INVESTMENT OUTLOOK MARCH 2009 • Lessons from a bear market page 4 • Bond investors get choosy page 6 • Nine Signposts for 2009: an update page 9 • Sharpening our advice page 10 • Hedge funds make small gains page 12 • The cult of equity under attack page 14 CITIGROUP GLOBAL MARKETS INC. The $2.5 Trillion Repair Job Geithner’s plan to fix the Geithner needs to put it to work, Treasury, Federal Reserve and other financial system is a good one. which is what we—and the mar- agencies are committed to making Now he needs to execute. kets, somewhat more tentatively— sure banks have the capital and BY JEFF APPLEGATE AND expect to see in the weeks ahead. liquidity necessary to make credit CHARLES REINHARD STRESS TEST. The first element available. A vital aspect of the first Moments after US Trea- of the FSP is a comprehensive reg- piece of the FSP is that the govern- sury Secretary Timothy ulatory stress test for major banks. ment will provide a temporary Geithner unveiled the The aims of this test are to make capital buffer to recapitalize banks Obama administration’s much- sure the banks could still lend even that need it and take convertible anticipated Financial Stability if they suffer further losses and to preferred shares in exchange. The Plan (FSP) on Feb. 10, the stock recapitalize banks that fall short. budget released Feb. 26 includes market began sinking. Curiously The exam looks at a bank under $750 billion for the financial rescue enough, the credit markets barely worsening economic conditions—a plan as needed to be carried on the budged—a sign, perhaps, that the 3.3% contraction in GDP in 2009, books as a $250 billion loss. What fixed income players were willing to an average 10.3% unemployment if the banks need more? That will give the $2.5 trillion plan a chance. rate in 2010 and another 25% depend on the extent of further In our view, the FSP has the decline in home prices. losses, which the next part of the features needed to get bank lending After the review, banks needing FSP, the Public-Private Investment and securitized markets function- more capital will be encouraged to Fund, is designed to address. ing in a more normal fashion. Now seek private sources. Still, the US (continued on inside cover) Cover Story The $2.5 Trillion Repair Job (continued from cover) This investment fund, which is to acquire this is a further extension of the Fed’s credit bad assets from banks, is crucial. The govern- easing, as the central bank will now become a ment will lend money to private investors such market maker in securitized credit card, auto, as hedge funds to buy these assets, thereby student, commercial and residential loans. The letting the market set the price. The difference Fed’s initial foray into credit easing in the com- between that price and whatever values banks mercial paper market last autumn succeeded in BY JEFF APPLEGATE Chief Investment Officer are carrying on their books would have to be getting that market working again with lower Citi Global Wealth Management absorbed as additional bank losses. Since the absolute yields and spreads. The subsequent private-sector cost of borrowing will be low and venture into the mortgage market achieved the loan is nonrecourse, demand for these assets positive results as well. We think the TALF will could be quite robust; by extension, potential work, too. This should also mean the Federal bank write-downs and additional recapitaliza- Reserve’s balance sheet, which had recently tion needs will be commensurately lower. dropped back below $2 trillion as some of its LEVERAGING UP. The third part of the commercial paper holdings matured, will rise BY CHARLES REINHARD FSP is the expansion, up to $1 trillion, of the again—potentially to $3 trillion—as the TALF Senior Investment Strategist Citi Global Wealth Management Federal Reserve’s previously announced Term ramps up (see chart). Asset-Backed Securities Loan Facility (TALF). While the FSP may fall short of what The plan calls for using $100 billion of ultimately will be required, in our view it is an Troubled Asset Relief Program funds, and then innovative initiative. Combined with the $787 leveraging them by a factor of 10. In essence, billion stimulus package signed by President Obama on Feb. 17 and the $275 billion Homeowner Affordability and Stability Plan Temporary Dip The Federal Reserve’s balance sheet is introduced by the president on Feb. 18, the expected to climb to $3 trillion as the Term Asset-Backed Securities Loan Facility starts acquiring loans. FSP is another element that should lead to a recovery in economic growth in the second half of 2009. This recovery should be anticipated $2.5 first in US and global equity markets. More- ) 2.3 over, this steady flow of initiatives from the Obama White House confirms our view that 2.1 this administration will be much more activist 1.9 than its predecessor. nding ($ trillions ta 1.7 BEYOND THE US. Developed-country cen- tral banks, such as those in the UK, Japan and 1.5 edit Outs edit Canada, are moving toward a Fed-type ZIRP 1.3 (Zero Interest Rate Policy) or deploying credit 1.1 easing to keep local credit markets function- e Bank Cr rv ing. Unfortunately, the European Central Bank 0.9 ese R hasn’t been aggressive enough on rates, though 0.7 we expect that it will move closer to ZIRP this Jan ‘08 Apr ‘08 Jul ‘08 Oct ‘08 Dec ‘08 Feb ‘09 summer. Developing-country central banks, such as those of China and Brazil, continue to Data Source: Federal Reserve as of 18 February 2009 reduce interest rates—albeit from much higher 2 MARCH 2009 • Citi PRivAte BAnk Investment Products: Not FDIC Insured • No Bank Guarantee • May Lose Value levels—to stimulate their local economies. toward more-normalized valuations in the Finally, global fiscal policy stimulus is at work, months and quarters ahead. In addition, mar- too. Including the US, our economists estimate ket recoveries usually take place in a favorable fiscal stimulus will be more than 5% of global liquidity environment—and that liquidity is in GDP across 2009 and 2010 (see table). place. Moreover, while the credit markets have As long as an adequate global policy not returned to normal, they are moving in response is forthcoming, the US and global fi- that direction—and borrowing costs are low. nancial markets and economy should complete REAL YIELD. The US equity market also its bottoming process. Almost across the board, looks promising in terms of real yield, or the that policy mix seems appropriate, in our view. yield on risk-free Treasury bonds less the infla- However, there remain concerns over the risk tion rate. In the 1950 through 2008 period, of protectionism. The “Buy American” provi- any time real yields were below 3%, as they are sion in the US fiscal stimulus package is one now, stocks were up an average of 13.5% in the example; fortunately, it was mostly gutted after next 12 months. That is significantly greater the White House opposed it. than the 5.1% afforded to Treasury bonds or PROTECTIONIST RISKS. In some circles, 3.1% to cash in the same environment. That it’s considered “financial protectionism” when history is yet another reason for investors to global banks reduce lending or sell assets stay resolute through these difficult times. outside their markets. In our view, such ac- tions are more a corporate response to the downturn. Similarly, we disagree that backing Global Fiscal Stimulus The US and China have the biggest programs underway to stimulate their economies. All together, the various plans add up to some 5% of world GDP. US automakers is “industrial protectionism.” Canada and Germany, for example, have been Country Comment supportive of American auto companies in US $787 billion plan, 65% spending and 35% tax relief. Lower withholding taxes should those nations just as the US has been. So, while start in mid March. infrastructure spending should be felt later on. protectionism remains a risk to markets, it is a China Rmb 4 trillion with 75%+ for infrastructure development, earthquake fairly low-level threat, given the globalization reconstruction and other projects. Provincial governments have added another of labor and capital extant today. Rmb 25 trillion in proposals. early signs stimulus is already being felt. ROUND TRIP. US and global equities have Euro Zone Targeting households and businesses via tax and subsidy changes, plus some investment. round-tripped back to their November lows, Japan Direct subsidies to households, tax incentives for business investment and security as consensus earnings estimates and valuation investment, and subsidies for industries hit by higher input costs in 2008. reflect the deeper recession. US and global ex- UK Cut in the value Added tax (vAt). pected earnings for 2009 are now $64 and $17, Australia Fiscal stimulus to families, pensioners, first-home buyers, increased payments to respectively, versus $87 and $24 in November, the states and a focus on infrastructure. while forward price/earnings ratios are 12 and Canada infrastructure spending, tax cuts, increased unemployment benefits and 11, respectively, versus nine and eight previously. backstopping of key industries, including the autos, telecommunications, forestry Historically, prospective equity returns have and aerospace. depended quite a bit on the characteristics Korea 35.6 trillion won total fiscal package was approved last year. Households and firms will receive tax cuts, while construction firms will gain from higher direct subsidies defining the starting point. Currently, P/E and infrastructure spending.