Economy worsens, investment outlook improving

The economy is still traversing a downward spiral, according to the Bank of Canada’s latest monetary policy report. The economy and financial markets tend to travel in the same direction, but rarely at exactly the same time. While economists are growing increasingly worried about the “real” economy, managers are seeing signs of hope for investing.

But first, the bad news. The economy is getting worse, according to the BoC, which released its Monetary Policy Report today, saying the intensifying financial crisis is spilling over into real economic activity.

“Heightened uncertainty is undermining business and household confidence worldwide and further eroding domestic demand. Major advanced economies, including Canada’s, are now in recession, and emerging-market economies are increasingly affected,” the BoC writes.

The BoC has a negative outlook for growth for the coming year. Canada’s economy is projected to contract through mid-2009, with real GDP dropping by 1.2% on an annual average basis — a fairly significant contraction.

“As policy actions begin to take hold in Canada and globally, and with support from the past depreciation of the Canadian dollar, real GDP is expected to rebound, growing by 3.8% in 2010,” the BoC writes.

A client may look at this outlook and decide that staying in cash for 2009 would be appropriate, followed by a more aggressive stance going into 2010.

Markets are correlated to the economy, but they tend to price in economic factors much faster than the real economy. Add to the mix that this economic downturn is directly related to the financial markets, and investors who play the economy are likely to miss a large portion of gains when markets stabilize — since their stabilization is a precondition to the normalization of the economy.

In fact, during two of the last big recessions, one in the early 1980s and one in the early 1990s, stocks recovered well in advance of the economy, according to data presented to advisors at Franklin Templeton’s road show for its Quotential program.

From the market bottom to the first signals of an economic recovery, the S&P 500 grew 38.2% in 1980. Similarly, investors who timed the economy between 1990 and 1991 missed out on 25.6% of the market’s recovery from the bottom.

If a bottom could be ascertained with certainty then it would make sense to wait for it. That’s just not feasible, though, points out Stephen Lingard, vice-president of the Fiduciary Trust Company of Canada, and co-lead portfolio manager of the Quotential Program.

What can be ascertained is that there will be a recovery, as there always has been with bear markets in the past. The main trigger is the U.S. consumer, who drives 70% of the American economic activity. The debt-to-income ratios reached very high historical averages, which led to the current financial crisis.

Lingard notes that much of the recovery of the U.S. financial system will require a de-leveraging of U.S. consumer debt — which he estimates to be around $3 trillion — which still negatively offsets the estimated $1 trillion in stimulus the Obama administration is expected to pump into the economy. There’s no consensus timeline on how long it will take for U.S. debt-to-income ratios to decline to their historical average.

“Will this occur in one to two years, or will it occur over the next decade? That’s the key question. Debt-to-income ratios will be much higher than historical averages in the short term,” he says. “If de-leveraging is drawn out over the next decade as occurred from the mid-1960s to early 1980s, it may mean that the economy will bottom sooner but this outcome could lead to a continuation of a secular bear market we’ve currently been in for several years.”

Long-term buy-and-hold investors have not seen their patience rewarded as major U.S. equity markets remain at their 2000 levels, when looked at over the entire period. This phenomenon — referred to as a sideways or “secular” bear market — is not something to be feared, though, Lingard says. In fact if anything, it’s a huge vote of confidence for active management strategies.

Good stock pickers and active re-balancers have historically made money during these periods. Investors made money between 2004 and 2007 — the trick is not to lose those gains. Investors who rebalanced have muted the downside returns and likely have long-term gains to show for it.

“Money can be made in secular bear markets,” he says. “Certainly over the shorter term there are opportunities.”

Lingard admits it’s been hard to find those opportunities with virtually every asset class, even non-government fixed income, being correlated to the market. He’s seeing signs of an upswing.

His team has been tactically allocating the Quotential portfolios to take advantage of asset classes that have significant downside risk already priced in, because things could get worse before they get better.

The asset class with the most upside potential in his opinion is corporate bonds, which he says have priced in risk on par with the default levels of the Great Depression. Even if things take a turn for the worse, the risk on the assets is priced in.

“Corporate bonds are arguably the cheapest asset class out there,” he says. “Even with the default rates of a [Great Depression] scenario, you’re likely to earn decent returns.”

Lingard will not make the same call on equities, even though he notes many indicators suggest their outlook is improving. For example, the volatility indexes have come down considerably from their peaks from the fall. He makes the case that small-cap and emerging market equities have historically performed extremely well during market rebounds, and are asset classes his management team is looking to add, too.

“Equities are not yet pricing in a depression at current asset levels,” he says.

(01/22/09)