'September 2008 Was Quite an Eye-opener'

Does she still considers herself an optimist? Abby Joseph Cohen's voice turns gruff. No wonder: Goldman Sachs' senior U.S. investment strategist, who constantly ranks among the most powerful women on Wall Street, has had her fair share of ridicule due to her bullish forecasts.

She correctly predicted the bull market of the 1990s, but also failed to anticipate the sharp decline in the stock market after the dot-com bubble burst.

"Other people are the ones who defined me one way or the other," she says, after sharing her somewhat cautious views about the state of the U.S. economy and the financial markets.

Joseph Cohen - senior U.S. investment strategist at Goldman Sachs and president of Goldman's Global Markets Institute - is one of the most influential analysts on Wall Street. Yet in the last two years she's been on the defensive, constantly defending her record after critics claimed she failed to predict the current financial crisis and sneered that she'd lost her touch.

She doesn't take the sniping to heart, though, and calmly continues to issue clear and lucid forecasts. One thing is for sure: almost no one could have predicted what happened on September 15, when Lehman Brothers filed for bankruptcy, Merrill Lynch announced its sale to Bank of America, and all hell broke loose.

"Even before the disruptions in the financial markets took place in the summer of 2008, we were uncomfortable with the fundamentals of the American economy," recalls Joseph Cohen. "While we had one of the most cautions economic forecasts on Wall Street at that point, we did not expect the financial markets to freeze up the way that they did, and so to watch the developments in September of last year was quite an eye-opener. To see firms having problems staying in business was disturbing. Its one thing to be unhappy with the price; it's another thing not to be able to get a price because the markets are not functioning."

A year earlier, Joseph Cohen had quite a different forecast in mind for the economy, as Goldman Sachs predicted a moderate recession in the United States.

"Last year the view of our economics department was that there would be a deceleration in economic growth in the U.S., but that forecast changed in the second half of 2008 to an outright recession. We were very concerned that the slowdown in the housing market had moved to an outright decline and we also felt that GDP in the U.S. would turn negative and unemployment would rise, so there was a very big change of view in the second half of last year," she says.

Even so, admits Joseph Cohen, "clearly the situation that happened is something we discussed internally. We did not assign the right probability to something of that nature occurring. We thought it was a possibility, but we had assigned a low probability to it."

Eventually, pessimists like NYU economist Nouriel Roubini, who predicted an Armageddon-like financial collapse, were right. But those economists were in a position that allowed them to make those predictions, says Joseph Cohen.

"What we need to do is to present to our clients what we think is the most likely scenario, and that's what we did. We presented a forecast in which we thought there would be a moderate recession in the U.S. and financial markets would have a rough time, but certainly nothing of this sort. Is it possible to forecast extreme cases, even very ugly or very happy? Of course it is. But we feel that we have a responsibility, given our role as advisers, not to provide provocative forecasts or extreme forecasts, but what we believe is most likely to occur."

Do you agree that the worst of the crisis has passed?

"Let's separate it. There have been two crises. Separate but related. One crisis has been related to the economy, and one has been related to the financial markets. With regard to the economy, we do think the worst has passed. That doesn't mean the situation is now good, but the worst performance of our economy occurred in the last few months of 2008 and early this year. Between September 2008 and February and March 2009 the economic data were terrible, not just in housing but in industrial production and investment by companies in equipment, and we began to see very significant increases in unemployment. The most recent data are not that bad. There are signs, not of a sharp recovery, but of stabilization. So that's a good starting point. In some industries things have gotten somewhat better and in other industries things are not deteriorating as dramatically as they were.

"Overall we think that the GDP tells an interesting story. In the first quarter the GDP declined 6%, in the second quarter we think the decline will be about minus 3%. In the third quarter we think we will see a positive number, not a strong one but at least it will be a plus sign instead of a minus sign, and our forecast for the quarter is a 1% rise in GDP.

"Clearly, the financial markets have begun to be repaired. They are back toward normal, but they are not normal yet. The fixed income markets had been our biggest concern, they just stopped working in September 2008 and it became impossible, even for good quality borrowers, to get money. What we have seen in the last 3 months or so is actually quite encouraging. For example, we have seen that corporations and universities and even some state and local governments have been able to go into the financial markets again and borrow. This is something that suggests things are moving toward normal, since earlier they couldn't borrow if the Federal Reserve didn't guarantee those bonds. Over the past several weeks, federal government guarantees have not been needed. That's a sign."

Markets in the U.S. have rallied since March, even though unemployment is still rising and the economy is still in decline. So is this a fool's rally, or a sign markets are returning to normal?

"Since March we have seen a 35% recovery in the S&P 500. That by itself is not enough to say that things are moving back toward normal, but there are some other things that have happened. We have seen a very sharp reduction in volatility. During the worst parts of the financial crisis the volatility in the U.S. stock market had been at a level of 85%, when it is usually around 16% to 18%. What has happened since March is that volatility has moved dramatically lower. It is still double the normal level of volatility, but it is better than five times the level of normal volatility. We don't expect it to surge again, unless there is some dramatically bad news, but it will stay somewhat elevated.

"The other thing that we see is that there is a lot of liquidity available for the U.S. stock market. By some estimates that is between $3 trillion and $4 trillion of cash that is sitting on the sidelines. And of course, let's not forget the Treasury bonds. For an extended period of time, the last 18 months, almost every financial asset in the U.S. and around the world were correlated on the downside, they all went down together. The principal exception was U.S. Treasuries. Investors around the world viewed U.S. Treasury bonds as a safe haven. There were some investors who moved into gold, but more turned to Treasury bonds.

"What happened since March is that some of the money that was hiding in the U.S. Treasury market is now coming back into stocks but also corporate bonds. Investors are somewhat more tolerant of risk, because they are not quite as nervous as they were previously."

Renewed confidence thanks to Obama

The yield on the 10-year American Treasuries this month is at its highest level since October. Does this represent an easing of the crisis, or a growing discomfort with the quantity of U.S. debt?

"I would basically say that the truth lies somewhere in between. I think that most of the rise in Treasury yields has been related to the more positive construct, that investors are feeling better about the economy and are therefore willing to own assets other than the U.S. Treasury. However, let's also recognize that on a day-to-day basis there are other factors that drive U.S. Treasury yields. I think it's wise for most investors not to worry so much about the day-to-day moves, because you can often get hung up in the noise. With that said, I concur that we should watch the deficit more carefully."

Surely U.S. President Barack Obama can take some credit for the renewed confidence in the markets? How do you feel about the new administration so far?

"It's very hard to differentiate between the different factors, but certainly there has been a renewed confidence in the country about this administration. There's a feeling there's action on policy; there was general support for the stimulus plan. However, I believe it's way too soon to be assigning them grades, but we have seen a very strong team put together, a very thoughtful team.

"But it's not just what the president thinks, it's also what the Congress thinks. The president has presented a very aggressive agenda for a number of things that I think would be very helpful, and we will have to wait and see what Congress does with it.

"One point I would make is that the people Obama put in place with regard to fiscal policy are people who are very serious about keeping budget deficits under control. When we dig in the details of the president's proposed budget we all know that this year will look bad, but when we take a look at the numbers two to three years from now, we see that the budget deficit probably will decline from the very high number now to about 5% to 6% of GDP. While we would like it to be lower than that, that is the level it was during the entire Reagan administration."

Will the growing deficit hurt demand for U.S. dollars and U.S. Treasuries?

"There are a lot of factors influencing the demand for the dollar, and the dollar itself is a relative price. The dollar doesn't do anything by itself in a vacuum; it goes up and down relative to other currencies. And as we take a look at the other senior currencies, it's hard to argue for dramatic moves in one direction or the other. The dollar versus the euro, for instance, we think will be in the trading range for a period of time. The European economy looks weaker than the U.S., and it appears the euro zone will lag the United States."

Not too long ago it seemed like the U.S. was hit harder by the credit crisis. Can you offer an explanation for the stalled recovery in Europe?

"Historically Europe does tend to lag behind the United States. The U.S. is a huge trade partner of Europe, Europe exports much more to the U.S. than we export to Europe, so we are a more important customer to them, so they typically wait for us to recover and then we help them along. Also, a great deal of growth in Europe was coming from emerging markets in Eastern Europe and many of those economies are now under significant duress."

Inflation fears are premature

Many economists have warned lately that the excessive amount of debt the U.S. is taking will inevitably lead to inflation, or even hyperinflation. Do you share this fear?

"I think fears of inflation in the United States are spectacularly premature. What will drive inflation in the next quarters and couple of years will be utilization rates. What we basically see is many of our industries are operating below their full capacity, our labor market is dramatically below its full capacity, and even though some commodity prices are rising we don't think that that's enough to generate a worrisome inflation in the U.S. The time to be concerned about large deficits and government spending that is large and proportionate to the economy is when the private economy is itself robust, and that is not the case."

Many banks are seeking to return the government aid they got from TARP. Does this mean the crisis in the banking sector is coming to an end, or is this just an attempt to escape increased regulation?

"There are several different ways to look at this. The stress tests revealed a great deal of information. Some financial institutions now seem to be on very sound footing, and those are the institutions that have been allowed to return some of the money that was provided under TARP. But I think it's appropriate that we remain very diligent about the health of the banking sector. Our teams indicate there's still some clean-up ahead, in commercial real estate and in credit cards. Some of the European banks also have some more accounting clean up to do."

How can the U.S. and other governments and central banks retreat from supporting the economy and the financial system, without reigniting the crisis?

"One thing that gives us some confidence on this matter is that we have people in positions of responsibility who understand that potential risk. Ben Bernanke is an expert on the Great Depression, not only on what triggered it but also what prolonged it, and of course what worsened it. The fact that he is so familiar with these aspects is important.

"But also, let's recognize there are many ways in which this situation, however serious, is not the Great Depression. For example, in the 1930s the Federal Reserve didn't understand the role of providing liquidity. They provided some liquidity and withdrew it too quickly. Also, some of the mechanisms people often call the automatic stabilizers, like unemployment insurance or income relief, were not present in the U.S. economy. There was no FDIC, and there was a surge in protectionism in which almost every major economy erected barriers to trade. That hasn't happened, and in fact there has been a good level of cooperation between countries in keeping trade open."

Where do you see the S&P 500 a year from now?

"To talk about the outlook 6 to 12 months from now requires that we talk about what we think would happen in the economy. One of the assumptions we are making is that the economy gradually will look better. We also think corporate profits will look much better.

"But we have to be careful, economic data get reported quarter by quarter. Corporate profits are reported year on year. One thing that we expect is that the apparent recovery in profits will be more vigorous.

"We've seen in other recoveries from other bear markets that recovery is not V shaped, or U shaped. It is a staircase. We think it would be a staircase. We have taken the first upward step, from 666 points in March to about 950 today. We think we will get stuck on that step for a while."