Fk Commentary 15 September 2009

QInvest Private Client Advisory Commentary Fatih Karatash, Head of Private Client Advisory September 15 2009

QInvest Private Client Advisory Commentary

Markets have seen a rebound on better than expected earnings and the mirage that things are not only stabilized but also starting to improve. Bernanke coming out today to give the all clear is just whipped cream on the market froth.

What we’ve seen in the numbers though, has largely been above-consensus cost savings, inventory restocking, and other onetime events. These are all quite useless as it pertains to the market ascribing a multiple to these incremental earnings that are not repeatable in a sustainable manner.

What we need to see is top line revenue growth and employment pick up, which is effectively impossible as companies continue to dramatically reduce costs. Markets are gorging on available liquidity and getting ahead of themselves.

Leverage continues to be a problem in the world. We don’t believe you can work through the problems stemming from the bursting of the largest credit bubble in history with only a couple quarters of pain. Deleveraging around the world will continue, and it will come in the form of debt paydowns, bankruptcies, and home foreclosures. The pain may not be sharp like we’ve seen recently, but it will take years to get to the next secular growth phase for corporate earnings and cash flows.

China is pumping money into their economy in order to try and make up for lost exports as they wait for the US and Europe to recover, this in itself has resulted in the fastest rise in real estate prices in China over the past few years, with lending in excess of New Zealand’s GDP just in the first half being extended to borrowers.

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Qinvest Private Client Advisory Commentary

A significant amount of this money is adding to capacity in areas operating at very low utilization rates, creating more capacity, lowering utilization rates further. At the same time along with Bernanke’s triumphant proclamation, we see headlines on industrial capacity utilisation being at the lowest ever on record in Canada, thousands of layoffs a day from Corporates worldwide and none of the positive talk from company executives in private.

The US and Europe have quantitative easing (monetary diarrhea, see the attached Monetary Base Growth chart) programs in place as well as other subsidy-like programs (TARP, TALF, cash for clunkers, cash for appliances) that all are focused on adding liquidity to the system but all of which will need to be paid for one day in higher savings and lower government spending and higher taxes. For the recovery to be real, it must come from real demand, not government programs, inducements and bailouts that will help near term, but hold back real recovery as they take their hidden toll.

Companies will continue to focus on cost cutting to maintain profitability. This may look positive in the near-term. This will however trickle down negatively, as cost saving has a knock on effect down the value chain, whether it’s squeezing another company’s margins or lost jobs and consumption. Either way, there is no clear evidence corporate earnings and cash flows will recover robustly as long as consumption contracts, which it will so long as unemployment trends do not reverse drastically. Consumers have to continue to save. Employment drives consumption, and the employment picture is still bad. See the graph in the chart deck, which depicts the unemployment rate including discouraged workers who have dropped out of the labor market.

Older Americans are actually gaining jobs, even as other age groups lose them. This is because skilled, older Americans who should be enjoying their Golden Years, are now being forced to return to the labor market due to the wealth destruction that has occurred in the value of their homes and retirment plans which were supposed to fund their lifestyles. This event of Generations X and Y, seeing their Baby Boomer parents and grandparents go back to work will have a profound effect on the US Consumer’s Psyche for years to come.

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Where are we now?

Market decline of -52% from peak to trough, rally of more than 53% from post collapse trough Source: Bloomberg

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Where have we seen this before?

Market decline of -48% from peak to trough, rally of more than 44% from post collapse trough Source: Bloomberg

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Shockingly Similar

Business is continuing on the upgrade, with the danger of a long depression apparently "fairly over," Julius H. Barnes, chairman of the National Business Survey Conference, declared today – Feb 18, 1930

Calls Cheap Money a Costly Panacea – Dr. Anderson of Chemical Bank Says Remedy for Business Slump is only TemporaryB Boon to the SpeculatorB IntoxicantB very substantial temporary effect can be brought about. But Headaches follow – Apr 12, 1930

If one has any doubts about how similar the market action has been between the two periods, here’s an overlay of August 1929 – May 1930 and May 2008 – Present Source: Bloomberg

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The big rally only foretold the next big fall

The red box is where the prior chart fits in with the consequent years’ market action – Yes the Great Depression Source: Bloomberg

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How did we get here?

US Debt (Household, Corporate and Government) as a percentage of GDP

Source: Ned Davis Research, Federal Reserve

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Leverage ratios as high as 1200:1

Poor underwriting and excessive leverage led to Equity, BBB and even AA tranches being wiped out in mortgage backed securities. If one had a CDO with AAA ratings, made up from the BBB tranche of an MBS, it could be fully wiped out The Commercial Real Estate market has yet to see the same kind of decimation the Housing market has seen, which it inevitably will, unless the economy has a rapid full recovery

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Home prices and demand decoupled

Home Sales and Median House Prices decouple, as a result of speculative demand introduced from the free option given to speculators by “zero down” mortgages Exacerbated by the limited liability in the US on home mortgages, where one’s liability is limited to the home the mortgage is on, and any obligations end with the return of the key Source: US Census Bureau

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US Household Consumption % of GDP

Household consumption was driven by easy monetisation of home price appreciation, which in turn was driven by loose underwriting for speculators Absent this, household saving rates will have to increase and consumption must collapse for the foreseeable future

Source: US Bureau of Economic Analysis

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US Savings Rate Savings as % of Disposable Income

Spending as % of GDP

As part of the deleveraging process, the Savings rate must increase and the Consumer Spending must decrease back to somewhere in the middle The current wall of liquidity injected by central banks will only soften the blow and drag it out over a longer period, not take away the need for deleveraging Source: US Bureau of Economic Analysis

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Defaults are bound to rise further Defaults as % of outstanding High Yield Issuance

Default rates will go much higher as growth doesn’t materialise the way the market expects, at least to the 90s level if not higher Source: JPM

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Industrial Production Index

This time it is much worse than prior recessions, and closer to a Depression. One must not be fooled by the 50% rally in equities Source: US Federal Reserve and NBER

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Monetary Diarrhea 2000000

1800000 Monetary Base in Millions of $ 1600000

1400000

1200000

The Monetary Base expansion has simply been explosive and unprecedented. No other words to describe it

1000000

800000

600000

400000

1/6/2009

7/5/2007

2/5/2006

9/5/2004

11/5/20…

4/5/2003

6/5/2000

1/5/1999

7/4/1997

2/4/1996

9/4/1994

11/4/19…

4/4/1993

6/4/1990

1/4/1989

7/3/1987

2/3/1986

9/3/1984

11/3/19…

4/3/1983

6/3/1980

1/3/1979

7/2/1977

2/2/1976

9/2/1974

4/2/1973

11/2/19…

6/2/1970

1/2/1969

7/1/1967

2/1/1966

9/1/1964

4/1/1963

6/1/1960

1/1/1959

0

11/1/19…

200000

We’ve witnessed an unprecedented explosion in the Monetary Base in the US Source: US Federal Reserve

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Unemployment is the elephant in the room

Soaring U6 Unemployment Rate – this is the real rate of unemployment The "U-6" includes two groups of people that the "U-3" which media and the government tend to quote, do not: 1. "Marginally attached workers" people who are not actively looking for work, but who have indicated that they want a job and have looked for work (without success) sometime in the past 12 months. This class also includes "discouraged workers" who have completely given up on finding a job because they feel that they just won't find one. 2. People who are looking for full-time work but have to settle on a part-time job due to economic reasons. This means that they want full-time work, but can't find it.

All the bailouts and stimuli are being used to repair financial balance sheets and not going towards funding real growth and investment, while unemployment continues to rise Source: BLS

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