More Stimulus, Please · 2018-06-28 · • Buying opportunity in tax-free bonds page 12 • Hedge...

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INVESTMENT OUTLOOK JANUARY 2009 CITIGROUP GLOBAL MARKETS INC. A better year for stocks? page 4 High yields for high-quality bonds page 6 Nine indicators to watch in 2009 page 8 Buying opportunity in tax-free bonds page 12 Hedge funds: caught in a downward spiral page 13 Quantitative easing is the Fed’s new weapon page 14 We need aggressive monetary and fiscal measures to spur the ailing economy BY JEFF APPLEGATE AND CHARLES REINHARD More Stimulus, Please Combating a recession that has shaken business and consumer confidence and is spreading fear around the world requires the most aggressive policy responses imaginable—and then some. e Federal Reserve is on that track, having cut interest rates to zero. Now President-Elect Barack Obama has pledged to put forth the biggest public-works spending pack- age since the 1950s. e plan targets investment in roads and bridges, as well as outlays for making public buildings more energy efficient, with the hope of preserving jobs and creat- ing three million new ones within two years. Together with tax cuts for 95% of households, mortgage relief for homeowners, financial assistance for state and local governments and other bailout programs, we estimate the total fiscal stimulus to amount to between 4% and 5% of GDP. More- over, we expect new programs to im- prove housing affordability and credit availability, though the magnitude of those initiatives remains unclear. Bold fiscal stimulus can’t come too soon. e Federal Reserve has taken the federal-funds rate down to essentially 0%, from 5.25%, in 15 months, without having a mate- rial impact on lowering financing costs. at means conventional monetary policy has played out, since the Fed can’t take the rate below zero. Dr. Robert Barbera, our consultant with Investment Technology Group, says the ideal policy rate—one which optimizes the Fed’s dual goals of achieving full employment with low inflation—is now -1.5%. Barbera comes to that conclusion using a model based on work by economists John B. Taylor and Hyman Minsky. It incorporates readings of inflation, unemploy- ment and corporate bond spreads. Accordingly, the Fed has increas- ingly been using an unconventional policy tool called “quantitative eas- (continued on inside cover)

Transcript of More Stimulus, Please · 2018-06-28 · • Buying opportunity in tax-free bonds page 12 • Hedge...

Page 1: More Stimulus, Please · 2018-06-28 · • Buying opportunity in tax-free bonds page 12 • Hedge funds: caught in a downward spiral page 13 • Quantitative easing is the Fed’s

investment outlook JAnuARY 2009

CITIGROUP GLOBAL MARKETS INC.

A better year for stocks? •page 4

High yields for high-quality bonds •page 6

Nine indicators to watch in 2009 •page 8

Buying opportunity in tax-free bonds •page 12

Hedge funds: caught in a downward •spiral page 13

Quantitative easing is the Fed’s new •weapon page 14

We need aggressive monetary and fiscal measures to spur the ailing economy

by JEFF APPLEGATE And ChArLEs rEinhArd

More Stimulus, Please

Combating a recession that has shaken business and consumer confidence and

is spreading fear around the world requires the most aggressive policy responses imaginable—and then some. The Federal Reserve is on that track, having cut interest rates to zero. Now President-Elect Barack Obama has pledged to put forth the biggest public-works spending pack-age since the 1950s. The plan targets investment in roads and bridges, as well as outlays for making public

buildings more energy efficient, with the hope of preserving jobs and creat-ing three million new ones within two years. Together with tax cuts for 95% of households, mortgage relief for homeowners, financial assistance for state and local governments and other bailout programs, we estimate the total fiscal stimulus to amount to between 4% and 5% of GDP. More-over, we expect new programs to im-prove housing affordability and credit availability, though the magnitude of those initiatives remains unclear.

Bold fiscal stimulus can’t come too soon. The Federal Reserve has taken the federal-funds rate down to essentially 0%, from 5.25%, in 15 months, without having a mate-

rial impact on lowering financing costs. That means conventional monetary policy has played out, since the Fed can’t take the rate below zero. Dr. Robert Barbera, our consultant with Investment Technology Group, says the ideal policy rate—one which optimizes the Fed’s dual goals of achieving full employment with low inflation—is now -1.5%. Barbera comes to that conclusion using a model based on work by economists John B. Taylor and Hyman Minsky. It incorporates readings of inflation, unemploy-ment and corporate bond spreads.

Accordingly, the Fed has increas-ingly been using an unconventional policy tool called “quantitative eas-

(continued on inside cover)

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2 JANUARY 2009 • Citi PRivAte BANk

ing,” in which the Fed increases the size of its balance sheet by aggressively purchasing securities and financing those purchases with reserves (see “Quantitative Easing: the Fed’s New Weapon,” page 14). Since the Fed cannot ensure that banks will quickly lend this money, it is becoming a market maker itself. The Fed is now a key player in commercial paper and mortgages, and the central bank is expected to follow suit in other markets.

neAR-teRm CHAllenGes. Efforts to stimu-late the economy and bolster financial market liquidity will face challenges in the coming months. Since the Bush administration tapped the remaining $15 billion in the Troubled Asset Relief Program (TARP) for loans to General Motors and Chrysler, the Obama administra-tion will have to ask Congress for the second $350 billion of TARP funds—and perhaps much more. According to Tom Gallagher, a public policy analyst with International Strategy and Investment Group and a member of our Global Investment Committee, TARP II could be significantly larger than $350 billion. A larger

amount could be necessary to bolster the Fed’s quantitative easing as well as to put in place an additional backstop for the banking system.

Second, in our opinion, there are going to be more initiatives to improve housing affordability and stem the decline in home values. One way to do that is to explicitly guarantee Fannie Mae and Freddie Mac obligations. Another possibil-ity is to earmark some portion of the new TARP funds for housing relief. That aid, for example, could be subsidies to lower mortgage rates for new and existing homeowners. Politically, since the vast majority of Americans don’t have sub-prime loans and pay their mortgages on time, housing relief needs to be broad-based and not aimed solely at homeowners facing foreclosure.

Third, we expect that the new president and Congress will consider initiatives to improve credit availability. One approach would be to create a “good bank/bad bank” solution along the lines of the Resolution Trust Corp., which warehoused bad thrift loans following the sav-ings and loan crisis in the late 1980s. By further strengthening bank balance sheets, this would

More Stimulus, Please

by JEFF APPLEGATE Chief Investment OfficerCiti Global Wealth Management

(continued from cover)

Investment Products: Not FDIC Insured • No Bank Guarantee • May Lose Value

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Role Reversal This chart shows the ratio of the dividend yield on US stocks to the yield on US government bonds. The ratio tended to increase during recessions (gray bars), because stock prices fell causing yields to rise. Also in recessions, bond prices rose, causing yields to fall. The ratio recently climbed above 1.0 for the first time in 50 years as stocks now yield more than bonds. This ratio is yet another example of the valuation case for equities.

Data Source: Ibbotson Associates, Citi Global Investment Committee as of 8 December 2008

Cover story

by ChArLEs rEinhArdSenior Investment StrategistCiti Global Wealth Management

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JANUARY 2009 • Citi PRivAte BANk 3

make banks more willing to lend.Finally, all these policy proposals have vari-

ous time lags to consider. People, processes and systems need to be put into place to execute programs such as the Fed’s recently announced $200 billion Term Asset-Backed Securities Loan Facility. That program is to provide liquidity and lower rates on student loans, credit card loans and auto loans, but it won’t be functioning until February. Moreover, not all the public works that could receive funds will be “shovel ready” on the day the money becomes available.

sPeeD uP tHe moneY. Should the new Congress enact tax cuts structured like the 2008 rebates, most of the money would not reach households until late spring or early summer. Given that delay, a quicker solution to get money to taxpayers would be to lower with-holding taxes, which we expect will be enacted. Moreover, it is likely to be geared to lower- and middle-income taxpayers with whom the pro-pensity to consume versus save is higher.

On balance, we think a rapid and robust policy response, as implied by the Fed’s promise to “employ all available tools,” is the best way to combat the recession and financial crisis, especially as a downturn in the global economy threatens to make the recession in the US more severe over the next few months.

Other governments are also moving forward to stimulate their economies, though most trail the US. Central bankers in the UK, Europe, China, India and elsewhere are lowering policy rates. China announced a stimulus plan of almost $600 billion that accelerates already-planned projects to provide economic relief over the next two years. According to Dan Zhou at International Strategy & Investment, most of the spending is earmarked for transporta-tion infrastructure (45%), earthquake recovery (25%), rural infrastructure (9%), environmental efficiency (9%) and low-income housing (7%). Local governments have an additional $2.7 tril-

lion in plans that covers a wider range of spend-ing, but it remains to be seen how many of these projects can actually be carried out in light of the downturn and logistical challenges. Fiscal stimulus across Europe has been more modest, with several countries targeting spending plans in the neighborhood of 1% of GDP.

Even though we are deep in recession, stocks could have a good run. Valuation is attractive by many metrics, including the ratio of dividend yield to bond yield (see chart). In addition, the US equity market has historically bottomed about five months prior to the end of a reces-sion; but lead times have been as long as 13 months. Our research shows that median gains have been 9% in the first month off the low, 16% after three months, 26% after six months and 36% after a year. So, it would not be un-usual for the stock market to advance by a mate-rial amount from its low before the recession actually ends. The Standard & Poor’s 500 gained 20% from Nov. 20 to Dec. 31; the MSCI All Country World index is up 19.5% concurrently. We expect that US and global equity markets will continue to be highly correlated.

Anecdotally, we have been impressed of late with the equity market’s ability to absorb bad news. We were encouraged by the way the stock market advanced on Dec. 5 despite the news of 533,000 jobs lost in November, the highest seasonally adjusted decline in one month since 1974. The results of the fourth-quarter earn-ings season, when released in early 2009, should provide another test. During the course of 2009, we expect progress on a wide array of financial and economic indicators (see “Nine Signposts for 2009,” page 8). Given low inflation expecta-tions, we anticipate aggressive policy to adjoin the already negative real or inflation-adjusted fed-funds rate to play a vital role in righting the markets. These measures will be tapping into the economy’s natural strengths and recuperative properties, setting the stage for recovery.

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4 JANUARY 2009 • Citi PRivAte BANk

For most investors, 2009 could not come soon enough. There is a natural tendency to want to start the New

Year with a clean slate—and 2008 was one year we would all like to wipe away. Still, turning the calendar does nothing to change the many forces that are acting upon the equity markets. When the markets opened on Jan. 2, worries about the economy, the housing market, corpo-rate earnings and the health of the financial sys-tem did not disappear. However, the New Year means that the unprecedented policy response by the US government has had more time to take hold, helping spur what Citi economists believe will be an eventual recovery in economic and corporate activity by the second half. For equity investors, it makes sense to discuss what we believe is needed for market volatility to subside and equity markets to stage a recovery.

tHe BAD neWs Bulls. In the past year, stock prices reacted swiftly and violently to each incremental data point, unlike their traditional

tendency to discount news in advance. In our view, this phenomenon was exacerbated by hedge funds dumping stock to lower their leverage and raise cash for redemptions. Now our analysis suggests that this painful process has actually brought equities to levels that allow difficult news to be absorbed without further, significantly adverse effects on prices. If the mar-ket advances on days with bad news, as it has on occasion over the last month, it is a positive development. How long this ability to shrug off negative news lasts, however, will be determined by both the depth and duration of the decline in corporate earnings. In our view, the major indexes already reflect earnings declines well in excess of our published forecasts of $64 per share for the S&P 500. The key will be how long they remain at depressed levels.

sentiment A Plus. Tobias Levkovich, chief US equity strategist for Citi Investment Research & Analysis, notes that his proprietary Panic/Euphoria Model, a gauge of investor behavior, has reached a level that historically has served as a harbinger for better times ahead (see chart). With the model at this level, stocks have climbed an average of nearly 19% in the subsequent 12 months. While consumer confidence readings and bearishness reported by the American Association of Individual Inves-tors point to poor investor sentiment, they are measures of how investors are feeling, not what they are doing.

vAluAtion suPPoRt. We believe equity market valuations are attractive, as illustrated by a variety of metrics. The market trades approxi-mately at a price/earnings ratio of 14, based on expected 2009 earnings, which is reasonable by historical standards. Moreover, other measures, such as price to book value and price to sales, are considerably below their long-term averages. Finally, for the first time since 1958, the yield on the Standard & Poor’s 500 has eclipsed that

A Better Year Ahead for Stocks?

Contrary indications The Panic/Euphoria Model uses sentiment indicators to gauge the market’s mood. The model now reads “panic.” When this has happened in the past, stocks made gains in the ensuing 12 months.

Data Source: Citi Investment Research as of 12 December 2008

by MArshALL KAPLAnSenior Equity Strategist Smith Barney Private Client Investment Strategy

by WiLLiAM MAnnEuropean Equity Strategist Smith Barney Private Client Investment Strategy

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JANUARY 2009 • Citi PRivAte BANk 5

of US government bonds, indicating, to us, that investors are still hesitant to take on equity risk. This could change quickly, however, once inves-tors perceive that the policy responses are indeed going to be effective, ultimately resulting in a stronger equity market.

seCtoRAl PlAYs. Our projection of sharply negative GDP growth for the fourth quarter and a double-digit decline in corporate earnings for the year prompts us to focus on some of the more defensive areas of the market, such as select health care companies and well-capitalized financials. Only when the economic upturn comes into focus will it be optimal to move into the cyclical sectors such as energy and materials.

GooD metRiCs in euRoPe. Euro Zone eq-uity markets entered 2009 with attractive valu-ations. The P/E ratio is 8.4 and dividend yield is 5% based on consensus earnings forecasts of the Institutional Brokers’ Estimate System, commonly known as I/B/E/S. While earnings expectations for the New Year, at 7.3% growth, in our view are too high, we believe the market already appears to have priced in a sharp decline. However, an apparent lack of willingness by the European Central Bank to pursue an aggressive monetary policy and the somewhat thin fiscal packages put forward in many countries suggest that continental European markets may be held back, to some extent, in 2009.

vAlue in tHe uk. In our view, UK equity market expectations and valuations are so low that much bad news has already been discount-ed. The consensus earnings growth forecast is -10.1%. The P/E multiple is 8.3, based on 2009 earnings estimates, and the expected dividend yield is 5.4%. That is a strong rate of return to collect while waiting for higher prices. In addition, the sterling is down 25% against the dollar and 17% versus the euro over the last four months. That means the corporate sector stands to benefit, since 70% of its revenues come from

overseas. Most of the effects of currency risk for US investors may already have passed as well.

stRonGeR FinAnCiAls in AsiA. This region entered the 2008 downturn in a much stronger financial position than many of its developed Western peers. That is because many of these nations were hit hard by the financial crisis in the late 1990s and have worked hard since to clean up their debt. Nonetheless, share prices and valuations have moved sharply lower in 2008’s worldwide equity meltdown.

With the region trading on a price-to-book ratio of just 1.2, Asian markets appear to be cheap. However, we see few obvious catalysts for a bull market. What’s more, we are concerned that even though fiscal pump priming and proactive monetary policy may help mitigate some of the external slowdown, they may not be sufficient to hold up corporate earnings.

We believe that dollar weakness and refla-tion remain the key props for a stock market recovery. Once these emerge, we would look favorably toward the region’s prospects. We remain overweight for the markets in Korea, Taiwan and Hong Kong, while retaining our underweight stances on India and China.

less lAtin GRoWtH. Our regional econ-omists continue to lower their Latin American GDP growth forecasts for 2009 as the reces-sion in the developed economies threatens to spill over here. In our view, only Mexico is at risk for recession, because of its strong trade links to the ailing US. In Brazil, our forecast is that growth will fall to 2.2% in 2009 from an estimated 3% in 2008. However, with regional valuations pricing in a 60% fall in earnings against our forecast for a 50% decline, cur-rent stock prices look like an attractive entry point. In 2009 we will be looking for signs of a bottoming in the pace of the global growth slowdown and a rebound in commodity prices. Brazil remains our preferred market.

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6 JANUARY 2009 • Citi PRivAte BANk

Even after several months of extraordi-nary measures by the Federal Reserve and other central banks to get the

credit markets moving again, the only thing in motion for sure is government debt. In the US, for example, Treasury bill rates are essentially zero, and the 30-year bond yield dropped to 3% from about 4.4% in less than four weeks. Bond yields have dropped to these historically low levels despite the federal government’s plan to substantially ramp up the auction schedule in 2009.

Indeed, net Treasury supply is expected to exceed $1 trillion during this fiscal year so as to finance a record budget deficit that is swelled by a new fiscal stimulus package and an assortment of additional government initia-tives. While a huge surge in new supply might concern some investors, in our view worsening economic prospects and risk aversion are likely to be better determinants of Treasury yields in

the near term. Given our base-case view that recessionary conditions and low inflation are likely to persist well into 2009, risk-free rates should remain relatively low.

With that said, the Treasury sector is rich relative to other high-quality fixed income al-ternatives. Moreover, given the substantial rally that has already taken place, we believe Trea-sury investors are not going to earn enough at these levels to justify taking the risk that the sector could sell off. The risk-reward proposi-tion is better in, for example, FDIC-insured certificates of deposit and FDIC-backed bank debt. The trade-off is lower liquidity, though that should not be a major concern for buy-and-hold investors.

tiPs toP tReAsuRY notes. We expect global price pressures to recede further and inflation expectations to moderate as growth slows. Some inflation-linked markets are implying outright deflation. For example, since late October, five-year TIPS yields have mostly traded above five-year Treasury note yields (see chart). This is very unusual since TIPS are adjusted for inflation and conventional T-notes are not. For long-term fixed income investors, the attractive valuations are an opportunity to hedge against inflation risks down the road.

Corporate bond market cash and credit default swap spreads are mostly wider from al-ready historically high levels. For example, the Citigroup High-Grade Corporate Bond index hit a peak spread of 630 basis points on Dec. 5; the Citigroup High Yield Market index hit a record spread of 2157 basis points on Dec. 16. Default swaps in the US and Europe exhib-ited the same pattern, as global credit risks are heightened by slowing economic momentum. Assuming the Obama administration moves to a “good bank/bad bank” remedy, that should help markets function more normally.

Forget treasurys: Go for High-Quality Bonds

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inflation insurance Five-year TIPS, or inflation-adjusted Treasury bonds, yield more than conventional five-year Treasurys. Investors get the “inflation insurance” at no cost.

Data Source: The Yield Book as of 31 December 2008

by MiChAEL brAndEsSenior Fixed Income Strategist Smith Barney Private Client Investment Strategy

by sTEvE rEiChEconomic ResearchCiti Global Wealth Management

Fixed income

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JANUARY 2009 • Citi PRivAte BANk 7

DoWn on loW QuAlitY. We are still wary of low-quality corporate bonds, despite what appear to be compelling valuations. Indeed, tight bank lending standards and declining profits make junk-rated companies more vul-nerable to the deteriorating economy and the severely constrained credit market. Moreover, while corporate defaults have been slow to surface and are only about 3% on a trailing 12-month basis, we expect that pace to rise to about 10% to 12% next year. In past cycles, high yield spreads typically spiked around the peak in the default rate. Even if this does not hold true in this cycle, we expect the high yield sector to remain under pressure in the near term as fragile credit markets, high volatility and illiquidity hinder performance.

HiGH on HiGH GRADe. While we are still cautious about near-term market conditions, in our view high-quality corporate bonds currently provide long-term investors with superior re-wards for the potential credit risk. For example, despite the shoring up of the banking sector that has helped make firm the prices in that sec-tor, the index yield is still around 8% and the overall spread over comparable Treasurys is still near its historic high. In these uncertain times, even traditional equity investors might consider diversifying their portfolios with high-quality fixed income securities that reside higher on the capital structure and have historically exhibited lower volatility relative to returns.

euRo BonDs RAllY. European govern-ment bonds continued to rally with yields setting a new record low in mid December, closing below the psychologically unsettling 3% level. Government bond yields are moving lower as three key trends remain intact: declin-ing inflation, decelerating economic growth and investors’ flight to safety. Bonds were helped by confirmation that inflation has been

tamed in the Euro Zone. Inflation recently dipped to 2.1%, which gives the inflation-wary European Central Bank (ECB) room to lower its policy rate, currently at 2.5%. The futures market is pricing in another 100 basis points in cuts, which takes the rate down to 1.5%. Citi’s economists are forecasting the ECB will ulti-mately take the rate to 1%, which is modestly bullish for short-term paper.

eAsinG in enGlAnD. In December, the Bank of England (BOE) continued its aggres-sive pace of easing, slashing its policy rate by 100 basis points, to 2%, atop November’s 150 basis-point cut. While the latest UK inflation data—4.1% for headline and 2% for core inflation—does not necessarily support this move, we think that the BOE is just ahead of the curve. The large drop in US inflation data can be used to make a strong case for the easing of inflationary pressures globally. The UK gilt curve is already pricing in the BOE cuts, reducing the base rate to 1%, since two-year gilt yields are already around 1.3%. With 10-year gilts at 3.1%, we see better values in the longer maturities and expect further price appreciation as inflation expectations decline.

BonDs uP, YielDs DoWn in JAPAn. Japanese government bonds rallied ahead of the Bank of Japan’s (BOJ) move to lower its policy rate by 20 basis points to 0.1% in mid December. Economic conditions continue to deteriorate in Japan. In fact, all the compo-nents of the leading and coincident indicators were down in November. The recent govern-ment bond rally has drawn strength from risk-averse Japanese investors who are choos-ing to keep their assets at home. We believe government bond yields will stay low well into 2009, as Japanese policymakers are likely keep monetary policy accommodative.

Forget treasurys: Go for High-Quality Bonds

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8 JANUARY 2009 • Citi PRivAte BANk

Is the spurt in the stock market sustainable, or just a head fake? Are financial conditions im-proving? Are housing prices going to stabilize? And most importantly, when will the economic recovery kick in? No one can say with certainty, but we will be watching many market and economic indicators to shine some light on the answers. You can watch them, too.

Nine Signposts for 2009

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the korea Composite Stock Price index (kOSPi) is among the world’s most economically sensitive equity indexes. korea’s larg-est trading partners are China, the US and Japan. A pick-up in the kOSPi would be an early recovery signal for the global economy.

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A market index can be moving up, but if the move is driven by a small number of stocks, the rally may not be sus-tainable. that’s why we watch the advance-decline line, an indicator that takes the difference between the number of advancing and declining issues each day and adds the result to the previous value. if this line is moving higher, along with the index, it is a positive sign for stocks.

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the London interbank Offered Rate (LiBOR) reflects credit and liquidity risk. the Overnight index Swap (OiS) is a stand-in for policy rates. the three-month US LiBOR-OiS spread is a proxy for corporate fund-ing costs. A contraction is considered to be positive.

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Spreads on high grade and high yield bonds are at or near historically wide levels due to poor earn-ings visibility, anticipated defaults and investor risk aversion. A substantial decline in these spreads would indicate that the credit market is improving.

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JANUARY 2009 • Citi PRivAte BANk 9

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When the housing bubble burst, this indica-tor, which is the ratio of inventory to monthly sales, rose sharply. A decline in this number would signal less downward pressure on home prices and possibly presage more stability in this important sector.

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this index measures rates on 26 shipping routes for vessels of different sizes. the index plunged in the second half of 2008, along with commodity prices, as the recession spread glob-ally. it should be quick to record an improvement in global trade.

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this proprietary index uses corporate bond spreads, the money supply, equity values, mortgages rates, energy prices and the dollar to gauge the likely impact of financial conditions on economic activity. the index is at extremely depressed levels, so any improvement will be welcome news.

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Citi Financial Conditions index

the 10 indicators in this index of business activity range from average weekly hours worked to orders for capital goods and supplier delivery times, and it tends to turn up in advance of an improvement in the economy. if the US is recovering, it will be a big plus for the global economy.

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Page 10: More Stimulus, Please · 2018-06-28 · • Buying opportunity in tax-free bonds page 12 • Hedge funds: caught in a downward spiral page 13 • Quantitative easing is the Fed’s

10 JANUARY 2009 • Citi PRivAte BANk

The US dollar took a stiff beating since the Federal Reserve, in mid December, slashed policy rates to essentially zero.

The reverberation from the historic rate cut brought the US dollar/euro rate back to the levels of September and left the greenback at a 13-year low against the yen. After a strong run in the latter half of 2008, the dollar seemed ripe for consolidation. Still, the longer-term outlook for the dollar is strong. The US economy has been struggling with severe economic head-winds for a longer period of time than most others, and thus could be the first to emerge from recession. Supporting that view is an ag-gressive monetary policy and what is expected to be a vigorous fiscal stimulus plan.

Measured against the US, the Euro Zone policy response has been tepid, and, if not made more aggressive, could prolong the reces-sion, putting pressure on the euro, especially in relation to the dollar. We do anticipate, however, that the euro probably will continue to appreciate against other European currencies.

steRlinG slumPs. Sterling is likely to remain weak well into 2009, reflecting the UK’s severe recession, ballooning fiscal deficit and falling policy rates. A weak pound will help un-derpin exports and offer useful support in the face of shrinking domestic demand. Of course, there is a potential boost to inflation from a weaker pound, but in our view, that should be offset by the squeeze on margins from the reces-sion and collapse in commodity prices.

uniQue Yen. We expect the Japanese yen to retain its unique position in the currency market in 2009. It will likely continue to appreciate against the US dollar through the year, as uncer-tainty persists surrounding the global economic outlook and volatile financial markets. However, economic spillover from a strong yen will likely be capped by Japan’s Ministry of Finance. The government will probably intervene in the cur-

rency market if the yen appreciates against the US dollar in a way that takes a significant toll on the economy and financial markets.

YuAn on HolD. Asian currencies ex Japan generally weakened in the final weeks of 2008 on reduced risk appetite, slowing growth and deteriorating current accounts. The Korean won, the Indonesian rupiah and the Indian rupee led the decline due to their external financing risks. Even the Chinese yuan, having appreciated rapidly against the dollar earlier in 2008, has stagnated of late. Once global finan-cial risks subside, we believe the yuan will likely resume a path of around 5% annual apprecia-tion against the greenback.

DoWn, DoWn unDeR. The Australian dollar will likely trade with a downward bias in the near term, as global commodity prices continue to decline, policy rates are cut and risk appetite remains impaired. Further into 2009, however, we expect the Aussie dollar to recover some of its lost ground, especially if China can avoid the worst of the global downturn and the Austra-lian financial system remains in better shape than many of its peers.

CAnADiAn DollAR DRoPs. The Canadian dollar has retreated sharply with the slide in commodity prices. US dollar strength, spillover from ongoing global financial market imbalanc-es, monetary policy easing and downbeat Cana-dian data reports have also weighed heavily on the loonie. There is nothing in the outlook that will change that anytime soon.

lAtin HeADWinDs. Currencies in Latin America face headwinds in 2009 from weaker terms of trade, tight financial conditions and declining external demand. Our foreign ex-change forecasts indicate that once the financial volatility recedes, most currencies are likely to stay around current levels, as the deterioration in fundamentals does not allow much room to move to stronger levels.

Year of the Greenback

by sTEPhEn hALMAriCKSenior Economist Citi Economic & Market Analysis

Currencies

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At A GlAnCe

Base Case Below is a summary of the Global investment Committee’s base case for world economies. Unless noted, estimates are for 2009.

GDP Growth us: -1.5%, from 1.3% in 2008

euro Zone: -1.4%, from 1.0% in 2008

Japan: -1.2%, from 0.2% in 2008

uk: -1.5%, from 0.8% in 2008

Developing economies: 3.8%, from 5.8% in 2008

inflation us: 0.2%, from 4.0% in 2008

euro Zone: 1.2%, from 3.3% in 2008

Japan: -0.2%, from 1.5% in 2008

uk: 1.0%, from 3.5% in 2008

monetary Policy the us Federal Reserve: likely to remain steady at 0.0% to 0.25% through mid 2009

the european Central Bank: likely to lower rate 150 basis points by mid 2009

the Bank of Japan: likely to remain steady at 0.1% through mid 2009

the Bank of england: likely to lower rate at least 50 basis points by mid 2009

Hedge Funds & Managed FuturesRelAtive WeiGHt WitHin HeDGe FunDs BenCHmARk inDex

Relative Value/Event Driven NEUTRAL HFRX Blend*

Equity Long/Short NEUTRAL HFRX Equity Hedge

Managed Futures/Macro NEUTRAL HFRX Macro and CISDM CTA

* Consists of: Convertible Arbitrage, Distressed Securities, Merger Arbitrage, Fixed Income-Corporate and Equity Market Neutral indexes. Arrows indicate change from previous month.

investment outlook the following table summarizes our tactical (short-term) adjustments to our strategic portfolios, which represent the blend of asset classes we believe are best suited, over the long run, for achieving maximum return for various levels of risk tolerance. in our tactical recommendations, we identify which subasset classes to overweight or underweight within each global asset class.

Vis-à-vis the strategic allocation: Overweight means up to 10% greater; Neutral: no change to the strategic allocation; Underweight: up to 10% below.

RelAtive WeiGHt BenCHmARk inDex

Global Equities OVERWEIGHT MSCI All Country World

Global Bonds UNDERWEIGHT Barclays Capital Multiverse (hedged)

Hedge Funds & Managed Futures NEUTRAL HFRX Global Hedge Fund

Cash NEUTRAL Three-Month LIBOR

EquitiesRelAtive WeiGHt WitHin eQuities BenCHmARk inDex

Developed Market Large & Mid Cap UNDERWEIGHT MSCI World Large Cap

United States overWeIGHT S&P 500

Europe ex UK UNDerWeIGHT MSCI Europe ex UK Large Cap

United Kingdom UNDerWeIGHT MSCI UK Large Cap

Japan UNDerWeIGHT MSCI Japan Large Cap

Asia Pacific ex Japan NeUTrAL MSCI Pacific ex Japan Large Cap

Developed Market Small Cap OVERWEIGHT MSCI World Small Cap

Emerging Markets OVERWEIGHT MSCI Emerging Markets

JANUARY 2009 • Citi PRivAte BANk 11

Currencies

Based on 12-month horizon. o = +/- 5% change from current level; + = greater than 5% expected appreciation; – = greater than 5% expected depreciation. Arrows indicate change from previous month.

vs. US vs. Japan vs. Euro vs. Canada vs. Australia vs. UK vs. China vs. Brazil vs. Mexico

US $

Japan ¥

Euro ¤

Canada

Australia

UK £

China

Brazil

Mexico

BondsRelAtive WeiGHt WitHin BonDs BenCHmARk inDex

Global Investment-Grade NEUTRAL Barclays Capital Global Aggregate

Government UNDerWeIGHT Barclays Capital Global Government

Agencies & Government-Related NeUTrAL Barclays Capital Multiverse–Govt.-Related

Corporate overWeIGHT Barclays Capital Global Corporate

Securitized NeUTrAL Barclays Capital Global Securitized

High Yield NEUTRAL Barclays Capital Global High Yield

Emerging Markets NEUTRAL Barclays Capital Global Emg. Mkts.

Inflation Protected NEUTRAL Barclays Capital Global Inflation-Linked

At a Glance

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12 JANUARY 2009 • Citi PRivAte BANk

Financial crisis and recession woes have wreaked havoc on the typically staid municipal bond market. Muni yields as

a percentage of Treasury yields have more than doubled since early 2007. Long-term yields have moved higher, even as short-term yields have collapsed. Credit spreads have widened sharply and rapidly: In 30-year maturities, the AAA-Baa spread has widened to 255 basis points in late December from 87 basis points on Sept. 30. In our view, these distorted relationships will even-tually return to a more normalized state. For investors, that means high tax-free income now with the opportunity for capital gains later.

What is going on? Institutional demand has virtually disappeared. Muni hedge fund posi-tions are down to perhaps 10% of peak levels. Property and casualty insurers are largely on the sidelines. Muni mutual funds are facing heavy outflows. Individual investors have been buying, but they prefer to spend on bonds with short maturities and the best credit ratings.

oveRstAteD WoRRies. We believe the worries about credit quality are greatly over-

stated. There is no question that many states and municipalities are facing massive budget shortfalls for fiscal years 2009 and 2010. Pres-sure at the local level will be severe, specifically where subprime housing concentration is the worst. Some defaults at this level are likely. But unlike with taxable securities, recoveries in muni defaults tend to be very high.

Even more important, we strongly believe the federal government will provide financial aid to the state and local sectors. With the federal government working to stimulate the economy, it would be counterproductive to allow the states to become fiscally restrictive. The constitu-tions of 49 states limit spending by requiring balanced budgets. The exception is Vermont.

lookinG AHeAD. We anticipate that the muni market will remain under pressure for some time from a heavy calendar of deals, many of which were delayed due to market disrup-tions in 2008’s fourth quarter. Yet there are good reasons to believe that the muni market will do better in 2009. First, we expect that some cross-over buyers—tax-exempt investors such as pen-sion plans that normally do not buy munis—will enter the market, attracted by potential total returns generated as the market normalizes.

Moreover, we believe US households, which hold more than $8.5 trillion in short-term assets, will gravitate to munis because taxable yields are so low. Even when taxable yields rebound, we believe there is room for municipal bond to rally. In our view, investors should seek bonds in high-quality sectors with attractive yields. These sectors include essential service rev-enue bonds rated A1/A+ or higher, and bonds backed by any of the three remaining AAA-rated insurers—Berkshire, FSA and Assured.

Investors may have to wait one or two years to see a payoff from bonds returning to more normalized valuations. But in the interim, they will collect ample tax-free income.

Buying Opportunity in tax-Free Bonds

30-Yr. Muni Yield as a Percentage of Treasury Yield

10-Yr. Muni Yield as a Percentage of Treasury Yield

Jan

'08

Jan

'07

Jan

'06

Jan

'05

Jan

'04

Jan

'03

Jan

'02

Jan

'01

Jan

'00

Jan

'99

Jan

'98

Jan

'97

Jan

'09

50

100

150

200

250

out of Whack Because they are tax-free, municipal bonds normally yield 75% to 90% of comparable-maturity Trea-surys. But now, because of the financial crisis, muni yields are well in excess of those of taxable government bonds.

Data Source: Muni Market Data-Line, Citi as of 30 December 2008

by GEorGE FriEdLAndErSenior Fixed Income Strategist Smith Barney Private Client Investment Strategy

municipal Bonds

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JANUARY 2009 • Citi PRivAte BANk 13

by rAy noLTEChief Executive Officer Hedge Fund Management Group Citi Alternative Investments

Hedge Funds

The final numbers won’t be compiled for a few weeks yet, but it’s a pretty good bet that 2008 will go down in

hedge fund annals as the industry’s worst year. At the end of November, the HFRI Fund Weighted Composite Index, a broad industry benchmark, was down 18% for the year to date (see chart). Until now, the worst year for the index was 2002, when the return was -1.5%.

After many months, the funds are still caught in a downward spiral. Market turmoil puts pressure on asset values. That, in turn, prompts investors to withdraw money, leading to more selling. Fund managers have been sell-ing to raise cash and lower their risk exposure.

no BuYeRs. The damage has been worst among funds that trade in assets in which hedge funds are major buyers—high yield bonds, bank loans, leveraged loans and convertible securities. Regardless of the fundamental value of these as-sets, technical factors are driving prices down.

By far, the worst-performing substrategy is convertible bond arbitrage. For the year to date, the HFRI Convertible Arbitrage Index is

down 55.8%. Long-short equity strategies declined 24.2% in the same period, accord-ing to the HFRX Equity Hedge Index. Still, this strategy has outperformed the Standard & Poor’s 500 by nearly 15 percentage points.

stAnDout seCtoR. The one bright spot is the Systematic Macro substrategy, which is up 16.8% for the year through November, based on the HFRI Systematic Macro Index. These managers mainly use exchange-traded futures, on which margin rules are clear and the trading is transparent. It is one segment of the hedge fund market not experiencing a liquidity crisis. In our view, more fund managers will start to use exchange-traded contracts in the future and step away from the OTC derivatives, especially in the market for credit default swaps.

sHRinkinG FunDs. The industry is seeing its first significant outflows ever. Assets under management (AUM) were nearly $2 trillion during the second quarter of 2008 and are now in rapid decline. We expect AUM to fall to $1 trillion in early 2009, with about half the loss coming from negative returns and half from re-demptions. We would not be surprised to see an additional 10% decline in AUM by mid 2009.

BARRieRs to ReDemPtion. To manage outflows, many funds built “gates,” such as sus-pension of redemptions or issuance of special-purpose liquidating shares. In the past, such measures would have stigmatized a fund, but now they are almost the norm. Institutional in-vestors tend to be understanding while individu-als are less accepting. Funds have been trying to mollify investors by lowering fees for those who agree to lock up their money for a longer period or for those who cancel redemptions. However, some investors have been balking. With high-water marks so far away from current net asset values, many funds will be working for a long time with no performance fees. So, investors ask, why tie up money in return for a lower performance fee that may never be collected?

Caught in a Downward Spiral

-25

-20

-15

-10

-5

0

5

10

15

20

25

30

35

2008

2006

2004

2000

1998

1996

1994

1992

1990

2002%

Rat

e of

Ret

urn

1991

1993

1995

1997

1999

2001

2003

2005

2007

Plunging Returns Hedge fund managers aim to deliver positive returns no matter what the markets are doing. Most fell short of that goal in 2008. Through November, the HFRI Fund Weighted Composite Index was down 18%.

Data Source: Hedge Fund Research as of 30 November 2008

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14 JANUARY 2009 • Citi PRivAte BANk

Since the onset of the credit market crisis in the summer of 2007, the Federal Reserve has done what it is supposed to

do in the face of a slowing economy or financial distress: lower interest rates. The central bank does that by adding reserves to the banking system to move the federal-funds policy interest rate to its targeted level. Indeed, the Fed cut the rate nine times, taking it to 1% from 5.25% in just 15 months without any material impact on lowering financing costs in the credit markets. Then, on Dec. 17, the Fed took its boldest step yet: lower-ing the target rate to the 0% to 0.25% range.

Now, with the fed-funds rate effectively at zero, conventional monetary policy measures have been played out without the desired effects on the real economy. Is the Fed powerless to do further easing? Not at all. In fact, in recent months the central bank has begun to practice another form of monetary accommodation called “quantitative easing.” It is a little known but increasingly impor-tant monetary policy tool aimed at insuring finan-cial market liquidity and solvency while providing stimulus for an economic recovery. It basically moves monetary policy from targeting the price of money to managing the supply of money.

To better understand quantitative easing, we should first review the basic functions of central bank policy rates and credit creation. By way of background, banks are required to maintain a certain percentage of their deposits in reserve accounts at the Federal Reserve. Banks with excess reserves at the Fed can lend them to banks facing a reserve shortfall; and the rate at which these reserve loans are made is the fed-funds rate. The Federal Open Market Committee, which consists of the seven governors of the Federal Reserve Board and the presidents of five of the 12 regional Federal Reserve Banks, is the group that sets a target for the fed-funds rate. The Fed uses open-market operations—buying and selling securities—to control the supply of reserves in the

banking system so that the fed-funds rate stays close to its target.

tARGetinG moneY suPPlY. By target-ing the quantity of reserves in the banking system—and that’s literally what quantitative easing means—the central bank has essen-tially displaced the fed-funds policy rate as its primary tool. To create those reserves, the Fed buys securities, typically US government issues. The payments for those securities add cash to the financial system, and the securities go on the Fed’s balance sheet as assets. Since the Leh-man Brothers bankruptcy in mid September, the Fed’s balance sheet has grown more than 150%, to over $2 trillion (see chart), which is roughly 14% of GDP. Where does the Fed get the money to buy those assets? It just prints it.

How did the balance sheet grow so big so fast? For starters, the Fed has extended short-term loans to banks using the new Term Auction Facility and has purchased highly rated commercial paper directly from corporate issuers. Another factor has been the currency swap lines in which the Fed provides dollars to developed-country central banks in return for yen, euros, sterling or other currencies. In exercising this function, the Fed is ensuring an ample supply of US dollars as the world’s reserve currency to maintain global liquid-ity. Together, these activities account for nearly 90% of the Fed’s asset growth. The corresponding liability growth has resulted from the creation of reserves by the Fed and a supplemental financing plan put in place by the US Treasury Department.

BAllooninG BAlAnCe sHeet. The Fed’s balance sheet is about to get bigger still, as it now intends to purchase $600 billion in mortgage-related assets. The mere announce-ment of this program, on Nov. 25, had a no-table impact on lowering conventional 30-year mortgage rates: It was immediately followed by a jump in mortgage refinancing activity. That’s the point of quantitative easing: to transmit

Quantitative easing: the Fed’s New Weapon

by JEFF APPLEGATE Chief Investment OfficerCiti Global Wealth Management

by ChArLEs rEinhArdSenior Investment StrategistCiti Global Wealth Management

by douGLAs sChindEWoLFDirector of Tactical Asset AllocationCiti Global Wealth Management

Perspectives

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JANUARY 2009 • Citi PRivAte BANk 15

monetary policy ease to credit markets and the real economy, in this case refinancing that puts spending power in consumers’ pockets that otherwise would not have occurred.

The follow-up policy initiative to this mortgage program is the $200 billion Term Asset-Backed Securities Loan Facility aimed at improving liquidity in the auto loan, credit card and student loan securities markets, which in turn should lead to improved availability of consumer credit in those markets. Going forward, insofar as other credit markets remain challenged, we expect the Fed to announce additional facilities—and further increase its balance sheet—as needed.

tHe JAPAnese exPeRienCe. The last central bank to engage in quantitative easing was the Bank of Japan (BOJ). Because the BOJ experience with quantitative easing didn’t lead to clear-cut positive economic results, there is some concern that the Fed’s efforts will not work. We disagree. The Japanese policy response to the financial market and economic challenges was generally too little, too late and too soon reversed. During the current crisis and recession, the Fed and other central bank-ers have studied the Japanese experience so as to avoid making the same mistakes. For ex-ample, the US policy response has been much faster: It took the BOJ years to get its balance sheet up to appropriate size—ultimately 30% of GDP—to deal with its challenges. By con-trast, the Fed’s balance sheet has expanded rap-idly within months, not years. This constitutes an important difference between the Japanese experience and the Fed’s current effort that augurs a higher probability of success.

An additional issue raised is that the balloon-ing Fed balance sheet will “crowd out” private-sector borrowing. In our view, we are far from that happening. Indeed, quantitative easing is the appropriate tool to reliquify credit markets and lower household and corporate borrowing costs.

Finally, there is the concern is that quantitative easing will result in higher inflation and currency devaluation. While these are certainly long-term risks, once financial and economic conditions normalize, the need for quantitative easing will recede. It then will be vital for the Fed to begin reversing the process to avoid future potential crowding out—competing for funds with the private sector—and inflation. But until that recovery gets under way, quantitative easing is a crucial component in the multifaceted campaign to normalize the credit markets and ultimately spur the next recovery in economic activity.

0.7

0.9

1.1

1.3

1.5

1.7

1.9

2.1

2.3

Oct '08Jul '08Apr '08Jan '08Oct '07Jul '07Apr '07Jan '07

Rese

rve

Ban

k C

redi

t Out

stan

ding

($tr

illio

n)

Jan '09

Big leap Forward With “quantitative easing,” the Fed buys securities and puts them on its balance sheet, thereby creating reserves for the financial system. This jump in reserve bank credit shows the policy in action.

Data Source: Federal Reserve as of 24 December 2008

Page 16: More Stimulus, Please · 2018-06-28 · • Buying opportunity in tax-free bonds page 12 • Hedge funds: caught in a downward spiral page 13 • Quantitative easing is the Fed’s

UNITED ARAB EMIRATESAbu Dhabi971-2-678-2727Dubai971-4-604-4411

UNITED KINGDOMLondon44-207-508-8000

UNITED STATESAtlanta, GA877-248-4418Beverly Hills, CA310-205-3000Boston, MA800-279-7158Chicago, IL312-384-1450Denver, CO303-296-5800Greenwich, CT800-870-1073Houston, TX713-654-2863 (US)713-966-5102 (Int’l)Los Angeles, CA213-239-1927

AUSTRALIAMelbourne61-3-8643-9981Sydney61-2-8225-4295

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If you have questions or comments, please write to [email protected].

All expressions of opinion are subject to change without notice and are not intended to be a guarantee of future events. This document is for information only and does not constitute a solicitation to buy or sell securities. Opinions expressed herein may differ from the opinions expressed by other businesses of Citigroup Inc., are not intended to be a forecast of future events or a guarantee of future results or investment advice and are subject to change based on market and other conditions. Past performance is not a guarantee of future results. Although information in this document has been obtained from sources believed to be reliable, Citigroup Inc. and its affiliates do not guarantee its accuracy or completeness and accept no liability for any direct or consequential losses arising from its use. Throughout this publication where charts indicate that a third party (parties) is the source, please note that the source references the raw data received from such parties.

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