower; wage growth will slow down; income growth will be eroding; the surge in commodity prices will lead to higher inflation; reduced consumers’ real purchasing power will crowd out discretionary spending.

Downward pressure on house prices will erode wealth and continue to weaken demand. Inventories of new and existing homes are in a 10-12 months supply. Based on values relative to consumer disposable income, house prices could decline close to 20% from present levels. Illiquidity in the individual’s housing asset – can’t sell it, can’t borrow against it - will force homeowners to rebuild savings out of income. Consumer spending will be subdued.

Tighter credit standards on all types of mortgage loans and other consumer loans such as home equity, credit cards and autos will place additional pressure on the consumer sector, leading to a further erosion of purchasing power, income and wealth. Ms. Stephansen’s view is that the Fed signaled an end to the easing cycle through monetary policy (interest rates and money supply) which is their province, and passed the baton to fiscal policy (tax rates and legislation), which is set by Congress, and in my view, will not be determined until the next President and Congress take office in 2009.

Regarding output, the ISM (Institute of Supply Management) manufacturing report is consistent with sluggish GDP growth over time. An inventory build is developing and manufacturing activity is contracting. We have a bifurcated US economy, a weak domestic economy with weak domestic demand being buffered by a strong export performance. GDP growth is running at an approximate 1.5% growth rate currently, and is projected by Credit Suisse to drop to 0.7% in the second half of the year.

Cyclical indicators point to weak growth in both Japan and Europe with China and Asia (without Japan) expected to continue good economic growth.

Foreign capital is becoming less willing to finance our current account deficit, and a massive de-leveraging is beginning to take place. The number of financial transactions is declining rapidly which will lead to a large and bumpy contraction in that industry.

This is a pretty subdued assessment of the economy and certainly the state of the consumer in the year ahead, but I should say that a negative economic outlook does not always translate into a negative investment outlook, since, as we all know from experience, on some occasions a bad economy co-exists with a good market performance and vice versa – a condition of divergence between Main Street and Wall Street.

US/Global Equity Strategy: Jonathan Morton, Credit Suisse

Consistent with the bank’s economic outlook, Jonathan Morton of Credit Suisse presented the US/Global Equity Strategy, which I will summarize here as well. They believe that total losses related to the banking/credit crisis will total around $650 billion (the IMF is estimating losses of $1 trillion) which equates to 4.7% of GDP (compared to the S&L crisis which took 3.2% of GDP), and estimate that perhaps 56% ($365 B) of total losses have already been announced. They expect “a sluggish path to recovery”, estimating three years for bank-lending to recover in this cycle.

This equates to an L-shaped rather than V-shaped recovery, estimating annual GDP growth for the next few years beginning in 2009 at 2% annually. Recall that earlier I quoted Ms. Stephansen’s Credit Suisse GDP estimates at 0.7% in the second half of 2008.

In housing, this relates to a probable rise in delinquencies, foreclosures, and negative householder equity and a further decline in prices that Morton estimates at 10%. Morton’s conclusions on the US equity market follow:

1. It’s too early to go overweight banks

2. The risk premium on equities in general could remain high as the economy becomes more volatile

3. Focus on cheap, quality growth stocks

4. Continue to avoid expensive highly leveraged stocks in an environment of tight credit conditions

5. In particular, remain cautious of expensive small cap stocks.

Credit Suisse sees severe risks to economic growth emerging in Continental Europe with high risks relating to corporate earnings and high stock valuations, and words of caution: “be cautious of expensive US cyclical stocks that have high exposure to Continental Europe.”

The New Financial Paradigm by George Soros:

Finally, to make my week complete and to add another dimension to the big picture, I read the new book by George Soros entitled “The New Financial Paradigm.” As a matter of fact, I read it twice with my comprehension improving on each occasion. There is a third reading in my future. Dickens will have to wait. As has been widely reported in the press, Mr. Soros is extremely negative but his negativism is not devoid of hope. He recognizes the breaking of the housing bubble signaling the end of a long period of credit creation and an economic expansion of long duration fueled by that credit expansion. The end of bubbles and cycles is never smooth and will be rocky and jarring – pretty much the conclusion that Kathleen Stephansen reaches.

The new paradigm Soros speaks of is complex and refers to a change in the idea that views markets guided by the “theory of equilibrium” (the idea that markets are self-correcting and revert toward equilibrium) to be replaced by the “theory of reflexivity” (the interaction between the participants’ views and the actual state of affairs) that he has developed. The book gives no investment suggestions or “hot stocks” as would be expected. He predicts a further decline of house prices and a period of de-leveraging and credit contraction, pretty much representative of a popular view and consistent with Credit Suisse, rather than the bullishness and “everything is great” free-market pumping of  Lawrence Kudlow and the CNBC staff. So far, Soros’ book has only been released in electronic form for the Sony reader or Amazon’s Kindle reader, but will soon be in the stores and accompanied by a big publicity effort, so be prepared for televison appearances and a lot of gloom and doom.

Investment Ideas:

I have previously written of my belief that the depth of the financial crisis has passed with the well-publicized rescue of Bear, Stearns that facilitated the implicit quieter rescue of Lehman Bros. People have made self-righteous arguments and complaints about the absence of negative consequences as punishment for bad behavior and about what is perceived as weakness on the part of the Fed, but I am absolutely convinced that a Bear, Stearns’ bankruptcy on Monday, March 17^th would have resulted in a global financial catastrophe of nuclear proportions. The systemic collapse of banks and financial institutions was avoided which was a major positive outcome.

The Fed has established unique new lending facilities to the financial industry and has been aggressive with existing facilities as well as rates. It couldn’t be clearer that they have put everything on the table to avert collapse of the industry and its leading institutions. On the other hand, there has been no guarantee of any extraordinary economic stimulation to bring about a quick recovery from the anticipated slowdown. The financial stocks will struggle with an industry that has shattered and must be rebuilt anew. This would be consistent with Credit Suisse’s view of an L shaped recovery.

Run for the hills or stay in equities? Perhaps a bit of both. It is very difficult to make a case for medium to longer-term bonds except to stay very safe, which is why Treasury bonds are not even keeping pace with inflation. Recycling of our dollars now residing in the Mid-East with oil barons and Iraqi pilferers, and residing in China with party leaders are finding their way into the US Treasury market, earning a low rate of interest but keeping their best customer, the US, alive. In the meantime, those Americans who wish to save, are forced into markets where they earn a pittance, having pushed the more venturesome into higher-risk equities, real estate speculation, or high yield bonds.

In the equity market, however, I believe that there are some investment themes that are intriguing and some companies whose prosperity and growth during the difficult days ahead look promising. Fitting that criteria is the Technology/Internet sector, marked by large cap growth stocks with realistic price/earnings ratios, strong balance sheets (primarily debt-free,) serving global growth markets in Asia and elsewhere and immune from the real estate woes and financial problems in the US and Europe. Many of these high quality growth stocks are selling at prices fractional to 2000 pre-bubble levels, with much more meat on the bones. Invention has been active during these years, leading to products such as the iPhone, which has elicited “… the most important product of the still-young 21^st century” says PC Magazine in the June 2008 issue.

The Commercial Aircraft market is interesting as a long lead-time business, with two new jumbo planes being introduced (although a little delayed) and with huge backlogs stretching out for years. The industry is also witnessing major build-outs of Chinese and Mid-East airlines, and an aged and outdated American aircraft fleet. New demand for mid-size jets favor secondary manufacturers in both China and Brazil, and the wide use of lightweight carbon graphite fibers in the Boeing Dreamliner and Airbus 380, for example, benefits those specialty materials suppliers.

The Global Automobile industry looks extremely interesting with tremendous growth going on now in many emerging regions of the world, and an industry in which technology shifts are in active development in response to environmental consciousness and high energy prices. This push is here to stay and will create major opportunities in new propulsion systems - hybrids, lithium-ion battery powered vehicles, new automobile diesel engines, and hybrid diesel/electric transmissions for trucks. The near term US market outlook is uncertain for all the major domestic and foreign manufacturers as currency swings, credit tightening, labor strikes in the US, bankruptcies of parts suppliers and a consumer slowdown create an uncertain picture and it’s probably wiser to invest in this industry as the economy emerges from slowdown rather than enters it, which may occur later in the year, but I believe that the long-term opportunity will be outstanding.

The Energy industry including conventional oil and gas, drilling and services, and alternatives such as solar and wind, and the much maligned ethanol, offers selective opportunities, although a tremendous amount of investment money is already in these stocks and will come out in a giant whoosh at some point in the future. When? Don’t know but I am one of the people who feel that the supply/demand characteristics of the oil industry are not plagued by physical shortage, but rather by both financial and security premiums. I have communicated the idea to Senators and regulators, that an increase in margin requirements on futures trading would exert some limitations on speculative trading, and thus result in lower prices, but no one has heeded my message.

Global Infrastructure, i.e.roads, bridges, government buildings, schools, airports, in emerging markets and in the US (if we are able to leave Iraq and recapture some discretionary spending) will grow for years to come. Again, these are long lead-time businesses with growing backlogs. The US engineering, service and equipment companies who will continue to participate in the global spend appear to have bright futures.

Health Care and Biotechnology remains a promising investment area as the elderly population rises, and as Democratic initiatives of universal or expanded health care are likely in the near future. Hopefully, a new Democratic administration will shake up the moribund FDA and put American research and drug discovery back on a scientific course, rather than on the conservative, religiously obsessed path it has been on for the last eight years. Later this year, I expect new findings to be announced in the treatment of Alzheimer’s disease, diabetes, and cancer as well, and the widespread use of genetic identification and personalized gene treatment will lead to great advances. The companies in this industry are well capitalized which will promote consolidation.

Basic Materials and Agriculture remain somewhat puzzling at present valuations and while global demand is rising for food, the thinness of the markets has led to very high valuations. Investing abroad in India, China and Brazil through ETFs will continue as an important part of portfolio strategy. Private Equity seems to be set for a diminished role as credit availability contracts. The very recent major earthquake in China could have significant implications for the US market. Capital demands necessary for the rebuilding of the affected Chinese cities, may cause China to divert substantial funds from their US Treasury bond investments for use back home. That would cause interest rates to rise, unless our friends in the Mid-East step up to continue their life support. It was interesting that today, interest rates on the 10 and 30 year T-Bonds rose significantly as prices fell, suggesting perhaps an early validation of that idea.

Because of space limitations and my effort to avoid regulatory complications and filings, no individual securities are mentioned herein. If anyone has specific questions on individual stocks or other matters you are free to call or e-mail me.

Peter R. Mack, May 14,2008

The information, opinions, estimates, projections and other materials contained herein are provided as the date hereof and are subject to change without notice. Peter R. Mack & Co., Inc. has obtained materials from various sources and believes the information contained herein is accurate and reliable, but makes no representation as to its accuracy or reliability. No statements contained herein should be construed as a solicitation to buy or sell any security or investment product mentioned. Peter R. Mack & Co. Inc. and/or its employees may from time to time, buy, sell or hold long or short positions in any security or investment mentioned herein. Peter R. Mack & Co., Inc. does no investment banking and has received no compensation from any entity named herein.