2009 and Beyond

The economic climate of 2009 will be very tough, especially for the average consumer. The U.S. and European consumers are officially tapped out. Retailers are barely clinging to life, fighting each other to be the last one standing. While 2008 hit the financial markets, 2009 will be much more visible and hit closer to home for most people. Instead of reading about toxic CDO’s and crooks such as Madoff, which most people have never heard of before, they will be seeing their communities afflicted with a lot more liquidation signs and then a lot of vacant commercial real estate. The job market will be brutal. This does not necessarily mean that asset prices will continue a perpetual downward spiral because much of this is already priced in.

Residential real estate prices in many parts of the United States will probably start to bottom out. During this period, which is likely to take some time, investors should be able to find very good deals if they look hard enough. Other areas such as NYC and Chicago will likely have significant downside left. In the case of New York and Chicago, this will be because the financial services industry will be undergoing dramatic consolidation. Most of the rest of the country should show signs of recovery as prices are considerably lower and the federal programs will begin to help set a floor on prices. Some areas that have seen the most dramatic price declines are beginning to present tremendous opportunities. In particular, Miami seems to be one great place to look for good value and upside potential.

There are several reasons why Miami real estate is beginning to be very appealing. Price declines have been much steeper relative to most other U.S. cities which will likely attract more buyers looking for a bargain. Strong buyers have significant leverage over sellers in this market. About six months ago, banks were still not willing to reduce mortgage principals by much in order to close a sale. Now, I am finally seeing huge write-downs on mortgage principals to facilitate short sales. I have observed recent closed sales where the final price is approximately 50% of the original mortgage balance. Over the longer term, another potential upside to Miami is improved relations with Cuba. Obama is much more likely to change US trade policy towards Cuba, which would most likely be initiated by removing travel restrictions. With Fidel Castro’s health being very fragile, it seems more likely now than ever that we will soon see some fundamental changes in U.S.-Cuba trade relations. Some people question whether or not this would be good for Miami. However, I think it would clearly be a strong positive growth factor for both Miami and Cuba. Miami will benefit by being the natural staging point for trade between the United States and Cuba. Another reason why I am leaning towards Miami is that if dollar declines resume, Miami’s tourism industry should benefit somewhat. Although I see a lot of upside potential, It is still a little too early for me to be bold enough to declare a bottom because selling pressure and lack of buyers will likely cause prices to decline further over the next couple of months.

Commercial real estate may take longer to find a bottom than residential real estate, in large part, due to a lack of financing. Commercial real estate is slightly behind the curve because investors had incorrectly assumed that cash flows would not be significantly impaired by the economic downturn. With high-grade fixed income securities offering enticing yields, commercial real estate will not become attractive until sellers get realistic about the relative value of their properties and market them at higher cap rates. The U.S. government and Federal Reserve are unlikely to offer the same type of direct backstops they have been offering to the residential market through their support of the GSE’s, Fannie Mae and Freddie Mac and purchase of their mortgage backed securities. Many commercial property owners will not be able to refinance loans made over the past three to five years, which will have balloon payments coming due. Those with some equity will be forced to sell which will create more downward pressure on the market. Mortgage lenders will have to accept lower principal payments if we are to reach the bottom more quickly.

The economy is and will continue to be in a deep recession the likes of which the MTV generation has never seen. The most difficult question to answer is how long will the deflationary tendencies of this recession last. If I had to make a call on that, I would say probably less than a year. This is how long I think it would take for many inventories to be cleared and for many bankruptcy liquidations to take their course. Once the excess supply and competition is thinned out considerably the survivors will regain some pricing power. The market seems to be pricing a much longer deflationary period based on the relatively high yields offered by Treasury Inflation Protected Securities (TIPS).? I believe TIPS offer much better capital preservation than any other U.S. Government bonds.

The Obama administration will likely succeed in restarting inflation. Many emerging markets that were at one point trying to support their currencies in face of the downturn are now trying to cheapen their currencies in order to revive exports. The interesting thing now is that so many countries are debasing their currencies at the same time that it will have very little impact on their balance of trade. In the short run this will provide some support to dollar. However, in the end it will only hurt global sentiment for paper currencies as a store of value. Currency debasement will likely encourage speculation in commodities once again as they are relatively cheap. I expect this to happen sooner rather than later. Oil at less than $40 is very cheap will force severe supply contraction if it stays this low for much longer. Even the industrial metals have gotten so low that it seems a depression is already priced in.

The Democratic Party came just short of the 60 senate seats required to block filibusters. However, the terrible shape of the real economy will give the Obama administration the ability to rubber stamp almost any legislation it wants. While I do expect significant stimulus programs, it is unclear to me which promises, if any, will Obama have to sacrifice. It seems that Obama will try to incorporate his promises for green initiatives into various stimulus packages. However, it is likely that in many instances he will have to settle for simply trying to keep the titanic from sinking.

From my perspective, it seems as if there are finally some signs that the worst of the asset deflation is over. One of these being that there is so much forced liquidation, the type of condition you need to reach a bottom. Volatility and corporate bond spreads over government securities show just how intense the fear is. These spreads have come in a little but are still very wide. I think that it is time to shift gears from extremely defensive to more offensive. I would still focus on companies with quality earnings and strong balance sheets. High-grade corporate bonds also offer very good yields currently and the impending wave of bankruptcies has already been priced in. I would still stick to shorter maturities because of the risk that inflation accelerates rapidly in the coming years. Things remain very unpredictable but I am more optimistic than I was last year. The biggest concern I have going forward is the expansion of the Fed’s balance sheet and what the longer term impact of trying to keep interest rates so low will have on the economy. Considering all of these government bailouts and impending obligations it is a wonder to me that the 30-year treasury currently yields less than 2.9%. As Marc Faber puts it in a recent Barron’s panel discussion, “This was the last bubble the Fed was able to inflate, aside from their egos.”

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