Retail spending, bleak statistics - but is it a good forecast for 2009?

Economic statistics have been pointing only one way since the past 3-4 quarters - down! Though the NBER announced a few months back that we 'technically' entered recession some time in Q4 2007, we really didn't feel the intensity of the slow down till Q3 2008, especially after the Lehman-Merrill day in September '08. Almost all indicators are very bleak by now - retail sales fell by 1.8 and 1.2 percent respectively in November and December, with same store sales falling close to 2.2 percent on the average as compared to the same period in 2007. This, along with an exteremly depressing unemployment rate of 7.2%, paints the picture of a deep, gloomy slow down period. The big question in every one's mind is - is this the start of a deeper recession or is the worst behind us?

WIthout doubt, the slow down has deeply impacted consumer sentiment and thus damaged the trend of the single largest factor which drives over 2/3rd of this nations GDP - consumer spending. However, I would personally argue this is more of a reversal of the exuberant trends seen from '05-'07 rather than point to anything that's inherently unhealthy in this sector. The consumer hasn't stopped spending - just to illustrate this point, let me mention an interesting experience i had when i was at an outlet mall south of Boston recently along with my spouse. We saw a long line of 15+ people waiting outside the door of an Uggs store and was curious as to why - apparently, Uggs was offering some good deals, and there were more than enough people interested...to make the folks who run the store 'control' intake of customers to prevent over crowding! We saw pretty much the same at a nearby Coach outlet...they were offering 50%+ discounts (which still doesn't make the purchase price reasonable for many!) and there were throngs of women pouring over their handbags, clutches and other accessories on sale. I have heard the same from many of my colleagues and friends across the region - which all points to the fact that the consumer is still willing to spend money, provided the deals are 'right'. So, what's happening is more of a change in the way consumers approach spending than any doomsday no-spending behavior as many would expect us to believe. If people prefer buying at Walmart and pay less dollar for exactly the same merchandise as compared to the fancy department store locally, or if they switch from Saks to Gap for a larger percentage of their clothing purchases, it's probably for the good. We saw a long period of (close to) reckless spending, depleted savings rates and bloated same-store retail numbers...a period where 'value' took a backseat and the consumer stretched savings and on-paper home equity values to splurge on not-so-necessities. We are just seeing a 'good' reversal of these trends - this is exactly the same psyche that led consumers to (hopefully) permenently alter their outlook on fuel-related spending when oil touched 147 a barrel in Q3 '08...despite prices crashing down to 40 a barrel levels, consumers have continued to stay more 'conscious' of the money that are spending on running their cars and heating up their homes. As i had said earlier, this was probably one of the best things to happen from the oil price shock in late '08. And probably this retail spending 'pattern change' is a better thing for the consumer in the long run too!

My basic argument is that there is still some 'sentiment' around and consumers are not sitting at their homes and looking out of their windows altogether - which means good for the economy. As i had mentioned in one of my blogs in late '08, the only way to step up from this slow down is to loosen fiscal prudence for a brief while and indulge in drastic government spending. Don't get me wrong - i am not typically a demand-side economics supporter, but the current unprecendented situation warrants unusual strength in fiscal and monetary actions. We don't have much of a leverage in monetary policy, with fed rates already close to zero - thus there's no option but to use the fiscal lever! If Obama does succeed, even moderately in targeting fresh money in to areas like construction, healthcare, green energy and education, the very impact of this in down stream sectors and resulting gains in employment would be more than enough to crank the engine back. From what he's said so far, it looks very much like it's going to be a very common-sensical approach - every one cannot expect taxes to be cut and sops to be given , but still expect the economy to be revived...sops can only be targetd at the right sectors (high-employment industry areas and low-income population). Once we see early signals in the US, there would be downstream impact across global markets and a synchronized global recession can probably be turned around! There are many who opine that history points to a longer period of slow-down, but when we compare this slow down to earlier slowdowns, what we should note is that everything's been played in pretty much fast forward so far - and a pickup in trends would be quite quick too, given the right stimulus. Advances in economic theory and fiscal and monetary tools and policies have just made economic cycles more drastic! But hopefully we should see some thing even better - if policy makers can use this opportunity to drive permanent shifts in trends towards increased savings, tempered leverage and fiscal prudence (long-term), we should see a more stable growth trend once a turn-around happens!

Even by risking the probability of being wrong, i would stick out my neck and say that we should be back to near-sanity conditions by mid-to-late Q3 2009. We shoud see unemployment trends slowly reverting, housing and real estate stabilizing, and manufacturing looking up from it's trough. So, we are still looking at another 2 quarters of bad statistics and sad news on the unemployment and consumer spending fronts, but there's light at the end of the tunnel. That is assuming Obama and his team does not flounder completely - the chances of which look pretty grim. Here's promising and hoping a more cheerful look-back blog for late 2009!

Where to Invest in 2008?

Consider this - the US economy has slowed down from a quarterly annualized growth rate of 3-4% to about 1% in Q4 2007. With all my due respects to Larry Kudlow & company, I would bet safely that we are clearly facing the start of a period of economic slowdown in the US. If markets behave the way they usually do, here's my prognosis for 2008:

1. The US housing market would face prolonged slowdown atleast till end of Q3 2008. With more ARMs resetting over the next few quarters, subsequent delinquencies and further write-downs of bank Level 3/sub-prime assets as home prices continue to fall, there's enough negative momentum left for another 2-3 quarters.
2. Negative fall-out from the housing market will impact consumer spending in a bigger way in Q1 and Q2 2008. Consumer spending (accounts for 2/3rd of Gross GDP) slowdown will eventually affect corporate spending and capex, and the job market by Q2 2008. We should expect to see job market contraction around late Q1-mid Q2 2008.
3. Despite the magnified effect of the housing market on th eeconomy, global economic factors (continued growth in Europe, Asia & Japan) would help the US to avoid a recession next year. This would mean sustained 1-2% growth numbers for most of 2008.
4. Emerging markets, primarily India & China, would face significant stock market corrections around Q3 2008. Slow down in US growth will eventually affect certain sectors in these economies, forcing corrections in market valuations. Market PE in India, for example, would drop from ~22s to ~18-19 in the medium term.

What does this all mean - where to invest & where NOT to invest in 2008? [Stocks, Bonds, Real Estate....]

US STOCKS

• Contrary to perception, the US financial services sector will infact MODERATELY OUTPERFORM the market in 2008. Most of the negative news has already been factored in, and any positive news would create significant upsides. Stocks to watch for significant gains: Citigroup (C - far more resilient due to global presence. Sub-prime write-down impact has been over-played by the market. Expect Vikram Pandit to take some drastic steps to address operational efficiency issues), E*Trade (ETFC - Inherent strength of the original business model will help hold customers. It's fire-sale of high-risk assets to Citadel will cushion earnings impact for the next 2-3 quarters and help ride over the current crisis). However, in this sector, you need to have a 6-12 month time horizon for Q1 investments!
• Oil, Heavy Engineering, Automobile stocks will face significant pressure as the slow-down spreads to the broader economy. Avoid CAT, XOM.
• Technology stocks including darlings like AAPL, MSFT will face pressure by Q2 2008 due to broader economy slow down - their continued strength in Q4 2007 is more due to lag effects associated with a slow down than anything else!
• Commodity stocks (notable - Goldcorp:GG) MIGHT see significant gains over the next 4-8 quarters. However, the recent bull run in these segments will force near-term corrections. So, get in only after a significant correction - and only if you thrive in volatility!
• As in any slowdown scenario, staple-consumer and pharma stocks will hold strong. Notables - JNJ, BMY, KO, PG.

OTHER INVESTMENTS

• As you would have figured by now, stay OUT of the US housing market (from an investment perspective) till end of Q3 2008. We should see the bottom by late 2008, though it will be a slow climb up from there!
• Avoid increased exposure to emerging market stocks and funds. As mentioned above, these markets would be negative-to-neutral on an annual basis in 2008, and will face significant medium term corrections. An interesting pick - Indian offshore providers (INFY, WIT, CTSH) will have positive momentum as rupee appreciation is contained in 2008 (~5%) and US economic slowdown pushes more offshoring to India and China.
• The real estate sector correction in US & ripple effects on the global economy will force corrections to real estate market in emerging market economies (India being a notable example). However, we will see continued growth in Tier II/III business centers in these economies, as businesses relocate and overall demand remains stable/upward.
• As the US economy slows down and its ripple effect on the global economy starts felt by Q3-Q4 2008, there will be a continued flight of money to safer quasi-sovereign investments. Expect to see abnormal returns on high-grade bond investments (treasuries, high-grade munis, AAA corporate etc) over the second half of 2008 and extending well in to 2009, as even emerging market and European economies are forced to cut benchmark rates to push continued growth. Try parking some money in income funds with a heavy focus on high-grade paper.

"As in everything, investing is an art & we learn more as we know more."

More to follow....stay with me to track markets as we step in to a brand new year!