Take a long term view

Insurance experts from Colonial Group International (of which BritCay is the Cayman representative) recently brought investment professionals from Vanguard Group to Cayman in a bid to assist investors here make sense of the current economic crisis and find a way through the mire. Business Editor Lindsey Turnbull was in attendance at one of four presentations, and reports.

With around 1.1 trillion assets under management at the last count and a history of managing investments that spans more than thirty years, Pennsylvania-based Vanguard Group has a strong pedigree in the investment business. Its managers run over 200 portfolios, investing in a mix of equities, fixed income and short term reserves. The firm’s Sales Executive Tom Schwartzendruber says their client-centric approach (its clients own the business) means they can operate with unusual cost efficiency.

David Wilson, investment analyst with Vanguard gave attendees an overview of the current economic situation and explained that the current disarray in the global credit market had been funneling down to the man-in-the-street in the US, as credit lines tightened while banks drew in their credit reigns.

A critical juncture
Looking back at the pattern of problems that have gradually built up to recession, Wilson said the warning signs were lit with Bear Stearns falling by the wayside in the summer of 2008.
“People mistook Bear Stearns’ demise as a one-off. But as the summer progressed, some of the world’s most admired names in investment banking fell into difficulty,” he said.

Wilson said that there was no initial government plan for rescue at the early stage, merely an attempt to avoid recession by the cutting of interest rates by the Federal Reserve to 2 per cent. By the summer Wilson said the US government, in attempting to avoid contagion, had saved quasi-government mortgage companies Fanny Mae and Freddie Mac, while big name private companies were allowed to fall.

By September 2008 Wilson said the panic had well and truly set in and the US government was then galvanised into preparing a US Treasury rescue plan to break the gridlock in the credit market and foster trust and confidence.

Wilson said, “There was a real worry that the international financial system would seize up and fail, 1930s-style.”

US Treasury to the rescue
The US Congress finally passed a motion to grant the US Treasury a mind-boggling US$700 billion to help buy up troubled financial assets, in the hope that banks would return to normal business. With regard to this rescue plan, Wilson asked three questions: will the rescue plan work; what will be the economic fallout and what are the investment implications.

The original TARP (troubled asset relief programme) was for the purchase of the troubled assets to bring relief to the market via a trickle-down effect in an attempt to ease bank solvency.
However plans for the US$700 billion are in the process of change, according to Wilson, as the US Treasury considers recapitalising the banks directly. By reducing banks’ capital losses the US Treasury hopes the banks will be more likely to resume lending.

Wilson described how a debt for equity deal was being forged, whereby US financial institutions would receive Treasury debt, i.e. fresh capital, and in return banks could provide the Treasury with equity. Wilson said this could be an effective solution because it specifically targets insolvency and would reduce systemic fear of counterparty risk.

Long lasting effects
Assessing the effects of recent market turmoil, Wilson said these would be long-lasting. In his view the financial strains currently being felt will persist well into this year and there will be a recessionary economy throughout this year. The rebalancing of US growth will continue well into 2011 and beyond as markets see significantly less asset-based consumption. There will be a regime shift in the global financial sector as consolidation takes place, creating “universal” banks and new regulation. Down the road, economies could see higher future inflation risk and fiscal pressures from current policy actions.

Wilson said that severe financial crises require a long adjustment period and home prices were the key to recovery. In this instance, however, home prices still had another 10 to 15 per cent to fall during this year before flat-lining and foreclosures have not yet peaked. Wilson predicted more losses and write-downs in the near future. Because financial stability requires the stabalisation of the housing market Wilson predicted the likelihood of more stimulus to come.

An indication of worse to come
Economic indicators do not look promising for the short term. Housing inventories in the US remain high (over 4 million homes for sale as at May 2008, double the figure of the low of January 2001), while homeowner equity is at historical lows – in 1980, for example homeowners in the US had 70 per cent equity in their homes; in 2008 that figure was just 50 per cent.

According to Wilson, the US consumer is currently deleveraging with annual growth in inflation-adjusted liabilities per capita falling to 1980 levels, and at the same time household wealth is deteriorating, with the annual growth in real household net worth per capita dropping like a stone, from a high of around 15 per cent in 1998 down to negative 12 per cent and falling in 2008.

The Vanguard Economy Strategy Group predicts a recession that will last around 18 months, i.e. longer than all recent recessions (the early 1980s recession lasted 16 months; as did the recession of the early to mid Seventies).

Looking at key high frequency indicators for 2009, Wilson identified the TED spread (i.e. the difference between the interest rates on interbank loans and short-term U.S. government debt) and mortgages to affect liquidity conditions, while he was focusing on jobless claims and bank lending statistics when viewing economic conditions. Oil futures and inflation expectations of Treasury Inflation-Protected Securities (TIPS) would be key inflation indicators for this coming year.

Wilson expected the slowdown to go global as noted by the IMF’s real GDP growth estimates for 2009 by region, which indicate a 3 per cent growth for the world’s GDP in October (down 0.9 per cent from the July forecast.) Japan’s growth was down to just 0.5 per cent from 1.5 per cent over the same time frame; the UK down to negative 0.1 per cent from 1.9 per cent and the US down to 0.1 per cent from 0.8 per cent.

What should investors do?
Wilson said the economic game plan for investors should be a two-pronged focus: firstly on strategic allocation, i.e. expected long-term returns, volatility and correlations, and return assumptions that reflect macroeconomic expectations. Secondly investors ought top be focusing on the big picture, looking at the dominant themes in the years ahead, and assessing whether they will materially alter future risk-adjusted returns. Investors need to realise that market sentiment tends to overshoot in both directions and that initial conditions matter.
Positive outlook for stocks

Historical returns of 9 per cent plus or minus 20 per cent volatility means that the outlook for stocks is positive. Stocks, according to Wilson, lead the business cycle and a global slowdown underscores global diversification. Acute pessimism and risk aversion were contrarian signals, according to Wilson.
Bonds – a mixed bag

Bonds, on the other hand had a positive but mixed future. Treasuries were a powerful diversifier but short-dated Treasuries were challenged, given low yields. The spreads were extremely wide which were favourable for long-horizon investors.



David Wilson and Tom Schwartzendruber