Steep Drop, Slow Ascent

Investing for the long haul is even more important in today's volatile markets, but as John Maynard Keynes once quipped: "In the long run, we're all dead." Right now most people just want to know what's in store for the coming year. To get some ideas, BusinessWeek surveyed 45 economists around the nation about their expectations for everything from growth and profits to inflation and unemployment.

It's not a pretty picture. On average, the forecasters expect the economy to contract 0.2% in 2009, the same as in 2008. The worst of the declines in real gross domestic product will come early, with some stabilization in growth by midyear, followed by a tepid start toward recovery. That scenario will lift the jobless rate to a peak of 8.1% by yearend.

The recession, plus plunging oil prices, will push inflation sharply lower. By yearend these prognosticators believe consumer price inflation will have fallen to 1.2%, having already slid to an expected 2.1% by the end of 2008. Not surprisingly, profits will get hammered. Even before the Federal Reserve's latest radical move, the forecasters looked for the Fed to cut its target federal funds rate to nearly zero and hold it there, perhaps all year. The Fed accommodated that expectation much earlier than expected by slashing its target rate on Dec. 16 to a range of zero to 0.25% and committing to hold it there for as long as it deems necessary.

The tumble in homebuilding is expected to bottom out by midyear, but house prices will fall an additional 9.8% by yearend 2009, the economists project, after a nearly 20% decline in 2008. On balance, they believe that enormous policy efforts by the Fed and Congress will prevent a serious recession from becoming worse. Here's a more detailed view of how they see the coming year:

RECESSION—HOW BAD?

The recession already is a year old. If the forecasters are right, it will easily exceed the severe 1973-75 and 1981-82 downturns in length and about match them in depth. Those two slumps each lasted 16 months, with peak-to-trough declines in real GDP of 3.1% and 2.6%, respectively.

Almost all economists, however, think the risks of an even worse outcome are high. "There are no precedents in modern-day experience for the breakdowns in financial markets dominating this recession," says Robert DiClemente at Citigroup. (C) In the classic pattern of past slumps, the Fed eased, financial conditions improved, and recovery took root. This time, faced with dysfunctional markets, conventional Fed policy is powerless to kick-start growth. "The downturn in the economy and problems in the financial markets are self-reinforcing, and the current dynamic will not self-correct any time soon," says Robert Mellman at JPMorgan Chase (JPM).

Much damage has already been done, and the economy faces a bleak winter. "Consumer spending is the No. 1 factor taking the economy down right now," says Nariman Behravesh at research firm IHS Global Insight. Job losses, tight credit, and crumbling confidence are overwhelming the benefits of lower energy prices, and declines in real estate and stock market wealth are devastating nest eggs. "Individuals will need to begin accumulating wealth the old-fashioned way—by higher savings, which will limit growth in spending," says Michael Moran at Daiwa Securities America.

With demand slumping badly, businesses are throwing in the towel. The Business Roundtable says CEO confidence tumbled at yearend, and sharp cutbacks in hiring and capital spending are sure to follow. "Costs cannot be cut fast enough," says Kevin Logan at the investment bank Dresdner Kleinwort, as businesses scramble to protect their bottom lines. Donald Straszheim, who heads his own consulting firm, thinks earnings estimates are still too optimistic. "Few sell-side stock analysts have any adult memory of past serious business cycles," he says. "They weren't even in the business yet."

The Great Inflation Debate

Credit Crisis: The Risk Hits Russia

The Fed's Risky Backdoor Bailouts

The U.S. Treasury Dept. has been blasted for handing out huge sums of money to banks without clear taxpayer safeguards or ground rules for the recipients. Yet the Federal Reserve is pouring trillions into banks with little transparency. The moves have helped to shore up the wobbly financial system in the short term. But some of the deals could end up hurting taxpayers, weakening the central bank, and weighing on the economy in the future.

In one of its latest transactions, the Fed in November channeled $20 billion—more than the size of the proposed auto bailout—to a group of U.S. and European banks, including Socit (SCGLY), Deutsche Bank (DB), and Goldman Sachs (GS), according to people familiar with the deals. The only evidence that the vast sum had changed hands was an entry on the Fed's most recent balance sheet called "Maiden Lane III" and a series of cryptic regulatory documents.

By making loans to financial institutions that can't get credit elsewhere, the Fed is the only part of the government that has the power to pump capital quickly into the financial system to stave off crisis. Historically such moves have been rare, and they've been made behind a curtain of secrecy on the thinking that public disclosure could spark a market panic. "We keep these transactions private because the Fed, as a lender of last resort, seeks to provide liquidity and not stigmatize those who seek it," says Calvin Mitchell, a spokesman for the New York branch of the Fed, which set up the Maiden Lane III transaction.

The banks likely welcomed the fresh capital from Maiden Lane III. But in recent months the Fed has pushed the boundaries of its authority by taking larger and more opaque risks on its books. The central bank currently has $2.2 trillion in outstanding loans, up from $900 billion in September. It's also using new and untested weapons. Until this year the Fed mainly loaned to banks. Now it's buying securities, some tied to poisonous mortgages. If those bets don't pay off, the Fed will eat the loss.

dangers lurk

That could spell trouble for taxpayers—and the economy. If the Fed's new deals don't work out and the losses are too great, the central bank may have to print more money, flooding the financial system with dollars. Inflation could surge, making it harder for the Fed to focus on other objectives, such as economic growth. "We have to wonder if the Fed's balance sheet might be in danger," says Roy C. Smith, a finance professor at New York University's Stern School of Business. "It is legitimate to ask the Fed to defend [its actions]."

There are growing calls for more accountability of the government's far-flung bailout efforts. The Congressional Oversight Panel, which monitors how Treasury spends its $700 billion bailout pool, is closely watching the Fed's moves as well. Elizabeth Warren, the independent chair of the panel and a Harvard Law School professor, says that's because the Treasury's actions dovetail with those of the Fed. Warren recently met with Fed staff to discuss how the central bank spends taxpayer money. As part of the ongoing inquiry she is also looking at Treasury money that indirectly funded the Maiden Lane III deal. "There were good reasons the Fed was made independent of oversight," says Warren. But "these are not ordinary times, and the amount of money and intervention by the Fed is extraordinary."

The roots of Maiden Lane III can be traced to the Fed's rescue of troubled insurer American International Group (AIG) in September. With AIG on the brink of collapse, the Fed and Treasury stepped in to prevent a meltdown of the financial system.

Will Bank Rescues Mean Fewer Banks?

Britain’s Big Banks Bailout

Is the Fed’s $800 Billion Plan Cause for Concern?

Attractive Stocks in an Ugly Old World

The Continent's leading stock indexes have plummeted more than 40% this year, and Old World companies—from steelmakers to insurers to purveyors of luxury goods—are trading at valuations not seen since the early 1980s.

The question is whether to buy now or wait for prices to drop even further. Caution seems appropriate: The gloom in Corporate Europe is deepening as recession tightens its grip. "Over the last few weeks we have seen short-notice cancellation of orders," says Jean-Pierre Clamadieu, CEO of Paris-based chemicals group Rhodia, which issued a profit warning on Dec. 8.

Even businesses that have plenty of orders are hamstrung by tight credit. "Firms could go under just because they lack liquidity," says Porsche CEO Wendelin Wiedeking. He says the automaker is paying some suppliers in advance because they can't get loans. It's no surprise, then, that many investors are hunkering down with shares in utilities, pharmaceuticals, food, and other businesses that offer reliable cash flow.

Most analysts think it's unlikely that Old World bourses will rally before the second half of 2009. Still, investors with more appetite for risk—and a willingness to pore over balance sheets—can find some good values even in cyclical businesses such as manufacturing. Bleak earnings outlooks have already been factored into many share prices. And, says Philip Isherwood, chief European equities strategist for investment bank Dresdner Kleinwort in London, managers at some companies "are becoming more realistic," trimming their forecasts and moving aggressively to slash costs.

Such companies are likely to outperform rivals even in a lousy economy, and they'll be well-positioned for the next upturn. One example: steelmaker Arcelor-Mittal (MT), which faces a collapse in demand from automakers and other big customers. It has announced tough cost-saving measures, including a plan to save $1 billion by cutting some 9,000 jobs. With its price-to-earnings ratio of just 2 based on 2009 predictions, it's now turning up on analysts' buy lists.

Companies that dominate their sectors also can make good bets, as they may emerge from the downturn with a tighter grip on their markets. "In tough times, the people who are stronger and able to invest are better off than weaker competitors," says Nokia CEO Olli-Pekka Kallasvuo. Nokia (NOK), which holds 38% of the global cell-phone market, has twice revised its 2008 sales forecast downward, but it has a healthy balance sheet and generated more than $1.6 billion in cash flow during the third quarter. With its shares off by two-thirds in this year's market mayhem, it looks like a good buy, say managers.

Currency gyrations could produce some winners, too. Shares of luxury-goods giant LVMH Mot Hennessy Louis Vuitton have fallen some 30% since September as key markets such as Russia and China faltered. Although LVMH's sales growth in 2009 will be only 3%, HSBC (HBC) predicts earnings will jump 6% because LVMH books about half its sales in dollars and yen, which have risen sharply against the euro.

Though pickings are good, patience is a must. Morgan Stanley's (MS) European equities team is predicting a 33% drop in corporate profits next year, after a 14% slide in 2008. It's advising clients to boost cash positions and buy mainly defensive stocks, topped off with a few well-chosen cyclicals.

With Jack Ewing in Frankfurt

Return to the Investment Outlook Table of Contents

Stocks: Still Too Expensive?

Paulson: 'Orderly' Auto Bankruptcy May Be Necessary

Treasury Secretary Henry Paulson said Dec. 18 that the government should exhaust all other options before allowing troubled U.S. automakers to fall into bankruptcy. But Paulson said bankruptcy might end up being the right solution if other measures fail.

Speaking at a BusinessWeek-sponsored Captains of Industry forum at the 92nd Street Y on Manhattan's Upper East Side, Paulson showed mixed feelings about how to deal with General Motors (GM) and Chrysler, which are seeking emergency government assistance to stay in business.

Paulson said he generally prefers free-market solutions, but said he agrees with President Bush that it would be imprudent to allow a disorderly failure of the automakers. Said Paulson: "This is a time when it makes sense to be prudent." The Treasury Secretary added, "If the right outcome is bankruptcy, then it's better to get there through an orderly process."

Favors Oversight of Hedge Funds

In other news, Paulson said he favors regulation of any institution whose failure could jeopardize the financial system, and that includes hedge funds, which traditionally have been lightly regulated. "The [Federal Reserve] should have oversight over hedge funds," he said.

Paulson was interviewed by BusinessWeek Editor-in-Chief Stephen Adler as part of the 10-year-old Captains of Industry series, which features leading newsmakers.

Among other points, Paulson said:

• An economic downturn remains much more of a risk than inflation from the money that's now flooding the system. "That'll be a high-class problem when we can start worrying about growth and inflation again," Paulson said, adding: "The real cost would be to not do enough and then have the economy go into a free fall."

• Banks that took U.S. funding should lend more, but he defended the Treasury's emphasis on getting them money right away without strings. "Our first priority was always, and we were clear from the day we went to Congress, to prevent the collapse of the financial system." He said, "There was literally a wave, just a string of financial institution failures or near-failures." Paulson added: "They need to lend more. We don't want them hoarding, we want them lending." However, he also said, "It is not in my judgment practical or prudent to have government…saying 'Make this loan, don't make this loan.'"

• He defended the amount of disclosure by Treasury on the Troubled Asset Relief Program, or TARP. Paulson said, "We have been moving with lightning speed," and added, "We're building this organization as we're going."

• "The No. 1 thing we need to do is stem the housing correction."

• The government lacked the authority to prevent the failure of Lehman Brothers, the investment bank that went under in September. But he said that Lehman's failure was "in my judgment a symptom, not a cause" of the financial turmoil.

• President Bush "is very current and he's on top of everything we've done." He said, "I know that's not conventional wisdom among some people but it's absolutely true."

• China and the U.S. should be good partners. "We won't always have the same view, but engagement in my view is exceptionally important."

Adler's final question to Paulson was what advice he would give his successor, Timothy Geithner, who is now president of the Federal Reserve Bank of New York. Paulson said Geithner doesn't need his advice, but added, "It's important when you're going through a time like this to define your job expansively."

Wall Street’s Perfect Storm

Mort Zuckerman on the Madoff Scandal

As if the housing crisis, liquidity freeze, deepening recession, and prospect of deflation weren't enough, now we have the Madoff Affair rocking Wall Street and investors everywhere. While no indictments have been handed down yet, prosecutors allege that Bernard Madoff, founder of Bernard L. Madoff Investment Securities, has orchestrated a long-running Ponzi scheme that duped investors—among them hedge funds, charities, and the rich and famous—out of billions. One big name allegedly taken to the cleaners was Mort Zuckerman, a principal of Boston Properties, proprietor of the New York Daily News and U.S. News & World Report, a political commentator, and a philanthropist who was on BusinessWeek's recent list of most generous givers. Zuckerman says he lost none of his personal wealth, but a chunk of the assets in a charity he controlled was invested with Ascot Partners, a hedge fund run by J. Ezra Merkin, managing partner of Gabriel Capital Group and chairman of GMAC Financial Services. Zuckerman said he got a letter from Ascot last week saying almost all its assets had been invested with Madoff and were presumed lost. At least one suit against Ascot has already been filed in federal court in Manhattan, according to news reports, and when I talked with Zuckerman on Dec. 16, he said he, too, would be going after Ascot. In an e-mail, Merkin's lawyer, Andrew Levander of the Dechert law firm, said: "The offering Memorandum for Ascot expressly named Madoff Securities as a prime broker for the fund in several places and accurately described Ascot's trading strategy. Moreover, Mr. Merkin regularly consulted with Mr. Madoff about the trades he was supposedly executing for Ascot, and Mr. Merkin's management team contemporaneously reviewed the trading tickets provided by Madoff Securities. To our horror, it now appears that those discussions and those trade tickets were a sham."

MARIA BARTIROMO

What's the impact of the Madoff scandal on your charitable trust?

MORTIMER ZUCKERMAN

Well, about $30 million, or about 10%, was invested in the Ascot fund, which had somewhere around $1.8 billion [under management]. To my astonishment, the fund manager put the entire amount into Mr. Madoff's hands. I had no idea of this. I never knew Mr. Madoff, never heard of him, and then last Friday I get the notice that the entire fund has been lost because of Mr. Madoff's activities. So, obviously, it's going to affect the ability of this [charity] to do more things. Thirty million is a lot of money that I intended to spend for the welfare of others.

With that kind of money, you trusted somebody you knew, right? Was that someone Ezra Merkin?

Yes.

What has been his response about giving the money to Madoff?

Oh, he has not given anybody a satisfactory response. I had a conversation with him, and I don't want to go into it.

I understand. So…

And nobody knew that he was doing it. I mean, there are dozens and dozens of people who…thought they were investing in a multiple and diverse group of funds. If you were going to invest all this money in another fund, it seems to me you should have told everybody that you were doing this so that they could decide whether or not that person was the person with whom they wanted to invest.

Mutual Funds: Know Where the Risks Lie

Mutual Funds: Know Where the Risks Lie

The Price of Forgoing Basic Research

In the "good old days," the industrialized world was peppered with corporate research labs. At the same time, universities were generally well funded. Curiosity-driven research, a key component in innovation was the ethic of the academy. The university produced great minds that were encouraged to think deeply and creatively without the consideration of commercial relevance. Industry selected appropriate candidates from among this cohort and gave them a home where they could generate proprietary intellectual property on which that company's future could be based. Along the way, all did some outstanding basic science.

But since about 1970, we have been on a path where industry's investment in basic research has been in decline. At the same time, there has been a significant shift toward applied, "industry-relevant" research within academia. I believe that these trends do not augur well for the future of industry, academia, or society as a whole.

The Decline of the Corporate Lab

Some might argue that the decline in the number of corporate research labs is no bad thing—that the market made a correction and halted investment in things that did not provide an adequate return. I can even hear someone bringing up Xerox PARC (where I worked) as an example. "Hey, they developed the laser printer, local area networks, and personal workstations and were still not a player in personal computing!" Well, if you want to argue that a failure in a particular technology transfer is sufficient to condemn the whole notion of corporate research, then we will just have to disagree. The invention of Nylon, Lycra, Spandex, Teflon, and Kevlar provide a clear illustration of how investment in research can sustain the long-term viability of a corporation (in that case, Dupont (DD).)

Others might argue that corporate research has simply moved to other parts of the organization—to places where it can be more integrated with the rest of the company and therefore accelerate the adoption of research. They might even support such a conclusion by referring to the data reported in sources such as the OECD Science, Technology & Industry Scoreboard 200 which indicates that, in general, reasonable investments in research and development are being made by industry, academia, and government.

But the term R&D is so broad as to border on useless for the purpose of analysis, since it covers the whole gamut of activities from basic research to product development. It ignores the significant difference between the work of a Nobel Prize laureate and a junior programmer. As early as 1980, the economist Edwin Mansfield showed that throwing everything into one R&D bucket obscured the fact that corporate investment in basic research, and even advanced development, was in decline. In this now-classic paper, Mansfield surveyed the R&D spending of 119 firms, representing about 50% of R&D expenditures in the U.S. He found approximately a 25% reduction in their investment in basic research between 1967 and 1977.

That may seem like a long time ago—but think how long it can take for research or development to play out (for more on this topic, see my previous column, "The Long Nose of Innovation"). All of a sudden, the issue becomes contemporary. As a result, we should be skeptical of reports which lull us into believing that our R&D bucket is adequately full.

There will still be those who argue that industry can no longer afford to undertake basic research and that any investment is best made in applied research and development.

Marcial: Procter & Gamble, Durable in a Downturn

Clouds over the Solar Power Industry

Marcial: Procter & Gamble, Durable in a Downturn

Clouds over the Solar Power Industry

If the recent five-year boom in solar energy marked the birth of a global industry, the next half-decade should be its coming of age. But like most adolescents, solar is experiencing growing pains. The economic crisis has weakened demand for everything from polysilicon to rooftop panels, just as manufacturers have spent billions expanding production. The overcapacity has caused prices to plummet and left the industry financially exposed. A number of companies—especially startups—may not survive a shakeout that could last 18 months or longer.

The causes of the downturn are complex and interrelated. As the price of oil plunged from its peak last summer, solar and other forms of renewable energy became relatively less cost-competitive—dampening demand from industrial, commercial, and residential customers. At the same time, the credit squeeze has made it harder for customers, whether power companies or energy-conscious homeowners, to finance solar projects. Some also are holding back in anticipation that solar equipment prices will fall even further.

Consider the story of Peng Xiaofeng, chairman of China's LDK Solar (LDK), a maker of solar wafers. During a recent trip to Europe, he toured major solar projects that have been, in some cases, on the drawing boards for two to three years. "They're all delayed," Peng says."I don't think they'll be ready [even] in 2010 or 2011."

Trimmed Subsidies

The industry impact has been swift. After increasing at roughly 50% annually every year since 2004, the overall market for new solar installations could slow to just 15% growth in 2009, according to analyst estimates. Retail prices for photovoltaic (PV) panels may fall by as much as one-third in 2009 because of a continued glut. Adding to the gloom: Spain and Germany, the world's top two markets for PV panels, have recently trimmed the subsidies they offered to jump-start local industries. "We're moving from a seller's to a buyer's market," says Adel El Gammal, secretary general of the European Photovoltaic Industry Assn. (EPIA).

Shares in major solar players reflect the brutal turn of events. The Claymore/MAC Global Solar Energy Index (TAN) has dropped 71% since its launch on Apr. 15 this year, and some leading companies have fared even worse. China's SunTech (STP)—founded in 2001 and now the world's largest manufacturer by revenue of PV cells, the basic building-block of panels that convert sunlight to electricity—has seen its stock plunge almost 90% since the start of 2008. Shares in Germany's Q-Cells (QCEG.DE), the global leader in PV cells by volume, have fallen more than 80% over the same period.

Despite this carnage, industry observers remain bullish on solar's longer-term prospects. As the price of panels drops in the next 12 to 18 months, solar power will become more attractive compared with other forms of energy. Consolidation among companies in the industry—especially as weaker players drop out or get acquired—also should lower costs and improve profitability.

All told, figures energy consultancy Navigants (NCI), the total amount of electricity produced worldwide via solar should soar from 3 gigawatts this year to 15 GW in 2012, the equivalent of 19 coal-fired power plants. Beyond the immediate period, says the EPIA's El Gammal, "the fundamentals are intact. There's no option but a very fast growth rate."

Will Demand for Solar Homes Pick Up?