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The Globe and Mail

NEW YORK — Goldman Sachs on Wednesday said it expects the U.S. economy to drop into recession this year, prompting the Federal Reserve to slash benchmark lending rates to 2.5% by the third quarter.

In a note to clients, Goldman said real gross domestic product would contract by 1% on an annualized basis in both the second and third quarters. For all of 2008, the investment bank said GDP would rise by 0.8%.

The unemployment rate will rise to 6.5% in 2009 from the current 5%, it said.

The weakening economy will force the Fed to lower policy rates by an additional 1.75 percentage points from the current 4.25%. Starting in September, the Fed cut rates at the last three meetings of the Federal Open Market Committee, reducing the target rate on loans between banks by 1 percentage point from 5.25%.

Goldman strongly advises fund managers to overweight health care, consumer staples, energy and utilities. They are significantly underweight consumer discretionary, financials, industrials, materials and information technology.

The three most significant changes to their sector recommendations are the reduction in the financial sector weighting by 300 basis points to 14%, the information technology weighting by 400 basis points to 15%, and the increase in their health care weighting by 300 basis points to 17%, the firm said.

Their reduced allocation to financials reflects weak fundamentals and their declining weight in the S&P 500. The reduction in information technology reflects that the group has been the second-worst performing sector in both the six months leading up to a recession and during the first phase of a recession, Goldman said.

The health care weighting change reflects strong performance of the group during the six months leading up to and during the first phase of a recession in addition to an attractive valuation, Goldman said.

On Monday, Merrill Lynch economist David Rosenberg said the jump in U.S. unemployment in December confirmed that the economy was entering a recession.

Quote from today’s letter:

“We are of the camp that the US economy is weakening, and our thesis was bolstered by the employment index which fell 14 points in December. This is the largest one month drop on record”

THE DOW INDUSTRIALS:

“The Internal Technicals are Breaking Down:

Note that the RSI made its top back in May, and each top since has been at progressively lower levels, while the Dow itself made its high in early October, suggesting what the old guard technicals call a “divergence”. Since then, the Dow has made a lower high, and has broken this long uptrend line. We are turning quietly but steadily more and more bearish, and shall “skew” our trades in that manner henceforth.”

Paul Danesi, CIM

Director, Portfolio Advisory Group

Probably the biggest near-term concern for financial markets is the state of the U.S. bond insurers. S&P and Moody’s currently have Ambac and MBIA, the two largest industry participants under review with negative implications. Recently ACA Capital Holdings and other bond insurers have been downgraded. Why is this of such great concern? If the insurers themselves are downgraded then effectively all of the bonds and derivatives they’ve insured are downgraded and will need to be repriced in the market leading to massive losses for banks and investors. Many investors holding AAA rated securities are precluded from holding bond with lower ratings and could be forced to sell. Bond insurers in the U.S. provide guarantees on nearly U$2.4 trillion worth of securities, so the magnitude of the problem becomes quite obvious.

Below is my U.S. strategy piece from this week’s Weekly Market Strategy. Discusses risk of downgrades to monoline bond insurers.

RATING CUTS AND THE U.S. BOND INSURERS

There are about 10 companies in the industry in the U.S. The idea of bond insurance was created to provide credit enhancement for issuers. If an issuer is a BBB rated credit, then in theory they should issue bonds that are rated BBB. However, if a company (bond insurer) with a AAA credit rating were to guarantee the interest and premiums, then those bonds being issued by the BBB credit could be rated AAA. The issuer pays the insurer a premium for that guarantee. The issuers financing costs fall by the difference in yield between a AAA rated bond and a BBB rated bond less the premium.

Until recently AMBAC, MBI, FGIC and others conducted a straight forward profitable business. They wrote insurance primarily on municipal bonds. There were few defaults and the business generated steady revenue and cash flow. Over the last five years, they began to aggressively move into the derivatives market, insuring financial instruments such as CDOs (Collateralized Debt Obligations). The premiums were much larger than on the boring old “muni” business, but so was the risk.

Today, of the roughly U$2.4 trillion in bonds insured, roughly two thirds are municipal bonds and about U$800 billion are ABS (asset-backed securities). According to a recent report by Barclays, banks hold as much as 75% of the ABS guaranteed by insurers. If the large bond insurers were downgraded from AAA to A, they estimate banks will need another U$143 billion in capital to offset writedowns.

Shouldn’t bond insurers themselves be hedged against the risk of defaults? They were until the meltdown in the U.S. housing and subprime mortgage market began to spillover into CDO’s (collateralized debt obligation) and the broader financial market. Bond insures have numerous cushions built into their business to provide protection against defaults; over-collateralization, excess spread, reinsurance, and small reserves. Generally they insure 80% of the value of the bond; that is until losses exceed 20% on the insured security, the bond insurer pays nothing. The problem is due to significant dislocations in the financial market, the ABX index (family of credit derivative indexes referencing asset-backed securities) is trading at 20 cents to the dollar for BBB rated tranches. Downgrades would lead to significant market-to-market losses on these securities. That would result in substantial losses for U.S. and some Canadian banks. So far financial institutions have been holding their cards close to their chest with the exception of CIBC and Merrill Lynch which have been more forthright about their exposures. Merrill has about U$20 billion of insured CDOs on its balance sheet.

In a recent report from Credit Suisse, they also suggested, if the bond insurers were to lose their AAA ratings, losses would be significant with far reaching economic consequences. In their opinion regulators are unlikely to let this happen. To that end, New York State insurance regulators have asked interested parties to meet to discuss a bailout package. However, the proposed cash infusion of U$5 B to U$15 B may not be enough according to some analysts, as losses could reach U$70 B. There are also rumours circulating that activist investor Wilbur Ross is taking a close look at AMBAC. Either would be welcomed by investors to backstop an industry that sorely needs the capital. Warren Buffet has passed on existing guarantors because of their financial problems and has chosen instead to start his own company. We’re pretty sure he will stick to his knitting and provide insurance to the municipal bond market.

A Moody’s or S&P downgrade on AMBAC or MBIA could come anytime, some have suggested as early as this week. We believe news of a downgrade represents massive event risk for the financial sector and would result in a dramatic decline in the equity market sending financial stocks to new lows. However, this is only a symptom of the broader issue, which is a downturn in the U.S. housing sector and looming U.S. recession. We continue to recommend investors avoid committing new money to the U.S. financial services sector.