Ernie's Three Observations for the Times

1. Combo pool shots and market uncertainty.
2. Banks aren't lending—Duh!
3. Portfolio rebalancing and "plan b."

By Ernie Ankrim, Senior Markets Advisor
Russell Investments

February 2009

While I typically constrain my comments to one topic, I have three observations that I feel compelled to share with you this month.

1. Combo Pool Shots and Market Uncertainty
I'm not good at pool and I've never played billiards, I know enough about physics to believe that there is a striking similarity between the challenges of a combo shot and the serious uncertainty that pervades today's equity markets. Bear with me on this one.

In the game of pool, the object is to strike the white (cue) ball with the pool cue, causing it to strike another ball into a pocket of the pool table. A combo shot involves striking the cue ball to hit another ball with the hopes that THIS ball will drive a third ball into a pocket. Every pool website I visited in preparing this column (you can tell from this description I'm no hustler) cautioned about trying combo shots except as a last resort because small errors in direction of the cue ball tend to increase errors in the objective outcome multiplicatively. Translation: errors in the first strike cause errors on the second strike which cause even larger errors in the direction of the third ball. I believe that we are in a similar situation in today's economy and the behavior of financial markets.

It is hard enough to formulate market expectations based on current and anticipated economic conditions. But in the current environment, market participants have to formulate a "combo shot" analysis in which we try to figure out what monetary authorities, Treasury officials, Congress and the Obama administration will be doing in the coming months to help us exit from the current recession. It is wise that these parties are not leaving a collapsing economy to its own fate. But given the scale of intervention that is being discussed, the combo of this "third ball" increases the uncertainty regarding when the economy will be improving, by how much and whether other unintended economic consequences might be on the horizon.

I'm cautiously optimistic about the economy and the markets this year. But things could turn out much better or much worse than I expect. If the Administration and Congress quickly institute policies expected by the market to be very effective, this could raise expectations of much quicker than expected economic improvements and thus substantial improvements in financial markets much earlier than I or most observers expect. Conversely, if conflicts and delays result in policies that the market believes will be ineffective, this could cause expectations of our economic future to be much worse than we now anticipate and might cause disappointed reactions to worsen the state of financial markets. I believe that, in the end, results of these actions will be good for the economy and markets — at least in the intermediate term. But the extreme outcomes possible from this economic combo have caused market uncertainty to be as great as I've seen in decades.

2. Banks Aren't Lending—Duh!
Much of the frustration being voiced in the media and in Washington seems to be aimed at banks that received funds from the Treasuries Troubled Asset Relief Program (TARP) but have yet begun to aggressively re-enter the lending business. My view is that expectations for this program aimed at only one element of putting the economy on the track to recovery (albeit an important one) were far too grand. The economy is stuck in a tough spot where businesses, financial institutions and households are all simultaneously trying to repair their balance sheets. Adding capital to financial institutions (the primary application of the first TARP funds) is a necessary but not sufficient condition for the economy to turn around. What we need more than anything is for spending to begin to rise. Lending can help make this happen, but availability of credit by itself won't get the job done.

The Federal Reserve has worked hard to make sure interest rates are low and liquidity is pervasive. But again, cheap funds do not by themselves spur spending.

For households, low borrowing rates must be accompanied by positive expectations regarding future employment and income as well as a willingness to lever up their own balance sheet. The current level of consumer confidence is at record lows. Given the stress most households have been through, along with the pain that over-extending their borrowing has imposed over the last couple years, it is hard to imagine re-levering will be happening again in large measure anytime soon.

For businesses, lower cost of capital for investments is helpful, but with continued economic weakness only the most optimistic firms are thinking expansion of plants or markets. In addition, current costs of intermediate or long-term borrowing for firms are higher now than in any recent time. Only the U.S. Treasury is currently able to borrow at historically low rates, as investors seek the safest investments possible.

Finally, for the few households or firms that might be willing to borrow, many of the banks that took advantage of the capital injections from the first round of TARP have been reluctant to lend. But this reluctance is understandable given the frail nature of the current economy. Critics railing for more aggressive lending would be asking the lending institutions to repeat their mistakes of the last few years: making loans to parties with significant risk that future economic circumstances would leave them unable to make their loan payments.

What we need is a significant fiscal stimulus (in either the form of tax cuts or spending programs) that could provide firms and households confidence enough that expenditures in business or personal assets could be taken on without serious threat of facing a replay of the current challenges they face. It is also important that a sense of permanence exist in the spending or tax cuts if we expect firms and households to make significant financial commitments on the basis of these policies.

Banks will begin lending again when they see economic strength on the horizon that allows them to believe that borrowers have a reasonable chance of making the payments. Likewise firms and households will begin spending again when they believe they can do so without putting themselves in even greater economic danger. This will happen when both the policies to unlock the credit markets AND the spending jumpstart to the economy is in place and well understood.

3. Portfolio Rebalancing and Plan B.
As I've often written, the benefits of a long-term asset allocation require a long-term commitment to keeping the allocation in place. I still believe that the market lows we saw on November 20, 2008 will not be seen again. I don't believe it a coincidence that the data we have on investors getting out of stock market mutual funds indicate that October and November saw the biggest outflows in the last 25 years. I believe that there is a good chance we'll look back on the index levels of November as the bottom of this market.

On the other hand (doesn't it bug you when economists do that?) we currently face the simultaneous record differences between interest rates on Treasury and Corporate bonds along with the record levels of equity volatility. These two developments present an interesting alternative "Plan B" for investors frightened by equity risk but wanting to participate in an improving economy.

Corporate bonds may benefit from any improvement in economic progress and reversals in the dismal levels of confidence we currently see. This is exactly the opposite of what worked last year when the safety of Treasuries was so aggressively sought by fearful investors, leading them to be the best investment for 2008. It also caused the interest rates on corporate bonds to rise dramatically.

From June 30 1989 through the first three weeks on this year, the average difference between Treasury and Corporate interest rates was about 1.9%. Today that difference is about 6.5%1. The previous record difference before 2008 was 3.7% in October 2002. If any of my expectations about progress on economic or financial improvement are correct, and we see shrinkage of these spreads even half-way toward the old record, the returns on investment grade corporate bonds could easily find themselves in the low- to mid-teens for 2009. While our expectations are that equities could do better than this, taking risk into account this would be a very generous return for the year. Keep in mind that the returns on corporate bonds are not without risk. The risk of default on corporate bonds is higher than Treasury bonds. This explains the normal spread between their yields. That current fears are significant, the current spreads are more understandable. However, my view is that the fears reflected in these spreads are greater than what will have turned out to be necessary to compensate investors for these risks. As always of course, I could be wrong.

Here's Hoping . . .
I'll probably go back to my tradition of taking on one topic at a time next month, but I hope this diversion from form presents you with a perspective on where we've been, where we are right now and where we might be by year end. This year won't likely be easy, but at least 2009 (unlike last year) might be rewarding.

¹ As measured by the Barclays Capital U.S. Baa Average Option Adjusted Spread. Source: Bloomberg

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Barclays Capital U.S. Baa Average Option Adjusted Spread: An option adjusted spread is a measurement tool for evaluating yield differences between similar maturity fixed income products with different embedded options. In this case, it's measuring bonds in the Barclays Capital U.S. Baa Average, an unmanaged index consisting of bonds rated Baa versus similar maturity Treasury bonds.

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First used: February 2009
RFS 09-1577