Economic
Perspective Updated—December 4, 2007
Despite the current market turmoil, can recession be avoided
and will stocks continue to advance?
Since our last comment in early October, financial markets
have swooned. The S&P 500 registered an official "correction"
of 10% the Monday after Thanksgiving after having hit an all
time high on October 10th (two days before we posted our last
Economic Perspective). The bond market has similarly demonstrated
signs of uneasiness as investors have driven yields on Treasuries
to recession-like lows in a flight to quality, while investment
grade and high-yield bond yields have both widened substantially
in response to higher perceived risk. Only in the past several
days has the stock market been able to mount a rally, although
the yields on bonds have suggested continued investor fear.
On September 18th the Federal Reserve lowered the Fed Funds
and Discount rates by 50 basis points. There is one event
that seems to have prompted the beginning of a reversal in
the optimism following this reduction in both the Fed Funds
rate and the Discount Rate. That event was news that a group
of global banks, including Citigroup, J.P. Morgan and Bank
of America, in coordination with the U.S. Treasury Department,
was attempting to structure a bailout of an important portion
of the nearly $400 billion in various types of asset-backed
securities held by about 40 Special Investment Vehicles (SIV's)
that had been created over the previous half decade. The announcement
was vague, and indicated that the finalization of the plan
would take some time. While the bailout was clearly intended
to address a problem and thereby reassure markets, in fact
it seems to have raised suspicions that things were worse
than expected and that the recent Fed easing might not be
as effective as first thought.
What really took stocks down was the Federal Reserve's October
31st "Halloween" surprise, a 25 basis point reduction in Fed
Funds and the Discount Rate, in line with most expectations,
but accompanied by comments that made it evident that the
Fed believed no further rate reductions were likely needed.
Their press release stated that they believed the risks between
slower growth on the one hand, and higher inflation on the
other, were now "balanced." Over the next few weeks, public
comments by Federal Reserve Board Members and Federal Reserve
Bank Presidents reiterated the message that further rate cuts
were unlikely because they were not needed.
The markets clearly disagreed. Supporting the market's perception,
subsequent to the Fed's rate cut, was a steady stream of data
suggesting softness, if not deterioration, in the domestic
economy, accompanied by almost daily news announcements of
continued and potentially worsening problems in the domestic
and global credit markets. Increased daily stock price volatility,
lower stock prices, and widening credit spreads suggested
that investors were beginning to behave in anticipation of
a possible recession in the United States, and were becoming
increasingly skeptical that global growth would be enough
to prevent a global recession. In essence, the markets and
the Fed were locked in a very dangerous game of "chicken."
The Federal Reserve was taking the stand that financial excesses
would have to be worked out by the markets, while the markets
were giving the Fed a preview of what such a market "workout"
would look and feel like.
The Fed blinked first. On the same day that the Dow and
S&P 500 registered a 10% or greater decline from their
previous highs, the Vice Chairman of the Federal Reserve,
Donald Cohn, in response to questions following a speech,
signaled the Fed's increasing recognition of the rising distress
in financial markets and the risks that it created for the
domestic economy. Similar statements by Ben Bernanke, the
Chairman of the Federal Reserve, followed Cohn's comments
two days later. Over that three-day period, the S&P 500
advanced almost 4.5%, and has continued to edge up modestly
since then. At the same time, the odds of a rate cut at the
upcoming December 11th FOMC meeting, as measured by activity
in the interest rate futures market, increased dramatically,
with some commentators beginning to raise the possibility
of a 50 basis point reduction rather than just a measured
25 basis points that was the best hope of the extreme optimists
only a week before.
The underlying cause of these recent volatile market movements,
as well as those experienced in February and, especially August,
is uncertainty over the economic consequences from the ongoing
deterioration of the domestic housing market, and the continuing
turmoil in the credit markets as a result of the huge number
of sub-prime mortgages of uncertain or declining value still
held in investor portfolios throughout the world. These factors
are beginning to undermine confidence in the real economy;
consumers are becoming cautious in their spending, and businesses
are becoming wary of new hiring and additional capital spending.
The credit markets themselves are faltering; there are signs
that banks are reluctant to lend to each other, as well as,
increasingly, to consumers and businesses, regardless of what
interest rates can be charged. The issuance of new bonds has
remained anemic, even among top-flight borrowers. What is
particularly alarming is that, despite the fact that central
banks in the United States, Europe and Japan have injected
hundreds of billions of dollars of liquidity into the global
banking system in an attempt to encourage the banks to extend
credit, banks have tightened lending standards and have only
extended credit begrudgingly relative to most normal environments.
At the same time, a host of remedial efforts are being implemented
or suggested from both the private and public sectors. Citigroup,
the bank with the largest exposure to SIV's, was able to raise
$7.5 billion in fresh capital by issuing an 11% convertible
preferred bond to the Abu Dhabi Investment Authority in exchange
for a passive, 4.9% interest. Morgan Stanley just purchased
11,000 homes from Lennar Corporation for $525 million, clearly
a speculation but at the discounted average price of $47,000
per house. On a larger and public scale, the U.S. Treasury,
as noted before, is helping to coordinate a structure to take
pressure off banks with particularly large exposure to off-balance
sheet investment vehicles they created in the past. The head
of the FDIC has proposed a plan to freeze interest rates on
the mortgages of sub prime borrowers who have good prospects
of maintaining their loans at current rates but who are least
able to survive scheduled upward resets in rates, and thus,
monthly payments. Those who have the least ability to handle
their loans as they currently sit, however, may be excluded
from the plan, on the basis that they are over their heads
even under the current loan terms and should probably never
have gotten a mortgage to begin with. Borrowers with sufficient
wherewithal to handle the upticks in rates also would be excluded.
And, as noted also, the Federal Reserve has made borrowing
by banks easy and has increasingly suggested its willingness
to cut short-term interest rates in the near future.
It is clear that the risks of a recession have increased
substantially over the past few months, and we believe that
that the workout in the housing and credit markets will be
drawn out and hazardous. However, it is still our contention
that recession can be avoided and that stocks should continue
their advance once that becomes clear. The more quickly and
dramatically the Federal Reserve responds on the rate front,
the more quickly can the economy, and the stock market, get
back on a growth track.
The views expressed in this article are subject to change
at any time based on market and other conditions, and should
not be construed as a recommendation. This article contains
forward-looking statements, which speak only as of the date
they were made and involve risks and uncertainties that could
cause actual results to differ materially from those expressed
herein. Readers are cautioned not to rely on our forward-looking
statements.
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