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What a Difference a Year Makes
“The only thing we have to fear, is fear itself”
Franklin Delano Roosevelt
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(32nd President of the United States, Inauguration Speech,
March 4, 1933)
2009 Special Report: February, 2009
Richard Papadina,
I recently spent some time listening to inauguration
speeches from former presidents, Clinton, Reagan, Kennedy
and Roosevelt, in preparation for President Obama’s
historic January 20 inauguration speech. Political pundits
talk about the enormity of the task at hand for President
Obama, whose administration must deal with a financial
crisis that has tipped the U.S. and other global economies
into recessions, while managing two wars, a ballooning U.S.
deficit, and other campaign pledges. Although the current
administration is faced with numerous challenges, previous
leaders had to contend with – and overcame – comparable
crises.
One such crisis was the Great Depression. President Franklin Roosevelt (FDR) inherited this from his predecessor
President Herbert Hoover. In FDR’s inauguration speech on
March 4, 1933, he eloquently described the state of the
country after three and a half years of continuous economic
decline and the work they all, as citizens, had ahead of them
to mend things. The lack of policy direction by the Hoover
administration and the mistakes made by the Federal
Reserve (the Fed) exacerbated the problems, cloaking
Americans with a grip of “fear” that paralyzed the country
from recovering out of this depression.
In my opinion, the quote above encapsulates the crux of the
problem – then and, to a certain degree, today. Fear is best
described as an emotional response to threats and dangers.
As fear grew in Americans during the 1930s, panic arose
and thousands of banks failed as depositors withdrew their
money. Without a healthy and strong financial system, the
concept of capitalism evaporates and economies suffer –
that is what occurred during the 1930s. Today, fear and a
general lack of trust has developed between financial inter-
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Financial Planner
David R. Bowen,
B.Sc. (Econ), AICB
Investment Advisor
Main line: (416) 289-6652
mediaries (investment and retail banks,
insurance companies etc.). As a result, credit
markets froze this past fall, causing asset
prices to tumble rapidly over a 60 - 90 day
period as investors steered clear of any and
all perceived risks. In addition, consumers
started spending less while businesses cut
expenses to try to remain profitable and
ultimately solvent.
The Roosevelt administration was able to pull
the U.S. out of the Great Depression by creating – among other things – fiscal policy initiatives, jobs and a social welfare system. Fortunately, governments have learned a lot from
the 1930s Depression and today they are
responding swiftly and strategically to
prevent another Depression from occurring. I
believe that citizens of today are also more
informed and, therefore, better equipped to
manage their fears. Although it will not be
easy, I am confident that the current
economic crisis will be overcome.
2008 – The Year in Review
In dialogue with clients at our annual reviews
and seminars, and in our written reports, we
have communicated our concerns regarding
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the following: an impending burst of the U.S. housing bubble (first written in our summer 2005 Common
Cents Newsletter), a Chinese stock market implosion, a probable U.S. recession and the fact that the Canadian Loonies’ altitude against the U.S. could not be maintained. With these theories in mind, we tactically
adjusted weightings for client portfolios by removing corporate bonds from our holdings in 2006, reducing
our small cap and resource sector funds throughout 2006/2007, staying clear of direct investments into
Chinese or Indian funds, buying unhedged global bond positions throughout 2007/2008 (taking advantage of
any significant weakness that may come from the Canadian dollar in the year ahead), and building up other
Canadian bond and cash positions.
Unfortunately, no one could have anticipated the nationalization or forced sale of major portions of the banking industry in Europe, the United States and elsewhere. Nor could we have foreseen that traditional Wall
Street investment banking firms, as we know them, would virtually disappear. Or that any and all companies,
good or bad, would be avoided like the plague by investors. What has actually transpired in the past three
months is simply unbelievable!
In December 2007, I was looking for similar opinions to my own: that a deflating U.S. housing bubble would
translate into a U.S. recession. What I found was commentary from a Mr. Jan Hatzius, chief U.S. Economist
of Goldman Sachs & Co. He theorized around the financial impact of a deflating housing bubble and he also
developed a “back of the envelope” calculation that would see $1 trillion in sub-prime write downs by mortgage companies and banks.
We began to see the effects of these write downs with the near bankruptcy of Bear Stearns in March 2008.
The Fed swiftly forced the near bankrupt company into the arms of J.P. Morgan to prevent widespread fear
and panic from developing in financial circles. Things subsided through the spring and summer but bailouts
were required within the mortgage space for Freddie Mac and Fannie Mae, which were nationalized on September 7. Soon afterward came the collapse of Lehman Brothers Holdings Inc., a significant misstep by the
Fed which exacerbated the financial crisis and froze credit markets in the fall. On the same weekend the
orchestrated sale of Merrill Lynch to Bank of America took place followed closely behind by the $85 billion
bailout of AIG, Washington Mutual’s and Wachovia’s virtual collapse on the back of their concentrated investments in the mortgage market In a short time the titans of banking were driven to the edge of the abyss and
the crisis that ensued has left many industry analysts in a state close to shock.
Recession or Depression - The Trillion Dollar Question?
The standard newspaper definition of a recession is a decline in GDP for two or more consecutive quarters.
The National Bureau of Economic Research (NBER) defines a recession as the time when business activity has
reached its peak (business activity is defined as employment, industrial production, real incomes and
wholesale-retail sales) and starts to fall until the time when business activity bottoms out. Since the Second
World War, our 10 recessions under this definition average approximately 12 months in duration with the
longest lasting close to 16 months (1973-1974 and 1981-1982 recessions).
A depression, on the other hand, is an economic downturn where real GDP declines by 10% or greater. By
this measure we had two depressions develop during the 1930s. First, a severe depression (August 1929 to
March 1933) where real GDP declined by a whopping 33% and again four years later (May 1937 to June 1938)
when real GDP declined again by 18.2%. In contrast, since the Second World War our worst recession, global
in nature, occurred from November 1973 to March 1975 when real GDP declined by a scant 4.9%. Equity
markets have presently replicated similar declines to this period (~ -50% decline globally from peak to trough
today) indicating a belief by investors that we are in a global recession.
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Another Great Depression - I think not!
The number of people with personal memory of the Great Depression is significantly declining. When most of
us think of the Depression, we picture grainy, black-and-white images of men in hats and long coats standing
in bread lines. Although the Depression was long ago — October this past year marked the seventy-ninth
anniversary of the famous 1929 crash – its influence is still very much with us. In particular, the experience
of the Depression helped forge a consensus that the government bears the important responsibility of
trying to stabilize the economy and the financial system, as well as assisting people affected by
economic downturns.
Many factors played a role in creating the Great Depression – a depression that we in the financial community
believe should be avoided today. Fortunately, we have learned many lessons from that time and we are better
equipped than ever to do what it takes to turn the economic downturn around.
The Root Cause of the Great Depression
We tend to think of the Depression as having been triggered by the stock-market crash of 1929. On "Black
Monday" (Oct. 28), the market plunged 13%, the next day a further 12%. Over the next three years, the U.S.
stock market declined a staggering 89%, reaching its bottom in July 1932.
Contrary to popular belief, the underlying cause of the 1930s Great Depression was not the stock-market
crash of October 1929, but rather a greater contraction of credit in the marketplace due to a number of missteps and complacency by the Fed and the Hoover administration of that time:
•
No support of U.S. banking system by the Fed. The Fed should have been more aggressive
in lending cash to banks or simply put more cash into circulation to avoid these calamities.
Today, the Fed and governments are openly supporting their banking systems.
•
A lack of a strong monetary policy. The Fed tightened monetary policy three times
(throughout 1929, in the fall of 1931 and in the summer of 1932) early on as the economic
depression grew. Instead the Fed should have loosened their monetary policy as they have
now dealing with this financial crisis.
•
Almost a non-existent fiscal policy. President Herbert Hoover did not intervene with any
coordinated fiscal policy efforts to create jobs during the economic slump. Today, countries
around the world are implementing numerous fiscal policies to support economic recovery.
•
There was no Federal Deposit Insurance Corp. (FDIC) guarantees in the 1930’s. This
missing link leads to 10,000 bank failures during the depression. Today, not only does FDIC
& CDIC exist (lessons learned from the depression) but FDIC was raised in the U.S. from
$100,000 to $250,000 to calm retail banking client’s fears.
•
Protectionism reigned supreme. The U.S. Senate erred when it passed the Smoot-Hawley
Tariff Act, which raised duties on some 20,000 imported goods. It was defined as one of the
critical steps that led to the Great Depression. We hope government’s today have learned
from the lessons of the past and avoid this instinctive political response.
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Lessons Learned from Past Mistakes
It’s hard to imagine that the market volatility and economic uncertainty that propelled this present day fear
and panic has only been around for the past 3 to -4 months. even though it feels as if it’s been 3-4 years in
length. There are some significant and promising differences in the way this financial crisis and economic
contraction is being handled today versus yesteryear.
The U.S. Federal Reserve’s Actions
Since the onset of the credit crunch in August 2007, Federal Reserve chairman, Ben Bernanke, and his board
have chopped the federal fund’s rate down to only 0.13% from a high of 5.25%. This is in addition to the $1.1
trillion the Fed has pumped into the financial system to support and merge weaker institutions with stronger
ones. As long-term interest rates have been stubborn to fall to the degree expected with the central bank rate
cuts, the Fed has warned that they will conduct open market operations whereby they will buy back their
long-term treasuries from the marketplace so as to forcefully lower longer-term yields. This would help
borrowers to either refinance debt or propel new purchases of homes, equipment for businesses and the overall economy. All these actions have occurred in just under 16 months but more actions may be necessary.
The Federal Governments Actions
The Federal government is also active in ways it wasn't during the Depression. Back then, conventional
wisdom held that the government should try to run a balanced budget in a crisis, even if that meant cutting
welfare spending while raising taxes. A generation of economists inspired by John Maynard Keynes taught us
that this is precisely the wrong thing to do. Government deficits in a recession are good, they argued, because
they stimulate demand.
President Bush’s administration sent out tax rebates in the spring of 2008. Then the FDIC limits were raised
from $100,000 to $250,000, money market funds received government guarantees to calm investors’ nerves
after one fund “broke the buck”, while credit markets received similar government guarantees to thaw the
credit freeze between financial intermediaries. The TARP program was created with $750 billion to help buy
up toxic debt, invest or loan funds to financial institutions and the automotive industry. Last, but not least,
President Obama’s fiscal policy initiative is expected to inject $800 billion into new infrastructure work projects.
All of these efforts are distinctly different from what occurred during the early 1930s and they are being
orchestrated by most of the G20 nations, including Canada, in a similar fashion: coordinating rate cuts,
increasing depositor insurance levels, supporting their financial institutions and deploying fiscal policy measures.
Through Panic, Opportunities Arise
Corporate Bonds
Credit related issues appear increasingly attractive today as spreads have grown significantly from their lows
in 2007 to the highs of late 2008. In mid-2007, when economic storm clouds were not yet on the horizon,
high-yield bonds (BB rated or lower), on average, were only garnering 250 basis points (100 basis points =
1%) more than 10-year U.S. Treasuries. By mid-2008, after Bear Stearns nearly went bankrupt, spreads rose
quickly to 800 basis points and continued to rise after Lehman Brothers declared bankruptcy on September
15. Spreads jumped to 1400 basis points by the end of October and peaked at 2200 basis points in early
December.
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Typically, high-yield spreads average 450 to 500 basis points above treasuries while investment grade corporate bonds (BBB rated or better) average 50 basis points more than U.S. treasuries (spreads increased to over
700 basis points). Default risk is a prime consideration for markets as yield spreads widen to these all-time
highs, typically occurring during recessions. Recently a 26% average yield to maturity for the Merrill Lynch
High Yield Masters II Bond Index implied a 20% default rate by the overall marketplace. These default rates
have not been seen since the Great Depression.
In this current crisis, opportunity has presented itself to investors. Corporate bonds with near record premiums arguably offer better return potential than some common stocks, especially relative to their risks. As all
central bankers’ and politicians’ eyes are now on the preverbal economic ball, with efforts concentrated on
re-inflating their domestic economies with trillions of dollars in stimulus, it is obvious to all of us that they
will do whatever it takes – at all costs – to avoid a deflationary downward spiral like the one that occurred in
the 1930s. This logic suggests that corporate bonds (both investment grade and high yields) offer value at
these depression-era price levels, with their inverted higher yields relative to treasuries and risk adjusted
returns relative to common stocks.
Conclusion
Investor Psychology
Since the onset of the credit crunch in August 2007, Federal Reserve chairman, Ben Bernanke, and his board
There is always a strong tendency amongst investors to try to time the markets. Resorting to all cash when
markets are to decline and investing once again when the bottom hits. Studies and experience indicate that
this is hardly successful over the long-term. Some may have been lucky to time out near the top but will
either miss the re-entry required at the very bottom or attempt similar maneuvers as other hazards cross
their investment path in the future.
For long-term success, investors need to avoid the temptation to time the markets, and instead focus on the
time-tested strategic asset allocation approach (growth = 10 years plus, balanced = 5 years plus, income
growth = 3 years plus, etc). The biggest mistake an investor can make once their investment strategy has been
set is to deviate or change strategy at critical junctures.
Did you know that in the 83 years since 1925, U.S. equities have recorded a total of 24 negative annual
returns (approximately 1 in 3)? Of these, 8 years recorded losses between 10% – 25% and 3 years recorded
losses exceeding 25%. The worst may be behind us!
The world economy is in a dark place, but central banks and governments are honouring their commitment
to the G-20 Action Plan with policies aimed at restoring confidence in the financial system, easing credit costs
and providing a lifeline to households and businesses. We believe that the combination of low interest rates
and fiscal stimulus will ultimately revive the global economy. And, although it is likely to be a slow recovery,
we see the economy growing again by mid-to-late 2009. Now, unlike in the Great Depression, central banks
and finance ministries know it's better to run deficits and print money than to suffer massive losses of output
and jobs. Furthermore, central banks outside the United States are poised to follow the lead of the Fed and
ease policy rates further as policymakers lay the groundwork for stronger demand in the second half of the
year.
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There are glimmers of light at the end of the tunnel with thanks to declining mortgage and /loan rates declining, LIBOR rates along with contracting corporate bond spreads contracting, and with equities bouncing off
lows set on November 21st, 2008. In the months ahead, mMore economic and corporate evidence will be measured in the months to come to definitively answer our nagging question: of when we will we escape this
global recession.? While we stay tuned for the answer to that question, let’s not forget that history has proven
that economies do recover from crises. Stay tuned.Until the economy recovers from this one, rest assured
that we will continue to stay apprised of all developments. And, as always, we will look out for new investment
opportunities that will benefit your portfolio’s long-term performance trajectory and overall financial goals.
This publication is not intended as nor does it constitute tax or legal advice. Readers should consult their own lawyer, accountant or other professional advisor when
planning to implement a strategy. This information is not investment advice and should be used only in conjunction with a discussion with your RBC Dominion Securities
Inc. Investment Advisor. This will ensure that your own circumstances have been considered properly and that action is taken on the latest available information. The
information contained herein has been obtained from sources believed to be reliable at the time obtained but neither RBC Dominion Securities Inc. nor its employees,
agents, or information suppliers can guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell or the
solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that neither RBC Dominion Securities Inc. nor its employees, agents,
or information suppliers is to be under any responsibility or liability whatsoever in respect thereof. RBC Dominion Securities Inc.* and Royal Bank of Canada are separate
corporate entities which are affiliated. *Member CIPF. ®Registered trademark of Royal Bank of Canada. Used under licence. RBC Dominion Securities is a registered
trademark of Royal Bank of Canada. Used under licence. ©Copyright 2008. All rights reserved.
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