Stimulus Package: An Overview and Outlook

Summary

• While many analysts feel that government intervention is necessary for recovery, the latest round of stimulus efforts offered few details.
• While we agree that something had to be done, we feel that the overall value remains to be seen.
• Unlike many economists, SEI sees little risk of mounting inflationary pressures in the current environment.
• At the present time, we see nothing in the stimulus package that would lead to changes in our asset allocation recommendations. 
• Active managers can be expected to find opportunities in this environment. 
• Agency and mortgage-backed securities should be particularly attractive.

Market reaction to the latest stimulus measures announced recently by newly-appointed US Treasury Secretary Tim Geithner and others enacted by Congress a few days later has been skeptical at best, and at times panic-inducing. Yet many analysts and investors would agree that the outlook would be much worse if markets were simply left to sort themselves out. As US Federal Reserve (Fed) Chairman Bernanke suggested recently, if the US economy is to emerge from recession in 2010, it will depend on the ability of policymakers to break the negative feedback loop of a dysfunctional banking system, job losses and falling corporate profits.

The American Recovery and Reinvestment Act, and the updated version of the original Troubled Asset Relief Program (TARP), includes a variety of new initiatives but does not offer much in the way of key details behind these initiatives. Still, while warning of the consequences of failure, Fed Chairman Bernanke also suggested there was a reasonable prospect that the combined efforts of the government and the Fed would result in a recovery in lending and in the broader economy by next year.

What’s in the Updated TARP?

Broadly speaking, the plan is aimed at stabilising the banks to the point that they can once again begin to attract private investment to boost their capital base and increase their lending capacity. While many of the details still have to be worked out, the specific goals of the plan are to:

• Keep banks lending
• Address their accumulated bad debts
• Increase oversight, accountability, and monitoring of the banking sector
• Support entrepreneurs and small business owners
• Support the housing market and prevent foreclosures

Following Geithner’s outline of TARP 2 on February 10, the S&P 500 Index ($) fell 12.1% to its close on February 25. Within this benchmark, the financials sector was down 19.8% over that same time period. Mirroring the US, the MSCI World Index ($) declined 12.9% over this period, and the financial sector within that index dropped 19.4%. Despite this less than warm response, the financials later moved from their lows, although they remain under stress.

Our View on the American Recovery and Reinvestment Act

Although the fiscal stimulus is likely to help the economy recover from recession, it’s difficult to determine how much help it will provide. First, the stimulus is tilted towards government spending, the timing of which is unknown in most cases. The tax cut component, which has a clearer impact on the economy than the spending, was scaled down during the political process.

Second, the 121 separate measures include a number of politically motivated initiatives for increased government spending. By delaying the revenue-positive portion of Obama’s agenda — tax hikes on wealthy Americans — the spending increases combine with the tax cuts to constitute a stimulus. However, the economic effects of these measures are less predictable than they would be if the spending measures had been chosen strictly according to their value as economic stimulants.

The most thorough review of the stimulus is likely the Congressional Budget Office’s (CBO) analysis, although they acknowledge that their estimates are highly uncertain. The CBO projected an increase in net government spending (estimated outlays minus incremental revenue) in 2009 of $185 billion, or just under 25% of the headline $787 billion stimulus amount. The remaining stimulus is concentrated in 2010 ($399 billion) and 2011 ($134 billion).

The CBO has taken their analysis one step further by estimating the impact on gross domestic product (GDP) and other economic variables. Although the estimated impact on 2009 US GDP ranges from 1.4% to 3.8%, we believe the effect is more likely to be in the lower end of that range. Furthermore, these positive effects could be offset to some degree by rising yields, which could occur as deficit spending swells the supply of Treasury bonds. Absent an offsetting increase in demand, rising supply tends to push down prices, which move inversely to yields.

Capital Assistance Program

With the latest round of initiatives, there is little new information about the Capital Assistance Program (CAP). Based on statements by policymakers dating back to last fall, we already knew the government was committed to supporting the banking system and avoiding another major bankruptcy. Increased government holdings of the common stock of troubled financial institutions also seemed likely, with the potential for troubled institutions to be nationalized (following the precedent set when the government took over Fannie Mae and Freddie Mac last September).

CAP provides guidelines for the government’s support and shows that the Treasury is attempting to be proactive by getting ahead of future balance sheet deterioration, rather than being reactive. Specifically, CAP requires all banking institutions with assets greater than $100 billion to conduct stress tests on their balance sheets. While the stress tests could be helpful in channeling government funds, they will be conducted by the banks themselves and it’s not clear that they will provide any additional clarity into the health of banks’ balance sheets. Furthermore, the Treasury does not intend to publicise the results of the stress tests or the names of the banks that have applied for assistance under the CAP.

Public-Private Investment Fund

If successful, a new initiative called the Public-Private Investment Fund could have a positive effect on the financial markets, as well as the broader economy, by helping to clear out the illiquid securities that are clogging up the financial system. The Treasury’s stated financial commitment is significant, starting at $500 billion and potentially increasing to $1 trillion. The details are critical, however, and these are unavailable as of yet. If the Fund is set up to purchase troubled assets at existing market prices, then it would be difficult to see a benefit to either existing holders of those assets or potential private market buyers. Holders may prefer not to sell troubled assets and lock in losses. Potential buyers may see no advantage to buying assets through the Fund instead of buying them in the open market. However, if the Fund offers sufficient subsidies to sellers and buyers to dislodge the troubled assets, then it could help the economy by improving bank balance sheets and increasing liquidity in the fixed income markets. The key drawback to the Fund is the potential for rising Treasury yields (and the associated costs of paying higher interest rates to investors) should government support for the program lead to a further significant increase in the federal deficit and the supply of Treasury securities.

Housing Support and Foreclosure Prevention

This is a $75 billion program to reduce foreclosures, primarily by offering financial inducements to lenders for mortgage-payment reductions, while also offering incentives to borrowers for agreeing to stay current on their reduced payments. Further details are required to assess the effectiveness of this program. At best, however, the program is not large enough to provide more than a modest incremental stimulus. At worst, the program will not only add to the government’s funding requirements and put upward pressure on Treasury yields, but it could also adversely affect mortgages rates as lenders add a premium to compensate for potential mortgage rate reductions.

Expansion of Term Asset-Backed Securities Loan Facility

This is an expansion of the Term Asset-Backed Securities Loan Facility (TALF) from an original capacity of $200 billion to $1 trillion. TALF will also be expanded to include commercial mortgage-backed securities (CMBS). It could also potentially include non-agency residential mortgage-backed securities (MBS) and assets collateralised by corporate debt. Although TALF was announced in November 2008, it has yet to start operations. After announcing an increase in the size and scope of the program in February, the Federal Reserve Bank of New York later announced that the initial subscription date for institutions seeking to participate in TALF will be March 17, with monthly subscriptions thereafter.

In SEI’s view, TALF should help reduce the spread between US Treasury yields and yields in the mortgage and ABS markets, but the degree of the reduction and the benefit to the economy remains to be seen. As a guide, we can look at the Fed’s program of purchasing up to $500 billion in MBS, announced on November 25, 2008. The Fed’s commitment to purchasing mortgage securities triggered a downward trend in mortgage rates that continued into mid-January, which is when the Fed actually began to buy MBS. However, mortgage rates are linked to Treasury yields and have followed Treasury yields higher since mid-January. While the Fed could have resisted the rise in mortgage rates by buying Treasury securities as they hinted they might in late 2008, they have so far chosen not to. Furthermore, MBS purchases have proceeded slowly, amounting to $68.5 billion through February 25.

Like MBS, other structured securities have also frustrated policy makers’ attempts to influence market rates. For example, CMBS yields and their spread over Treasury yields have both increased since early in the year despite the announcement that these securities would be added to TALF. Market participants have questioned several TALF provisions that they expect to limit the effects on CMBS. Because the three-year maturity of the TALF loans is less than the typical CMBS maturity of five or ten years, program participants would remain exposed to price risk on the CMBS that they pledge to the Fed as collateral. In addition, TALF has stipulated that the Fed will only take new debt as collateral, not existing debt. Both of these features are expected to limit participation in the program.

Market complaints about specific TALF provisions are not surprising in view of various policy proposals that have been presented with conviction but have not worked in practice, such as the initial TARP proposal in September 2008. It seems optimistic to expect TALF to work exactly as intended by its designers. Therefore, while TALF is likely to have some positive effect on yield spreads and the economy, that effect may fall well short of the policy goals.

Risks of Inflation and Rising Treasury Yields

Unlike many economists, SEI sees little risk of mounting inflationary pressures in the current environment, even as interest rates go toward zero around the globe and central banks flood their economies with money. All around the world unemployment is rising, production capacity is being under-utilized and the gap between what is produced and what is being consumed is increasing. SEI does not view inflation as being a risk until some years after the global economy reaches full capacity again, and sees deflation as the greater risk for at least the next three years.

Perhaps the most worrisome development related to the government’s various stimulus measures is the rise in Treasury yields since the beginning of the year, which appears to be in expectation of a surge in the supply of Treasuries as stimulus measures add to the government’s debt.

The Fed late last year floated the idea of purchasing Treasuries in order to soak up some of this supply and bring yields lower to reduce the government’s costs. If Treasury yields continue to rise, SEI believes the potential economic benefits of other forms of fiscal and monetary stimulus may be negated.

Investment Strategy

At the present time, we see nothing in the stimulus package that would lead to changes in our asset allocation recommendations. At the security selection level, it’s a different story.

Many fixed-income portfolios moved to underweight positions in Treasuries as yields fell to historic lows. Yield spreads between Treasuries and non-Treasury securities increased dramatically. Non-government issuers of debt have had to pay a higher yield given the lack of buyers in the frozen credit market and concerns about business failures. Exhibit 1 highlights this spread difference.

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Exhibit 1 Source: Barclays, as of end February, 2009. Option-adjusted spreads are the spreads between the yield on corporate bonds and US Treasuries, adjusted to account for certain options available on corporate bonds and not on Treasuries. 100 basis points equal 1 percentage point.

The stimulus package will continue to drive a massive volume of new Treasury issuance. Yields have started to rise in order to attract more investors to meet this increased supply. Returns, which move in the opposite direction, have begun to decline despite economic deceleration and little sign of inflation pressure, two factors which are normally positive for bond holders. Exhibit 2 shows the change in the yield curve in the first two months in 2009, and Exhibit 3 shows the returns.

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Exhibit 2 Source: Bloomberg. Yield curves calculated using yield to maturity (%) for a given maturity length. A bond’s yield to maturity is the anticipated rate of return on a bond if one was to hold the bond until its maturity date.

(click image to enlarge)

Exhibit 3 Source: Bloomberg. Total returns (%, in $) for US Treasuries of various maturity lengths.

Active managers may be better enabled to find opportunities in this environment. Agency and mortgage-backed securities should be particularly attractive. SEI will seek to expand our platform by adding managers that we believe can add value under these market conditions.

Another Point of View on Inflation

In recent months, deflation fears were driven largely by the decrease in energy prices witnessed in 2008 along with a deteriorating labour market. While inflation has remained in check, some fixed-income managers believe that inflation will rear its ugly head over the upcoming years, in a manner similar to the late 70s and early 80s, if the stimulus package takes hold. Once the banks start lending again, these managers expect to see a lot of dollars chasing a limited number of products.

Treasury Inflation Protected Securities (TIPS, which have yields that are linked to the inflation rate) would be attractive in that environment, especially if the overall supply remains in line with expectations and historical levels. TIPS followed the commodity sell-off in the fourth quarter of 2008, enabling managers to position their portfolios to take advantage of the value they saw within the sector following this sell-off. The threat of deflation drove TIPS prices even lower. If month-over-month inflation numbers stop decelerating and slowly increase through 2009 and 2010, TIPS could come into favour.

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SEI sources data directly from the following vendors: Factset, MSCI Barra, Russell, TOPIX, FTSE, Barclays Capital and Merrill Lynch. Where appropriate, returns in base currencies are converted to the relevant currency using WM Reuters 4pm Spot rates.