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And the Winner Is . . .
It's early in the electoral process — there is still uncertainty about who will be the Democratic candidate, while confusion is rampant on the Republican front — but already, the focus is beginning to turn towards November and beyond. The run-up to the elections, the outcome itself, and the political landscape in 2009 will impact how markets behave and will, at least indirectly, shape Fed policy.
Following President Bush's announcement last week and the surprise Fed rate cut this morning, it's likely that some sort of fairly substantial stimulus package will be adopted, mainly because every faction is on the bandwagon with the elections looming and the economy and stock market in trouble. The size of the package, its timing, and the reaction from consumers will determine its success or failure. While it appears as though the size will be meaningful, possibly around $150 billion (or 1 percent of GDP), the timing is less certain and any delay would significantly lessen the impact on what might already be an economy in recession. It is hard to predict whether consumers will spend most of their tax rebates (the most favorable economic impact) or will use them to rebuild their depleted savings. The administration is hoping for the former, but with confidence low and sentiment about current and future economic prospects looking increasingly shaky, the actual boost to consumer spending might fall well short of expectations.
Looking beyond the stimulus package, it's almost impossible that any significant legislation or structural reform will be passed affecting Medicare, Social Security, or other programs prior to the elections. The only measures likely to get through will be bipartisan stimulus (tax cut and spending) measures to address a struggling economy, which may have an unfavorable short-term impact on the deficit. Even though that will concern the Fed, I believe they will largely focus on the near-term downside risks to the economy and will continue to ease fairly aggressively; with Fed Funds now at 3.50 percent following their aggressive inter-meeting cut this morning, I expect the low for this cycle to approach 2 to 2.5 percent, possibly by this summer. While they are concerned about currently elevated inflation readings, most of it is outside their control — it's the result of a weaker dollar, higher oil prices, food inflation, and high rents. It has not so far resulted in significantly higher wage negotiations or broadly higher prices for intermediate and finished goods — that sort of structural inflation would be more concerning. The Fed cannot control the dollar (except indirectly) or the price of oil; food prices are volatile and do not normally provoke a policy response, while rents should ultimately fall if house prices keep falling.
Despite the rally last week, the dollar should remain weak for some months; once risk aversion diminishes, additional Fed easing will create a headwind, as will a weak economy and a shaky stock market. The impact might be more muted versus other major currencies, as most of the developed world appears to be slowing as well, but the weakness should continue vis-à-vis many emerging market currencies, as additional rate cuts will lead to a rebound in risk appetite and decrease the relative attractiveness of dollar assets.
If the economy continues to slide (as it appears to be doing), the odds favor Democratic gains in the congressional elections and a Democratic president. This is especially true if the employment picture worsens; historically, that tends to influence voting patterns more than most other economic indicators. There are differences between the candidates, but as a general rule expect taxes to increase (or tax cuts to be rolled back), spending on Iraq to decrease and hence the deficit situation to improve. That scenario would exert downward pressure on future growth and inflation, result in lower bond yields and make it easier for the Fed to justify accommodative monetary policy for longer than they might otherwise. For equities, it would generally favor alternative energy over the oil industry, be a negative for the pharmaceutical and insurance industries, and favor non-defense domestic manufacturing over imports as protectionist sentiment increases. While that might have a short-term positive impact on the trade deficit, the combination of weaker growth, higher taxes, looser monetary policy, and protectionism should result in another bout of dollar weakness.
If a Republican is elected president, it remains likely that the Democrats will control Congress; gridlock generally equates to less new spending in non-election years. Several Republican presidential candidates (John McCain and Mitt Romney, in particular) are currently advocating fiscal responsibility through reduced non-defense spending (as opposed to higher taxes); if they follow through on that, the net result could be possibly lower deficits and lower yields, relatively low interest rates, but a somewhat different sector outcome for the stock market. The dollar might do better in the near-term on reduced protectionism and, perhaps, a healthier stock market, but a possibly less favorable longer-term deficit picture because of military spending and lower taxes would weigh on its long-term prospects.
My conclusions from this are two-fold — and linked. The first is that almost irrespective of the election outcome, the dollar bounce most expect later this year into 2009 is questionable. Even though valuation favors a dollar rally versus most major currencies (even beyond the recent bounce), currency markets generally react to short-term catalysts and not long-term valuation; other than risk aversion, there are no catalysts working in its favor. My second conclusion is that Fed Funds and market interest rates are on balance likely to fall further and remain lower for longer than most currently expect, as a result of sub-par economic growth, consumer pessimism, moderating inflation, and less fiscal extravagance.
— Dave Bhagat, Senior Advisor, SVB Silicon Valley Bank's Global Financial Services
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Googling for Charity
True to the pledge it made to investors when it went public, Google will reserve 1 percent of its profit and equity to charities. The company's philanthropic arm, Google.org, will spend up to $175 million over the next three years on grants and for-profit investments, encouraging Google employees to participate directly and lobbying public officials for changes in policies. Employees are permitted to spend 20 percent of their time at the foundation or in other charitable ventures. (New York Times)
'Desk Set' Revisited
To eliminate the confusion from text-message shorthand, a new search service from ChaCha is employing human beings to answer queries sent by cell phones: human beings. ChaCha promises that one of its 5,000 "guides" will respond in an average of three minutes to a text message, though some answers take 10 minutes or longer. The company says at least 500 guides are always online. ChaCha is better at answering more subjective queries, such as "Best thin-crust pizza upper w side." (AP)
A Drug by Any Other Name . . .
Millions of dollars are spent choosing just the right name for most popular medications. Research shows that letters with a hard edge like P, T, or K convey effectiveness, while X seems scientific. L, R, or S provide a calming or relaxing feel, and Z means speed. As regulatory guidelines are becoming more restrictive (and the brand market is more crowded), naming is getting more challenging. And, before a new drug earns its first dollar, companies must find a brand that works in many languages, passes U.S. trademark and FDA reviews, and proves unique in the European Union's 27 countries. The entire process can last up to three years. (AP)
PATH to Fight the Flu
Seattle-based PATH is using a $39 million grant from the Gates Foundation to help developing countries identify ways to manufacture and stockpile vaccines that could be used to defend their populations against an influenza pandemic. Although developed countries have stockpiled hundreds of millions of doses of flu vaccine, developing countries are likely to be left to their own devices in the event of a pandemic. The Gates funds will go to public and private vaccine development partnerships in low- and middle-income countries. (Seattle Post-Intelligencer)
Cash Aplenty for VCs
Venture capitalists will have no shortage of cash to invest over the next three to five years. According to numbers from the National Venture Capital Association, 2007 fundraising reached $34.7 billion in 235 funds, its highest level since 2001. Early-stage funds garnered $9.7 billion, but balanced-stage funds raised the most with $10.6 billion. Later-stage vehicles secured $7.2 billion, while expansion-focused funds raised $4.8 billion. However, VCs are facing a challenge to deploy their cash, with startups needing less money to get off the ground, an economic slowdown, and valuations in some industries (cleantech and Web 2.0) reaching astronomical heights (TheDeal.com)
David vs. Goliath in Electric Car Race
The race to develop an electric car is drawing interest from prominent VCs. Silicon Valley money is backing an array of green-car projects that including startups such as Aptera Motors Inc. and Phoenix Motorcars Inc. High-profile Tesla Motors Inc. has raised $105 million from investors, including VantagePoint Venture Partners, Technology Partners, and Draper Fisher Jurvetson. Big auto makers are competing in the mix, rushing to develop their own electric cars before they're beaten to the market by a startup. (VentureWire)
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January 22, 2008
Shill Bidders?
The competition for the economic stimulus package has become so intense that we checked to see if it had been listed on eBay. The bidding began only a few weeks ago with Senators Obama and Clinton talking around a $70 billion level. President Bush topped them both last week, declaring a number equal to about 1 percent of GDP — or around $145 billion. Then Mitt Romney kicked aside the competition with an offer befitting his role as wealthiest candidate, calling for a whopping $233 billion. So it seems we have a bipartisan (and possibly irrational) consensus that a stimulus package is needed. As usual, the detail below those headlines is where the devil lies. The big idea is to give working families some of their taxes back so they can go out and spend it on consumables, thus increasing demand. Well, actually the government is broke so they can't truly send any money to working families without borrowing it first in the treasury market.
A fiscal stimulus essentially means deficit spending by the government to add to GDP. The notion dates back to John Maynard Keynes and the Great Depression. During that time, all manner of deficit spending occurred; most of it was used for large scale building projects to create jobs. The Hoover Dam is an example. Once the projects were finished, the jobs would disappear, and since there was no permanent employment or long-term change in family circumstances, demand or consumption did not change very much. After years of privation and hard luck, families would save any extra cash that came their way to help them through the next dry spell. Thus the various public works projects during the Depression had little economic effect until the government began the largest public construction project in history — weaponry to fight WWII. In theory, a job building B-17 bombers would not have been permanent either, except that the Nazi's kept shooting them down so there was always demand for more.
Despite that notable success, no one in Washington is suggesting we expand the war on terror to combat the risk of recession. Studying the savings rate during the Depression, Milton Friedman developed the Permanent Income Hypothesis (1957), which explained that a temporary refund of tax dollars won't have much impact on demand. This is because people won't alter their behavior unless they sense a lasting change in their circumstances. For example, if inflation is low for a long period of time, then the expectation of annual pay raises might be reduced. According to Friedman, only a relatively long-term change in policy would make a real difference. In that regard, there is not much mention is this debate of the reviled Bush tax cuts which Greenspan termed "remarkably well timed" during a period of falling prices and economic weakness. Whether the timing was prescience or just dumb luck (we think the latter), they kicked in during 2002 when the Fed was desperately worried about a deflationary spiral.
A tax refund of $150 billion is enough money to give $500 to every man woman and child in the country. It won't be evenly distributed, of course, as there is no reason to give the money to rich people who don't need it. Suppose they dropped $2,500 into the hands of every family of four in the country tomorrow, what would happen? Would they spend it or sock it away for that next rainy day? Empirical evidence is that not much would get spent. So, other than increasing deposits in banks, there would not be much impact. One way to force the desired behavior is to give them $2,500 worth of gift cards that would expire in six months. (The Japanese considered handing out shopping coupons instead of tax rebates during their decades-long battle with deflation.)
It's difficult for us to say where all this is headed. We remain skeptical. All politicians must, of course, make noise about supporting the economy. The unfortunate dynamic in Washington today is such that both parties find more comfort is assigning blame for a policy failure than sharing the success of good legislation.
Not Your Father's Fed
This may be the day that Bernanke steps out from under-market pressure to set his own course for his chairmanship at the Fed. With a surprise inter-meeting cut of 75 bps, he certainly had the markets jumping to his tune. Bonds are in the midst of a massive rally. The cut was the largest emergency reduction in the Fed Funds rate in history.
As we have noted before, in every Fed action there are two elements. First, consumers and individuals will enjoy the relatively modest benefit of lower interest rates. Second, and much more important, is the message contained in the rate decision. The message to the market this morning is that the U.S. economy is in very bad shape and equities are selling off in reaction.
Speculation is that the Fed hopes this quick action will dampen recession fears and they can get back to a positive real interest rate stance quickly before core inflation edges from the 2 to 3 percent range into the 5 to 6 percent range. The market, however, has a different interpretation. Like offering a drunk a beer, once consumed they only come back for more. Fed funds futures are already forecasting another 50 bps easing by March.
End Note
Former chess genius, Bobby Fischer died last week. On September 1, 1972, he won the world title, defeating the Soviet champion Boris Spassky in Reykjavik, Iceland. The victory came at a difficult time for the U.S. The war in Vietnam was winding down with no sign of success, and the Soviet Union and her proxy states were making in roads around the globe. That this young eccentric genius could defeat the best of the Soviet chess machine gave everyone hope that the future need not be so bleak. Fisher's bizarre behavior post Reykjavik notwithstanding, we will always remember him as the lone American who embarrassed the Soviet empire in front of the world.
— Jim Anderson, Editor
Investment Strategy Outlook is published each week to highlight issues we hope you find relevant and topical. The views expressed in this newsletter are solely those of its authors and do not reflect the views of SVB Asset Management, Silicon Valley Bank, or any of its affiliates.
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After Dropping 465 Points, Dow Rebounds
Wall Street struggled to steady itself today, climbing back from an early plunge after the Federal Reserve implemented an emergency rate cut in hopes of restoring stability to a faltering U.S. economy. The Dow Industirals, down 465 points at the start of the session, recovered somewhat intraday. The U.S. markets joined a global sell-off amid growing fears that a U.S. recession could send economies around the world into a downturn. The rate cut created little, if any, optimism on Wall Street, in part because some analysts were predicting that the Fed might act sooner rather than later. (AP)
Housing Starts at 16-year Low
Construction on new homes fell 14 percent in December to a seasonally adjusted annual rate of 1.01 million, the slowest building pace in more than 16 years, the Commerce Dept. reported last week. The gruesome figures show builders are cutting back on production at a furious pace to try to work off a large backload of unsold homes. The bad news is that housing is still contracting; the good news is that the sooner builders stop adding supply to overbuilt markets, the sooner the housing market can recover. (MarketWatch)
A Weary Consumer Rests
In another sign of a weakening economy, retail sales ended the year on a sour note, dropping 0.4 percent in December, the Commerce Dept. reported last week. It was the first decline in sales in six months. Higher energy prices, falling home values and slowing job growth are weighing on consumer spending, which has been the main engine of U.S. growth over the past two years. Economists worry that consumers may be flagging, which could be the final straw for an economy teetering on the edge of recession. (MarketWatch)
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Emergency Action: Fed Cuts 0.75%
In an emergency session this morning, Ben Bernanke's Federal Open Market Committee cut the benchmark interest rate by three quarters of a percentage point. This was the first emergency reduction since the September 11 attacks, after stock markets tumbled from Hong Kong to London amid increasing signs of a U.S. recession. The central bank cut the target overnight lending rate to 3.5 percent from 4.25 percent. Policy makers weren't scheduled to gather until next week. It's the biggest single reduction since the Fed began using the rate as the principal tool of monetary policy around 1990. (Bloomberg)
Bernanke Fights to Disappoint Treasury Bulls
Bond investors banking on a recession to sustain the biggest rally in Treasuries since 2002 may find that Fed Chairman Ben Bernanke has already laid the groundwork for a rebound. The cost of borrowing dollars for three months fell below the Fed's benchmark rate last week for the first time since June 2003. The amount of commercial paper backed by assets, including mortgages and credit-card receivables, expanded for a third week after a five-month contraction, adding to speculation that central bankers are breaking the lending gridlock sparked by the collapse of the U.S. subprime-mortgage market. (Bloomberg)
Ambac & MBIA's AAA Success Undermined by CDO Fees
Muni bond insurers MBIA Inc. and Ambac Financial Group Inc. had a good thing going. Earning some of the highest profit margins in any industry during the past five years, 48 percent for Ambac and 39 percent for MBIA, both have to feel burned by their pursuit of the fees from subprime debt insurance. Facing potential claims that may deplete their capital, their share prices have plunged, and credit rating companies are scrutinizing their AAA status. Ambac became the first insurer to lose its triple-A rating when Fitch downgraded the company to AA on Friday. (Bloomberg)
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