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Market Strategy
2009 Outlook
OVERVIEW
Sometimes the unthinkable does happen. Consensus expectations for a normalized
economic recovery in the second half of the year are likely to be dashed. Despite the best
efforts of President-elect Obama and Congress, economic recovery will likely evolve into a
2010 story. In our judgment, market expectations price in neither the severity nor longevity
of the current recession—a retest of last November’s lows the logical outcome.
Nonetheless, in the near term the market may seek solace in positive rhetoric emanating
from Washington around the inauguration, and rally in the hope that a solution to the
nation’s ills is in the offing.
We have updated our global allocation model and model portfolio of exchange-traded funds
(ETFs), which is one approach to implementing a global allocation strategy. Strategy and
sector allocation is done by Steve Gluckstein while coverage and selection of individual
ETFs is provided by Kris Rollenhagen.
2009 Outlook—The Big Picture 2
The Fed Rolls Up Its Sleeves 4
Surprise: a $2 Trillion Deficit 5
Housing Recovery Still Remote 6
Employment Leads The Way Lower 7
The Lending Paradox 8
Consumers Say Goodbye Not Buy 9
The Next Shoe to Drop: Commercial Real Estate 10
Add It All Up: Economic Recovery Pushed Out to 2010 11
When The U.S. Sneezes, The World Still Catches Cold 12
Global Asset Allocation Model 14
Global ETF Model Portfolio 18
2009 Outlook—the Big Picture
The era of debt-fueled asset inflation and growth is over. In its wake is the unresolved battle between
the opposing forces of debt deflation and central-bank-induced reflation that will likely be the dominant
story for 2009. Desperate to avoid the economy pitching into a deflationary spiral, the Fed has
embarked on the path of quantitative
easing that will witness expanding forays
into uncharted policy waters over the next
several months. After a number of
missteps in 2008 (most notably allowing
the bankruptcy of Lehman Brothers), the
Fed has moved aggressively with growing
consistency and success to allay fears of
systemic risk to the financial system
through massive injections of liquidity. Yet
it still remains to be seen what action the
Fed implements to overcome the negative
influence of that continues to pull the
economy into a steepening contraction (we forecast -3.5% GDP for 2009). Regardless of what
initiatives the Fed takes or what fiscal stimulus the incoming Obama administration enacts, our view is
that they cannot prevent 2009 marking the deepest and longest recession of the post-war period.
The deteriorating employment numbers point toward an economy in freefall. We believe that the
economy contracted by more than 5% in the fourth quarter, with little likelihood of material improvement
in the current quarter. While pink slips multiply as business investment gets ratcheted down in
response to the ongoing slowdown in consumer spending, we see virtually no chance of a reversal in
the economy in the second quarter. That will be the fourth consecutive quarter of negative economic
growth—the first time that the U.S. has experienced this since the 1930’s. Economic growth will likely
continue to prove elusive in the second half of 2009 as well. We are skeptical that most of the cash
finding its way into taxpayers’ pockets, courtesy of the impending Obama stimulus package, will be
spent rather than used to pay down debt or saved. Boosts to economic activity from various work
projects won’t begin to filter into the economy until late in the year and will fall far short of compensating
for slowing private sector business activity based on current trends. Our concern is heightened
because re-emerging economic growth leading out of recession has always been predicated on
increased availability of credit—essential for small business expansion that is the backbone of job
creation in this country. And while the Fed has pumped liquidity into the financial system, it has only
enhanced the capital structure of lenders that continue to hoard cash. To the contrary, access to credit
for individual and most business borrowers alike remains impaired as lending standards continue to
tighten and borrowing costs rise in real (and even nominal) terms.
The view here is that the quantitative easing by the Fed will ultimately prove successful but that the
magnitude of the effort required is still somewhat underappreciated by the market. Interest rates will
continue to be pushed down by the Fed. We take a contrarian view that with the exception of short
term technical corrections, interest rates on U.S. Treasuries will move even lower. With the short end of
the curve near zero, we expect the Fed to take renewed aim at the longer end of the curve, particularly
the 10 year bond in an effort to drive down borrowing costs, especially for mortgages. Although we
believe Treasuries are overvalued in a long term context, a crowded market is likely to become even
more so. As rising private sector savings contribute to more cash building up on the sidelines, demand
for Treasuries will be sustained. We believe that this trumps the argument that growing supply from
fiscal stimulus will force rates higher. In fact, we would not be surprised to see the Fed enter the market
as a buyer of Treasuries. With virtually no limit to how much the Fed is willing to expand its balance
sheet, the potential impact is enormous given that the total combined issues of Treasury bonds are
under $600 billion. Additionally, we see foreign central banks as motivated buyers in 2009 as a way to
prevent a precipitous drop in the dollar, which we think would be a disaster for their own efforts to
reflate their respective economies.
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