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"The
worst of the financial pain may have passed, but the U.S.
economic pain could just be starting." Wall Street Journal, 5/5/08
An
Uncertain Outlook
The sense that the worst
of the financial crisis may have passed draws in part from
the recent advance of stock prices around the world since
the government-engineered sale of Bear Stearns to J.P.
Morgan. The markets seemingly interpreted that act as an
implicit guarantee that the powers that be would do anything
to avoid a collapse of the financial system.
However, the future
is murkier than usual. For instance, the market for Credit
Default Swaps (private insurance contracts) has an estimated
value of $45 trillion, a far greater amount than the value
of all the potentially publicly insurable credit instruments.
But, unlike listed securities or exchange traded derivatives,
these instruments have no clearing mechanism. That means
there is no repository of records of insured and insurers,
and no self-regulating body to assure that these contracts
will be honored.
Even within the sub-prime
mortgage market, where it is possible to quantify the wave
of upward interest rate resets and to reasonably project
delinquencies, defaults and foreclosures, there remains
a fairly high degree of uncertainty, especially as housing
prices continue to plummet, mortgage interest rates remain
high and available only to the most qualified borrowers,
and the federal mortgage agencies (Fannie Mae, Freddie
Mac) remain hesitant to purchase existing mortgages, and
continue to be undercapitalized.
Addressing
the Financial Crisis
The spate of varied,
dynamic and creative responses to the credit crunch over
the past six to eight months has been unprecedented, and
more importantly, seems to have quelled the turmoil in
most markets, at least for the time being. To recount:
The Federal Reserve
has lowered the Federal Funds rate and the Discount Rates
seven times since last September, for a total reduction
of 325 basis points.
In addition, the U.S.
central bank has created liquidity of other means for member
banks, primary dealers, and, surprisingly, for brokers,
the latter in the wake of the forced sale of Bear Stearns
to J.P. Morgan.
The
Administration and Congress have also been active; for
instance, the Federal Housing Authority has been charged
with the task of working with banks and mortgagees to restructure
troubled mortgages, and in some cases, purchasing certain
mortgages outright. However, the capitalization for this
effort has been small, and the rules for the types of mortgages
that can be restructured pertain to a relatively small
group of homeowners. Similarly, the federally-sponsored
housing agencies, Fannie Mae and Freddie Mac, have only
reluctantly raised additional capital and have only tepidly
begun to purchase mortgages in order to jump start the
mortgage lending cycle again.
Addressing
the Housing Crisis
These
administrative and legislative efforts have been aimed
at unclogging the credit market for mortgages in order
to address the key economic issue the U.S. economy is currently
facing, namely, the housing recession. As long as housing
prices continue to fall (and price declines have accelerated
in recent months), the mortgage lending market will remain
anemic, if not moribund. More importantly, falling house
prices compound the housing crisis, reduce the wealth of
consumers, and present a continuing drag on consumer spending.
And consumer spending has been the engine of real U.S.
and global economic growth for decades.
If
the U.S. economy is in recession, or will soon fall into
recession, experts believe the cause is the housing recession.
As such, a
possible key to preventing recession, or ensuring that
it remains short and of limited depth, would be to resolve
the housing crisis.
The
Stimulus Bill and Potential Impact
On
an interim basis, Congress has responded to the threat
of a consumer-based recession by enacting a $150 billion
plus stimulus bill that provides a cash tax rebate. Those
checks are in the process of being sent out. Provided that
consumers respond as they generally do to tax rebates by
spending a good percentage of the proceeds, the U.S. economy
will see an uptick. There is considerable debate about
the magnitude or sustainability of the effect. One criticism
is that recent oil price increases will absorb a good amount
of the rebates. Another is that, unless the underlying
housing issue is resolved, the economy will continue to
struggle.
We
believe the stimulus package will be largely spent in a
few months rather than over an entire year. Furthermore,
the historical "marginal propensity to consume" of
U.S.-based consumers (how much of each new dollar of income
gets spent) has been around 90% over the long term. In
recent times it could be argued it's been over 100% because
of credit card usage and home equity drawdowns. However,
one key hurdle will be the banking system's reluctance
to lend; the Fed's recent bank lending survey revealed
that banks across the board have tightened lending standards
and costs for any loans they do make.
Recession—or
Weak Economy?
In
the meantime, the recent economic data, although decidedly
much weaker than a year, six months or even three months
ago, have actually proven better than expected. Most economists
now believe we entered a recession during the 1Q'08. The
familiar definition of a recession is two consecutive quarters
of absolute decline in Real GDP. However, the agency that
ultimately determines whether the U.S. economy actually
experienced a recession and when it began and ended, the
National Bureau of Economic Research, actually looks at
a more comprehensive set of data that includes employment,
personal income, consumer and business spending, and industrial
production. They are looking for a broad decline in economic
activity across all sectors and geographies. So far the
data suggest the possibility that we may have avoided a
true recession.
Specifically,
GDP growth for the 1Q'08, the first of three readings,
came in at 0.6%, a bit stronger than the expected 0.5%.
Similarly, 1Q'08 Personal Consumption Expenditures came
in at 1.0%, ahead of the 0.7% consensus expectation, while
the GDP Price Index, which measures inflation, came in
at 2.6% versus an expectation of 3.0% on an annualized
basis. Likewise, non-farm payrolls in April declined by
20,000 jobs, but that was substantially less than in March,
when they were down by 80,000, and less than the expected
job loss of 75,000. And the unemployment rate declined
from 5.1% in March to 5.0% in April when it was expected
to ratchet up to 5.2%.
While
better than expected, these numbers all suggest a weak
economy. And not all numbers are as encouraging. Consumer
Confidence readings are approaching decade lows, as were
recently reported auto sales on an annualized basis. Recent
readings on Personal Income and Average Hourly Earnings
came in below expectations, and the S&P/CaseShiller
Home Price Index showed a near 13% decline in housing prices
year over year, down from the 11% decline registered for
March. Moreover, the history of economic data series is
that they often get revised, usually in the direction of
the current trend, which today is clearly down.
However,
other factors that argue for possible avoidance of recession
are fairly robust S&P corporate profits during the
1Q'08 excluding the writedown-laden results for financial
services. Guidance from managements regarding the outlook
for the rest of the year was also surprisingly sanguine
relative to expectations. Furthermore, corporate balance
sheets are in very good shape, as suggested by a historical
low in the Moody's domestic default rate.
A
Difficult Next Six to Twelve Months
All
that said, the headwind of continuing falling housing prices,
and the consequent decline in net worth across a broad
swath of home-owning American consumers, compounded by
rising energy and food prices, and the threat of stagnant
wage and salary growth, and for some the real possibility
of job losses in the face of stagnant or declining sales
and rising inventories among manufacturers and service
providers, sets a dismal background for optimism on the
domestic economic front. Thus the concern that we have
yet to witness the real pain of economic weakness and recession.
It
is our belief that the efforts to address the credit crunch
and the steps already taken to stimulate the economy, coupled
with further initiatives to help address the housing situation
and to promote new lending, will eventually prove successful
in preventing a deep and prolonged recession. However,
it is also our belief that any recovery will be labored
and long in coming.
In
summary, we see a difficult economic and market environment
over the next six to twelve months. There will be moments
when markets rally, followed by corrections, but it is
our best estimate that the upside will remain limited.
That does not mean portfolios cannot do well, only that
the premium on portfolio risk controls and good security
selection is much higher.
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. |
