CFA LA Society Forecast Dinner

[HenryTo]

Link to the program tonight:

http://www.cfala.org/cfmfiles/cal/eventlist2.cfm?id=685&t=g&d=Z

I will provide a quick summary of this tomorrow.

[nodoodahs]

Hey, the "Money Honey" will be there!

[insert off-color remark about her behavior on planes with corporate execs here]

[insert joke about staying away from "Maria 1.0" or the fiancé will be jealous here]


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He was wearing my Harvard tie. Can you believe it? My Harvard tie. Like oh, sure, HE went to Harvard.

[HenryTo]

Here is a link to the 2008 CFA LA Society Annual Forecasting dinner, scheduled to be held on February 27th. I just registered and will report back with any interesting information.

https://www.cfala.org/cfala/EventDesc.aspx?ID=760

[HenryTo]

Sorry, I meant post 1990s recession - that is, the 2001 recession.

Capital spending has actually been rising at a good pace over the last few years. Few have noticed, and I also expect it to accelerate over the next 18 to 24 months.

[rffrydr]

1990 recession one of "excess capital spending"?! The end of the cold war, the end of baby boomers "me" decade, the heretofore and maybe still biggest Real Esate bubble in America (and utlimate Federal Bailout), the japanese buying of Rockefeller Plaza and Pebble Beach.....

Here in MT we refer to that time as a "consumer-led" recession.

What does a "Platform Economy" export? It's hard to see the capital investment when banks are busy buying themselves, but maybe banks are just out of loop these days.

The yield-curve is not a problem--one because of steep rate rises, the other because of steep rate cuts. That's convenient!
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Today is the Tomorrow you worried about Yesterday!

[HenryTo]

Hi Everyone, here is the summary of the CFA Annual Forecast Dinner held on February 1st. Panelists include Abby Joseph Cohen, Paul McCulley of PIMCO, John Taylor (Stanford professor and creator of the "Taylor Rule" in making monetary policy). Moderator: Donald Straszheim of Roth Capital Partners.

The U.S. Economy in 2007

Abby Cohen:

• US economy is changing in that it is decelerating from above trend to below trend
• Strength is rotating: economy energy no longer coming from housing sector/consumption, but shifting to capital spending & exports
• Inflation drifting upwards, not galloping, because income growth is slightly higher than inflation – which will be an important issue in the 2008 election
• The Fed is still very watchful with regards to inflation trends and job growth. The question is: When will they step on the gas again? Most probably do not need to step on the brakes, but all these will also depend heavily on where the European and Japanese economies are heading.

Paul McCulley:

• The soft landing (aka “Goldilocks”) scenario is now the most appropriate. Paul believes that a recession occurs as a means to purge the “sins” and “excesses” of the preceding boom, and he doesn’t believe that the economy has “sinned enough” in the last boom in order to warrant “recession hell.”
• That being said, for the most part, he agrees with Abby that the economy is decelerating. The 4th quarter preliminary GDP growth of 3.5% was a temporary spike, as the month of December (and the first two weeks of January) represented the warmest December in 117 years – resulting in significantly more economic activity than during a typical December.
• Believes that real estate market will continue to experience negative growth. There is still an overhang of unsold vacant homes – and it is still too early to be calling a bottom. The most important/telling data point will come in spring – when non-seasonally adjusted sales data should pick up.
• Believes that the “neutral” Fed Funds rate is 4 to 4.5% and that the Fed should ease later this year.
• Believes that the biggest risk in the financial markets today is the extreme complacency in the financial markets – what Paul McCulley has termed “The Great Moderation” – such as record low yield spreads, low volatility, etc. Stability leads folks to take on excessive risks – which will inevitably lead to instability (quoting Hyman Minsky).

John Taylor:

• Does not believe in the current consensus of a soft landing in the US. Rather, he believes the economy is “flying right along” and should maintain a 3% to 3.25% growth rate in 2007.
• The expansion since 2002 is now the third longest expansion in modern history. Compare that to the expansion during the 1990s and the 1980s, which ranked 1st and 2nd, respectively. This is no coincidence. Rather, this is a result of good monetary policy (with a focus of inflation targeting) – not just in the US but around the world. Good policy will ensure that this expansion will continue.
• Risk factors include: Losing financial stability at the end of this year as well as higher inflation – which will induce the Fed to raise rates.
• On a global basis, we have also witnessed much better policies in recent years. For the first time in a long time, there is no financial crisis or recession occurring in the emerging markets today. At this point, there may be some “overshoot” in risk assessment and enthusiasm, but most likely, we will only see a small correction.

On Globalization, and Are We Now in an Era of Long Booms?

Abby Cohen:

• Today, in general, there is very good management in US corporations.
• We also have a period of low inflation. Combined with improved technologies and the development of an inventory “just-in-time system,” there is no reason to build inventories. As a result, the I/S ratio has been on a secular downtrend.
• If you read a 1940s – 1950s era economic textbook, business cycles back then were known as “inventory cycles.” That is, the business cycle was driven by the overbuilding and the subsequent purging of inventories. The 1990s recession was mainly caused by an excess in capital spending and subsequent readjustment, which is very similar. Today, capital spending is growing but not as strong as the 1990s. This is good for the economy going forward. [note: Abby is implying that consumer spending is not the main driver of business cycles, even though it makes up 70% of GDP]
• Today, we also much more focused on “quality growth” – as opposed to sales growth which was all the rage during the 1990s. Cash levels currently at very high levels as well. In general, U.S. corporations are very disciplined and this ensure continued economic growth going forward.
• [Henry’s note: Economic growth driven by capital spending – as opposed to a construction/housing boom which also drives consumer spending higher among the lower middle income class – is deflationary in nature. Not only does this mean benign CPI readings going forward, but depending on where this money is spent (and right now, it increasingly looks like a main drive will be the “alternative energy”), chances are that energy and commodity prices will decline going forward as well]

John Taylor:

• Globalization has helped in a very constructive way. Believes it is essential for foreign countries to do well in order to ensure a stable world as well as sustained US economic growth. In general, globalization is a win-win proposition for the US economy.

Housing – Why hasn’t housing cause a dramatic slide in the economy?

Paul McCulley:

• It takes time. For example, there was no widespread recognition that the market was rolling over until 12 months ago. And it has only been six months since reality has set in. There is more damage to come, especially since oil prices have most probably bottomed.
• Residential construction will continue to be a drag on growth for a couple of more quarters.
• Sees 25,000 to 30,000 monthly job losses in the residential construction sector for the next six months.

John Taylor:

• Believes that housing has already bottomed.
• Most people forget that there could be “good spillover” effects from a cooling in the housing market – such as a potential increase in the official savings rate when house prices stop appreciating.

Abby Cohen:

• The housing construction correction is not over. Employment in this sector will continue to decline.
• However, the non-residential real estate market will continue to boom and this will offset some of the weakness in the residential sector.
• The ugly numbers in new construction will continue over the next few months.
• Personal consumption has surprised on the upside – since only low to lower-middle income class families have felt the pain in the housing correction thus far.
• Low to Lower-middle class income families have been using monies from mortgage equity withdrawals (“MEW”) for current consumption, while others have been utilizing MEW to pay down their higher-yield (such as credit card) debt, or for home improvements. Borrowing at 6% and paying down debt yielding 16% makes perfect sense. Moreover, many families have also locked in their mortgages at relatively low long-term rates, with both suggesting that any correction in housing prices will have no further impact on the economy.


Crude Oil

Abby Cohen:

• Believes crude oil prices will be determined by physical demand/supply – as opposed to financial participation. Estimates that $12 of the run-up in 2005 to 2006 was due to financial (such as hedge funds and pension funds) participation.
• Oil should trade between $50 and $65 a barrel in 2007.
• However, the average economic impact of higher energy prices is not that big of a deal, since 1) As a percentage of household spending, spending on energy has been on a secular downtrend since the early 1980s, and 2) the “energy intensity” (amount of energy needed to produce a certain unit of GDP) of the U.S. economy is only about half of that 20 years ago.
• However, the “energy intensity” of the US is still higher than that in Western Europe and Japan.

John Taylor:

• Still worried over the supply side.
• Economic impact has changed so much since the 1970s.
• Inflationary expectations still very low. Competition is good so producers are very reluctant to raise prices – and thus no significant pass-through of higher energy prices to consumers.

Inflation and Interest Rates

John Taylor:

• According to what he sees now, he believes a FFR of 5.25% is about right (which coincidentally, would be the rate calculated under the “Taylor Rule”).
• However, the FFR will probably have to rise unless inflation keeps coming down to the Fed’s “comfort zone” of 1% to 2%. If inflation increases from current levels, then you will definitely see an increase in the FFR.
• Inflation will remain elevated for awhile.

Paul McCulley:

• Does not believe the 1% to 2% “comfort zone” is the right target for the Fed.
• 1.5% to 2.5% is probably the better range (don’t forget that the Fed was scared about deflation when the CPI was at 1.5% in 2002) – meaning that the Fed is willing to tolerate a slightly higher inflation rate if job growth or financial stability is at risk.
• The Fed will only raise the FFR if unemployment declines below 4%.
• The Fed should be on hold at this time, but should lower rates if unemployment hits 5% sometime this year.


Abby Cohen:

• Concurs with Paul McCulley regarding flexibility as opposed to strictly using mechanical rules.
• Today’s economy is driven by services, and since productivity is very difficult to measure in a service-based economy (unlike manufacturing where you are producing tangible goods), the Fed’s decisions should not be driven by purely mechanical indicators.

Equities

Abby Cohen:

• U.S. equities today are underpriced. Using a DCF approach, and using some conservative assumptions (e.g. lower-than-consensus GAAP earnings estimates, an increase in the long-term interest rate of 50 to 75 basis points, etc.), Goldman strategists believe that the S&P 500 is approximately 10% under fair value today.
• Since the peak of the S&P 500 in March 2000, earnings have risen 70% (and they are better quality as well), and cash levels have risen 102%.
• Historically, small and mid caps are usually undervalued compared to large caps, but this is no longer the case. There has been an enormous appetite for risky assets such as small caps and emerging markets in recent years, and they are increasingly getting nervous about them.


Paul McCulley:

• Also likes equities, and believes the “soft landing” scenario will allow the Fed to ease.
• From a relative valuation standpoint, the equity “risk premium” has moved up – and thus, there is no longer “irrational exuberance” in the stock market anymore.
• Large cap value the most underpriced asset class today.
• From a valuation standpoint, the stock market is the “cleanest dirty shirt” among all the asset classes in the financial markets today.

John Taylor:

• Also likes equities.

International

Abby Cohen:

• Trade gap between US vs. Euro Zone and Japan are mainly due to much better-than-expected growth of the US economy vs. both the Euro Zone’s and the Japanese economy. Not coincidentally, imports from the Euro Zone and Japan have grown at a pace that is similar to US GDP growth over the last few years.
• Despite our trade deficit with China, China’s net trade balance is relatively even.
• 40% of revenues and earnings of the S&P 500 now come from outside the US.

Global Markets – Best/Worst in 2007?

Abby Cohen:

• On an absolute return basis, Abby likes EM Asia, but they are also the most volatile. Out of the developed countries, Japan offers the best value. US and Europe comparable. 10% appreciation in both stock markets very easily achievable.

Yield Curve in 2007?


Paul McCulley:

• Yield curve will be flatter than historically. That being said, he doesn’t believe there is a permanent reduction in the term premium.
• By the end of this year, the yield curve will be steeper because of cuts in the FFR, and he expects long-term rates to stay relatively the same.

John Taylor:

• No reason to think that inverted yield curve will cause recession.
• Believes that because of low inflation (and thus low long-term rates), the yield curve will invert when the Fed tightens.

Corporate Profit Margins in 2007?


Paul McCulley:

• Margins have been pretty lofty and will stay so since corporate sector has pricing power relative to labor sector.

John Taylor:

• Over the long-run, wage growth tends to be very similar to productivity growth. Over the last few years, this has not been the case. He expects wage growth to “catch up,” but in the meantime, he also expects corporate profit margins to stay high.

Private Equity and Hedge Fund Growth in 2007?

Abby Cohen:

• Historically, the best returns in an asset class are made if you are one of the first investors to be in that asset class. The question to ask is: When happens now that there are so much money going into both hedge funds and private equity funds?
• As a result, returns should be lower going forward.

Paul McCulley:

• To the extent that these funds make the global markets more “efficient,” he believes that there is a definitely a role for these funds in the financial markets. However, there is now too much money chasing too few themes, and this could be destabilizing going forward.