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By Chip Gehle, Thunderbird graduate
2008 will be remembered as one of the worst years in the history of the U.S. stock and capital markets. The Dow Jones Industrial Average dropped by as much as 44.2 percent, and the Nasdaq Composite Index dropped by as much as 51.6 percent during 2008. They closed the year with losses of 36.3 percent and 43.8 percent, respectively. The declines in the U.S. stock markets were mirrored or exceeded in foreign stock markets, as seen in the chart below:
The root cause of this severe market adjustment is that our entire economic system has become over-leveraged. Individuals, banks, hedge funds and the U.S. government have simply taken on too much debt. Fannie Mae and Freddie Mac, which account for about 50 percent of all mortgages in the U.S., were leveraged 30 to 1.
Simple math shows that a 3.3 percent decline in the value of the assets of Fannie and Freddie would wipe out all of their equity. With the housing bubble and subprime crisis, and with that degree of leverage, it is no surprise that they needed a bailout. Why weren’t the warning signs heeded?
In addition to our systemic over-leverage, our economic leadership was caught with their heads in the sand. In March 2008, U.S. Treasury Secretary Paulson said: “I’ve got great confidence in our financial market. Our institutions, our banks and investment banks are strong.” By mid-July, Paulson proposed the bailout of Fannie Mae and Freddie Mac (for a mere $25 billion).
By October, Paulson and President Bush desperately and urgently requested the approval of the $700 billion package, covered extensively on worldwide media.
World capital markets panicked, banks stopped inter-bank lending. Lehman Brothers, Bear Stearns, WAMU, Wachovia, AIG and hundreds of other institutions in the U.S. and worldwide faced immediate insolvency as a result of the confidence and liquidity crisis.
By November 2008, the Fed had loaned an incremental $1.5 trillion to major institutions including Citigroup and Goldman Sachs. Bloomberg sued the Fed under the Freedom of Information Act to find out where all the money was invested, but the Fed, so far, is not divulging.
In an attempt to improve confidence in the banking system, the FDIC increased its deposit insurance for all insured banks from $100,000 to $250,000 per interest bearing account, and to 100 percent for all noninterest bearing accounts, through 2009.
Amazingly, the FDIC also guaranteed $139 billion of the debt of one of the most prestigious financial companies in the U.S., GE Capital. American Express, CIT and others filed to convert to banks to be eligible for FDIC insurance. Through the Fed, the FDIC and the bailout package, the government has become the lifeline for the economy. Adam Smith, rest in peace!
Uncle Sam and all of us taxpayers will be footing the bill. During the George W. Bush administration, the national debt has officially increased from $5.7 trillion to $10.6 trillion as of Dec. 29 (an increase of 85 percent, so far), and the national debt has increased from less than 60 percent of the gross domestic product to about 70 percent of the GDP.
Congress has approved further increasing the debt ceiling to accommodate the $700 billion bailout package. I remember when Republicans were Conservatives and sought to balance the budget. Notice the red (upward) sections of the chart to the left under Republican administrations over the last 28 years.
The U.S. continues to be the largest economy in the world, and other countries still depend on the strength and stability of the U.S. to stimulate and stabilize their own economies. When the U.S. financial markets were shaken hard in the second half of 2008, financial markets throughout the world were also sent into a tailspin.
Faced with the imminent collapse of banking systems worldwide, other countries such as the United Kingdom, Germany, France, Japan, Russia and China joined the U.S. in pumping hundreds of billions of dollars and Euros of credit and equity into banks and capital markets in a coordinated attempt to restore liquidity and confidence.
The worldwide credit crisis has had a major downward impact on global economic activity. According to projections released by the International Monetary Fund, “World growth is projected to slow from 5 percent in 2007 to 3¾ percent in 2008 and to just over 2 percent in 2009, with the downturn led by advanced economies.”
As shown in the chart to the left, the IMF projects that the U.S. and U.K. economies will shrink by 5 percent in 2009. Although frenzied trading and fears of a growing supply/demand imbalance drove oil prices to record highs by June 2008, expectations of slower global growth led to a precipitous drop in oil prices (about 75 percent) since June.
While this is good news to the consumer at the gas pump, it has had a chilling effect on deep water oil exploration, and it is having a very adverse effect on the incentive to develop alternate sources of energy. These effects will exacerbate the supply/demand imbalance for oil in the future.
2009 market outlook
The economists’ crystal balls have been badly shaken, and the liquid within them has not cleared. Having lived through a few down economic cycles, I think we are nearing the bottom of this down cycle. But we in the U.S. are poised for a long and painful recovery.
I see the following in my own cloudy crystal ball for 2009:
The inauguration of Barack Obama in January will bring a sigh of relief to most of the world. Again we will have a president who is a methodical decision maker, who will use the carrot more than the stick in his foreign policy. Obama is inheriting a difficult world economic and political situation, and I believe the main mission of his administration will be to restore confidence and trust in the U.S.
The domestic and international banking system will gradually get back to business. The banks will be much more cautious, with much more focus on prudent risk management than on aggressive growth and earnings targets. I anticipate that many institutions will shrink to more reasonable leverage levels.
In the U.S., Canada and Europe, we will have slight deflation and additional unemployment as the economies slow even further, and as our governments strive to keep interest rates low.
The wild card is whether China, India, Brazil, Russia and other developing and maturing economies will maintain robust growth rates. If employment levels in these developing and maturing countries can be maintained, these countries will consume an increasing share of world oil supplies and investment capital, in turn driving up oil prices and interest rates worldwide.
The Middle East, which has accumulated vast oil proceeds and invested heavily in the U.S. and in other countries, will invest a much larger share of its oil revenue in its own economic development programs. This in turn will consume a larger share of world oil and investment capital.
Mexico will have an increasingly difficult time as its oil revenue declines, remittances from nationals working in the U.S. continues to decline, tourism declines and as the confidence of its citizens decreases due to increased poverty and organized crime. The U.S. will have to focus more on Mexico.
By the end of 2009, we will have significantly higher interest rates and oil prices, and inflation will be a primary concern. It will be a while before inflation hits the U.S. housing sector, however.
By the end of 2009 the world stock markets on average will have recovered by at least 20 percent but will remain well below levels of mid-2007.
The events of recent years and particularly those of 2008 have shown that the world is increasingly one market, and that money and commodities can move from region to region with Internet speed. Companies will seek to capitalize on the competitive advantages they have in domestic and international markets, in order to compete on a global scale.
Although communications, investment and commodities can move with Internet speed, there are significant differences in opportunities and in risks between developed and developing economies. The U.S. will continue to lead the world economy, but to a decreasing extent.
There were lessons learned from the Enron collapse in 2001. Since then companies and institutions have been inundated with SOX and other corporate governance issues. The events of 2008 have shown, however, that despite all these measures, controls and best practices, even the most prestigious commercial banks, investment banks, insurance companies and government-backed finance companies have done a very poor job of managing or mitigating their investment and business risks.
It is time for companies and institutions to return to the basics of managing themselves. Credit swaps, interest rate swaps, futures contracts and other hedges with counterparties can be helpful in managing risks, provided the house of cards (and the counterparties) do not collapse, as they did in 2008.
Rather than “betting the farm” in order to squeeze another few cents of earnings per share to the bottom line (and to executive bonus pools), it is time for companies and institutions to plan and manage conservatively for the long run.
Although the world’s stock and financial markets have taken a severe beating in 2008, I believe that:
– Many public and private companies worldwide are now significantly undervalued, and present excellent opportunities for equity investors to achieve substantial returns, and for acquirers to gain strong and profitable entries in markets that will recover, or that are still expanding.
– Companies that have solid core businesses will find it easier during the year to renew their financing agreements, and to finance their selected growth opportunities.
– Companies that have “propped up” their financial performance for years will need to take a hard look at their business and financial disclosures, and make the appropriate adjustments, the sooner the better.
– Individuals, companies and institutions will all need to be more prudent in selecting new investment opportunities, with emphasis on reducing leverage and improving core earnings.
– Companies and institutions will need to place more focus on cross border opportunities and cross border competitive risks. Geographic and market diversification, to the extent it can be managed, will help companies to survive and adapt to changes in the marketplace.
– Multilateral institutions such as the International Finance Corporation, the Inter-American Investment Corporation, the European Bank for Reconstruction and Development, and agencies such as the Overseas Private Investment Corporation and the Export Credit Agencies, will play a larger role in promoting and financing viable cross border projects. These projects, particularly in China, India, the Middle East and Brazil, will serve as opportunities for companies to expand their sales of goods and services viably.
Wishing you a healthy and prosperous 1999, I look forward to cooperating with Thunderbirds in:
– The identification and selection of international and domestic corporate investment and expansion opportunities.
– Due diligence, business planning, financial engineering and financial packaging related to those corporate opportunities.
– The coordination of equity, commercial and multilateral bank financing for growth, acquisitions, cross border trade and projects.
Chip Gehle is a 1973 graduate of Thunderbird School of Global Management. His company, International Development & Finance, is a consulting firm based in Sugar Land, Texas, that helps companies to evaluate, develop and finance domestic and international opportunities.
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