Any company can do well when the economy is expanding. What separates the women from the girls is precognition, the vision that allows the anticipation of where the opportunities are coming from year after year. That skill is never more in demand than when we reach what economists call a saddle point, the ridge connecting two higher elevations, the pass between two mountains, if you will. With 1999 behind us and 2009 ahead, we're beginning the climb to the next economic peak.
Balancing any portfolio in a changing environment is always a challenge. But keeping track of investment and lending under interest-rate uncertainty is why bankers get paid the big bucks. While the Fed funds rate moved from 1 percent to 2.5 percent in the last six months, the underlying changes in the money supply are what really matter. After all, that is the real target of Fed policy. The 2004 shift from lower to higher interest rates came with an increase of nearly $80 billion in retail savings. This suggests that the Fed shift comes at the right time. Individuals are moving more money into savings as they begin to see the benefits from the end of a difficult economic time.
That entire retail savings flush also helps explain why the widely anticipated rise in mortgage defaults did not materialize. Apparently, those who took out adjustable-rate mortgages really did think through the consequences of rising interest rates. They bet correctly that their own financial position would improve across time so that, as their payments rose, their income would go with it. For example, they anticipated life changes, like new jobs and expanding businesses. Finding ways to capture more of that rising income as savings and investment at the retail level will be important for a healthy bottom line this year.
Next, there's good news on the yield curve, where bankers make their real money: The tightening of the spread between short-term rates and long-term rates slowed in the last quarter, finally turning a favorable direction at the end of December. Here, also, watching changes in the money supply will help sharpen foresight. Cash has reigned supreme in the post-9/11 world of uncertainty. Pre-9/11, the deeply invested component of money (M3) grew a lot faster than the cash component (M1), meaning investors weren't keeping money in liquid form. All that money was working and a lot of it was used to fuel the unprecedented growth in productivity during the expansion years. Post-9/11, however, we see that the growth rate of the cash component of money has caught up to the investment component, so they are growing at about the same rate. All this excess cash in the system means banks face significant new competition, including new sources of competition, for capital lending and investment. This is where the Fed watchers have the advantage. Anyone who took Economics 101 should remember that economic growth is moderated by fiscal policy, not monetary policy. Monetary policy applies to, well, money. And there's plenty of that around these days. While merger specialists are debating the exact amount of "dry powder" available for investment by private-equity firms, there seems to be no doubt about its existence.
Which brings us to another anticipated change: small and mid-sized companies (up to $500 million in market value) will be breaking down the door for expansion money. Those companies have been going private in droves primarily because of the increased cost of financial reporting resulting from the implementation of Sarbanes-Oxley. In 2003 nearly 30 percent of public takeovers resulted in companies going private, compared to an average of about 13 percent from 1998 to 2002.
Lance Jon Kimmel, a Los Angeles attorney specializing in this market, says a recent survey by Foley & Lardner shows that nearly 13 percent of executives are considering taking their companies off the public market as a result of SOX-imposed cost increases. For companies headquartered in some states, like Florida, more than 50 percent of surveyed executives said they will be looking for financing from sources other than the public capital markets. There is now talk in Canada of a dramatic rise in the number of small and mid-sized companies going private this year because the Ontario Securities Commission is expected to introduce SOX-style requirements. While this is bad news for stock exchanges and broker-dealers, this is very good news for bankers. Finding ways to fill that need for financing, especially during the economic expansion and in the face of strong competition, will be important for a healthy bottom line this year.
One doesn't need trances, channeling or divination to develop economic precognition. One can close one's eyes, take a deep breath, get in touch with the inner self and hold onto the vision of standing at the top of the next economic mountain.
Susanne Trimbath is senior research economist at STP Advisory Services.
