Friday, February 27, 2009

Nasty,brutal but short - the 2009 recession.

Equity markets were chastened by the revision in US Q4 GDP numbers from minus 3.8% to minus 6.2% the worst results since 1982. The downwards revision should have been no surprise based on the rapid contraction in Asian exports in the same period - after all why should the US be faring so much better than anywhere else?.

We take some perverse comfort from the numbers as they show that we are in for a sharp recession that is much more likely to be brief and fiery rather than a Japanese 1990's style recession which was long and gradual. By Q3 we should be seeing some marked slowdown in US economic contraction with stabilization emerging in Q1 2010 and an upturn thereafter.

If true this has a number of important effects:
1) The US budget is too optimistic in its revenue assumptions - the deficits will emerge larger than currently forecast
2) Banks that have weathered the Q4 storm should only have one more quarter of dire contraction ( 6% annualised ) to face before the storm starts to ease - this should make provisioning easier
3) With the worst numbers since 1982 there can be some confidence that this is not going to be a long drawn out mild recession - it is going to be red in tooth and claw , brief and savage. The epicentre of the storm is upon us and it won't be too many more months before the cash sitting on the sidelines starts looking for a new home. The US was the first in to the downturn and should be the first out .

Of course with higher taxes on the way, cuts in government spending, and a propensity for households to save rather than spend the upturn when it comes may disappoint. As I used to say about the cheese plate in my local hotel 'there is less to this tham meets the eye'.

Tuesday, February 24, 2009

Not the time to start a new airline

The 'revamped' Alitalia that was launched with much fanfare and bravado a month ago is finding it hard going.In the first month of operation of the new carrier the load factor on the Milan-New York flight has sunk to 26% from 65%. Capacity to Turin has been cut by 22% but traffic has fallen by 43%.

Markets seem to be in denial about the state of the banking industry. In H1 2008 nearly a third of UK short term corporate debt was provided by foreign, largely EU based banks. They are now retrenching as fast as possible to deal with their own domestic liquidity problems. Add to this the near 30% mortgage market share of Bradford and Bingley and Northern Rock and the chance of boosting domestic lending in the UK is absolutely zero. To replace these two gaps in the lending market would require the remaining loan books to grow at double the rate seen in the bubble years! This is before the defaults on corporate and credit card loans start to kick in. Lending will contract across Europe this year and banks, all banks, will need to raise their capital base again.

Fear of hyper-inflation has been a factor in the surge in gold prices. This last week has shown that it is an overblown fear. We are witnessing an economic downturn the like of which hasn't been seen since the early 30's but this time at a faster rate and with a more widespread reach.LDV, Volvo, SAAB are just a few of the companies that teeter on the brink. A large number of Euroland and US companies that have been relying on China, Russia and other emerging markets to bail them out will shortly join this list. Widespread corporate consolidation and the erasure of the weaker players will leave those still standing in a much stronger position - there will come a time when investors flee the corporate debt market and rush back into equities - that time simply isn't here yet.

Sunday, February 22, 2009

Back from Zurich -Sunday thoughts.

Back from giving a speech in Zurich. General feeling among Swiss managers was that equities have a place in portfolios as long as actively traded and restricted to strong franchises with access to bank capital. Small and medium sized companies simply not being touched. There was some enthusiasm for gold but with a preference for physical as opposed to ETF's. General laughter greeted the thought that the all embracing lack of confidence in the market based on the poor '08 reported results marks the darkest hour before the dawn and a strong upside rally - a capitulation on heavy volumes still is needed - forecasts of DJII to 5600 and DAX to 3000 based on no broad earnings recovery until 2011 were widely discussed. Private clients are still driven by fear amid growing signs of social unrest - the general strike in France next month will be closely watched. The U.S State Department has added Mexico to its watch list noting that ' large firefights have taken place in many towns and cities across Mexico.U.S citizens have been trapped and temporarily prevented from leaving the area'. In this environment risk is still very much premium rated.

Love CNBC - so much more interesting than the alternatives. But, am I the only one who thinks that they seem to be blaming everything on Obama's stimulus package or his mortgage foreclosure amelioration plan? Was very worried about the widely broadcast rant against the mortgage plan - yes it could lead to moral hazard but it might also help prevent a collapse in house prices that could wash away many, many more households and financial institutions. This ill tempered sniping undermines market confidence.

UK government revenues in January were a nightmare. For the next fiscal year starting in April it looks as if the government will only be able to raise £2 out of every £3 it plans to spend. That can't go on for very long. The contraction in public spending when it comes will be severe - the hike in tax rates equally bitter. The recovery when it comes will be shallower than predicted.

Commercial property prices in the UK fell by 3.5% in January after a 27% fall in 2008.1600 smaller property firms with £1.1 billion of assets are expected to face liquidation this year.

Moody's forecasts corporate bond defaults will rise to 16.4% by 11/09 - the highest since the Great Depression and 3x the current rate.

Only 25%-30% of ex-Bush administration officials seeking full time employment have succeeded.

Saturday, February 21, 2009

'Today's lows could be tomorrow's highs'.

Random thoughts picked up from today's press:

UK January car production down 58.7% from year ago levels. Commercial vehicle production down 59.9%.

S&P says the credit crunch may only be in its early stages and a bigger contraction in lending in coming months could have serious implications for the US economy.

Over the last year, first as Senator, then as President Obama has seen the largest outlay of federal money -$2 trillion - since World War II.

Sources close to the Obama administration say they remain open to nationalizing selected banks as a matter of last resort.

Although the Dow has given back all its gains -and more - from the five year bull market that ended in 2007, it is unlikely the market has hit bottom.

Coupled with slowing tax collections because of the recession the budget deficit is being pushed to $1.4 trillion or 10% of US GDP. Trillion dollar deficits are forecast for much of the next ten years as the skyrocketing costs of caring for the retiring baby boom generation start to arrive.

Bank nationalisation - finding a politically acceptable term for it.

Markets took a pummeling this last week as investors digested the US governments plans for a 'stress test' of the solvency of leading banks. There had been a widespread assumption that Tim Geithner would come up with a plan that would keep the banking system going with a combination of loan guarantee programmes, capital hikes through preferred share issues to the Fed, and purchases of toxic assets at 'attractive' prices.Markets have now woken up to the realisation that by inviting the private sector in to co-invest in the purchase of toxic assets the government has taken a huge step in ensuring that they wont overpay. The proposed 'stress tests' are likely to show that at market valuations many of America's major financial institutions are to all intents insolvent. Yesterday, the administration had to reassure markets that they had no plans for nationalising the banks but the reality is that the government will be calling the shots in the near term and the shareholders and unsecured creditors will be paying the price. Pre-privatisation really is the stage that they are at.

Heard a marvellous phrase in Zurich yesterday. A fund manager said he had a portfolio fitted with ABS. ABS , I asked. Anything but Sterling came the reply.

UK car production was down nearly 58% in January. There are rumours that a major producer is set to announce closure of its manufacturing ( Ford,Honda,Toyota ?) in the UK. With collapsing output, rising unemployment, and tumbling tax receipts the tax burden of the British taxpayer is going to rise and remain high for sometime to come. What's the betting that this government won't take any of the necessary steps to curb government spending, or cap public sector wages and pensions? Much better to leave the harsh and needed political and budgetary decisions to someone else. Meanwhile as Nero fiddles....

Tuesday, February 17, 2009


Just looked at my pension fund valuations. Ouch! Institutional investors such as pension fund managers seem to be slow in recognizing the structural shifts in the corporate world that are underway. This can be boiled down to one simple maxim :Only market leaders can access the credit markets - their smaller and medium sized competitors are cash starved and are set to close or be acquired.

Eastern Europe

British banks can take some comfort - they did not buy into the Central and Eastern European banking sector in any major way. The same cannot be said for the Belgian,Austrian,Italian,French and German banks who conflated EU membership with economic stability. We've written before about the hard currency exposure of the Italian banks to Hungarian and Slovak mortgages but now the contagion is spreading to corporate and credit card loan books. The more I look at what is going on the more I come to the view that the UK won't have the worst recession in the EU - Ireland is already contracting more rapidly ( but like the UK has a flexible labour market ) but Austria having advertised itself as the gateway to the East finds itself very exposed to the downturn as does Italy with its large sub-components sector in the north.Q2 and Q3 GDP numbers are likely to worsen from what are likely to be depressing Q1 numbers. Sterling and the Euro are likely set to carry on weakening against the greenback for the immediate future.

Airline as a reflection of the health of the economy - Thoughts from the Association of European Airlines.

Airline traffic is a pretty good reflection of what is going on in the real economy. It reflects personal and corporate confidence levels and points to where companies are trying to constrain costs. The Association of European Airlines reported a 21.4% fall on y-o-y cargo traffic in December 2008 and had the following comment for last year : " We have seen figures as weak as these on only 3 occasions in the last 25 years..We have no reason to suppose that we are at,or even approaching the bottom of the cycle...19 of our member airlines reduced seat capacity in 12/08, 8 of them by more than 10% - yet overall the traffic decline was still greater than the capacity cutbacks".

Ryanair's Chairman has said that he is still in negotiations with Boeing and Airbus for a $7bn, 200 aircraft order. However, he is happy to wait 'until their order books collapse' in order to negotiate a better deal.

Monday, February 16, 2009


A speech last night by the Deputy Governor of the Bank of England said that there was a 'three in four chance that the economy would contract by more than the 4% predicted by the Governor last Wednesday'. I'm left speechless - in less than a week the Bank of England has torn up its forecast for the economy! It now seems to be hinting that the worst case scenario it outlined in its quarterly inflation report of a 6% fall this year with further meaningful declines in 2010 before stabilization in mid-2011 is the most likely outcome. This would be a decline of nearly 10% of GDP with a huge impact on tax receipts. No wonder the budget has been delayed.

Spoke to an old friend in Moscow last night. Industrial output was down 20% in January. Gold and diamond output is falling sharply because the mines can't access finance either from the government or the banks. With the scale of the slowdown in Russia now apparent I'm coming round to the view that both Germany and Italy will see their exports to the country fall off a cliff - look for German and Italian GDP growth of -4% this year. Civil unrest in Russia may rise as the number of unpaid workers in the state sector skyrockets.

Sunday, February 15, 2009

What if?

Weekend press coverage of the economy in the UK was decidedly mediocre. One journalist said it was time to consider stocking up with foodstuffs and buying a gun ahead of the breakdown of law and order. In the same paper another writer was saying that small caps would provide superior returns in 2009.

It seems to me that the City has failed to raise its commentary game to address the severity and speed of the proto-recession - there is still far too much standard thinking. I would like to see some fresh thinking about the possible structural market impact of political banana skins that are being thrown out by the current economic downturn and the series of uncoordinated government and half baked responses to it. What would happen to currencies , equities and fixed income markets if one of the following was to play out ?:

What if Israel decides that the US administration is fixated on the economy and ignoring the threat posed by Iran? Will a new government in Jerusalem take the view that Iran is close to developing a workable nuclear warhead and attack Teheran's nuclear facilities? The recent election results seem to have boosted the hawks. Where would oil trade? Would the economic and psychological benefits of the stimulus be choked off leading to a second major leg of the downturn?

The lack of policy response at the weekend G7 meeting in Rome shows that the market state is dead. What will replace the political consensus of the last 60 years in the UK? Socialist safety net, Thatcherite austerity or something new? What does this mean for equities - will higher tax rates of say 60% on income slow corporate growth or will new high margin and strengthened corporate entities emerge to drive market valuations?

What if Ireland defaults (see previous posts)? Will the ECB bail them out or will German voters surprise us all and say no to their government and no to bail outs for the other PIIGS - what would the ECB do then?
Would the Euro survive the withdrawal of its key economy? 49% of Germans want a return of the Deutsche Mark according to the latest polls.

Clearly government austerity is on the cards for the UK. Will the UK be forced into a major reduction of defence spending? If Trident is cancelled will the UK have any justification for retaining a seat on the UN security council?

What if Russian foreign policy continues to trend towards nationalist goals? Will Moscow use the economic crisis to destabilize Ukraine in the belief that gas hungry Germany and Italy will prevent any concerted action against it?

Saturday, February 14, 2009

Europe wakes up to the recession

Dinner in Rome on Monday night with the management of an Italian manufacturing company that held the opinion that the recession was caused by anglo-saxon bankers and wouldn't really impact them.Fridays figures showing a 1.8% decline in Italy's fourth quarter GDP was presumably an aberration.

There has been and still is a widespread view in Europe that the downturn would hit the UK and Ireland but would leave the continental economies relatively unscathed. That outlook is only now beginning to change and be replaced by a growing sense of despair. This is warranted .The current downturn will be deeper than previous recessions and modern information technology will force it through the system very quickly. By 2010 things should have stabilized , but some 10% of installed capacity will be wiped out.

The UK has been in the doldrums for some time - it looks to me as if the contraction will continue there until the tail end of this year before stabilizing. In Europe there will be a rapid forced reduction in manufacturing capacity as credit dries up- steel, shipping and electronics are already feeling the pain and consolidation, closures and steep write downs in goodwill,inventory and plant and equipment will hit the reported numbers over the next three quarters.

Governments are throwing money at the car sector - in the short term this helps maintain employment but the distortions created by this failure to deal with excess capacity will stay with us in the form of subsidies for years to come.

Savings rates are rising across the EU. The consumer is increasingly frightened. In this environment industries dependent on discretionary spending or status are to be avoided. A return to the growth levels seen in the '80's and '90's is impossible against a backdrop of government regulation of the banking industry with higher credit and reserve requirements . Welcome to an EU where 1% annualised growth will become the norm.

Thursday, February 12, 2009

Bankers and parliament

Watched the heads of UK banks giving evidence to the parliamentary finance committee yesterday live on Sky. It was riveting stuff. Varley from Barclays came across with that patrician English style that often masks a sharp mind. The poor guy from Santander was clearly wondering why some Scottish MP with an impenetrable Gorbals accent and little knowledge of banking was berating him over the loss of E20m in the Madoff funds. HSBC had sent along a typical corporate apparatchik who did his best not to gloat over his peers weak balance sheets and runaway bonus culture. The frightening thing was the hectoring manner and visible lack of knowledge of many of the MP's on the committee. Their populist rudeness was a disservice to democracy and had the perverse effect of generating sympathy for the bankers. The new boss of RBS had the guts to reply to one of his new masters that his allegations were 'outrageous'. Well done.

Monday, February 9, 2009

Looks more like '46 every day

There are rumours floating around today that Boeing and Airbus will scale back production by 35% over the next two years as their airline customers are finding it almost impossible to finance orders for delivery in the 2010-2012 time frame. Cancels and deferrals look as though they will exceed new orders this year. This is proving to be a sustained downturn unlike the post 9/11 quick rebound template that many corporate boards have been using as the basis of their forecasts. This production scaleback would indicate that a second round of job cuts is about to sweep the economy as companies are faced with the stark fact that the turnaround is still some way off. The 2009 forecasts for demand made at the end of last year are being discarded in the face of a worse than forecast downturn. Emerging markets that had been held out as the counterbalance to established economies have been shown to be built on the same foundation of sand. As workers are laid off so they stop being consumers and so firms see their sales decline .

The scope for a further round of major job cuts is made all the more likely by the snail like progress of the US stimulus package. Allowing for a bad tempered and decidedly partisan passage of the $800 billion today the final legislation is unlikely to be drafted and signed into law until the end of the month. The vast majority of the funds are unlikely to start flowing until the tail end of this year and a turnaround or stabilization is unlikely until early 2010. Shops,autos,banks,airlines and hotels all face further layoffs. A major worry will be if the profitable sectors of the economy like health care,pharmaceuticals , tech and media follow Boeing and decide during Q2 that the outlook is looking bleak and opt for a further round of job cuts . Instead of 9% unemployment the number might grow to 12%.

There is some good news. Press reports over the weekend hint that the Treasury is set to guarantee a floor value on contaminated assets. This would enable pension funds to step into the market and enable markups on written down assets at some banks. However, the lack of transparency in the banks year end numbers would indicate that they will have to bite the bullet and take more write downs and raise more capital. Pre-privatization of the banks still looks likely.

Saturday, February 7, 2009

You can't defy gravity - the recession runs its course.

Was in London for much of the last week talking to old friends about how the recession is playing out. Britain never changes - a few inches of snow and the infrastructure comes to a grinding halt. Interesting to note how quiet the shops were after the January sales - Fortnums on Thursday lunchtime was almost deserted an impression I got in the other stores along Jermyn Street.

Economic news has been as dire as might be expected at the front end of a deep recession or a proto-depression as a number of City folks are now calling it. Everyone seems to be panicking about the downturn but the Darwinian laws of economics are simply re balancing the economy after a decade of excessive debt extension. This isn't much fun for the 20 million laid off in Guangdong and Shanghai in last years final quarter but is a necessary step in forming a base.
My guess is that we will see a 10% destruction of global installed capacity within the next year with weaker players going to the wall and consolidation reinforcing the stronger market participants who will be able to hike operating margins. Governments will of course try to keep some of the no hopers like Chrysler and Saab going but the writing is on the wall. Taxes will need to rise to pay for structural unemployment levels of 10-15% ( excluding those deemed unfit for work ) and a reversion to the 60%+ tax rates of the pre-Thatcher era in the UK are just a matter of time. This draining of personal cash into the governments coffers to pay for all the new debt issuance would indicate that the recovery when it comes will be more gradual than many are forecasting with the consumer yoked to debt repayment for the next decade.

After talking to those at the coal face in the markets I'm more than ever convinced that the banks will still need to be taken into government ownership - pre-privatization is a new moniker for the unspeakable term 'nationalization'. So far we've seen write downs by the banks of $1 trillion of which 68% has been taken by the US firms with the Europeans only writing off 29% of this total. It can't be long before the Europeans and the continentals in particular start to match their American peers - a total deleveraging through the global banking system of $2.5 trillion isn't impossible.

Weaker companies are also likely to find this a challenging environment. 30% of installed US factory capacity is idle - a figure not seen since the early 80's. Too much capacity and too little demand underlies the implied 40% default rate over the next five years in the corporate bond market. Government debt is also a worry. Italy with a debt level of 109% of GDP has to refinance Euro 377 Billion of borrowing in 2009 so expect yields on Rome's debt to balloon.Ireland is perhaps the most exposed Euro member and continues to worsen- 25% of exports go to the UK and have become prohibitively expensive since sterlings fall against the Euro- further help from Europe will be needed if the Lisbon treaty is to be passed. At least Ireland has a modern educational system and will ultimately be able to work its way out of the problems - countries like Italy have much greater challenge ahead of them.

Sunday, February 1, 2009

Boeing and Russia's S7 cancellation

So S7 (formerly Sibir) the Russian airline has cancelled its orders with Boeing for the 787 Dreamliner that was originally placed in May 2007. Some analysts had expected Northwest to cancel but it turned out to be the Russians. Looking at the order backlogs one has to wonder how many of the orders for both airframe manufacturers Airbus and Boeing have financing committed? There may be more disappointments to come. Europe has something like 70 low cost carriers and in an environment like this 10 or so are likely to be profitable - the rest burning cash. Amazing how many hedge funds took stakes in LCC's in the boom times and in the absence of bank financing now find themselves with effective control. In a separate development Aeroflot took control of Malev Hungarian Airlines last week - where does that leave their bid for Czech CSA?

The coming week will be important for all of us.

This coming week sees the unveiling of the new administrations ideas on a 'bad bank' to buy up the delinquent loans and assets that are corroding the system. The issues at stake are huge. If the new bad bank buys bad assets at say 30 cents on the dollar then we could see another huge round of write downs ,bankruptcies and capital raising's in the banking sector. If on the other hand the government pays par for the toxic debts then the taxpayer ends up footing the bill - the old 'privatization of profit, socialization of failure' moral problem.

I've written before that the real threat to the global economy and financial order would be a 'W' shaped recession where the stimulus creates a minor recovery followed by a further major leg downwards when monetary and fiscal policy have to be tightened. It looks as if the emphasis on capital spending with the required long lead times and planning approvals will delay the impact of the stimulus for a year or two and might turn the 'W' into a 'V'.

What's becoming abundantly clear is that with the government setting the agenda any business model that relied on access to easy capital or substantial leverage is going to be reporting red ink for a while yet. The deleveraging that has been going on through the banking sector is likely to accelerate through the rest of this year before stabilising next year. At some stage the market is going to recognize this and make a clear distinction in company and sector valuations.