mg 2009 outlook 011509

The Outlook for 2009

Marshall Gittler

Chief Strategist, International

Deutsche Bank (Suisse) SA

Tel: +41(0)22 739 0463

e-mail: [email protected]

Investing in uncertain times

mailto:[email protected]

2


Overview: a tough year economically; a better year financially?

The first global balance sheet recession

We have seen a period of unprecedented drama in the financial markets, culminating in a collapse of most markets (stocks, credit, commodities) and a freezing of the world‟s credit markets

At the same time, governments around the world have gone to extraordinary lengths to offset the effects of the financial market disaster and prevent a downward spiral

Nonetheless, we believe economic policy cannot reverse the course of the business cycle, only soften it. This is because we are in a different type of recession than we have seen before in the post-war period: a global balance sheet recession. We expect the downturn to intensify in 2009

The question is, how much is in the price already?

No one expects the global economy to do well. On the other hand, markets have already plunged

The big question is whether they have fallen enough to discount the future economic problems or whether we will get hit again as the real economy catches up with the financial markets

Strategy recommendations: we still like fixed income

This may be the buying opportunity of the century for equities, but with the economic outlook so uncertain we still prefer fixed income

Investment grade corporates are our preferred assets, as well as index-linked bonds

Within equities, we recommend infrastructure, a sector that is likely to benefit from government efforts to reflate. Also sectors with a guaranteed real yield, such as regulated utilities

3


Outlook for the economy

4


The typical recession

In the past, most US recessions came about through monetary policy. The Fed raised interest rates until the economy went into recession. Then it cut rates, and the economy eventually recovered

The previous two recessions – 1990/91 and 2000/01 – are different. In the first case, the Fed had already cut rates by 150 bps when the recession started (although it may have raised them too high to begin with); in the second case, the rise was not excessive, and in any case the Fed had started to cut rates before the recession started

The current recession too probably cannot be blamed on overly tight monetary policy

Typically, recessions start & end with the Fed

Source: Bloomberg, National Bureau of Economic Research

0

5

10

15

20

1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

Recessions

Fed Funds %

5


The balance sheet recession: a schematic

6


How a balance sheet recession unfolds

Low interest rates encourage excessive borrowing

The cycle starts when interest rates stay too low for too long. People believe rates will stay low

indefinitely. With the hurdle rate for investment low, companies are encouraged to invest in

increasingly marginal projects, while low repayments allow households to borrow (often against their

house) to buy financial assets, boats, expensive vacations, and more houses

When asset prices start to fall, the value of the debt does not. This creates balance sheet problems

Companies switch from profit maximisation (households = consumption maximisation) to repaying

debt. Companies cut investment and slash jobs, households spend less, save more. Lower interest

rates do not stimulate further investment or consumption until the debts are repaid. (Traditional

economics could not explain this point until Japan’s balance sheet recession made it clear)

A vicious circle results as companies and households do what is best for them but worst for the

economy overall (“fallacy of composition”). As the economy spirals downward, prices start to fall,

which worsen the problem as incomes fall but debt doesn‟t

More and more borrowers default. Increasing amounts of non-performing loans (NLPs) make banks

less willing to lend and increasing the pressure on even healthy borrowers to pay back debt.

Asset prices fall further as people sell assets to pay down debt (= deleveraging). Go back to step #2

Central bank tries to solve the problem by easing monetary policy, but it doesn‟t work because

nobody wants to borrow. Even if they did, in many cases the banks wouldn‟t lend to them

We arrive at a liquidity trap, where monetary policy is no longer effective

7


How a balance sheet recession ends (we hope)

With monetary policy at an impasse, fiscal stimulus is needed to break the vicious cycle

Govt builds bridges etc. They buy steel, employ bridge-builders, and otherwise support demand

Over time, the private sector can pay down its debt:

Companies can continue to sell products. This provides them with profits to repay their banks;

eventually they get their debt down to a manageable level

Individuals keep their jobs and, by cutting back on consumption, eventually repay their mortgages,

credit card loans, auto loans, etc.

Meanwhile, the government‟s borrowing keeps the money supply growing while the private sector is

repaying debt. This prevents deflation and thereby diminishes the forced deleveraging

Key word: eventually

8


Why quantitative easing is essential to the process

Monetary and fiscal authorities have to work together

Fiscal stimulus is an essential part of the process of getting out from a balance sheet recession

Fiscal stimulus financed by raising taxes would be counter-productive, because there would be no net increase in demand. It must be debt financed

Selling large amounts of debt to the private sector could push long rates up. That would force borrowers to accelerate their repayment of debt, making things worse

Instead, the central bank often steps up purchases of bonds from the private sector to help fund the stimulus (technically known as “monetizing the debt,” popularly known as “printing money”)

In any event, rates tend to remainy low during such a period anyway because of deflation, the absence of other borrowers, and a lack of other attractive investment vehicles

It‟s natural then that interest rates should be unusually low, possibly around zero

9


Why the current recession looks like a balance sheet recession

The US is emerging from an enormous credit binge, equalled only during WWII. To bring the level of outstanding credit down to trend would mean a reduction of some $1.5tn in outstanding bank credit

US households are starting to reduce their debt and raise their savings – consumer credit fell by $6.4bn in August, $3.5bn in October and a record $7.9bn in November

This is somewhat different from the Japanese balance sheet recession, which was as much in companies as in households. Households are not marked to market

Their problems will be transferred to the corporate sector via the banks. We expect non-performing loans to double in the US to 3% and perhaps exceed the 3.4% at the depths of the Depression

Unwinding the credit bubble

Source: BCA Research

Households starting to cut debt

Source: DB Global Markets Research

10

11

12

13

14

15

1980 1985 1990 1995 2000 2005

-2

0

2

4

6

8

10

12

Household debt payments as a % of

disposable income (L)

Personal savings as a % of

disposable income (R)

%%

10


Hard-hit banks likely to make the problem worse

Banks are tightening lending conditions at the same time as demand plummets

The recent Senior Loan Officer surveys from the US, Eurozone and Japan have all shown that banks are tightening up conditions for loans to both companies and households

The tighter lending conditions coincide with a sharp fall-off in demand for loans as well. In the US, 17% of banks reported weaker demand for loans from companies in October, while 48% reported weaker demand from households. The figures were 26% and 21%, respectively, in Europe

The unwillingness to lend and lack of demand for loans means lower interest rates are not likely to be as effective in reviving (releveraging?) the economy as they were in the past

Businesses find loans harder to get as do households

Source: US Federal Reserve, ECB, DB Private Wealth Management

Senior Loan Officer Survey in US and Europe

Commercial loans

-40

-20

0

20

40

60

80

2003 2004 2005 2006 2007 2008

Lending conditions

Demand for funds

Tighter lending conditions,

more demand for funds

Looser lending conditions,

less demand for funds

Senior Loan Officer Survey in US and Europe

Household loans

-40

-20

0

20

40

60

2003 2004 2005 2006 2007 2008

Lending conditions

Demand for funds

Tighter lending conditions,

more demand for funds

Looser lending conditions,

less demand for funds

11


Housing market will be one key to finding the bottom

The housing market needs to bottom before we can feel confident that the worst is over. That‟s because stable home prices are necessary for investors to assess the value of banks‟ balance sheets and for consumers to feel confident of their net wealth

The signs so far are not encouraging. Price declines continue to accelerate, and the credit crunch has made it even more difficult for those few people who want to buy a home to do so

Our Mortgage group estimated on Sep. 10th that US house prices were only about halfway through the correction and would have to decline another 16% or so to restore affordability to historical levels

Of course, things could be even worse – in Japan, land prices have been falling for 16 years

Inventory of unsold homes still rising Japanese market still hasn’t bottomed

Source: Bloomberg, DB Private Wealth Management

Japanese land vs US house prices

-60%

-50%

-40%

-30%

-20%

-10%

0%

-6 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

Years from peak

% c

han

ge

fro

m p

eak

Japanese land prices(peak = Sep. 1991)

US house prices (peak =June 2006)

House prices and inventory

-15

-10

-5

0

5

10

15

20

03 04 05 06 07 08

3

4

5

6

7

8

9

10

11

12

Median home prices % yoy (R)

Existing home inventory (R)

Months of

sup p ly

12


Outlook for the markets

13


Market dislocations have improved, but are still high

Indications of market dislocations, such as TED spreads, CDS spreads on US financials, US agency

spreads and equity market volatility have generally receded from their previous highs, but they

remain well above even the abnormally high levels of last year

Looking at the futures market, investors expect the dislocations to persist at least into early 2010,

although expectations have improved notably from even just a month ago

Credit markets bad, but not worst Market getting more optimistic

Source: Bloomberg

HSBC Clog Index

0

100

200

300

400

500

600

Jan-08 Mar-08 May-08 Jul-08 Sep-08 Nov-08 Jan-09

Includes

1) TED spread & LIBOR-OIS spread;

2) US Financial CDS spreads; 3) US

agency credit spreads; and 4) VIX index

1 Jan 2008 = 100LIBOR/Fed Funds spread & market forecast

0

50

100

150

200

250

300

350

400

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10

Market forecast

Market forecast a month ago

3m LIBOR-Fed Funds spotspreadLevel (50 bps) that signifiesalmost back to normal

BPs

14


Market implications of the balance sheet recession

As we‟ve seen, a balance sheet recession can last for several years. It means little or no demand for funds, hence a fall in interest rates. It also means sluggish demand, at least in the country involved, and hence low corporate profitability

It‟s not surprising that Japan‟s balance sheet recession saw a multi-year rise in bond prices and fall in stock prices


Nikkei and JGB futures after the bubble burst

5000

10000

15000

20000

25000

30000

35000

40000

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

80

90

100

110

120

130

140

150

Nikkei (L)

JGB futures price (R)

15


Stock market performance during the balance sheet recession

From its peak at 39,000 in 1989, the Nikkei fell back to 14,800 in 1992, then spent the next nine years in a trading range of roughly 14,000~22,000 until the banking crisis sent it crashing out

There were substantial moves both up and down during this time: 13 rallies of over 20% from 1990 to 2003 and seven rallies exceeding 30%. But all the gains were lost eventually

The business cycle continued during this period and stocks continued to follow it. Once the major decline was over, the inflection points within the trading range were driven by the business cycle


13-year decline saw several rallies

5000

10000

15000

20000

25000

30000

35000

40000

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Period when companies

were repaying debt

= rallies of

more than 30%

Nikkei followed inventory cycle

13000

15000

17000

19000

21000

23000

92 93 94 95 96 97 98 99 00

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

Nikkei (L)

Shipments-to-inventory ratio,6m change (R)

16


Stock market performance: stock picking matters more than ever

While the market as a whole was rangebound for years, some stocks did better than others

A basket of the 15 “best of breed” blue chip stocks – companies with the best balance sheets, best management and best products (e.g. Toyota and Canon) – outperformed the market significantly. This basket rose 330% during the decade vs a 40% decline in the broad TOPIX index

Small cap stocks on the other hand underperformed, because small cap companies are “price takers” that do poorly in a deflationary environment. Also they lack access to funding and so are particularly troubled by the need to repay loans

Source: Merrill Lynch GEMS Equity Strategy

“Best of Breed” in Japan vs TOPIX TOPIX small cap index

Source: Bloomberg

0

10

20

30

40

50

60

70

80

90

100

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

TOPIX Small caps index

TOPIX

Jan 1990 = 100

Period when companies

were repaying debt

17


QE lowered yields, flattened the yield curve, helped MoF to issue bonds

Quantitative easing (QE) got yields down even more than the zero interest rate policy (ZIRP), especially at the short end (five years and below). The curve was quite flat out to two years

It had less of an effect further out the curve, in the 10s and beyond. Still, yields were extraordinarily low. The 10yr JGB hit the lowest level in recorded history for that maturity: 0.45% on 12 June 2003

This was despite massive bond issuance and downgrade of the country‟s credit rating

Low interest rates and purchases of JGBs by the central bank helped the Ministry of Finance (MoF) to issue a massive amount of bonds smoothly

2yr yields & 2yr/10yr curve Yield curve before, during & after


0.00

0.50

1.00

1.50

2.00

2.50

3.00

3m 6m1 2 3 4 5 6 7 8 9 10 15 20 30

2001 (before QE)

2003 (during QE)

2005 (during QE)

2007 (after QE)

%

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

0.90

1.00

1.10

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

40

60

80

100

120

140

160

180

QE

2yr yields (L)

2yr/10yr curve (R)

%

QE periodZIRP

18


Learning from past bear markets: How long might this bear market last?

During previous bear markets, stocks never went straight down, hit bottom and then rebounded. The

market usually makes a few false bottoms on the way down and takes some time to recover

We regressed how far the market fell during previous bear markets against a) the length of time from

peak to trough and b) the time it took to recover the peak level. Using the results, the 52% drop

from the Oct. 2007 peak to the November trough means that the market should in theory fall for 40

months (= until Feb 2011) and would not recover the previous peak for 96 months (until Oct 2015)

On that basis, if past trends hold true the US economy should bottom around end-2010. That is

quite a bearish estimate; Deutsche Bank‟s official forecast is for the economy to bottom in 1H 2009

% drop vs months to recover peak


% drop in market vs months to bottom

-55%

-50%

-45%

-40%

-35%

-30%

-25%

-20%

-15%

0 10 20 30 40 50

Months from peak to bottom

% d

ec

lin

e

1990~91

1966~67

1961~62

1987~88

1956~58

1980~82

1968~70This time =

40 months =

Feb 20111973~75

2000~03

y = -0.0078x - 0.2071

R2 = 0.5023

y = -0.0034x - 0.1939

R 2 = 0.8902

-55%

-50%

-45%

-40%

-35%

-30%

-25%

-20%

-15%

0 20 40 60 80 100 120

Months to recover peak

% d

ec

lin

e

1990~91

1966~67

1961~62

1987~88

1956~58

1980~82

1968~70

This time =

96 months =

Oct 2015

1973~75

2000~03

19


Stocks don’t always go up every year

People in the financial world often say that “stocks always go up in the long term,” but they forget to

specify just how long the long term is. After all, as Keynes said, “in the long term we are all dead.”

There have certainly been periods that anyone would call “long” when the US stock market did not

go anywhere. And let‟s not even talk about Japan, where the Nikkei is now back to 1983 levels

This illustrates two points: 1) past performance is no guarantee of future performance, and 2)

truisms about the financial markets based on historical experience are not like the laws of physics,

which hold true everywhere and at any time

DJIA has shown long periods of going nowhere

Source: BCA Research

20


The example that nobody wants to think about: 1929~1932

The Crash of 1929 remains the model for speculative booms & busts in the modern era

While everyone knows what happened in Oct. 1929, people forget that 1929 was only the beginning

of the bear market. Stocks rebounded early in 1930 but then started falling again and didn‟t bottom

until July 1932. By that time prices were down 89% from the 1929 peak

Anyone who bought at the bottom in 1929 was down 79% by 1932. They didn‟t recover their money

until Dec. 1949. Anyone who bought at the 1929 peak didn‟t get their money back until end-1954

DJIA 1929~1954

Source: Bloomberg

0

50

100

150

200

250

300

350

400

Jan-29 Jul-29 Jan-30 Jul-30 Jan-31 Jul-31 Jan-32 Jul-32

-89%

-48 ppt

(-48%)

-41 ppt

(-79%)

+48% from bottom

DJIA 1929~1932

0

50

100

150

200

250

300

350

400

1925 1930 1935 1940 1945 1950

1929 high

1929 low

21


Earnings still have to be revised down further

2008E & 2009E growth of country

earnings (%)

Source: Thomson Financial, IBES and Deutsche Bank Global Markets estimates

-41.3

-35.0

-29.8

-16.7

-13.6

-12.7

-12.5

-12.1

-12.0

-2.8

-1.1

1.6

9.1

16.1

-55 -45 -35 -25 -15 -5 5 15 25 35

Switzerland: SMI

TOPIX

Germany: Dax 30

MSCI Asia ex Japan

Euro Stoxx

Euro Stoxx 50

Stoxx 600

UK: FTSE 100

S&P 500

Italy: MIB 30

France: CAC 40

Spain: IBEX 35

MSCI EMEA

MSCI Latin America

2009E earnings growth (%)

2008E earnings growth (%)

96.6%

22


What to recommend in this environment

23


The key factor driving asset class performance is the business cycle

Investors have to decide whether growth is above or below trend and accelerating or slowing

Also, is inflation accelerating or decelerating?

Based on the level and direction of these two factors, we can identify four phases in a typical business cycle

Different asset classes tend to perform best in each phase

Appropriate investments for each part of the

business cycle

24


The phases of the business cycle --- Impact on asset allocation

25


Recommended portfolio strategy

Unconstrained*

Maximum*

Capital

Preservation

Benchmark Benchmark Benchmark

Cash & FX 15% 20% 15% 10% 25%

Fixed Income - Sovereign 10% 60% 20% 40% 15% 20% 5% 50%

Fixed Income - Corporate 35% 30% 20% 15% 20%

Developed Market Equity 10% 20% 10% 40% 20% 60% 30% 0%

Emerging Market Equity 5% 5% 10% 15% 0%

Private Equity 8% 0% 5% 8% 0%

Absolute Return 7% 20% 5% 20% 5% 20% 7% 0%

Real Estate & Infrastructure 5% 5% 5% 5% 0%

Commodities 5% 5% 5% 5% 5%

Expected Return 4.9% 4.6% 5.0% 5.5% 4.0%

Volatility 5.6% 3.7% 6.9% 10.3% 3.6%

* No benchmark

Capital Maintenance Balanced Growth

26


What to recommend in this environment: equities are for trading

With equity markets down so sharply so quickly and the prospective dividend yield greater than

government bond yields for the first time in 50 years, we believe much of the bad economic news is

already discounted in the market. However, valuations do not yet indicate “all clear”

Equity markets will need to see the credit markets and earnings expectations stabilize before they can

embark on a sustainable rally. That‟s still some time away. Until then, markets run the risk of reacting

again to news that‟s previously discounted (e.g., the impact of the credit crunch on companies)

This remains a trading market rather than an investing market. As a result, we remain defensive with

our sector selection and recommend covered call writing to benefit from heightened volatility

In general, we favor US equities over Europe and Japan, primarily because of more aggressive

government policy responses to the current credit crisis and slowing global economy. As a result, we

expect the slowdown in the US to be shorter and less severe than in the other regions. In addition, our

expectation that the dollar will continue to rally versus the euro and yen over the next year will hamper

outflows from the US into other markets

While emerging market equities have been down significantly (more than 55% from peak), pressure

will likely remain on these markets as de-leveraging, risk aversion and negative capital flows serve as

headwinds. The preferred BRICs region is China due to growth remaining at potential, fiscal stimulus,

decelerating inflation and flexible monetary policy. The two BRICs most vulnerable are Russia and

Brazil, driven by the substantial declines in commodity prices

27


What to recommend: We like market-neutral plays

Most investments make money when an asset price goes either up or down. However, there are

some investments that are not dependent on the direction of markets. These may be an attractive

way to boost return with a minimum of risk during a period like this

The DB Commodity Harvest indices profit from the difference in the roll between various commodity

contracts, not from the direction of commodity prices

The DB Currency Return index is a combination of carry, value and momentum currency indices

DB Commodity Harvest Indices DB Currency return indices

Source: DB Global Markets, Bloomberg

Past performance is no guarantee of future results. No assurance can be given that the investment objectives of the financial products represented will be achieved.

50

60

70

80

90

100

110

120

Jan-07 Jul-07 Jan-08 Jul-08 Jan-09

DB Commodity Harvest Total Return

DB Commodity Harvest Excess Return

MSCI World stock market index

1 Jan 07 = 100

50

60

70

80

90

100

110

120

130

Feb-08 Apr-08 Jun-08 Aug-08 Oct-08 Dec-08

DB Currency Returns Tracker

DB Currency Momentum Tracker

DB Currency Carry tracker

DB Currency Valuation Tracker

MSCI World equity index

15 Feb 2008 = 100

28

(1) Source: Bloomberg and Deutsche Bank calculations. Represents index value from 12/31/1987 through 10/10/08

(2) Source: Cambridge Associates and Deutsche Bank calculations.

Average Net IRR of top quartile

private equity firms(2)

MSCI World(1)

Meltdown years

Meltdown years

„86-„90 „91-„93 „94-„97 „98-„00 „01-„03 „04-„07(3)

?

Potential for

excellent vintage years

„08E-„10E

20% 19% 19%

34% 35%

10%(3)

Average Net IRR of top quartile

private equity firms (1986 to 2007)(2)


What to recommend: Private equity returns are best at the bottom of the cycle

29


One big question: will the cure cause its own problems?

Central banks have been pumping money into the system like there‟s no tomorrow (which they probably thought seemed entirely possible a few weeks ago). As a result, bank reserves have been growing at a record pace

The world‟s supply of dollars relative to the size of the US economy has exploded (latest reading = up over 50% yoy)

Will this cause inflation further down the line? Soaring commodities? Collapsing dollar?

Exploding world dollar means world awash in USD

Excess growth in world dollar vs USD index

-10

-5

0

5

10

15

20

82 84 86 88 90 92 94 96 98 00 02 04 06 08

-30%

-20%

-10%

0%

10%

20%

30%

World Dollar - Nominal US GDP growth (L)

USD Index (R, inverted)

Note: World dollar = US Base money ＋Treasuries held by foreign officials.

Latest observation is Nov. 19. Using expecrted US Q4 2008 GDP -5 % （YoY）.

% yoy

% yoy

30


Long term: what could provide the next economic theme?

The infrastructure story is coming back into fashion

The world‟s population is still growing by some 78mn people a year. That should continue until 2020

These people will want a higher standard of living than those who came before them: more and better houses, roads, bridges, electricity

The developed world‟s infrastructure also badly needs refurbishment (seen JFK Airport recently?)

Why now? Because infrastructure investment is a great way for governments to inject money into an economy during a downturn

The world is still growing There is still demand for cars in EM

Source: UN Population Division Source: US Dept of Transport, CEIC

Registered motor vehicles

0

50

100

150

200

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990

US

China (1908 = 1984)

mnAnnual change in world population

0

10

20

30

40

50

60

70

80

90

100

1955

1965

1975

1985

1995

2005

2015

2025

2035

2045

0%

2%

4%

6%

8%

10%

12%

# of people (L)

% change (R)

MN

Forecast

31



The commodity story is only delayed, not derailed

The sharp fall of commodity prices now has caused a major setback in plans to expand production –

in fact, some production capacity in industrial metals has been mothballed. This sets the stage for

future shortages as population continues to grow and people expect their living standards to rise

Global warming is not affected by the business cycle

The grain situation is particularly worrisome longer term as production growth is not keeping pace

with population or rising living standards

Oil use to rise as EM countries develop Grain output not keeping pace with population

Source: Earth Policy Institute Source: IMF, IEA, DB Global Markets Estimates

Grain production and harvested area per person

240

260

280

300

320

340

360

1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

0.05

0.10

0.15

0.20

0.25

Grain production per person (L)

Grain harvested area, per person(R)

HectaresKG

ChinaIndia

Brazil

US

UK

Canada

Sweden

MexicoRussia

Thailand

Indonesia

Venezuela

Japan

Italy

Australia

FranceGermany

South Korea Taiwan

0.0

0.5

1.0

1.5

2.0

2.5

3.0

0 5 10 15 20 25 30 35 40 45 50

Oil

consum

ptio

n p

er

capita (

gallo

ns p

er

day)

GDP per capita ('000 USD)

Per Capita Oil Consumption Relative to GDP

32



The Law of Accelerating Returns

Moore‟s Law states that the capacity of ICs doubles every 18 months. This is exponential growth, not the linear growth that we usually experience. Exponential growth is common among high-tech products, because of the evolutionary way that they develop (building on previous developments): DNA sequencing, electronic memory, ISPs, nanotechnology, brain scanning, software capabilities…

What‟s harder to see is that this exponential pace of growth is itself accelerating at an exponential rate as technologies reach the limit of their capabilities and are subsequently replaced by new technologies that progress even faster. This means the rate of technological progress in the 21st century is likely to be about 1,000 times faster than in the 20th!

Who knows what will arise from this unprecedented pace of development in electronics, energy, communications, etc.? And how should we value companies whose products improve like this?

Chip speed rises exponentially Growth grows exponentially too

Source: Intel Source: Ray Kurzweil

Intel chip speed

10

100

1,000

10,000

93 94 95 96 97 98 99 00 01 02 03 04

MHz

33


Summary

Economy: recession could last longer than market expects

Investors are not familiar with a balance sheet recession. They expect that this recession will be a normal one and that fiscal and monetary easing will allow the economy to recover in short order

As a result, we expect there could be some surprise at the depth and length of the recession

Europe may have fewer balance sheet problems, but it is less able to take coordinated fiscal action and therefore may suffer more than people think

Even after the problems are over, growth is likely to be sluggish due to “debt rejection syndrome”

Equities: a market of stocks

Equities overall tended to trade in a range during Japan‟s balance sheet recession. Simply buying and holding the market did not provide any return at all lover the long term in Japan

The best companies were able to perform nonetheless with products that set them apart and allowed them to maintain prices even in a deflationary environment. They also had better financial resources and so were able to get their balance sheets in order faster. Stock picking was essential

Small cap stocks on the other hand underperformed, for the opposite reasons

Bonds: unbelievable bull market

Short-term rates went down to zero and remained there. Long-term rates eventually hit the lowest level in history. Bond yields stayed low for a surprisingly long time. The yield curve flattened

Enormous issuance was not a problem as banks and insurers had no other outlet for funds. This time it could be different for US as US is a debtor nation, not a creditor

Credit spreads narrowed as investors moved further out the credit curve in search of yield

34

Important notes

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Documents

global balance sheet

typical recession

current recession

economic outlook

economic policy

different type of recession

debt doesnt

global economy