Investment products and services offered through Contango Capital Advisors, Inc., a registered investment adviser Contango Capital Advisors | 111 Sutter St. Suite 975, CA 94104 | www.contangoadvisors.com Investment products and services offered through Contango Capital Advisors, Inc., a registered investment adviser CCA #1210-0150 A Look Beyond the Crisis Perry Piazza Director of Investment Strategy Contango Capital Advisors, Inc. December 2, 2010
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Investment products and services offered through Contango Capital Advisors, Inc., a registered investment adviser
Contango Capital Advisors | 111 Sutter St. Suite 975, CA 94104 | www.contangoadvisors.com
Investment products and services offered through Contango Capital Advisors, Inc., a registered investment adviser CCA #1210-0150
A Look Beyond the Crisis
Perry PiazzaDirector of Investment StrategyContango Capital Advisors, Inc.
Part 1: Crisis Review, Deleveraging Update & Economic Forecast
Part 2: Our Fiscal Mess – Is There Hope?
Part 3: How to Invest in 2011
2
Setting the Scene
A debt bubble began to form in the mid 1990s and continued into the last decade. It was exacerbated by:
– Abnormally low interest rates.– A strong rally in the price of an easily leveragable asset – housing– A fundamental switch, from cash-flow based underwriting standards to asset-
based underwriting standards.– Fast growth in computer power and the ensuing ability to securitize all manner of
assets.– A miscalculation of risk by the ratings agencies.– Abdication of regulatory responsibility.
The debt bubble began to burst in 2007 when housing prices cracked and finally gave way fully in 2008 when Lehman Brothers failed.
3
The Debt Bubble in Hundred-Year Perspective
4
Quarterly Data 12/31/1922 - 6/30/2010 (Log Scale)
(E501A)
375.44
6/30/2010 Debt = $52.054 Trillion6/30/2010 GDP = $14.575 Trillion
= 357.1%
Annual interpolated GDP (including estimates prior to 1929) used prior to 1946. Domestic Nonfinancial Debt used prior to 1946. As of December, 1946 Domestic Nonfinancial Debt represented 99.4% of Total Credit Market Debt. 130
Copyright 2010 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. . www.ndr.com/vendorinfo/ . For data vendor disclaimers refer to www.ndr.com/copyright.htmlSee NDR Disclaimer at
TOTAL DEBT AS A PERCENTAGE OF GDP IN THE USA
Includes Government + Household + Corporate Debt
Source: Ned Davis Research
A large debt bubble burst in the 30s …
… and probably again in 2008
What Happens After a Debt Bubble Bursts?
Typical aftermath: Deeper than normal recession and a muted recovery Deleveraging by the biggest culprits (consumers, in this case) Austerity & reduced confidence to spend and invest A flirt with deflation Untested policy responses & political “tide-shifting” Large fiscal response Asset market(s) most affected (e.g., housing)
usually fall for years A shifting of relative economic strength to less indebted
countries. A transfer of risk from the private sector to the public sector Periodic “aftershock” crises..
2007 – 2009 was the first severe credit recession since the 30s.
Recommended Reading
5
Deeper Than Normal Recession
6
QUARTERLY GDP GROWTH IN THE UNITED STATES
The amplitude of economic activity has moderated greatly in recent decades
Source: Bloomberg, LP
Muted & Well-Below-Par Recovery
7
Corp. E
arnings
Shipmen
ts
Housing S
tarts
Retail S
ales
New Homes
Existi
ng Home S
ales
Industrial
Prod.
Non-Res. Constr
uction
Real G
DP
Orders
Nonfarm Pay
rolls
-
5.0
10.0
15.0
20.0
25.0
30.0
35.0
40.0 What’s Normal
Average increase in above economic variables, 34 Months after the start of a recession
(includes last 8 recessions with the exception of the truncated 1980 recession)
Source: Ned Davis Research
Real G
DP
Retail S
ales
Nonfarm Pay
rolls
Industrial
Prod.
Corp. E
arnings
Shipmen
ts
Existi
ng Home S
ales
Orders
Non-Res. Constr
uction
Housing S
tarts
New Homes
-60.0
-50.0
-40.0
-30.0
-20.0
-10.0
0.0What’s Not
Current “Recovery”
(E0026)
Monthly Data 6/30/2007 - 10/31/2011
*Dates used for determining economic expansionsare those designated by the National Bureau ofEconomic Research. The data has been adjustedfor ease of comparison with the current cycle.Expansion starting dates used: November 1970, March 1975, July 1980, November 1982, March 1991, and November 2001.
Performance of Coincident Indicators vs Average of Last Six Expansions
Copyright 2010 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. . www.ndr.com/vendorinfo/ . For data vendor disclaimers refer to www.ndr.com/copyright.htmlSee NDR Disclaimer at
Performance of Coincident Indicators vs. Average of Last Six Expansions
Consumer Deleveraging
(E516)
Quarterly Data 3/31/1952 - 6/30/2010 (Log Scale)
Index of Coincident Economic Indicators
Source: The Conference Board
Shaded areas representNational Bureau of
Economic Research recessions. 262932364146515764728090
Household Debt as a % of Disposable Personal Income
Copyright 2010 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. . www.ndr.com/vendorinfo/ . For data vendor disclaimers refer to www.ndr.com/copyright.htmlSee NDR Disclaimer at
8
HOUSEHOLD DEBT / DISPOSABLE INCOME
Source: Ned Davis Research
Austerity
To repair their net worth, individuals (representing 70% of our economy) save more and spend less. Confidence is eroded, leading to fewer purchases of “big ticket items (homes & cars, for example).
Source: Bloomberg
1
2
3
4
5
6
7
8
9
10
11
123 Decades of the U.S. Personal Savings Rate
?
19851987
19891990
19921994
19951997
19992000
20022004
20052007
200910,000
20,000
30,000
40,000
50,000
60,000
70,000Cumulative Net Worth in Trillions of All US Households
Individuals Feel Poorer So they save more
Compounding the problem, the baby boomers are now quickly approaching retirement.
9
10
Performance of Private Nonfarm Payrolls
Reduced Business Confidence + Structural Problems = Weak Hiring
Core Personal Consumption Expenditures Price Index
9/30/2010 = 1.2%( )
Inflation Too Low
Inflation Too High
Fed's Preferred Range 1995 thru 2007
0.9
1.2
1.5
1.8
2.1
2.4
2.7
3.0
3.3
3.6
3.9
4.2
4.5
4.8
5.1
5.4
5.7
6.0
6.3
6.6
6.9
7.2
7.5
7.8
8.1
8.4
8.7
9.0
9.3
9.6
9.9
10.2
0.9
1.2
1.5
1.8
2.1
2.4
2.7
3.0
3.3
3.6
3.9
4.2
4.5
4.8
5.1
5.4
5.7
6.0
6.3
6.6
6.9
7.2
7.5
7.8
8.1
8.4
8.7
9.0
9.3
9.6
9.9
10.2
Core PCE Price Index (Year-to-Year Change)
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11
Inflation (core personal consumption expenditure “PCE” y/y change)
Source: Ned Davis Research
Fed’s Target Range 1995 thru 2007
Untested Policy Response
12
As a Result of Unconventional Monetary Policy, Fed’s Balance Sheet Has Increased Substantially
Copyright 2010 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. . www.ndr.com/vendorinfo/ . For data vendor disclaimers refer to www.ndr.com/copyright.htmlSee NDR Disclaimer at
Federal Reserve Balance Sheet
Black Dotted Line = GSE (Fannie & Freddie) Debt
Red Dotted Line = MBS
Blue Line = Treasuries
Green Line = Total Securities Held
QE1 Begins
QE1 Expanded
End Treasury
Buys
End QE1
QE2 Begins
QE2
Securities Held by the Fed
Source: Ned Davis Research
The Fed’s Actions Have Effectively Engineered Lower Rates
14
30-Year Fixed Mortgage Rate 2-Year New Car Loan Rate
Sources: Haver Analytics and Gluskin Sheff & Associates
But Demand Hasn’t Significantly Picked Up for Housing
15
Mortgage Bankers Association: Mortgage Loan Application for Purchase (seasonally adjusted)
Conference Board: Consumer Confidence Survey: Plan to Buy a Home Within Six Months
9/30/2010 = -4.3% Source: Federal Housing Finance Agency-12 -11 -10
-9-8-7-6-5-4-3-2-10 1 2 3 4 5 6 7
-12 -11 -10
-9-8-7-6-5-4-3-2-10 1 2 3 4 5 6 7
1970 1975 1980 1985 1990 1995 2000 2005 2010
Real FHFA House Prices
Real FHFA House Prices (Year-to-Year Changes) Copyright 2010 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved.
. www.ndr.com/vendorinfo/ . For data vendor disclaimers refer to www.ndr.com/copyright.htmlSee NDR Disclaimer at
FHFA HOUSE PRICE INDEX
Source: Ned Davis Research
We’ve Also Had a Big Fiscal Response
I’m Back
17
With Spending Far Exceeding Tax Receipts
Monthly Data 12/31/1964 - 10/31/2010 (Log Scale)
(E0300)
Federal Outlays 10/31/2010 = 3430.7
( )
Federal Receipts10/31/2010 = 2172.4
( )
$ Billions
144
225
324
441
576
729
900
1089
1296
1521
1764
2025
2304
2601
2916
3249
144
225
324
441
576
729
900
1089
1296
1521
1764
2025
2304
2601
2916
3249
Federal Outlays 10/31/2010 = -2.3%
( )
Federal Receipts10/31/2010 = 4.7%
( )
-15 -12
-9-6-30 3 6 9
12151821242730333639
-15 -12
-9-6-30 3 6 9
12151821242730333639
1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Federal Outlays and Receipts (12-Month Totals)
Federal Outlays and Receipts (Year-to-Year Changes) Copyright 2010 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved.
. www.ndr.com/vendorinfo/ . For data vendor disclaimers refer to www.ndr.com/copyright.htmlSee NDR Disclaimer at
18
Federal OutlaysFederal Receipts
Source: Ned Davis Research
During massive stimulus programs (like the New Deal), outlays widely outstrip receipts. ‘Ammunition’ for the next battle becomes dangerously low.
And Federal Debt Rises
19
Quarterly Data 3/31/1952 - 6/30/2010 (Log Scale)
(E0507A)
Debt Measure Ratio
Gross Federal + State&Local + GSE* Debt ( ) 156. 8%Gross Federal + GSE Debt ( ) 136. 0%Gross Federal Debt ( ) 90. 6%Publicly Held Federal Debt ( ) 59. 7%
*GSE = Government Sponsored Enterprises e.g. Fannie Mae, Freddie Mac**Q1 2010 spike due to FAS 166/167
Government Debt (Federal, State, Local) + GSE Debt as a % of GDP
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U.S. Government Debt as a Percentage of Our GDP (post war period)
State and Local Government Debt
GSE (Fannie & Freddie) Debt
Treasury Bonds Outstanding
Treasury Bonds Held by the Public
American Recovery and Reinvestment Act of 2009
Source: Ned Davis Research
So We’re Getting Some Political Tide-Shifting
20
Economic Strength Is Shifting
21
BRICs - Brazil, Russia, India, China – (in billions of dollars)
Point: Emerging economies are growing and becoming more and more important
Sources: JP Morgan & Emerging Markets Management, Inc.
And Emerging Markets Have Outperformed
22
Source: MSCI
Performance of International Markets Since E/M Bottom
E/M Strength Has Also Been Driving Up Commodity Prices
23
Source: Ned Davis Research
(E780)
Weekly Data 6/05/1981 - 11/19/2010 (Log Scale)
Reuters Continuous Commodity Index (CCI)(Equal-Weighted)
Scale Right
Source: Commodity Research Bureau, www.crbtrader.com
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Standard & Poor's Industrials Sales, Earnings, and Profit Margin
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The “blue chips” are selling globally and have tapped into the best growth areas well. Have extracted huge productivity gains in recent years Labor outsourcing has helped improve margins; global supply chain reduces costs and improves
quality. They’re benefiting from ultra-low borrowing costs right now. They have captured market share from small business and failed competitors.
25
Apple Store - Beijing McDonalds - Shanghai
Conclusions: Part 1 Consumer deleveraging is ongoing and will continue to crimp growth. The crisis has generated deflationary tendencies, which are being fought aggressively
with monetary and fiscal stimulus. Government demand has partially substituted for private demand, but the recovery
remains subpar by historical standards. With a super-high debt level, the government has few “bullets” left. In any case, the
Tea Party crowd will probably fight any new stimulus. Active policy cycle means policy mistakes are a key risk:
•Too easy too long = inflation and asset bubbles.•Not easy enough = deflation and a dragged out Japan-style purgatory•Too much fiscal response = possible Greek/Irish-style debt crisis
There are two bright spots: both blue chip corporations and most emerging market countries are posting very decent growth.
26
Part 2: The Fiscal Mess: Can We Overcome our Debt Burden?
Publicly Held Federal Debt as a % of GDP Copyright 2010 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved.
. www.ndr.com/vendorinfo/ . For data vendor disclaimers refer to www.ndr.com/copyright.htmlSee NDR Disclaimer at
28
US Treasury Debt Relative to GDP (postwar period)
Source: Ned Davis Research
Is it possible to crawl out from under such a debt burden?
U.S.
U.K.
It Is Possible
29
US and U.K. Post War Debt Burdens (Debt to GDP)
Source: Niall Ferguson
But … Demographics were much more
favorable in the ‘50s– 16 workers per retiree in 1950– 3 workers per retiree today
We were in our China-like growth phase.
Fewer built-up entitlements. WW2 had destroyed the
competitiveness of much of the rest of world.
The UK did a lot of the work with inflation.
High Debt Has Led to A Crisis in Europe
30
PIGS = PORTUGAL
IRELANDGREECESPAIN
Yield Spread Over Treasuries
Source: Bloomberg, LP
But It’s Not That Much Worse in the PIGS?
31
Source: IMF
Government Debt to GDP (mid-2010)
Harvard economist Niall Ferguson has coined the phrase the PIGS ‘R US.
Unlike Japan, We Don’t Buy Our Own Debt
32
Source: Fusion IQ
33
Source: Fusion IQ
We Can Do It if We … Change the tax system and expenditures to foster growth. Accept that you cannot have a universal provision of social benefits. Eliminate debt via some inflation. Encourage a rebalancing of the economy away from consumption and toward
investment.
34
If We Don’t Get Smart
35
=
We’re Doomed to This Outcome
Japan Has Been in a Slow-Motion Depression for 2 Decades
36
Source: Gluskin Sheff & Associates
Similarities
37
Source: Gluskin Sheff & Associates
Similarities
38
Source: Gluskin Sheff & Associates
Similarities
39
Source: Gluskin Sheff & Associates
Part 3: Contango’s Investment Themes for 2011
How to Invest in 2011
In a slow-growth low-yield world, growth and income should carry a premium.– Invest in growing global franchises with cross-border brand appeal.– Invest in companies with strong free cash flow – especially ones that pay decent
and fair dividends.– Avoid companies with high commodity input costs.– Emerging market assets are OK for now but a bubble may be developing.
Some inflation is a goal of the Fed – keep a real asset allocation except at exuberant extremes (TIPS, commodities, real estate, infrastructure, MLPs)
Avoid long-duration fixed-income assets when inflation is a Fed goal. Push cash (zero-duration paper) into 2-year corporate paper – the Fed is on hold for at
least 18 months. Avoid the detritus of the last bubble (domestic real estate and financials) for 5-10
years (tech stocks are finally rallying after crashing 10 years ago and look good). Stock markets will grind higher but we’re past the best part of the rally and …
– Multiples (P/E ratios) remain in a bear market.– Sideways patterns last for 15 or 20 years.– In this environment be tactical – not a buy-and-hold investor.
Use valuation measures to avoid extreme bubbles but allow for some momentum.
41
100 Years of the Dow Highlights a Few Secular Bear Markets
42
Dow Jones Industrial Average (log scale)
Secular bear markets last an average of 15 years.
Source: Bloomberg, LP
Don’t “Buy and Hold” During Secular Bear Markets …
43
Offer Big Trading Ranges – Just Don’t Be a Buy-and-Hold Investor
Source: Bloomberg, LP
Part 4: Conclusions
In Review
The debt bubble had many causes and ultimately burst in late 2008. “Soggy” growth to continue in the U.S. on the back of an ongoing consumer
deleveraging cycle. Across the globe, the bursting of the debt bubble has shifted risk from the private to
the public sector. Bond investors have become vigilantes against the worst offenders and are picking off
the Euro peripherals. But the peripherals are not in that much worse shape than the reserve countries. The emerging world is growing at a good clip but asset prices are getting frothy. Corporations are doing well and have tapped into pockets of growth around the world. Equities have rebounded from their lows but remain in a secular bear market.
45
Common Sense Advice for CEOs & Directors
Try and tap into rapid growth in the emerging world (especially the BRICs).– Establish overseas sales channels in the BRICs.– Look for and try and sell to companies that have “cracked the code” and are
doing well in the emerging markets.– Some employees should be bilingual (Chinese, Spanish, Korean are important
languages).– Work on developing your brand.– Everyone’s online now – improve your non-US-facing web presence if you’re
looking to sell to the emerging markets. Geo-economic risks have made the currency markets quite volatile. Keep an eye on
the foreign exchange markets. Commodities remain in a long-term bull market. If you manufacture, watch all of your
commodity markets closely and consider hedging. Government customers will be much more frugal than in the past. Consumers will look for price points on the value side of the spectrum.
46
47
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