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. |
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