A Look Beyond the Crisis<br />Perry Piazza<br />Director of Investment Strategy<br />Contango Capital Advisors, Inc.<br />December 2, 2010<br />
Part 1: Crisis Review, Deleveraging Update & Economic Forecast<br />Part 2: Our Fiscal Mess – Is There Hope?<br />Part 3: How to Invest in 2011<br />2<br />
Setting the Scene<br />A debt bubble began to form in the mid 1990s and continued into the last decade.<br />It was exacerbated by:<br />Abnormally low interest rates.<br />A strong rally in the price of an easily leveragable asset – housing<br />A fundamental switch, from cash-flow based underwriting standards to asset-based underwriting standards.<br />Fast growth in computer power and the ensuing ability to securitize all manner of assets.<br />A miscalculation of risk by the ratings agencies.<br />Abdication of regulatory responsibility.<br />The debt bubble began to burst in 2007 when housing prices cracked and finally gave way fully in 2008 when Lehman Brothers failed.<br />3<br />
The Debt Bubble in Hundred-Year Perspective<br />4<br />Total Debt as a Percentage of GDP in the USA<br />… and probably again in 2008<br />Includes Government + Household + Corporate Debt<br />A large debt bubble burst in the 30s …<br />Source: Ned Davis Research<br />
What Happens After a Debt Bubble Bursts?<br />Typical aftermath:<br /><ul><li>Deeper than normal recession and a muted recovery
Deleveraging by the biggest culprits (consumers, in this case)
Austerity & reduced confidence to spend and invest
Asset market(s) most affected (e.g., housing) usually fall for years
A shifting of relative economic strength to less indebted countries.
A transfer of risk from the private sector to the public sector
Periodic “aftershock” crises.</li></ul>Recommended Reading<br />.<br /><ul><li>2007 – 2009 was the first severe credit recession since the 30s.</li></ul>5<br />
Deeper Than Normal Recession<br />6<br />Quarterly GDP Growth in the United States<br />Source: Bloomberg, LP<br />The amplitude of economic activity has moderated greatly in recent decades<br />
Muted & Well-Below-Par Recovery<br />7<br />Performance of Coincident Indicators vs. Average of Last Six Expansions<br />What’s Normal<br />What’s Not<br />Average increase in above economic variables, 34 Months after the start of a recession<br />(includes last 8 recessions with the exception of the truncated 1980 recession)<br />Current “Recovery”<br />Source: Ned Davis Research<br />
Consumer Deleveraging<br />8<br />Household Debt / Disposable Income<br />Source: Ned Davis Research<br />
Austerity<br />Cumulative Net Worth in Trillions of All US Households<br />To repair their net worth, individuals (representing 70% of our economy) save more and spend less. Confidence is eroded, leading to fewer purchases of “big ticket items (homes & cars, for example). <br />3 Decades of the U.S. Personal Savings Rate<br />Individuals Feel Poorer<br />So they save more<br />?<br />Source: Bloomberg<br />Compounding the problem, the baby boomers are now quickly approaching retirement.<br />9<br />
10<br />Reduced Business Confidence + Structural Problems = Weak Hiring<br />Performance of Private Nonfarm Payrolls<br />Millions of Employed Americans<br />Average of Last 6 Expansions<br />Why?<br /><ul><li>Outsourcing
As a Result of Unconventional Monetary Policy, Fed’s Balance Sheet Has Increased Substantially<br />13<br />QE2 Begins<br />Federal Reserve Balance Sheet<br />Black Dotted Line = GSE (Fannie & Freddie) Debt<br />Red Dotted Line = MBS<br />Blue Line = Treasuries<br />Green Line = Total Securities Held<br />QE2<br />QE1 Begins<br />End Treasury Buys<br />End QE1<br />Securities Held by the Fed<br />QE1 Expanded<br />Source: Ned Davis Research<br />
The Fed’s Actions Have Effectively Engineered Lower Rates<br />14<br />30-Year Fixed Mortgage Rate<br />2-Year New Car Loan Rate<br />Sources: Haver Analytics and Gluskin Sheff & Associates<br />
But Demand Hasn’t Significantly Picked Up for Housing<br />15<br />Mortgage Bankers Association: Mortgage Loan Application for Purchase (seasonally adjusted)<br />Conference Board: Consumer Confidence Survey: Plan to Buy a Home Within Six Months<br />Sources: Gluskin Sheff & Associates, Mortgage Bankers Association, Conference Board<br />
And Prices Keep Falling<br />16<br />FHFA House Price Index<br />Source: Ned Davis Research<br />
We’ve Also Had a Big Fiscal Response<br />I’m Back<br />17<br />
With Spending Far Exceeding Tax Receipts<br />18<br /><ul><li>During massive stimulus programs (like the New Deal), outlays widely outstrip receipts.
‘Ammunition’ for the next battle becomes dangerously low.</li></ul>Federal Receipts<br />Federal Outlays<br />Source: Ned Davis Research<br />
And Federal Debt Rises<br />19<br />U.S. Government Debt as a Percentage of Our GDP (post war period)<br />State and Local Government Debt<br />GSE (Fannie & Freddie) Debt<br />Treasury Bonds Outstanding<br />Treasury Bonds Held by the Public<br />American Recovery and Reinvestment Act of 2009<br />Source: Ned Davis Research<br />
So We’re Getting Some Political Tide-Shifting<br />20<br />
Economic Strength Is Shifting<br />21<br />BRICs - Brazil, Russia, India, China – (in billions of dollars)<br />Sources: JP Morgan & Emerging Markets Management, Inc.<br />Point: Emerging economies are growing and becoming more and more important<br />
And Emerging Markets Have Outperformed<br />22<br />Performance of International Markets Since E/M Bottom<br />Source: MSCI<br />
E/M Strength Has Also Been Driving Up Commodity Prices<br />23<br />Source: Ned Davis Research<br />
A Bright Spot Has Been Large U.S. Corporations<br />24<br />Source: Ned Davis Research<br />S&P Sales Growth, Earnings Growth, & Profit Margins<br />
Why Are Large U.S. Corporations Doing So Well?<br />The “blue chips” are selling globally and have tapped into the best growth areas well.<br />Have extracted huge productivity gains in recent years<br />Labor outsourcing has helped improve margins; global supply chain reduces costs and improves quality.<br />They’re benefiting from ultra-low borrowing costs right now.<br />They have captured market share from small business and failed competitors.<br />25<br />Apple Store - Beijing<br />McDonalds - Shanghai<br />
Conclusions: Part 1<br />Consumer deleveraging is ongoing and will continue to crimp growth.<br />The crisis has generated deflationary tendencies, which are being fought aggressively with monetary and fiscal stimulus.<br />Government demand has partially substituted for private demand, but the recovery remains subpar by historical standards.<br />With a super-high debt level, the government has few “bullets” left. In any case, the Tea Party crowd will probably fight any new stimulus.<br />Active policy cycle means policy mistakes are a key risk:<br /><ul><li>Too easy too long = inflation and asset bubbles.
Not easy enough = deflation and a dragged out Japan-style purgatory
Too much fiscal response = possible Greek/Irish-style debt crisis</li></ul>There are two bright spots: both blue chip corporations and most emerging market countries are posting very decent growth.<br />26<br />
Part 2: The Fiscal Mess: Can We Overcome our Debt Burden?<br />
Federal Debt to GDP at a New High<br />28<br />US Treasury Debt Relative to GDP (postwar period)<br />Source: Ned Davis Research<br />Is it possible to crawl out from under such a debt burden?<br />
U.K.<br />U.S.<br />It Is Possible<br />29<br />US and U.K. Post War Debt Burdens (Debt to GDP)<br />But …<br /><ul><li>Demographics were much more favorable in the ‘50s
We Can Do It if We …<br />Change the tax system and expenditures to foster growth.<br />Accept that you cannot have a universal provision of social benefits.<br />Eliminate debt via some inflation.<br />Encourage a rebalancing of the economy away from consumption and toward investment.<br />34<br />
If We Don’t Get Smart<br />35<br />=<br />We’re Doomed to This Outcome<br />
Japan Has Been in a Slow-Motion Depression for 2 Decades<br />36<br />Source: Gluskin Sheff & Associates<br />
Part 3: Contango’s Investment Themes for 2011<br />
How to Invest in 2011<br />In a slow-growth low-yield world, growth and income should carry a premium.<br />Invest in growing global franchises with cross-border brand appeal.<br />Invest in companies with strong free cash flow – especially ones that pay decent and fair dividends.<br />Avoid companies with high commodity input costs.<br />Emerging market assets are OK for now but a bubble may be developing.<br />Some inflation is a goal of the Fed – keep a real asset allocation except at exuberant extremes (TIPS, commodities, real estate, infrastructure, MLPs)<br />Avoid long-duration fixed-income assets when inflation is a Fed goal.<br />Push cash (zero-duration paper) into 2-year corporate paper – the Fed is on hold for at least 18 months.<br />Avoid the detritus of the last bubble (domestic real estate and financials) for 5-10 years (tech stocks are finally rallying after crashing 10 years ago and look good).<br />Stock markets will grind higher but we’re past the best part of the rally and …<br />Multiples (P/E ratios) remain in a bear market.<br />Sideways patterns last for 15 or 20 years.<br />In this environment be tactical – not a buy-and-hold investor.<br />Use valuation measures to avoid extreme bubbles but allow for some momentum.<br />41<br />
100 Years of the Dow Highlights a Few Secular Bear Markets<br />42<br />Dow Jones Industrial Average (log scale)<br />Source: Bloomberg, LP<br />Secular bear markets last an average of 15 years.<br />
Don’t “Buy and Hold” During Secular Bear Markets …<br />43<br />Offer Big Trading Ranges – Just Don’t Be a Buy-and-Hold Investor<br />Source: Bloomberg, LP<br />
In Review<br />The debt bubble had many causes and ultimately burst in late 2008.<br />“Soggy” growth to continue in the U.S. on the back of an ongoing consumer deleveraging cycle.<br />Across the globe, the bursting of the debt bubble has shifted risk from the private to the public sector.<br />Bond investors have become vigilantes against the worst offenders and are picking off the Euro peripherals.<br />But the peripherals are not in that much worse shape than the reserve countries.<br />The emerging world is growing at a good clip but asset prices are getting frothy.<br />Corporations are doing well and have tapped into pockets of growth around the world.<br />Equities have rebounded from their lows but remain in a secular bear market.<br />45<br />
Common Sense Advice for CEOs & Directors<br />Try and tap into rapid growth in the emerging world (especially the BRICs).<br />Establish overseas sales channels in the BRICs.<br />Look for and try and sell to companies that have “cracked the code” and are doing well in the emerging markets.<br />Some employees should be bilingual (Chinese, Spanish, Korean are important languages).<br />Work on developing your brand.<br />Everyone’s online now – improve your non-US-facing web presence if you’re looking to sell to the emerging markets.<br />Geo-economic risks have made the currency markets quite volatile. Keep an eye on the foreign exchange markets.<br />Commodities remain in a long-term bull market. If you manufacture, watch all of your commodity markets closely and consider hedging.<br />Government customers will be much more frugal than in the past.<br />Consumers will look for price points on the value side of the spectrum.<br />46<br />
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