January 2008

The Federal Reserve—Key Variable in Avoiding a Recession?

The Markets

On the surface, and in terms of the reported economic and market data, 2007 was not a particularly bad year, although it surely was not spectacular. The S&P 500, which we use as a proxy for the U.S. stock market, was up 3.5% in terms of price appreciation, and generated a total return of 5.5% when reinvested dividends are included. The Lehman Brothers Aggregate Bond Index produced a total return of just about 7.0%, driven by a strong return of 9.0% for U. S. Treasuries.

The U.S. GDP

As for the economy, U.S. GDP advanced 3.8% in the second quarter and a robust 4.9% in the third quarter after an anemic 0.6% in the first quarter. Corporate profits of the S&P 500 continued to register solid gains in the first two quarters of the year, but declined by 5.7% year-over-year. The third quarter's financial services company write-offs offset still-strong advances in most other sectors.

Fourth quarter GDP has still not been reported as of this writing, but will almost surely come in at less than 2.0% as the effects of the housing recession, escalating oil and gasoline prices, and the financial turmoil during the second half of 2007 have begun to negatively impact consumer spending. Corporate profits will likely continue to show year-over-year declines for the next few quarters, largely as the result of more massive write-offs in the financial services sectors.

Other sectors should continue to show solid advances for at least the last quarter of the year, but future prospects are clouded by uncertainty over the economic outlook, and are surely biased in a downward direction.

2007 an "OK Year" at First Glance. But Not Really.

Thus, it appeared to be an "ok" year at first glance, but that is not what is revealed by further examination. In fact, the year was characterized primarily by a rapidly rising sense of uncertainty that manifested itself in increased risk aversion and volatile markets. For instance, the S&P 500 hit an all time record high of 1562 on October 10th, up 10.2% from its beginning of the year opening price, and up 13.7% from its closing low on March 5th. But it also experienced two intra-year declines of about 10% each. The same uncertainties were witnessed in the bond market where, for instance, the 10-Year Treasury bond registered a high yield of 5.29% in early June and a low of 3.85% in early December.

Volatility Due to Housing and Subprime Mortgages

The primary underlying cause of market volatility in 2007 was the rapidly worsening housing recession. Housing starts have declined by over 1 million units on an annualized basis since the peak in early 2006, to a level not seen since 1992 when housing was coming out of its last recession. Despite the contraction in starts, the supply of new houses has risen from an average of 4-5 months to over 10 months at current sales rates.

Conditions are unlikely to improve much over the next six to twelve months as several waves of subprime mortgage interest resets (upward adjustments in variable interest rates that raise the monthly mortgage payments) could lead to a large and rapid rise in payment delinquencies and defaults, resulting in foreclosures and sales and placing more housing supply on the market.

To make matters worse, mortgage lending in general has contracted dramatically as banks and mortgage finance companies exit the subprime market, raise credit standards, and find that any loans extended must be kept on their balance sheets because the securitization market for new home loans outside the federally guaranteed system has all but dried up.

Perhaps more troubling than the housing recession by itself was the growing awareness of how damaging its follow-on effects would prove to be, first for financial markets, and second, for economic growth in general, in both cases not only domestically, but on a global basis.

Global Credit Markets–Intense Stress

As recounted in our previous reports, global credit markets began to enter a period of intense stress in early summer when two Bear Stearns mutual funds that specialized in subprime mortgages failed.

Previous hints of problems came in the form of data showing rising delinquency and default rates in subprime mortgages at the end of 2006 and in the early months of 2007. During the spring, a number of small, and some not so small, mortgage companies went bankrupt. But the problems at Bear Stearns initiated a frenzied search to identify the next place subprime paper would cause an implosion.

Over the next few months, a number of companies revealed large holdings in subprime paper that could not be accurately valued. In the United States, Countrywide Credit, the largest mortgage lender in the country, announced that third quarter earnings would be substantially below estimates, and one Street analyst predicted the company would go bankrupt. Northern Rock, the largest UK lender did effectively go into receivership while being propped up by a temporary government lifeline until the company found a buyer, either for itself, or the assets it held.

Then some of the large U.S. bank/brokerage firms began to own up to their exposure, revealing the need to take very large write-offs that would, in two high profile cases, force the resignation of their CEO's, namely, Charles Prince of Citicorp and Stanley O'Neil of Merrill Lynch.

Fed and Other Central Banks Begin to Mobilize

In the meantime, the Federal Reserve and other central banks around the world began to mobilize. One serious immediate effect of the subprime crisis was a rapidly growing reluctance of banks to continue lending to each other because they were afraid of hidden subprime exposure among potential bank borrowers. A corollary to this reluctance to lend to banks was a reduction in willingness to lend to anyone but their most creditworthy clients. In other words, the global credit creation process, which is the lubricant for global economic activity, was grinding to a halt.

The first central bank response was to make very large amounts of cash available to banks in order to reduce risk aversion within the banking system and to encourage lending.

In the U.S., the Federal Reserve took the dramatic step of lowering the Discount Rate (the rate the Fed charges member banks for overnight loans) by 50 basis points, reducing its spread over the Fed Funds rate (the rate set for overnight loans among member banks) by half. It also issued a statement that the risks of inflation and a slowdown in economic growth were equal, reversing their claim at their most recent FOMC meeting that the greatest risk was "inflation," in support of their decision to keep the Fed Funds rate at 5.25%.

However, as the old saying goes, "You can lead a horse to water, but you can't make him drink." Central bankers provided plenty of liquidity, but few were drinking.

Markets Continue to Struggle

In short, credit markets continued to struggle through August and early September, although markets began a recovery from their lows in anticipation that the Federal Reserve would be lowering the Fed Funds rate at their upcoming September 18th meeting. Investors were not disappointed. The Fed lowered both the Fed Funds rate and the Discount Rate by 50 basis points each and stated that it believed the downside risks to growth were greater than the upside risks to inflation.

Over the next five weeks, the S&P 500 rallied to new all-time highs, and Treasury yields showed signs of stabilizing after coming well off earlier highs, in expectation that an additional rate cut would be forthcoming at the Fed's October 31st meeting.

In fact, the Fed did deliver an additional 25 basis point reduction in both Fed funds and the Discount Rate, but they also delivered a "Halloween Surprise" in the form of a reversion to a balanced view regarding the relative risks to growth versus inflation. The December 11th 25 basis point reduction in both of the managed rates likewise disappointed the markets because it once again seemed to ignore the rapidly deteriorating prospects for the economy.

For the remainder of the year, stocks traded down with increased volatility while Treasury yields plummeted and credit spreads widened dramatically.

Heading Toward a Recession?

The Federal Reserve had signaled that further rate cuts were questionable and, if made, would be slow in coming and probably minimal in magnitude. Markets, on the other hand, were becoming convinced that the economy was heading into recession.

Despite strong third quarter GDP numbers, the data being generated during the fourth quarter was looking increasingly soft. Monthly nonfarm employment growth had been progressively slowing to fewer than 100,000 new jobs per month from year ago levels of 120,000-150,000. Unemployment insurance claims had been steadily rising from the low 300,000 per week level associated with an expanding economy toward the 350,000 per week level historically associated with slowdowns, and moving in the direction of recession levels. While reported retail sales continued to hold up well, part of the apparent strength derived from higher gasoline prices, a negative for consumer discretionary spending.

At the same time, consumer confidence declined steadily from mid-summer onward to levels not seen since 2004. Probably the most worrisome recent piece of information about the domestic economy was the just-reported employment report which showed an anemic increase in December nonfarm payrolls of only 18,000 with an unemployment rate of 5.0%, up from 4.7% the prior month and the cycle low of 4.4% in March.

A Few Positives to Note

First, U.S. exports have been expanding dramatically in response to a dollar whose value had declined by 25% over the past five years on a trade-weighted basis, most of that over the past two years. Of course, a key driver of stronger export growth is continued strong developing world (e.g. China) growth. Improvement in net exports has and should continue to serve as an offset to the negative GDP effect of the housing recession while at the same time contributing to a reduction in our trade deficits.

Second, federal government spending has remained firm, especially given the extraordinary military expenditures that have been necessitated by our actions in Iraq and Afghanistan. Surprisingly, despite high levels of spending, the federal budget deficits have been shrinking as tax receipts from the expansion have exceeded expectations. Finally, corporate spending has also held up relatively well so far.

That said, consumer spending remains two-thirds of our economy, and the constraints on consumer spending are becoming tighter. The near quintupling in the price of oil since the price trough of the last recession in 2002 has produced steady incremental bites out of disposable income. The housing recession is putting, and will continue to put, pressure on consumer spending in a number of ways.

As mortgage rates reset to higher levels, and monthly payments go up, there will be less money left over for other, discretionary purchases. In addition, the foreclosure rate will almost surely increase through much of 2008; people who have lost their homes are not likely to spend lots of money. Furthermore, the housing recession has caused house prices to decline, which reduces wealth, and thus the amount available for home equity loans (assuming one could find a lender willing to make these types of loans), as well as homeowners' general sense of confidence, a key factor in spending.

Finally, if the U.S. consumer retrenches, global growth, often cited as an offset to a sluggish U.S. economy, will not remain immune. Note that 25% of China's exports go to the United States.

Where the Economy is Headed?

Over the past couple of months, most market commentators have been raising their projected probabilities of recession in the United States. The markets are clearly signaling their heightened sense that the economy is headed into a serious slowdown, if not a recession.

Within the first week of 2008, stock markets are down across the world. In the U.S., most of the gains registered by the S&P 500 in 2007 were erased in the first several days of the new year. And U.S. Treasury yields are approaching levels generally associated with recession, although not as low as seen during the last one, which was unusual because the Fed Funds rate was lowered to 1.0% and kept there for a year as the Greenspan Fed fought the specter of a "Japanese-style" deflation.

The next meeting of the Federal Reserve is not until January 31st. As of this writing at the beginning of the month, the futures market for Fed Funds is priced for a 75% chance of a 50 basis point reduction in rates at the next meeting, and 66% odds of a cumulative 75 basis point cut in rates by the next scheduled meeting on March 18th. For the end of 2008, futures are priced for 100% odds of a 2.75% Fed Funds rate, 150 basis points lower than today. These projections express the market's belief that recession is imminent (if not already a reality), as well as the hope that the Federal Reserve will respond accordingly, that is, with aggressive rate reductions. A 25 basis point reduction at the end of January is probably a certainty, but an interim rate reduction (before the next meeting) is unlikely, although the Fed has been very creative in devising mechanisms to shore up the financial system with liquidity injections, and might opt for a surprise move on rates.

Fed—Key Variable in Avoiding Recession?

But so far, the Bernanke Fed has avoided actions that could be interpreted as panic, and has insisted on looking at the data as it comes in. That's the reason many investors believe the Fed is "behind the curve" in responding to the unfolding signs of growth slowdown. Given the severe dislocations that have already occurred in the global financial system, the near certainty that more financial "surprises" are lurking out there, and the clearly deteriorating economic statistics, the lack of some anticipatory action on the part of the Fed is contributing to anxiety, and thus to a diminishment of confidence on the part of business decision-makers.

In other words, the Fed may have actually become a part of problem. Alan Greenspan, by pushing rates so low during the last recession and keeping them there for so long, may in fact be responsible for the housing bubble that is now bursting and, thus for the ensuing financial crisis we are experiencing, but markets seem to be wishing he were back making the decisions.

We have been firm in our belief that the domestic economy would avoid a recession. Frankly, that conviction has been quickly waning. The key variable determining whether we enter a recession or not, and as a consequence, whether stock markets and bond yields continue to decline, is whether the Federal Reserve will act quickly and decisively enough to reverse the trajectory of growth. Some believe it has already missed the chance. We do not. But time is running out as the economy and the financial system become increasingly fragile.

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.