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08/10/2010

In Recovery: Looking Forward with Abby Cohen


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Abby_CohenAbby Joseph Cohen, CFA, is the president of the Global Markets Institute at Goldman Sachs, and the firm’s senior investment strategist. She’s been with the company since 1990, and became a partner in 1998.

Cohen’s career, which started when she joined the Federal Reserve Board in Washington, DC, as an economist, has been the subject of a Harvard Business School case study. She is the former chairman of the board of AIMR (Association for Investment Management and Research, now CFA Institute) and the recipient of that organization’s Distinguished Service Award.

PIZZANI: What is characteristically different about the current recession? What will distinguish it from other recessions in financial history?

COHEN: This has been an unusual recession in terms of severity and the circumstances that triggered it. There has been enormous financial disruption along with a deep and painful recession. The prior two recessions were relatively mild and the economy responded well to standard pro-growth policy tools such as interest rate reductions and targeted fiscal policy stimulus. But the circumstances of 2008–2009 have been extreme and these standard policy tools could not be easily applied. The financial system became frozen and economic activity threatened to grind to a halt. I believe that economic history will shine a favorable light on the performance of the Federal Reserve and the Treasury. Policy makers have faced many unprecedented stresses and were forced to improvise at several points during the crisis. Although 20–20 hindsight will undoubtedly reveal some errors, decisions were based on the best information available at the time.

Some experts predict the current recession will ease toward year-end 2009. Do you agree? How have the markets responded?

The recession was most severe between September 2008 and March 2009. Recent economic data are “less bad” and Goldman Sachs’s economists expect GDP (gross domestic product) to be slightly positive in the second half of 2009. The medium-term GDP growth rate will be muted by the appropriate rise in the consumer savings rate. But there may be some short-term positive surprises as corporate inventories are rebuilt from exceptionally low levels. Also, we’ve not yet seen the full thrust of the economic stimulus package approved by Congress.

Financial markets are moving toward more normal performance, although additional repair is needed. The volatility of stock price changes, using standard deviation measures, was near 85%, but beginning in March it began to decline sharply to now about 30%. Even so, volatility of the S&P 500 is still above its historical average of 16% to 18%.

Investors are again thinking like investors, focusing on fundamentals and valuation rather than momentum. There is again an appetite for risk. Equity issuance has risen dramatically, totaling more than $130 billion between March and June, including offerings from banks seeking to enhance their balance sheets. There was very little issuance of either equity or fixed income securities in the prior six months, especially without government guarantees.

I believe that economic history will shine a favorable light on the performance of the Federal Reserve and the Treasury. Policy makers have faced many unprecedented stresses and were forced to improvise at several points during the crisis. Although 20–20 hindsight will undoubtedly reveal some errors, decisions were based on the best information available at the time.

The crisis period witnessed historically high yield spreads between corporate bonds and Treasury securities of comparable maturities. These spreads have dramatically narrowed, although the spread remains above historical levels. This indicates that risk tolerance has increased but is not yet back to normal.

What—if anything—could derail an economic recovery?

There are many items to monitor. Let’s group these into three buckets: (1) ongoing weakness in the domestic US economy, including the consumer sector; (2) still unresolved financial issues mainly involving mortgages, consumer credit cards, and commercial real estate; and (3) potential policy missteps, here and abroad.

There was a period of high policy risk prior to the late 2008 meeting of the G-20 nations. This could have devolved into a series of protectionist measures ultimately harmful to the global economy. Instead, good leadership was shown by many nations, including the US and China, the world’s largest exporters.

Many investors worry about large US budget deficits. At Goldman Sachs, we too focus on the long-term structural deficits. But it’s important to distinguish these from the current cyclical deficits linked to the recession and to weakness in the private sector of the economy. Many in the Obama administration lean toward fiscal conservatism and will be keen to tighten policy once they believe the economy has moved out of recession.

The recovery of the US economy will be linked to the rest of the world. China is showing solid growth but the large developed economies, including Europe and Japan, are disappointing. The US looks to be stabilizing ahead of these other large nations, which are critical markets for our exports. Exports were the fastest growing sector of the US economy between 2003 and 2008, but demand for US exports is now muted by weakness in other countries.

span class="boldital">Do you think the government’s ambitious plans and the nation’s expanding federal deficit could push inflation back up to hyperinflation levels over the short or long term?

The term hyperinflation is often misused. This is not Weimar Germany and true hyperinflation seems highly unlikely. With that said, the current deflation or disinflation pattern is likely to give way to rising inflation when economic growth resumes and the capacity utilization rates in our factories, mines, and labor markets move higher. Price increases in global commodities such as energy and industrial metals will track global recovery, but US core inflation is likely to remain under good control for an extended period.

There’s been a lot of focus on underfunded pensions. But you are expecting underfunded health care liabilities to be a far larger problem. Why?

Let’s look at both the private and public sectors. Corporations have had accounting standards for pensions and post-retiree health care benefits for many years and therefore have good measures of their liabilities. The average corporate pension plan was overfunded prior to the financial crisis. The more challenging underfunding is found in post-retiree health care plans, and these are largely concentrated in the auto industry and other heavy industries.

The federal Social Security system need not be a big worry, in the view of many experts. There are some relatively straightforward solutions to enhance long-term funding, including modest increases in the retirement age for benefits. Social Security was introduced by the Roosevelt administration when the average life span in the US was 63 years. Life span has dramatically increased, yet the retirement age has increased only slightly from the original 65 years. Actuaries believe that the soundness of the Social Security trust fund can also be enhanced by tuning up the mechanism for cost-of-living adjustments.

Medicare is the larger problem. It is estimated that liabilities under Medicare are at least four times, and perhaps seven times, larger than those for the Social Security system. Unlike Social Security, the annual benefits received by individuals under the Medicare program are not capped. Health care costs are currently rising much faster than overall inflation and incomes. There is dramatic growth in the liabilities of employers, including state and local governments, offering health care programs for current workers and retirees.

In early March, with the S&P 500 at 666, you predicted that the index could rise sharply in the following 12 months to around 1,050. Do you still believe that?

In March we concluded that the S&P 500 was notably underpriced, even using our below-consensus forecasts for GDP and corporate profits. Our strategy team estimated that the index could move to a trading range bounded between 850 and 950. If we are correct that the worst is over in both the economy and corporate profits, although conditions are still weak, the fundamental outlook for 2010 could support a higher price range, roughly 950 to 1,050.

Think of share prices moving in a step function. Graphically, it looks like a staircase. Equity prices have taken a large upward step from 666 but are now stuck on the step, in the trading range, waiting for the next round of fundamental information. Our view is that the next large set of data will suggest that conditions are slowly improving. Forget the letters. It’s not a “U,” a “V,” or a “W.” It’s a staircase.

Profit margins have begun to recover in some industries, and reported growth in earnings per share may look great in the fourth quarter on a year-over-year basis. Of course, some of this will be an optical illusion, as profits were so dismal in the fourth quarter of 2008. In addition, several failed companies have been removed from the S&P 500, again making the comparisons to year-earlier levels much easier.

–Lori Pizzani, is an independent journalist in Brewster, New York.

This article was originally published in Summer 2009 Issue of the Investment Professional.

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