AMG Leadership and Former Presidents Alejandro Toledo (Peru) and Fernando de la Rúa (Argentina)

As part of AMG National Trust Bank’s continual assessment of capital market opportunities worldwide, we recently hosted a forum with Alejandro Toledo, former president of Peru, and Fernando de la Rúa, former president of Argentina. The candidness with which they spoke and answered questions was revealing and highlighted the challenges and opportunities for investing in South America.

For example:

• Argentina continues to have issues with inflation and a government trending towards socialism.
• Peru is like a young teenager. It has huge potential, but growing out of its adolescence can be awkward and full of missteps. However, its basic resources will allow it to grow and be prosperous.

Toledo explained that part of Peru’s struggle was a “curse of abundance.” An economy built primarily on exporting natural resources without equal regard to improving human capital cannot be stable or thrive in the way a more diverse economy can. Successful investors understand this and direct their investment accordingly. Chinese investment in Peru and other developing countries has been particularly insightful in understanding this issue.

However, China is not the only country investing in South America, and the environment has become quite competitive. U.S. multi-national companies are also well aware of the need to improve human capital as they invest within developing and emerging markets. They have the advantage in innovation and technology, but China has significant monetary resources and can afford to be quite aggressive.

Over the next decade we will continue to see developing and emerging countries benefit from China’s insatiable demand for resources to sustain its economic growth. The real question is if these countries can break the curse and diversify and grow their economies so they can survive should China falter or reach productive capacity.

As government rains money down on the economy, many astute AMG National Trust Bank clients are concerned that inflation could soon erode their financial futures.

While little reason exists to expect inflation to pick up speed soon, the risk is increasing. In coming months, intense price competition brought on by the recession and efforts to pare inventories will make it extremely difficult for businesses to make any price increase stick. That should keep inflation low in the near term. However, the Federal Reserve Bank also is likely to keep short-term interest rates near zero for an extended period. As a result, the money stock and excess bank reserves will grow considerably—which puts the economy at risk for future inflation.

Currently, households and businesses are content to sit on a mountain of cash because of their concerns about the severity of the recession and the lack of safety of other investments, financial or tangible, but this will not always be so. As the economy recovers and the gap between demand for goods and services and productive capacity diminishes, the Fed will have to shrink the excess of money and bank reserves, or we will have the classic cause for inflation—too much money chasing too few goods.

The Fed may not have an easy time shifting policy. Banks may not be eager to buy the non-Treasury private debt now held by the Fed, and the Fed may not have enough Treasury bonds to absorb the excess. Political pressures to maintain low interest rates, when they should be moving up, could also come into play. All indications are that Fed policy makers are attuned to the issue and determined to act—but success is far from guaranteed, and the time for investors to take protective measures is before inflation accelerates.

The contraction of economic output continued apace in the first quarter of 2009. The preliminary estimate released by the Bureau of Economic Analysis (BEA) at the end of April shows a first quarter decline in real GDP at an annualized rate of 5.7%. The first quarter decline follows on the heels of a similar 6.3% drop in the previous quarter. Real GDP has now contracted for three straight quarters, and according to the National Bureau of Economic Research, the economy has been in recession since December 2007. Presently, it appears that the downward path will continue for a couple more quarters, though at a decreasing rate of descent.

The collapse of investment activities was the driving force behind the recession during the first quarter. Real consumer spending actually advanced in the first quarter, increasing an annualized 1.5% after two quarters of declines near 4.0%. The increase fell far short of overcoming massive declines in business structures (down 42.3%), equipment and software (down 33.5%), and residential investment (down 38.7%). A drop in government purchases and a large liquidation of business inventories added to the poor showing of the economy, but net exports offset more than two times those declines.

Monetary and fiscal policies are extremely expansionary. The Federal Reserve (Fed) is effectively maintaining a zero interest rate policy and stepping up the use of non-traditional measures to increase the availability of credit to businesses and consumers. Unsurprisingly, in view of the sizeable drop in production, inflation has faded into the background as an immediate issue for policy makers. With near-term inflation concerns completely out of the picture, the Fed will not be taking its foot off of the accelerator any time soon.

We anticipate real GDP will be down roughly 3% in the second quarter and for 2009 as a whole, but fiscal policy will boost real GDP by nearly one percent in 2009, pulling the economy out of recession in the fourth quarter. Consumer spending, new home sales and home inventories now show signs that a bottoming-out phase has begun. Tight credit conditions and irrational fears that consumer spending was falling down a bottomless pit were prime factors in the miserable first quarter figures for business fixed investment. The Fed’s activities have already helped credit markets begin to thaw, as can be seen by narrowing credit spreads and increased new bond issuance. As improvements in these areas become increasingly apparent, the decline in capital spending will abate. The very worst of the bad news is over.

The stock market has likely seen its bottom for this recession cycle, but the near-term outlook remains problematic. Uncertainty in the banking sector will continue to drive investor sentiment. Nevertheless, equities markets are forward looking, and any demonstrable signs of earnings improvement could reinforce an upward trend as cash and other low-yielding investment holdings rotate back into riskier assets. Improvement in financial market conditions will continue, but as all of the bad economic news is not yet out, investors should anticipate a bumpy ride.

On February 27, 2009 the Bureau of Economic Analysis (BEA) released its preliminary estimate for fourth quarter real GDP. It shows a 6.2% annualized rate of contraction, considerably worse than the 3.8% downturn of January’s advance estimate. A revision to the estimated change in inventories was the largest factor in the downward revision to real GDP. Revisions to consumer spending and net exports were also material. The silver lining is that the revised inventory figure implies future changes to inventory stocks will be less of a drag on real GDP in the first half of 2009 than previously anticipated. New data indicate greater ongoing deterioration in private business activity than in other sectors, but recent budget legislation implies that increases in government purchases of goods and services will accelerate. The net result leaves our near-term outlook for real GDP about the same as anticipated in the March Notes on the Economy.

Background
The BEA’s advance estimates of the National Income and Product Accounts (NIPA) for fourth quarter 2008 indicated that total inventories grew slightly, boosting the annualize rate of change in real GDP by 1.3 percentage points. The preliminary estimate shows that inventory stocks were, instead, pared back. Since the shrinking of inventories took place more slowly than in the third quarter of 2008, the effect of inventories was still positive, albeit much reduced, adding 0.2 percentage points to the change in real GDP.

Estimates for consumer spending and net exports in the fourth quarter also had sizeable revisions. The advance estimate indicated an annualized decline of 3.5% for consumer spending. The preliminary estimate shows a decline of 4.3%, as consumer spending for nondurable goods and services weakened substantially late in the fourth quarter. Thus, the negative impact on real GDP was revised to 3.0 percentage points from 2.5 percentage points. Likewise, the estimated contraction in exports was revised from 19.7% to 23.6%, while there was little change in the estimate for imports. As a result, the impact on real GDP from net exports was changed from a positive 0.1 percentage points to a negative 0.5 percentage points.

Other revisions to the major sectors in the NIPA were of little effect on real GDP. Minor downward revisions to the level of business fixed investment were offset by higher estimates for homebuilding and government purchases.

Looking Ahead
Cuts to inventories will be a major drag on real GDP during the first half of 2009. The revision to the estimate for the change in inventories was not entirely unexpected. Prior to the publication of the advance NIPA estimates for the fourth quarter, we projected that the change in inventories would push the annualized rate of decline in real GDP down by 0.5 percentage points. Since the preliminary estimate still shows a positive contribution to real GDP, the implication is that businesses remain well behind in their efforts to bring inventories back in line with sales. New figures for December inventories confirm that inventory-to-sales ratios are considerably elevated. However, the downward impact on our projections for real GDP is reduced by roughly the amount of the difference between the advance and preliminary estimates for inventories.

The downward revision for consumer spending is cause for concern. Although retail sales increased in January, this does not signal that a bottom is at hand. Consumer sentiment expressed in University of Michigan and Conference Board surveys plummeted in February. Based on weekly unemployment claims data, we anticipate that payrolls shrunk by more than 700,000 in February and that the unemployment rate, which was 7.6% in January, will close in on 8.0%. So consumer spending will probably still be down about 4.0%, or so, in the current quarter before bottoming out in the second quarter.

The weakness in exports was hardly a surprise and the downward revision was not abnormally large for such a volatile series. Imports were off dramatically, as well, due to the overall weakness in domestic demand, and there was little downward revision to the total import figure. As discussed in the March Notes a bounce-back in next exports is probable in the first quarter, before net exports turn into a consistent drag on GDP growth. However, the outlook for the first quarter bounce has been pared back in view of deteriorating economic conditions abroad.

Large double-digit percentage declines for business fixed investment and residential investment are still a sure thing in the first half of 2009. Recent reports for durable goods orders and new housing permits confirm previous expectations. On the other hand Congress wrapped up the budget for fiscal year 2009 with an omnibus bill containing higher budget authority and proposed outlays for discretionary spending than we had previously anticipated, boosting the outlook for growth of government purchases.

The Bottom Line
The first quarter’s decline in real GDP will be in the range of 6.0% to 6.5% annualized, while the contraction for the full year 2009 will top 3.0%.

The Business Cycle Dating Committee of the National Bureau of Economic Research (NBER) has determined that business activity peaked in December 2007, marking the beginning of the present recession—notwithstanding the fact that total economic output, as measured by real GDP, reached its recent maximum in the second quarter of 2008. The NBER is generally recognized as the arbiter for dating peaks and troughs in economic activity, and it uses a number of data inputs in making such determinations. In reporting its decision that the economy is in recession, the NBER cited real (i.e. inflation-adjusted) personal income (less transfer payments), real manufacturing and wholesale-retail trade sales, industrial production, and employment estimates based on the Labor Department’s monthly household survey. Its report noted that all of the forgoing items reached peaks between November 2007 and June 2008. It stated that real GDP (which declined slightly in the fourth quarter of 2007, rose in the following two quarters and then declined again in the third quarter) was ambiguous. The NBER was apparently most convinced by payroll employment, which peaked in December 2007, in selecting a date for the business cycle peak.

On November 25, the Bureau of Economic Analysis released its preliminary estimates for third quarter GDP and related figures. This release revised the advance estimates that had been published in late October. The preliminary estimate for the annualized third quarter rate of decline in real GDP is 0.5%, only 0.2% greater than the advance estimate. Consumer spending fell more steeply than first estimated, 3.7% rather than 3.1%. That took 0.4 percentage points off of the real GDP growth rate, but the cut was nearly offset by a reduction of the estimated decline in inventory stocks. Unfortunately, that change in the composition of real GDP implies greater difficulties for the economy in the immediate future. The larger decline in consumer spending indicates aggregate demand is declining more rapidly than first estimated, while the inventory figures imply that businesses will have to cut back production even faster than expected in order to bring inventories down to desired levels.

Other recently released data confirm an accelerated rate of decline in economic activity. Initial claims for unemployment benefits have climbed, indicating that the payroll employment for November (when released December 5) will show job losses well above October’s figure of 240,000 and probably exceeding 350,000. The Institute for Supply Management reports that its indexes measuring both manufacturing and non-manufacturing business activity continued to decline further into recession territory. The Conference Board’s Index of Leading Indicators dropped 0.8% in October, indicating additional economic deterioration is likely in the near term. The October/November surveys conducted by the various regional Federal Reserve Banks, and reported in the Fed’s Beige Book this week, were decidedly downbeat. For the third consecutive month, all Federal Reserve districts reported weaker economic activity. The silver lining is the report that price pressures have eased and that lower prices, in general, are anticipated for the near term.

With the threat of inflation now virtually nonexistent (and the emergence of deflation a possibility), it is probable that the Federal Reserve (Fed) will cut its policy target for the federal funds rate again. We expect a 50 basis point cut to 0.5% following its December 15-16 meeting and, quite possibly, another 25 basis point cut at the end of January. We also anticipate an additional fiscal stimulus package worth more than $500 billion in the form of new benefits programs, tax cuts, state aid and infrastructure programs likely to be enacted in early 2009. Accommodative monetary and expansionary fiscal policies will provide the needed boost to revive the economy, but it will take time before they have a material impact on production of goods and services, and the delay in fully implementing the Troubled Asset Relief Program does not help.

The decline in real GDP will be deeper than projected in November’s Notes on the Economy. We currently anticipate an annualized decline of about 4.6% in the fourth quarter of 2008 and 3.9% in the first quarter of next year. Weak real GDP growth should resume by the third quarter of 2009, but a turn-around in home building is not expected until the fourth quarter. Considering the NBER’s dating for the peak in economic activity, the current recession will most likely last longer than the previous post-World-War-II record of 16 months for both the November 1973 to March 1975 recession and the July 1981 to November 1982 recession. The decline in real GDP from the NBER’s fourth quarter 2007 business cycle peak through the second quarter of 2009 is expected to be about 1.7%—slightly more than the 1.6% average of the decline calculated between the peak and trough quarters of the ten recessions dated by the NBER since 1948.

Except for the likelihood of an extended low-interest-rate environment for Treasury bonds, notes, and bills, the short-term outlook for investment is little changed by the recent economic news. As reported in more detail in November’s Notes, the main driver for the gross undervaluation of nearly all assets (except U.S. Treasury securities) is the global deleveraging that has taken place since August 2007. One cannot say the bottom in asset prices has been reached or that previous lows will not again be tested. However, it is likely that the actions undertaken by the Fed, the Treasury, and other monetary and fiscal authorities around the globe will soon begin to take hold, and financial markets are due for a rebound from oversold conditions.

The Bottom Line
Economic output will fall rapidly through March 2009 and continue to contract until mid year; recovery in the second half of 2009 will be tepid.