Waiting on Obama
“Change is coming,” the new president promises.
For investors and savers, that offers reasons to be both hopeful and fearful. More than likely, your personal finances already have been through enough wrenching change this year to last a lifetime.
We’ve witnessed a credit crisis of astounding magnitude, the demise of companies that were pillars of the U.S. financial system, massive government aid to shore up the system’s survivors, the collapse of stock and commodity markets worldwide, and the slashing of short-term interest rates to near zero.
What began as a real estate crash two years ago now is an economy-wide nightmare -- maybe the worst slump since the 1930s. As for the value of your home, it’s probably still falling.
For those Americans with stock mutual funds in their 401(k) savings accounts, the average decline year to date is about 40%. Just to get back to even, a fund that’s down 40% would have to rise 67%.
President-elect Barack Obama was elected to fix what went wrong. But he obviously won’t be able to accomplish that overnight. And the risk is that the government’s fixes for the financial system and economy could make things worse -- or be too late.
Nonetheless, it would be absurd to think that Uncle Sam could just stay on the sidelines given the severity of the financial system’s woes and the resulting economic fallout.
So government intervention -- the Obama administration’s policies and those of the Federal Reserve -- will be crucial in shaping expectations for the economy and markets in 2009, far more than usual.
If we boil it down, there are three key questions that will confront investors and savers in the new year, as Obama comes to power:
Will the economy recover in 2009?
Most analysts believe that the worst of this recession already is upon us. Goldman Sachs & Co. economists, for example, are forecasting that real U.S. gross domestic product (the inflation-adjusted total of goods and services produced) will slump at a 5% annualized rate this quarter, followed by a 3% drop in the first quarter of 2009, a 1% decline in the second quarter and then 1% growth in both the third and fourth quarters.
Optimism about a turnaround by midyear rests in large part on expectations for a huge government stimulus program to help fill the gap left by depressed consumer and corporate spending.
The latest numbers from the Obama camp suggest a spending program of nearly $800 billion over two years to fund infrastructure projects, tax cuts and aid to states.
What’s more, similar government stimulus plans are in the works abroad.
Carl Weinberg, chief economist at High Frequency Economics in Valhalla, N.Y., predicts that “fiscal stimulus in large size will be applied to all, or at least most, of the world’s economies starting sometime early in the first quarter.”
The money itself will help boost the global economy, but the psychological effect on frightened consumers and business owners also should be a big factor in spurring a turnaround, Weinberg said.
“Everyone will perceive that the governments are ‘in’ for an unprecedented round of new public spending” or tax cuts, he said.
As for the Federal Reserve, it already has won the global race to the bottom in short-term interest rates: Beating out other central banks, U.S. policymakers voted Dec. 16 to let their key rate fall as low as zero and stay there indefinitely. The Fed also pledged again to work at pulling down long-term interest rates.
The question is whether all of this government firepower will be enough. Wall Street wants to be optimistic, but it’s haunted by this reality: Almost no one foresaw how bad the credit crunch would become, or how far financial markets would crash as the crunch worsened last fall.
That raises suspicions about the consensus forecast for an economic rebound by mid-2009.
Inevitably, the accuracy of the projections will ride on consumer spending, which accounts for about 70% of the U.S. economy. If Americans keep their wallets closed, a recovery can’t happen.
Susan Sterne, head of Economic Analysis Associates in Greenwich, Conn., thinks it’s a mistake to count the consumer out in 2009. Although home equity and stock market wealth has taken a heavy hit, people are reaping the benefit of the dive in gasoline prices, and many will enjoy substantial savings in the first quarter by refinancing their mortgages, she said. (Of course, refis won’t help homeowners who are underwater.)
“When consumers are very pessimistic, it takes multiple events to make them feel better,” Sterne says. The Obama administration’s spending program, lower gas prices and a new mortgage refi boom could help do the trick by midyear, she says.
But if she’s wrong, the administration will be forced to go back to the drawing board for a way to keep fears of a depression from swamping the national psyche.
Will deflation take hold?
For most of the post-World War II era, consumers and investors have worried about inflation. Now, some analysts see the greatest threat as deflation -- a broad-based and sustained decline in prices, wages and the value of assets.
“Deflation is the economic battle that lies ahead,” asserts David Rosenberg, chief North American economist at Merrill Lynch & Co.
U.S. consumers, he says, are simply tapped out after years of buy-now/pay-later living. With layoffs soaring, Rosenberg believes Americans will continue to pare spending, pay down debt and boost savings in 2009, overwhelming federal stimulus efforts.
The result, he says, will be an environment ripe for deflation: Manufacturers and retailers will keep cutting prices to try to induce demand, but consumers still will stay away, just as many did this holiday shopping season.
Once a deflationary mind-set becomes ingrained, even people who have money to spend may wait, figuring prices will only get cheaper.
Wages, too, become threatened as companies seek to slash costs deeply to cope with plunging sales. That can fuel a debilitating downward spiral in the economy -- exactly what Japan faced from 1995 to 2005.
Despite her relative optimism about an economic turnaround next year, Sterne says she worries about the surge in layoffs. “I think companies have joined the panic, and they’re getting rid of too many people,” she said.
That is where Obama may find the bully pulpit of the presidency useful once he takes office. He could try to caution against excessive job cuts, while talking up his goal of creating or saving up to 3 million jobs in the next two years via stimulus spending.
Many analysts have a hard time envisioning a broad-based deflation scenario for one reason: They note that the Federal Reserve has literally pumped trillions of dollars into the financial system in recent months to pull interest rates down and bolster the finances of banks and major companies.
Eventually, that flood of dollars should begin to find its way into the real economy.
Paul Kasriel, head of economic research at Northern Trust Co. in Chicago, points out another incentive the government has to fight deflation with every policy tool available: In a deflation, debts become more onerous for borrowers, particularly if their incomes decline. Loans have to be repaid with cash that is becoming more valuable every day as prices slide.
With the U.S. the world’s biggest debtor nation, “on political grounds, deflation is not an option,” Kasriel said.
But as the Fed pumps unprecedented sums into the financial system, the risk is that it is setting the scene for the opposite harm: a jump in inflation down the road. The classic cause of inflation is too many dollars chasing too few goods.
Most economists acknowledge the inflation risk but say it’s one the Fed has to take. Ultimately, the Fed will have to sop up its dollar flood by raising interest rates -- but that’s a task for 2010 or beyond, and it’s one policymakers would relish compared with fighting deflation, said Paul McCulley, a managing director at bond-fund giant Pimco in Newport Beach.
“If the [anti-deflation] policy works too well, and inflation rises, that’s a pretty easy thing to deal with,” he said.
Stocks, bonds or cash in 2009?
The panic that gripped financial markets from mid-September to mid-November has subsided. U.S. stocks have bounced modestly since Nov. 20, and investors have been nibbling at other battered assets, such as corporate and municipal bonds.
Many foreign stock markets also have risen from their recent lows, although most remain deeply depressed.
Cash accounts, such as money market mutual funds, have been a great place to hide this year as markets crashed. But with the Fed’s benchmark short-term rate now at rock bottom, the average annualized money market fund yield is a mere 0.8%. Investors know they’ll earn virtually nothing if they stay in cash in 2009.
Besides trying to bolster wounded banks with cheap money, the Fed wants to push investors and savers to take more risk in search of higher returns.
Should you bite?
The argument for buying stocks is twofold: First, that share prices already reflect a serious recession and the accompanying plunge in corporate earnings.
With the average U.S. stock down 44% from the bull market peak in 2007, “I think we’ve priced in the severest of postwar recessions,” said Jim Swanson, chief investment strategist at MFS Investment Management in Boston.
Second, optimists are relying on the usual market pattern in recessions, which is that stocks begin to rise before an economic recovery begins.
“The rebound usually begins four to seven months before the end of the recession,” said Larry Adam, chief investment strategist at brokerage Deutsche Bank Alex. Brown in Baltimore. So if the betting is that the economy turns around at midyear, “We’re starting to get into that window of opportunity” for stocks, he said.
That’s Wall Street orthodoxy, and no doubt it will be difficult for many nervous investors to buy it, given all of the shocks of 2008 and the unknowns of 2009.
One alternative is just to wait, playing it safe in cash accounts until the economic picture gets clearer.
You may sacrifice some market gains, but you’ll also avoid the risk of another steep sell-off in stocks if pessimism worsens.
Some investment pros are taking another route: They advise shifting some cash into high-quality corporate and tax-free municipal bonds -- or, for the truly brave, into junk bonds.
The credit crunch has pushed up corporate and muni bond yields, while yields on Treasury bonds have plummeted as many investors have rushed into those issues for safety.
Gordon Fowler Jr., chief investment officer of Glenmede Trust Co. in Philadelphia, figures that high-quality corporate and muni bonds are a less risky way than stocks to make a bet on better times ahead.
With yields still elevated, he notes, you’re being paid reasonably well to take a chance that the economy will avoid the worst-case scenario.
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