Posted on April 8, 2009 by David Laidlaw
“These,” he said gravely, “are unpleasant facts; I know it. But then most historical facts are unpleasant.” – Aldous Huxley, Brave New World, Ch. 2
The shockingly rapid retreat of the economy and the stock market continued during the first quarter of the year. While the emotional toll has been wrenching, intellectually, it has been intriguing to watch our financial system and government respond to the shocks.
During the expansion that ended in 2007, credit financing mainly grew through the securitization of debt, especially mortgage debt. Wall Street packaged debt taken on by consumers and businesses and sold securities based on that debt to investors hungry for yields that exceeded what they could obtain from buying traditional bonds. This mechanism of financing for all types of purchases from houses to automobiles and commercial real estate has dried-up completely since mid-September of last year.
Our government has responded extremely aggressively by pumping incomprehensible amounts of money into the system. Aside from the explicit stimulus bill, the Federal Reserve has committed to purchasing $300 billion in Treasury bonds and $1 trillion or more of mortgage-backed securities. The goal is that purchasing the bonds will lower interest rates which will then entice borrowers to spend.The Public-Private Investment Program was also finally introduced after Treasury Secretary Geithner’s failed attempt in February. This program recruits private investment managers to buy depressed securities and loans from the banks using government financing. The basic idea is to create a market for various “toxic assets” that the banks can sell to these private funds and as a result banks will then feel free to expand their lending. The problem with this plan is that the banks may not want to sell the assets unless they receive top dollar.
The second casualty of the credit crisis has been a global demand destruction and recession. Consumers are afraid to spend and prefer to save as much as possible. Businesses are also leery about pursuing expansionary projects while their revenues and earnings are falling.
Given the interconnectedness of our global economy, no region has been spared.Unemployment continues to rise dramatically in the US as businesses race to reduce their costs. Asian exports from Japan and China have decreased about 25% compared to last year. Many developing economies, especially in Eastern Europe, are crumbling since these countries are not able to service their debt in Euros.During this writing, the G-20 is meeting to negotiate a more coordinated stimulus through the International Monetary Fund.
The severity of the imbalances in the financial system and the world economy will take years to heal; however, there are signs that recovery is occurring in certain sectors and that the downward spiral will not last indefinitely.
Housing sales are starting to increase in the hardest hit locales.Orders for durable goods and retail sales appear to have bottomed during the first quarter.
Additionally, merger and acquisition activity has been very robust in the U.S.According to Dealogic, businesses worth $215 billion were acquired during the first quarter which is 39% above last year’s volume.In the pharmaceutical space, Pfizer is buying Wyeth for $68 billion, Merck agreed to acquire Scherring-Plough for $41 billion and Roche is acquiring the piece of Genentech that it does not already own.Other transactions include the recently leaked deal that IBM is buying Sun Microsystems.
Each of these acquisitions was accomplished by payment of significant premiums to the market prices of the stocks when the deals were announced.News of IBM’s acquisition was reported before formal terms were announced, but Sun’s share price has doubled from its level prior to the news.The Wall Street Journal reported that IBM will pay roughly $7 billion which is almost a 100% premium to Sun’s market capitalization two weeks ago.Pfizer is paying a 30% premium to acquire Wyeth in cash and stock.To finance the purchase, Pfizer had to issue $13.5 billion in debt.Similarly, Merck paid a 34% premium for Scherring.While these deals are primarily defensive in nature (the pharmaceutical companies are trying to diversify their offerings and cut redundant costs to boost earnings as top-selling drugs lose patent protection), the acquisitions suggest that savvy managements believe that these combined businesses will profit.The managers are also making a judgment that they feel comfortable issuing debt and expect conditions within their markets to improve.
Similarly, we view the equities in client portfolios as underpriced even given the recent rebound.Capitalism is not dead and patient investors will be rewarded even though we expect continued volatility in the near term.