A Look Beyond the Crisis - Perry Piazza


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A Look Beyond the Crisis - Perry Piazza

  1. 1. A Look Beyond the Crisis<br />Perry Piazza<br />Director of Investment Strategy<br />Contango Capital Advisors, Inc.<br />December 2, 2010<br />
  2. 2. 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 />
  3. 3. 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 />
  4. 4. 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 />
  5. 5. What Happens After a Debt Bubble Bursts?<br />Typical aftermath:<br /><ul><li>Deeper than normal recession and a muted recovery
  6. 6. Deleveraging by the biggest culprits (consumers, in this case)
  7. 7. Austerity & reduced confidence to spend and invest
  8. 8. A flirt with deflation
  9. 9. Untested policy responses & political “tide-shifting”
  10. 10. Large fiscal response
  11. 11. Asset market(s) most affected (e.g., housing) usually fall for years
  12. 12. A shifting of relative economic strength to less indebted countries.
  13. 13. A transfer of risk from the private sector to the public sector
  14. 14. 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 />
  15. 15. 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 />
  16. 16. 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 />
  17. 17. Consumer Deleveraging<br />8<br />Household Debt / Disposable Income<br />Source: Ned Davis Research<br />
  18. 18. 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 />
  19. 19. 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
  20. 20. Machines replacing people
  21. 21. Failures of education system</li></ul>1991 “Jobless Recovery”<br />2001 “Jobless Recovery”<br />Source: Ned Davis Research<br />
  22. 22. Flirt with Deflation<br />11<br />Inflation (core personal consumption expenditure “PCE” y/y change)<br />Fed’s Target Range 1995 thru 2007<br />Source: Ned Davis Research<br />
  23. 23. Untested Policy Response<br />12<br />
  24. 24. 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 />
  25. 25. 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 />
  26. 26. 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 />
  27. 27. And Prices Keep Falling<br />16<br />FHFA House Price Index<br />Source: Ned Davis Research<br />
  28. 28. We’ve Also Had a Big Fiscal Response<br />I’m Back<br />17<br />
  29. 29. With Spending Far Exceeding Tax Receipts<br />18<br /><ul><li>During massive stimulus programs (like the New Deal), outlays widely outstrip receipts.
  30. 30. ‘Ammunition’ for the next battle becomes dangerously low.</li></ul>Federal Receipts<br />Federal Outlays<br />Source: Ned Davis Research<br />
  31. 31. 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 />
  32. 32. So We’re Getting Some Political Tide-Shifting<br />20<br />
  33. 33. 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 />
  34. 34. And Emerging Markets Have Outperformed<br />22<br />Performance of International Markets Since E/M Bottom<br />Source: MSCI<br />
  35. 35. E/M Strength Has Also Been Driving Up Commodity Prices<br />23<br />Source: Ned Davis Research<br />
  36. 36. 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 />
  37. 37. 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 />
  38. 38. 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.
  39. 39. Not easy enough = deflation and a dragged out Japan-style purgatory
  40. 40. 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 />
  41. 41. Part 2: The Fiscal Mess: Can We Overcome our Debt Burden?<br />
  42. 42. 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 />
  43. 43. 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
  44. 44. 16 workers per retiree in 1950
  45. 45. 3 workers per retiree today
  46. 46. We were in our China-like growth phase.
  47. 47. Fewer built-up entitlements.
  48. 48. WW2 had destroyed the competitiveness of much of the rest of world.
  49. 49. The UK did a lot of the work with inflation.</li></ul>Source: Niall Ferguson<br />
  50. 50. High Debt Has Led to A Crisis in Europe<br />30<br />PIGS = <br />PORTUGAL<br />IRELAND<br />GREECE<br />SPAIN<br />Yield Spread Over Treasuries<br />Source: Bloomberg, LP<br />
  51. 51. But It’s Not That Much Worse in the PIGS?<br />31<br />Government Debt to GDP (mid-2010)<br />Source: IMF<br />Harvard economist Niall Ferguson has coined the phrase the PIGS ‘R US.<br />
  52. 52. Unlike Japan, We Don’t Buy Our Own Debt<br />32<br />Source: Fusion IQ<br />
  53. 53. 33<br />Source: Fusion IQ<br />
  54. 54. 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 />
  55. 55. If We Don’t Get Smart<br />35<br />=<br />We’re Doomed to This Outcome<br />
  56. 56. Japan Has Been in a Slow-Motion Depression for 2 Decades<br />36<br />Source: Gluskin Sheff & Associates<br />
  57. 57. Similarities<br />37<br />Source: Gluskin Sheff & Associates<br />
  58. 58. Similarities<br />38<br />Source: Gluskin Sheff & Associates<br />
  59. 59. Similarities<br />39<br />Source: Gluskin Sheff & Associates<br />
  60. 60. Part 3: Contango’s Investment Themes for 2011<br />
  61. 61. 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 />
  62. 62. 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 />
  63. 63. 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 />
  64. 64. Part 4: Conclusions<br />
  65. 65. 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 />
  66. 66. 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 />
  67. 67. 47<br />Disclosures<br /><ul><li>This presentation is based on assumptions and market conditions known to Contango at the time this presentation material was prepared. Unless otherwise noted, all examples provided herein are hypothetical and for illustrative purposes only. Assumptions and market conditions are subject to change, which may affect Contango’s final recommendation after an Investment Policy Statement has been developed with the client.
  68. 68. Unless the investment is a deposit of a bank and insured or guaranteed by the Federal Deposit Insurance Corporation or other government agency, investments used in portfolios created by Contango are subject to losses.
  69. 69. Return information provided is hypothetical unless otherwise indicated. Additionally, return information represents the opinion of Contango. Information provided is not intended to provide specific advice, nor to be construed as a recommendation with regard to any particular investment or to provide any guarantee of results. The information contained herein employs proprietary projections of expected returns. Past performance is no guarantee of future results.
  70. 70. When constructing portfolios, Contango may use certain components that are subject to quarterly, semi-annual or annual redemption provisions. This may affect the liquidity of the portfolio and availability of funds.
  71. 71. Contango is not responsible for any clerical, computational or other errors that may occur as a result of using data from outside sources, such as pricing information obtained from standard quotation services.
  72. 72. All dividends and distributions are reinvested in the asset classes indicated for each portfolio consistent with the weighting for that asset class.
  73. 73. If included in this presentation, model results do not represent actual trading and may not reflect the impact that material economic and market factors might have if Contango were actually managing your portfolio.
  74. 74. If performance figures are provided, they are gross of Contango’s investment advisory fees and do not reflect costs and expenses associated with portfolio transactions or taxes. Actual portfolio returns would be reduced by Contango’s investment advisory fees and other expenses incurred in the management of its investment advisory account. For example, if Contango were to manage a $1 million portfolio from January 1, 2009 to December 31, 2009, an 8.00% annual return figure would be reduced by a management fee of approximately 1.38%. Contango's management fees differ according to size and nature of the specific investment portfolio. Please see Contango's Form ADV for full details.</li></ul>IMPORTANT NOTE: Investment products and services offered through Contango Capital Advisors, Inc., a registered investment adviser and a nonbank subsidiary of Zions Bancorporation, are not insured by the FDIC or any federal or state governmental agency, are not deposits or other obligations of, or guaranteed by, Zions Bancorporation or its affiliates, and may be subject to investment risks, including the possible loss of principal value of amount invested.<br />