Calvert News & Commentary

2008 Market Commentary and Outlook for 2009

The Tide Goes Out…


Untitled Document

By Natalie Trunow, Senior Vice President, Head of Equities
Calvert Asset Management Company, Inc.

In recent months, the receding tide has revealed much and offered ample food for thought. In this commentary, we revisit 2008, discussing the factors that we believe led to the present-day financial and economic crisis. We also share our economic and investment outlook, providing some perspective to help frame these insights.

Assessing the 2008 Market Crash

A prolonged period of low-cost, easily available credit in the years leading to 2008 spurred investors and consumers to take on excessive leverage—and risk—in search of higher yields. Risk premiums were driven to historic lows and contributed to bubbles in risky asset classes, ranging from commodities, precious metals, and real estate to emerging market equities, leveraged buyouts (LBOs), and collateralized debt obligations (CDOs).

As the economy slowed in 2008 and housing prices continued to decline, many home owners exercised put options on homes financed with artificially low teaser rates that had started to reset. Foreclosure rates accelerated, leaving vast amounts of toxic, mortgage-related assets on bank balance sheets—further fueling the credit crunch that began in 2007 and continued to engulf the global financial system in 2008.

A wide variety of parties have been exposed by the crisis—ranging from sub-prime borrowers, real estate speculators, hedge fund and private investors, to undiversified emerging market economies and the rating agencies and regulators themselves. In our view, as the tide continues to recede in 2009, more unscrupulous market participants will be revealed—especially in international and emerging-market waters.

The results of this mispricing of risk, combined with the overall lack of transparency and the failures of governance and due diligence, devastated the financial services sector and claimed Bear Stearns, Lehman Brothers, and insurance giant AIG. Numerous other financial institutions around the globe also faced collapse, with little end in sight.

Part of the problem was that large segments of the mortgage-backed securities market, especially the CDO market, were non-transparent. This lack of transparency affected price discovery, which should have allowed the market to transfer risk from seller to buyer by discounting the price of CDOs to properly reflect the inherent risk. Instead, few market participants had a clear idea of the actual size of the market and the risk to the system that it posed. A false sense of security also came from rating agencies, whose rosy AAA ratings for top CDO tranches masked underlying risk.

Regulators and their well-intentioned policies designed to encourage unprecedented home ownership and affordability also played a role, facilitating the crisis by encouraging market participants to lower the barriers to home ownership. Regulators were aware of the issues in the sub-prime market—loose covenants, minimal loan requirements, and predatory lending practices that included zero-down, no-interest teaser loans that required little-to-no proof of income or ability to pay on the part of borrowers. It was clear even at the time that the party could only continue until the bubble burst. When it did, taxpayers worldwide ended up paying the price.

In addition, statistical models used by Wall Street to stress test the investment strategies in sub-prime related securities did not incorporate risks stemming from the probability of default of undocumented loans, teaser rates, and unprecedented amounts of credit available to consumers. This omission was due to the fact that those risks were precisely that—unprecedented—and therefore were not included in the historical data sets available for the models from which to extrapolate. Nor was the system-wide leverage involving both borrowers and issuers taken into account by these models. Simply put—garbage in means garbage out.

While banks themselves were at risk, individual players within these institutions, as well as the banks, benefited from the environment, as skewed compensation schemes based on short-term results gave them little incentive to recognize the risks they had assumed or to subject themselves to serious risk management. This was partly because of the recognition that these practices were system-wide, and that for any one of the investment banks to get hurt badly, the entire financial system would have to collapse—which most participants could not fathom.

The resultant reliance on “the system”—or implied government backstopping—reintroduced the large-scale moral hazard inherited from the bailouts of S&Ls, which didn’t appear to understand the loans owned, and from Long-Term Capital Management, the firm whose lack of transparency, combined with leverage, briefly threatened the stability of the world financial system. If investment houses now caught in the crisis believed that the U.S. government would not back-stop them, it’s doubtful they would have taken such large risks with their balance sheets and franchises.

The “great unwind”

The global de-leveraging from unprecedented highs that began in 2007 intensified in 2008, destroying the investment banking model as we know it and sending the real economy into a recession more severe than anything we have experienced in decades. In the second half of the year, multiple and usually uncorrelated risks (including credit, liquidity, counterparty, and asset price risks) became correlated, combining into systemic risk and sending market volatility, as measured by VIX1, to record highs. As a result of the ensuing flight to safety—including the repatriation of funds from risky asset plays abroad and unraveling of the long-standing carry trades—the U.S. dollar strengthened and Treasurys rallied to unprecedented levels.

Moral hazard is revisited

Regulators around the world responded, attempting to resuscitate failing sectors and institutions. Among other tactics, U.S. regulators slashed interest rates to historic lows and telegraphed their intended purchases of Treasurys in an attempt to revive borrowing and spending. As a result, moral hazard has been re-introduced on a massive scale, with the government back-stopping colossal corporate failures in financials and in the automobile industry. And, despite the lower borrowing costs brought about in part by government intervention, lending to the real economy remained significantly impaired. As credit toxicity continued to spread through the economy, the effectiveness of the new U.S. administration’s economic rescue tactics was—and we expect will remain—diminished. Even the most effective regulatory measures are unlikely to produce serious results before 2010.

Some sectors did worse than others

As we had anticipated, the counter-cyclical sectors, including consumer staples, health care, and utilities, where earnings are more visible and sustainable, outperformed. Conversely, the financials, materials, and industrials sectors lagged in the second half of the year. Likewise, the emerging markets de-coupling story—the widely shared belief that emerging market economies had insulated themselves from economic and financial trends in developed countries—was proven unrealistic. For the one-year period ending 12/31/08, the MSCI Emerging Markets IMI posted its worst overall one-year performance, declining 53.63% in U.S. dollar terms and 46.26% in terms of local currencies. On balance, the S&P 500 declined 37% in 2008, while the MSCI EAFE IMI fell 43.40% in U.S. dollar terms and 40.38% in terms of local currencies for the same time period.

The U.S election raises hopes

At the end of the year, equity markets perked up as the historic results of the U.S. presidential election brought hope of greater certainty amidst the release of worsening economic indicators. Even before taking office, President-elect Obama unveiled an $800 billion economic stimulus plan, with many other countries following suit. However, investors remained skeptical that government measures would be sufficient to reverse the global recession or cure the scarcity of credit, which continued to constrain the ability of both individuals and corporations to borrow through the second half of the year and resulted in increased home foreclosures and corporate failures. But if the U.S. government overdoes it on the bailout and moral hazard side, things could get a lot worse before they get better as more individuals and corporations are enticed to restructure their debt, further fueling default rates and hurting lenders and investors.

Our 2009 Market Outlook

Deflation—a real possibility for 2009. While global inflation remained a concern for most of 2008, the bursting bubbles in multiple asset classes brought worries of deflation to the forefront by year-end, as a prolonged period of deflation became a real possibility. As prices fall, consumers will likely defer spending, negatively impacting pricing power and margins for businesses. Since consumers account for 70% of the U.S. gross domestic product (GDP), this will make for a more protracted recovery process and a likely deflationary scenario. These developments make the prospects for a V-shaped economic recovery in 2009 highly unlikely. Beyond 2009, we may see inflation return with a vengeance as stimulus packages and massive new liquidity take hold worldwide.

Improving employment picture will be key catalyst for recovery. The crisis on Main Street is likely to continue well into 2009, as low credit availability brings down even higher-quality companies and fuels default rates among consumers, further threatening lenders and the economy as a whole. Weak consumer sentiment and spending will also continue to put pressure on retailers and their creditworthiness. U.S. personal savings rates will continue to increase as consumers try to replenish the wealth eroded by sharp losses in the equity and housing markets, as well as by lost wages. The contracting economy is likely to drive unemployment even higher, possibly to 10-11% by year-end, pushing wages, consumer confidence, and prices further down.

As a result, American consumer behavior may undergo a significant change leading to generally more conservative longer-term consumer spending, savings, and investment patterns. This should be a welcome development for the longer-term health of U.S. economy.

Though widespread, the effects of this change in behavior will not be uniform.  Financial firms, the consumer discretionary sector, and households will be hurt the most, although households will continue to have a put option on their debt through defaults and foreclosures. But financial institutions, their stakeholders, and taxpayers who end up helping bail out firms that are considered too big to fail will not have that option. Bank balance sheets are impaired and will have to be restructured, with governments worldwide as either literal or de-factor shareholders.

Economic recovery in the second half of 2009—not a sure thing. We believe that Wall Street analysts’ consensus earnings forecasts for 2009 are still too optimistic and continue to be disconnected from the reality of the decelerating real economy. These earnings expectations will have to come down further, especially as both consumer demand and corporate capital expenditures continue to fall. As a result, while equity market price-to-earnings (P/E) multiples may appear to be getting quite attractive, we expect further deterioration in earnings to create more room for multiple contraction and further downside in equity markets. Corporate earnings beating analysts’ earnings forecasts will be a strong positive catalyst for market recovery.

Wishful thinking on the part of both Wall Street and investors will continue to be at odds with dismal economic realities, making for an environment in which equity markets are likely to zigzag, experiencing false starts throughout the year. While we may see some stabilization in the economy sometime in 2009, it is difficult to paint a rosy picture for a recovery in the second half of the year, which now seems to be the consensus.  Unemployment is likely to continue to rise throughout the year and may reach 10-11% before abating. A deceleration of unemployment rate will be a welcome sign and a foundation from which both the economy and markets can rebuild their momentum.

From a sector-specific perspective, luxury retailers will be hurt more than in past downturns, as the large proportion of demand coming from emerging market and petrodollar-rich consumers over the past decade recedes. This effect is already being seen by high-end retailers like Neiman Marcus, which reported a drop in net profits of 84% in the third quarter of 2008.

In the financials sector, we expect institutional investors will become ever more disenchanted with larger asset management firms, where investment products and teams can become unstable due to crisis impact elsewhere in these organizations. Given poor absolute and relative performance of late and eroding investor confidence, fees in the asset management industry—particularly in hedge funds—will come under intense pressure and, along with sharp declines in assets under management, will fuel consolidation of both firms and product lines. Some asset management firms, particularly hedge funds, will be forced to merge or will simply cease to exist. Transparency will also be given more attention as a result of an increased focus from within investment organizations, as well as from clients and regulators. Focus on good due-diligence and risk management will be a new, welcomed reality.

In emerging markets, gyrations around the bottoming markets will likely be more volatile, driven by higher betas and higher sovereign risk profiles. Eastern European economies and companies will likely face serious solvency issues. Within the “BRIC” 2countries, the Russian corporate sector accumulated twice the debt of Brazil, India, and China combined and will be pushed ever more under the influence of the government, reversing some of the free market advances of the past decade. Petrodollar spending in emerging market countries will continue to decline in 2009, putting additional pressure on the economies. As a result, higher levels of geopolitical friction are likely as governments in many emerging market countries attempt to divert domestic public attention from worsening economic conditions.

In currency markets, we expect that the U.S. dollar will come under pressure because of the unprecedented amount of stimulus underway in the United States.  However, this weakness will be counter-acted by the fact that the United States is likely, once again, to make needed adjustments faster, take more pain earlier in the cycle, and recover sooner than other world economies.


In 2009, we expect further economic weakening with equity markets positioning for a rebound. Historical data indicate that economic cycles have a median recession-to-recovery time span of 11 months. With current recession well into its 14th month and no immediate upturn evident, it is clear that this is no ordinary recession. While we expect this downturn to be more pronounced and drawn out than most past recessions, we expect the economy to start recovering sometime in 2010. We also believe that, once the unprecedented excesses of multiple bubbles of 2007-2008 are flushed out, a healthy foundation will emerge from which markets can recover and offer some of the most attractive investment opportunities on record.

1. VIX is a measure of the current level of market risk and is derived from the pricing of a variety of call and put options.

2. BRIC refers to the emerging market countries of Brazil, Russia, India, and China.

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