With the United States immersed in a recession, President Obama's administration and Congress continue taking unprecedented steps to stimulate the national economy. Thomas Dillman, Executive Vice President of Mutual of America Capital Management Corporation, takes a look back at the incredible events of 2008, and provides insights into the magnitude of the current economic crisis, its likely duration and the efforts being made to emerge from this historic predicament.
The year 2008 will go down in history as one of the worst ever for almost every conceivable type of asset. Except for a handful of small equity markets around the world and the U.S. government securities market, negative returns—generally of large magnitude—were the norm.
A World of Negative News
For equities, the U.S. Large Cap S&P 500 Index was down 37.0% on a total return basis. Russell Small Cap and Mid-Cap Indexes were down 33.8% and 41.5%, respectively. Outside the United States, equity returns declined by similar amounts in the larger European markets, Canada, Japan, Korea, and Brazil. However, among the smaller Western markets, and especially those of less developed economies, returns were much worse. In Europe, Italy was down 48.7%; Belgium, 53.8%; and Ireland, 66.2%. In Asia, the Philippines declined 48.3%, and Indonesia fell 50.6%. Finally, the Chinese (Shanghai) and Russian markets were down an astounding 70.1% and 72.4%, respectively, for the year.
Bonds also endured a very difficult year. In the U.S. market, the only sectors that had positive returns were U.S. Treasuries and U.S. agency securities, up 12.4% and 4.4%, respectively. Investment Grade Corporate bonds declined 3.1%, while High Yield Corporate bonds declined 26.2%. Foreign bond markets generally fared worse, especially among emerging markets.
Housing, of course, is another asset class that performed poorly. For the year, residential housing prices were down about 19%, and from their peak in mid-2006, are now down 25%. Commercial real estate prices have also come under pressure as the financial and economic crisis has deepened over the past five months.
And then there are commodities, which essentially collapsed in mid-2008 after having driven huge returns over the previous few years. In 2008, the CRB Index—which tracks a variety of industrial and agricultural goods—declined 36%, paced by mid-50% declines in oil and copper, but mediated by lesser declines in agricultural commodities such as corn and wheat. Gold, generally a haven from market tumult, only managed to eke out a 4.3% gain in a year marked by fear, panic and risk aversion.
The Domino Effect
The causes of this market turmoil have been exhaustively documented in past issues of this report and in the press. In summary, a housing bubble turned into a housing recession; the housing recession caused an implosion of the global financial system; and the financial meltdown caused a decline in overall economic activity. Now the financial crisis and economic contraction are feeding on each other in what economists, borrowing a concept from medicine, call a "negative feedback loop." This is characterized by a reduction of output in one system in response to a reduction in output of the other, and so on.
As a result, the United States economy, and nearly every other economy in the world, is in recession, the length and depth of which is the central issue of concern and debate. It has already been officially determined that the U.S. entered recession in December 2007, and it is fairly widely agreed that our recession began before those in other economies. Thus, even if the U.S. economy were to begin recovery within the next six months, global recovery would not be likely at least until early 2010.
15 Months...and Counting
Unfortunately, a U.S. recovery is probably unlikely to begin at least before the end of this year at the rate things are going. Most key economic statistics continue to show deterioration, including consumer spending, employment, industrial production, capital spending and exports. And from a historical point of view, the current U.S. recession looks to be in its early stages, even if it has been going on for over a year.
The chart below graphically depicts the duration of every U.S. recession on record. Each vertical bar represents a distinct recessionary period, and the length of the bar represents the duration of that particular recession. Note that the red bar representing the current recession is among the shorter. Furthermore, the longer bars representing the longer recessions of the past are characterized by simultaneous financial crises such as the one we are experiencing, suggesting that we have a ways to go before the economy begins a sustainable advance.
Desperately Seeking Solutions
At the same time, the financial crisis persists, despite the unprecedented actions already taken by policy makers throughout world. All central banks, led by our Federal Reserve, have lowered benchmark interest rates dramatically. In addition, the Fed has instituted a large number of programs to provide "liquidity"—or funding for day-to-day operations of various key components of the financial system—in order to keep the system as a whole functioning. The Fed, along with the U.S. Treasury, has facilitated the acquisition of several failing financial institutions by healthier ones, as it did with Bear Stearns and Wachovia, for example. And it has effectively taken over control of the key Federal mortgage lending agencies, Fannie Mae and Freddie Mac, as well as American International Group, formerly the largest insurance company in the world.
Furthermore, there's the Troubled Asset Relief Program, know better as T.A.R.P. This legislation, passed by Congress after a highly contentious debate, authorized the U.S. Treasury to inject an initial $350 billion into the banking system to shore it up. Recently T.A.R.P. authorized an additional $350 billion for actions yet to be determined, but probably including government purchase of bad assets held on bank balance sheets, and a subsidized loan modification program to help homeowners on the brink of foreclosure to stay in their homes. Notwithstanding these dramatic and expensive responses, the U.S. Treasury has had to provide emergency bailouts for Citibank and Bank of America, two of the largest banks in the world, within the last two months.
Crisis of Unprecedented Cost
To put the magnitude of this effort into historical context, the table below lists some major fiscal initiatives in U.S. history in comparison to the expenditures to date for the current financial system rescue operation. All figures have been adjusted for inflation so the dollar amounts are in today's dollars. This list includes the Marshall Plan (the program to reconstruct Europe after World War II); the New Deal (Franklin Roosevelt's program to end the Great Depression); and the Iraq War, at $600 billion and counting.
The conclusion: We've spent more so far on the current crisis than the total of all these other programs combined. That makes clear the magnitude of the challenge we face.
A Tough Year Ahead
Fortunately, more firepower is on the way. The new Obama administration is on the verge of announcing a comprehensive, wide-ranging fiscal plan proposing a variety of Federal spending programs totaling $850 billion over the next two years. Most commentators believe the final bill will end up being much higher, but that eventually such government spending will be successful in mitigating the downside of the recession and in laying the groundwork for a recovery.
However hopeful or convinced we are that the will and creativity of our leaders, the wealth generating capacity of the U.S. economy over time, and the strength and fortitude of the American people, will ultimately triumph over our current woes, it will take time, and it will be painful.
U.S. Gross Domestic Product, the broadest measure of economic growth, was just reported to have contracted 3.8% in the 4th Quarter of 2008, following a 0.5% contraction in the 3rd Quarter. Further contractions are likely in at least each of the next two quarters of 2009. Given such dire growth prospects, unemployment will likely rise from its current 7.2% to probably more than 10%. Many smaller banks will close their doors and many companies, large and small, will go bankrupt. Moody's projects that the corporate default rate, currently at 4.4% in the U.S., will hit 15% by the end of 2009, well above the previous peaks of 10-11% in the 1991 and 2002 recessions.
Under such circumstances, stock markets are unlikely to show any sustained advance, and will almost surely continue to show the type of volatility witnessed last year. In general, bull markets require at least a good chance of sustainable positive economic growth, and that is just not a reasonable expectation on any near term horizon at this time.
Seeking A Sustainable Advance
And yet, markets tend to anticipate the future. We probably saw the lows in stocks last November, unless the financial crisis and recession deepen further, or prove totally unresponsive to stimulus. And we will probably have to endure a series of rallies and retrenchments before the fundamentals sort themselves out and stabilize. This bear market has already witnessed two 18-23% advances since late October, only to see most of those gains given back.
But stocks will, at some point, begin a sustainable advance well before the news becomes positive. Investors are already looking for signs of such an inflexion point by looking at economic data as it is reported for signs that deterioration is slowing. For markets, "less bad" sometimes is good, especially when enough of the data seem to confirm that the worst of the declines have passed. That day will come, and we're hopeful it will arrive before the end of this year. Right now, unfortunately, too much is unknown while the data is still moving in the wrong direction.
In the meantime, Capital Management has positioned its portfolios for the current environment, and with the objective of outperforming its benchmarks and peers, as it did in almost all cases last year.
Editors' Note: On February 17, 2009, President Barack Obama signed his $787 billion recovery package into law. Provisions of the new law include: $116 billion in tax credits ($400 payroll tax credit for workers earning up to $75,000; married couples filing jointly get $800 for income up to $150,000); tens of billions to states to help balance education budgets, prevent cutbacks and modernize schools; and billions directed to infrastructure projects, renewable energy development, and healthcare aid.
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