Monday, October 27, 2008

Financial Projections for This Year and Next

Here are our predictions for the near and not so near term in the world of finance.

The Federal Reserve Board will lower interest rates this week. A half-point cut to a fed funds rate of 1% seems likely, and will very possibly be coordinated with interest rate cuts by the central banks of other major nations.

It won't make much difference. The financial markets will probably rally briefly on the interest rate cut(s). Then, the now familiar credit crisis malaise will settle back in, because interest rate cuts do little to restore confidence on the part of lenders. Banks are starting to lend to other banks again, only because banks have more or less been nationalized and the government will ensure that their debts are repaid. But banks are reluctant to lend to operating businesses in the real economy, because that involves actual risk. With the large amounts of mortgage-related losses that they probably still have to write off, banks would want to hold onto whatever capital they have to offset those write-offs. Making new loans is probably a lower priority than funding the company Christmas party.

Cash will be your new best friend for the next year or two or three. They that holdeth cash sleepeth well these days. That, by itself, makes saving worthwhile. In addition, cash can be used to buy stocks and real estate when they're cheap. Cash provides a buffer in case of job loss, illness or disability. The value of cash can be eroded by inflation, and the government isn't doing anything to combat inflation. The Fed's current anti-inflation policy is to hope that the economic slowdown will constrain price increases. That might work. But economic slowdowns and inflation aren't mutually exclusive. There was a time within living memory when seemingly normal men wore leisure suits and economic stagnation co-existed with nasty inflation. There have been some signs of leisure suits making a comeback. Let's hope that stagflation doesn't come along, too. Whether or not it does, cash has replaced the home equity loan as the latest measure of prosperity. Indeed, much of the purpose of the recent bailouts of banks, brokerage firms, and money market funds is to ensure that there are safe places to keep cash besides your mattress. The government will protect your cash even if it won't prop up your stock holdings or the value of your house.

Taxes will increase. Barack Obama has been pretty straightforward on this point. John McCain won't have much choice, with all the demands of the various federal bailouts along with the wars overseas. Fortunately for both candidates, the Bush 43 tax cuts expire soon, and whoever is the next President can monkey around with "extending" those cuts in ways that effectively raise taxes from current levels. Alternative minimum tax relief, which is needed every year, provides further opportunities for increasing the flow of dollars into the Treasury under the guise of giving taxpayers a break.

The recession will get worse before it gets better. At this point, only the most Panglossian of optimists (e.g., the members of the Board of Governors of the Federal Reserve System) don't see a stomach churner of a recession coming. The economic crisis has gone global. Nations from Iceland to the Ukraine to Pakistan to Hong Kong (which is part of China) are struggling. Even Kuwait, which by numerous measures is a wealthy place, has instituted bank deposit guarantees and bailed out a bank. There won't be any great safe haven overseas for your investment dollars. Even Switzerland, long time bastion of stability, recently infused capital into one of its major banks, UBS. Sovereign wealth funds won't be a source of succor, not with the price of oil falling by more than half in a couple of months. There are storm clouds in every direction and they all seem to be blowing toward us.

Eventually, things will get better. They always have, and that's a reason to think that they will again. Both the stock market and real estate market will find their way out of the abyss. But it's hard to see a quick recovery. Meanwhile, keep in mind the possibility of buying stocks and real estate when they are cheap. It's not clear that you should be buying now. Take your own counsel on that question. But buying low and selling high is probably a strategy you can implement beginning some time in the next year or two.

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