The recession is now running on all four cylinders.
We're referring to the four phases of the downturn that
we identified much earlier and discussed in numerous
Insights.
Phase 1, the collapse of the housing sector, touched
off by the subprime slime, as we dubbed it, and measured
by the ABX BBBindex, started early last year with the
$1.8 billion writedown of subprime mortgage securities
by big U.K. bank HSBC in February. Phase 2, the
spreading of the woes to Wall Street, commenced with the
implosion of two big Bear Stearns hedge funds in June
2007. These first two phases are largely financial, and
persist today.
Housing Horrors
Housing starts have nosedived from 2.3 million,
seasonally adjusted at annual rates, in January 2006 to
791,000 in October, a post-World War II low (Chart 1).
Meanwhile, homebuilder sentiment is now at record lows.
Leaping foreclosures, among other forces, have pushed up
the homeowner vacancy rate. Some of the victims of
declining homeowner rates are moving into rental
apartments as the bubble years' lure of homeownership
fades or they lose their houses. But others are doubling
up with friends and family, thereby adding to empty
house inventories.
Foreclosure Sales
As lenders spilled foreclosed houses on the market,
they were sold for only 70% of the unpaid loan balance
in the third quarter compared with 78% in 2007, and
losses averaged 44% of the loan balance compared with
29% a year earlier. With about 40% of existing home
sales coming from foreclosures, or "short sales" in
which the mortgage amount exceeds the house's value, the
prices for selling homeowners and builders are forced to
decline to compete.
25% More
Existing home prices are down in October 20% from
their peak in October 2005 as measured by the National
Association of Realtors, and 21% from their second
quarter 2006 peak according to the less-upward biased
Case-Shiller index (Chart 2). Curiously, a survey found
that in the second quarter, 62% of homeowners believed
their houses had appreciated in the last year even
though 77% had fallen over that time and only 19% had
risen, according to Zillow. Another survey found that
91% believe that a house is the best long-term
investment. A third poll revealed that 32% think this is
a good time to buy stocks, but 51% believe it's a good
time to invest in a home. We wonder if that optimism
will persist if our long-held forecast of a 37%
peak-totrough decline holds.
Underwater
At present around 12 million homeowners, a quarter of
those with mortgages, are underwater with their houses
worth less than their mortgages. Among those who bought
their homes in the past five years, 29% are underwater.
If our forecast of a 37% house price fall is reached,
about 25 million, or almost half the 51 million with
mortgages, will be underwater. Adding in the 24 million
who own their houses free and clear, and one-third of
the total will be in trouble. The destruction of the
American Dream of homeownership for so many people will
force a political response, even though the cost of
subsidizing their mortgages down to their house values
would be about $1 trillion.
Financial Problems
The woes of financial institutions also persist, fed
by bad mortgages and increasingly by other troubled
assets. The extreme stress on the financial system here
and abroad is manifested in two clear ways: first, the
consolidation and disappearance of many previously
impregnable financial institutions and second, by the
need for huge and continuing government bailout in order
to preserve the integrity of the financial structure
and, hence, the world's economies.
The list of the departed is well known: Bear Stearns,
WaMu, Lehman and Wachovia disappeared while Merrill
Lynch arranged a shotgun marriage with Bank of America
and Morgan Stanley and Goldman Sachs converted to the
safety of bank holding companies.
The FDIC recently announced that the institutions it
insures had only $1.7 billion in earnings in the third
quarter, down from $28.7 billion a year earlier. And
financial troubles aren't confined to banks. Many hedge
funds have suffered huge losses on their highly
leveraged positions this year. And their sales of
securities to limit further losses and to meet investor
redemptions are adding downward pressure on many
markets. In some, assets are down 50% while others are
folding their tents and still others are limiting
redemptions, only adding to investor restiveness.
Redemptions are expected to jump early next year.
Diversification
Many endowment and pension funds have been hard hit,
especially those with heavy alternative investments in
hedge funds, private equity funds, venture capital,
commodities, currencies, emerging market stocks and
bonds, real estate, junk securities, etc.
Diversification is a great idea -- if it works! But as
we've noted continually in Insights for more than 10
years, there are tremendous amounts of hot money flowing
around the world. And whether it's managed on the basis
of fundamental factors, momentum, technical analysis,
etc., it all tends to end up on the same side of the
same trade at the same time.
So when stocks get clobbered, as they have since
October 2007 (Chart 3), and force out hot money, it will
also retreat from otherwise unrelated long positions in,
say, grains, to conserve capital. Many institutional
investors believe in the Modern Portfolio Theory of
diversification, but erroneously thought that
alternative investments would have zero or better still,
negative correlation with their basic equity holdings.
They also became convinced that commodities and foreign
currencies were asset classes like equities and bonds,
and merited 5%, 10% or 15% of their portfolios. They're
learning the hard way that all those correlations have
proved to be close to 100% and that commodities and
currencies aren't asset classes but speculations.
The Overarching Reality
Washington policymakers do not appear to have
understood the overarching reality -- the massive and
painful deleveraging of the immense leverage accumulated
by the household and private financial sectors over the
last three decades (Chart 4). They were also initially
preoccupied with a philosophy of non-intervention in the
private sector and with concerns with creating moral
hazard if they bailed out troubled financial
institutions. Furthermore, they've been making up the
game plan as they go along. Last summer, Secretary
Paulson told Congress that the $700 billion bailout
money would be used primarily to buy troubled mortgages
and mortgage-related securities from banks. Somehow,
that would encourage banks to resume lending, but we
never understood how.
A TARP For All
Even though the majority of the $700 billion TARP
money is yet to be committed, that total is only a small
piece of the $4 trillion-and-counting sum the federal
government has made to bail out the financial sector.
Included in that total beyond the $700 billion TARP
program is $350 billion in FDIC guarantees on
bank-issued debt, and Goldman Sachs, JP Morgan Chase,
Morgan Stanley and Bank of America quickly raised $26
billion with Citigroup and Wells Fargo planning to
follow. Then there's an estimated $1.3 trillion from the
Fed to buy frozen commercial paper, $540 billion to buy
commercial paper and other short-term debt from money
market funds to stop the run on them, the new $200
billion Term Asset-Backed Securities Loan Facility
(TALF) to back credit card, auto, student aid and small
business loans and the $600 billion to buy
mortgage-backed securities and GSE debt.
Worst Since The 1930s
Of course, in what will probably be the worst
financial crisis and deepest recession since the 1930s,
it's not surprising that Depression-era bailout
structures are being copied. The Reconstruction Finance
Corp., instituted by President Hoover in 1932, bought
positions in over 6,000 financial institutions to the
tune of $50 billion, not adjusted for inflation or the
growth of the economy since then. The government got
senior voting rights to control these firms and barred
dividend payments to shareholders until the government
was repaid.
The worldwide recession is redirecting sovereign
wealth money homeward. For instance, seven sovereign
wealth funds in the Persian Gulf region are expected to
lose 15% of their value, or $190 billion, this year,
cancelling the likely $198 billion growth in crude oil
revenues.
It's interesting that the Fed, with its new
commercial paper program, is lending directly to nonbank
corporations for the first time since the 1930s. But
then the Fed can lend to anyone, you included, under
"unusual and exigent" circumstances. The Fed is, after
all, the nation's lender of last resort.
And don't worry about the remaining $370 billion in
TARP money being committed. Detroit automakers want $25
billion. Homebuilders want money from somewhere for
their $250 billion bailout, mentioned earlier. Banks not
included in the initial nine to receive TARP money in
the form of preferred stock purchases worry that if they
don't ask to be included, they'll appear too weak to
qualify. Many of the nation's 6,000 small, non-publicly
traded banks want their share of the government goodies
even though they can't issue preferred shares and
warrants.
Spreading Financial Woes
As consumers retrench and eliminate discretionary
spending, they are increasingly regarding monthly
payments on credit cards, auto, student and home equity
loans as discretionary. When it's a choice between
putting food on the table or making a credit card
payment, financial responsibility is suffering.
Delinquencies and charge-offs in these consumer loan
categories are mounting with a 9% increase in auto loans
30 days past due in the second quarter vs. a year
earlier and an 11% rise in those 60 days overdue.
Even upscale-oriented American Express, where over
half its revenues come from fees paid by merchants, is
suffering as charge volume falls and delinquencies and
charge-offs on its credit cards rise, leaping 6.7% in
September from 3.6% a year earlier. Consequently, the
firm recently became a bank holding company so it could
qualify for TARP money and hopes to get a $3.5 billion
infusion. Credit card issuer Capital One has received
preliminary approval for $3.55 billion in TARP money.
Credit card issuers are also reacting to weakening
volume and jumping charge-offs by raising interest rates
and fees.
Student loans more than doubled from $41 billion in
school year 1997- 1998 to $85 billion in 2007-2008, but
almost all of the growth was in private loans, with
subsidized federal aid relatively flat. And
delinquencies are jumping in that segment. SLM, or
Sallie Mae, the largest private student lender, reported
a delinquency rate of 9.4% in September vs. 8.5% a year
earlier. Parents, suffering from stock losses and the
disappearance of home equity, are no longer able to bail
out their debt-swamped offspring. Meanwhile, SUV and
other vehicle owners who are now upside down on their
auto loans due to weak used vehicle prices have limited
zeal to keep up on loan payments.
TALF
Adding the general freezing of credit markets to
these conditions and it's not surprising that investor
buying of securitized consumer loans, which normally
provide the funds to make fresh loans, has dried up. In
October, there was only one $500 million deal compared
to $50.7 billion a year earlier. And the interest cost
has leaped. From June to October, the risk premium on a
triple A credit card deal jumped from 3.2 percentage
points over 2-year Treasurys to 4.67. Treasury Secretary
Paulson recently said that that market "is currently in
distress, costs of funding have skyrocketed and new
issue activity has come to a halt."
So the government bailouts that we predicted in our
October Insight have commenced. The Department of
Education is buying $6.5 billion in federally-guaranteed
loans, which doesn't affect troubled private student
loans directly but does bolster the student loan market
overall.
Much more importantly, the government in late
November initiated the Term Asset-Backed Securities Loan
Facility (TALF) under which the New York Fed will extend
up to $200 billion in nonrecourse loans to holders of
asset-backed securities backed by highly-rated auto,
student, credit card and small business loans. The
program may be expanded later to include commercial and
residential mortgage-backed securities. The Treasury is
kicking in $20 billion from TARP to absorb any losses,
as noted earlier.
The hope is that this $200 billion infusion will
re-ignite consumer loans. But, as discussed in our
October report, leaping delinquencies and the eventual
huge writedowns by financial institutional holders of
bad consumer loan-related securities suggest that the
zeal for consumer loans on the part of lenders or
investors will remain subdued. Like TARP, TALF is likely
to be no more than a bailout for distressed lenders who
made a lot of bad loans. Since the Nov. 25 announcement
of TALF, yields on bonds backed by credit card and auto
loans remain at record levels.
Foreign Financial Woes
Phase 2 of the recession, financial woes, are, of
course, a global phenomenon. And so are the responses.
The U.K. initiated the direct injection of government
money into banks to buy preferred stocks. The British
government had hoped to attract some private capital
into HBOS and Royal Bank of Scotland, but collapsed
share prices left the government with most of the new
stock. Barclay's avoided government help, but with its
stock down 70% this year, it may ultimately end up with
a third of the bank owned by Middle East investors as it
raises $10 billion. The Bank of Japan is injecting
another $32 billion into the financial system by
expanding lending and easing collateral requirements.
Switzerland depends heavily on her reputation as a
super-safe haven for international money, and her
financial services industry contributes 11.4% to GDP and
employs 5.9% of her workforce. Yet the condition of her
banks has deteriorated to the point that in October, her
Economics Minister had to state publicly that the
government would not allow big banks UBS and Credit
Suisse to fail. The government is injecting $5 billion
into UBS to back $50 billion in illiquid UBS assets.
That bank has suffered over $40 billion in losses due to
bad mortgage-related securities.
Credit Suisse is in better shape but suffered a $2
billion third quarter loss due to writedowns on mortgage
securities and unsold buyout loans as well as currency
trading losses. The bank still holds $26 billion in
leveraged loans and conventional mortgagerelated
securities. Both banks are closing their bond funds for
outside investors due to huge withdrawals following
losses.
Meanwhile, the Netherlands agreed to inject $13
billion into the banking and insurance giant ING. In
2000, the Spanish central bank introduced its "dynamic
provisioning" system that required Spanish banks to
build up considerable reserves against potential future
losses. As a result, Spanish banks began this year with
200% coverage of nonperforming loans compared with 59%
for the average EU bank in 2006. Still, Spain recently
set aside $41 billion to fund illiquid assets of her
banks. And turbulent market conditions prompted Banco
Santander, Spain's largest bank, to unexpectedly
announce last month a $9 billion rights issue.
Russia has been floating on a sea of crude oil, but
has sunk along with oil prices. Russians are fleeing the
ruble for dollars and $83 billion left the country from
August to October. The government has raised interest
rates and spent heavily to cushion the currency's
descent and avoid a repeat of its 1998 collapse. Still,
the ruble is down 5% from its August high, and a halving
of its current value is forecast. Meanwhile, plunging
crop prices and a lack of credit is curtailing Brazil's
soaring farm sector.
In Asia, Pakistan, which reluctantly sought a $7.6
billion IMF loan, really needs $10 billion to $15
billion to prevent economic collapse, government
officials say. Dubai's pell-mell economic growth has
been heavily financed by international debt that may be
hard to refinance. South Korea, responding to shortages
of foreign currency for her banks and businesses, in
October announced a $100 billion government guarantee on
foreign currency loans and a $30 billion infusion of
dollars into her banks. More recently, that country has
problems with high household debt, which leaped from 38%
of GDP in 1997 to 66% last year and is probably higher
today. And rising credit costs and falling stock and
corporate bond prices are slashing the profits of
Japanese banks and their ability to provide capital to
the international financial system.
Central Bank Responses
Central banks have responded to the global financial
crisis in three ways. First, the Fed cut the discount
rate and then the federal funds rare repeatedly,
starting in August 2007. The Fed has continued this
traditional easing approach and other central banks have
followed more recently and aggressively, including the
European Central Bank, the Bank of England and the
central banks of India, China, Australia, Norway, Sweden
South Korea, the Czech Republic, Switzerland, Japan and
even Indonesia.
Nevertheless, it became clear early on that rate cuts
were of limited value since banks were so scared that
they didn't want to tend to each other much less
customers. The spread between the London Interbank
Lending rate on U.S. interbank loans and Treasury bills,
which leaped in the summer of 2007, remains wide.
Furthermore, central bank rates are approaching zero at
which point, as we understand it, they'll stop falling.
So the ammunition of rate cuts is almost all shot off.
The horse didn't want to voluntarily walk to the water
and, besides, the pond is almost empty. Fed Chairman
Bernanke recently said, "The scope for using
conventional interest rate policies to support the
economy is obviously limited."
So the Fed moved quickly to step 2, leading the horse
to the water. It introduced a succession of facilities
to auction money to member banks, make it available to
nonbank government security dealers, etc. The ECB and
the Bank of England introduced similar facilities. Last
August, the People's Bank of China, her central bank,
relaxed credit quotas so most banks can lend 5% more
this year and, more recently, allowed local companies to
easily sell yuan-denominated debt of three-to-five
years' duration. Then China, it increased quotes for
state-controlled lenders by $14.5 billion this year,
encouraged local governments to support credit guarantee
firms and opened new financing channels including loans
for mergers and acquisitions and for consumer finance.
India's central bank has repeatedly reduced bank
reserve requirements as has China's. And the Fed has
attempted to satisfy foreign banks' gigantic demand for
Treasurys by mushrooming its currency swap agreements
with foreign central banks and then providing unlimited
dollars to the ECB, Bank of England and Swiss National
Bank for lending to local banks. The top policymakers of
the cautious ECB recently called for an "abundant and
generalized" capital infusion into banks. But all these
central bank efforts resulted in the proverbial pushing
on a string. The funds have stayed in the banks and
haven't been lent out and entered the money supply to
any meaningful degree as banks want nothing but
Treasurys. The central banks led the commercial bank
horse to water, but he wouldn't drink.
So it's on to step 3 with the Fed and other central
banks, as well as governments, investing directly in
Fannie and Freddie, AIG, banks, credit card issuers,
insurers, etc. here and abroad, buying commercial paper
and, most recently, purchasing indirectly credit card,
auto, student and small business loan-backed securities
and maybe extending later to commercial and residential
mortgagebacked securities as well as subsidizing
mortgage rates, as noted earlier.
Washington officials cringe at the suggestion that
these measures amount to "quantitative easing," the
Japanese policy initiated in 2001, because it failed to
rapidly spur Japanese bank lending and the economy and
arrest deflation. The Bank of Japan drove its target
rate to zero with no effect and then tried to hype the
quantity of money by buying government bonds,
asset-backed securities and even stocks.
Current quantitative easing by the Fed may not be any
more successful than it was in Japan since the global
financial system is in a classic liquidity trap, as in
the 1930s when bankers were defined as people who wanted
to lend to those who didn't need to borrow and didn't
want to lend to those who did. Today, banks don't want
to lend to anyone but the U.S. Treasury.
Consumer Retrenchment
The financial crisis spawned by the collapse of the
residential mortgage market and the follow-on Wall
Street woes obviously just had to depress the goods and
services economy, and it has in Phases 3 and 4 of the
unfolding recession. With the collapse in stock prices
and evaporation of home equity, consumers have no other
meaningful source of borrowing to fund their spending
growth in excess of their after-tax income gains. Notice
that home equity withdrawals through cash-out mortgage
refinancing and home equity loans reached about $900
billion at annual rates, or around 10% of consumer
spending. Now it's negative as principal repayment
exceeds home equity withdrawals. So consumers' 25-year
borrowing and spending binge, as witnessed by their
quarter-century saving rate decline (Chart 5) and
borrowing rate surge (Chart 6), is over.
In addition, Americans, especially postwar babies,
have saved little for retirement as they concentrated
instead on spending. The nosedive in stocks has only
made retirement prospects more bleak. In the last 15
months, $2 trillion has disappeared from workplace
retirement accounts, including 401(k)s, which now are
the primary saving vehicle for 60% of employees.
Jobs
As the housing and financial sectors continue to drop
and U.S. consumers retrench, layoffs and unemployment
will continue to mount. Payroll employment, which fell
533,000 in November (Chart 7), will probably continue to
see monthly declines of 500,000 and the unemployment
rate will likely exceed 8% by the end of 2009.
Housing and financial services job cuts are already
large and more are coming. But job losses have spread
well beyond housing and finance. Manufacturing jobs will
continue to be lost as consumers buy fewer domestic
goods and foreigners buy fewer American-made products.
Retail jobs, normally the employment of last resort for
the newly unemployed, are shrinking rapidly. Retail
trade employs 10% of the total, but since November 2007,
accounted for a quarter of jobs lost, or 320,000, as
consumers cut their spending. And another 209,000 retail
employees had their full-time hours cut to part-time.
Estimates are that 6,100 U.S. stores -- ranging from
mom-and-pops to major chains -- will fold this year, up
25% from 2007, and followed by 14,000 stores in 2009.
Impotent Monetary Policy
Conventional monetary policy ease through central
bank target interest rate cuts at present is nearly
useless, i.e., pushing on a string. Qualitative easing,
now actively pursued by the Fed and the Treasury and by
central banks and governments abroad, will probably at
best only stabilize demoralized financial structures by
substituting government securities for questionable
assets with little near-term rejuvenation of lending and
economic activity.
Also, bear in mind that in democracies, governments
are almost guaranteed to be behind the curve in dealing
with financial and economic crises. That's because
voters elect them to respond to their concerns, not to
act in anticipation of yet-unseen problems. Politicians
are responders, not planners. In 2006, neither voters
nor politicians wanted to prepare for a mortgage market
collapse, but voters demanded and got swift action after
the crisis unfolded in 2007 and this year.
This means that any resuscitation of the global
economies falls on fiscal policy and, as usual, the
effects will be delayed, influencing the recovery after
the recession rather than shortening its normal course.
The incoming Obama Administration is, of course, talking
about a sizable fiscal package, perhaps $500 billion to
$700 billion, or 3.5% to 5% of GDP.
$700 Billion In Perspective
That's a lot compared to the size of post- World War
II recessions (Chart 8). Notice that the 1957-1958
recession, the most severe so far, has a peak to trough
decline in real GDP of 3.7%, and the long and deep
1973-1975 downturn saw a 3.1% decline. We're forecasting
the most severe recession since the 1930s with a 5.0%
decline. You may think that a 5% decline is not a lot,
but bear in mind that recessions are more interruptions
in growth than economic collapses -- growth that
business, consumers, employees and government assume
will continue without interruption. Similarly, the 21%
decline in the Case-Shiller house price index so far
(Chart 2) is small compared with the more-than-doubling
during the bubble years. Still, it's very painful for
those who made small downpayments at the top and those
who extracted their equity when prices were still high.
Even a $700 billion fiscal package would probably
have limited impact on the recession, and not start to
be effective until the end of 2009. And even then, the
effects will probably barely offset the negative
cumulative recessionary forces. Obama says his proposal
will create 2.5 million jobs over two years. But as
discussed earlier, payroll declines are likely to
continue to run 500,000 per month, so his program would
only offset five months of recessionary losses.
Phase 4
Phase 4 of the recession, its globalization, is
clearly underway with almost every major country's
economy falling whether or not the official recession
label has yet been applied. One indicator of weakness is
the 2.4% decline in global semiconductor sales in
October after a 2.1% fall in September from a year
earlier, reflecting softness in computer and cell phone
sales. The worldwide turndown is driven by housing
slumps, notably in Ireland, the U.K., Spain, Australia
and China. U.S. financial woes have spread to almost all
major financial institutions worldwide. And consumer
spending has been weak in Europe and Japan. U.S.
consumer spending accounts for 71% of GDP but less than
60% in all other G-7 countries except the U.K. Sure,
much more of healthcare and education expenditures tend
to come from government, not consumer pockets in those
lands, but households have traditionally been more
cautious spenders than Americans, especially in recent
years.
And this introduces another key reason for global
recession -- retrenchment of U.S. consumers, which
depresses U.S. imports on which the rest of the world
depends for growth. The huge U.S. trade deficit is the
counterpart of the rest of the world's huge surplus.
Commodities
Obviously, the commodities boom is over (Chart 9).
Prices of energy, base and precious metals and
agricultural products are all down significantly from
peak prices. The global recession has reversed the
earlier excess of demand over supply.
Also, institutional and individual investors who
earlier rushed into commodities under the belief that
they are a legitimate asset class like stocks and bonds
are stampeding out even faster. The financial crisis has
also made investors wary of structured notes and other
commoditylinked instruments -- and of the firms
espousing them.
Tsunami In The Swimming Pool
As noted at the outset, the first two phases of the
recession were largely financial, the residential
mortgage collapse and the following Wall Street woes.
Then, like a tsunami in a swimming pool, that financial
tidal wave rolled to the other side and inundated the
goods and services economy, with Phase 3, consumer
retrenchment, and Phase 4, global slump. Now the tsunami
is being reflected back to the financial side of the
pool in three ways.
First, retrenching consumers will keep pushing up
delinquencies on credit cards, home equity, auto and
student loan debt, which will result in big writedowns
for their many institutional holders. Collectively,
these four categories amount to $4.4 trillion, dwarfing
the $0.7 trillion in subprime loans.
Commercial real estate debt is the second problem
area, and of the $3.5 trillion outstanding, $800 billion
is in commercial mortgage- backed securities and $2
trillion in commercial mortgages held in regional and
community banks. As vacancies rise, big writedowns will
follow.
Third is nonfinancial leveraged loans and junk binds.
Delinquencies have barely risen from rock bottom levels,
but will as anticipated by yield spreads and 20% junk
bond yields. Recession-depressed revenues here and
abroad, collapsing commodity prices (Chart 9) and the
leaping dollar that will turn earlier currency
translation gains to losses, will all slaughter the
corporate earnings of nonfinancial corporations, so far
relatively untouched by the financial recession. So
delinquencies and charge-offs of junk securities will
leap and many investment-grade debts will be pushed into
junk territory. Junk bond spreads vs. Treasurys now
imply a 21% default rate, higher than in 1933 at the
bottom of the Depression. Financial institutions also
own a lot of the $3.7 trillion in leveraged loans and
junk bonds.
If the tsunami moving from the goods and services
side of the pool does considerably more damage to the
financial side, it will again be reflected back and even
tighter financing will devastate the real economy.
Policymakers here and abroad, of course, are trying to
erect baffles in the form of bailouts in the middle of
the pool to dampen the waves. They are learning that
they have to build those baffles bigger and stronger to
prevent the waves washing over them. Their moves from
Fed interest rate cuts to massive quantitative easing,
described earlier, shows they're making progress.
Recession Ends When?
If policymakers succeed in containing the mortgage
mess and bailing out financial crises related to
consumer borrowing, commercial real estate and junk
securities -- and other financial problems we haven't
explained in detail -- then the recession may well end
at the end of 2009 as massive fiscal stimulus begins to
take hold. If not, it probably will extend well into
2010 and perhaps beyond.
To end the crisis, four developments are needed, in
our view. The elimination of excess house inventories
will probably continue until at least the end of 2010,
as discussed earlier. The writedowns and
recapitalizations of financial institutions -- at least
those related mainly to mortgage-related problems that
have unfolded so far -- are well along.
Subsidizing the mortgages of underwater homeowners is
beginning to develop. And of course the quicker the
excess house inventories are eliminated, the more
limited will be further house price declines and the
fewer will be the additional homeowners who will slip
under water. Bailouts of bad loans and securities in the
three additional areas we've identified are big unknowns
in terms of cost and feasibility. Nevertheless,
policymakers are gaining experience as they grope their
way through the current round of bailouts and may be
real pros when further big problems surface.
The Dollar
At the end of last year, we forecast that the dollar
would end its seven-year slump and rally later in the
year against most currencies, but not the yen. And it
did, starting in July. It was obvious a year ago that
far too many were negative on the greenback. As with
commodities, many institutional and individual investors
considered foreign currencies as an asset class, worthy
of a certain percentage of their portfolio.
Much more importantly, we were forecasting a major
global recession and reasoned that, as usual in times of
trouble, the dollar would be the global safe haven. We
didn't expect the U.S. economy to improve but that the
rest of the world would join America in the tank. The
greenback would be the best of a universally bad lot. We
expect the dollar to keep rising for the next 5 to 7
years, continuing the long- run pattern.
Profits
With the nonfinancial sector joining financial
businesses in full retreat, domestic corporate earnings
will be decimated in coming quarters, as discussed
earlier. And U.S.-based multinationals will also be
clobbered by weak foreign revenues and the strong
dollar, which will make foreign earnings worth less in
dollar terms. Some 30% to 50% of revenues of consumer
staple companies like PepsiCo, Sara Lee and Campbell
Soup come from abroad. With our forecast of a severe
recession, we look for corporate profits, as defined by
the Commerce Department, to fall 48% from their peak in
the third quarter 2007 to the fourth quarter 2009, and
to drop 32% from 2008 to 2009.
P/Es and Stock Prices
Our forecasts imply S&P 500 operating earnings of
$40 per share in 2009, down 35% from our $62 estimate
for this year. That may sound extreme, but not for the
most severe worldwide financial crisis and deepest
global recession since the 1930s. At stock market
bottoms, the S&P 500 P/E tends to be in the 10-12
range. But low interest rates normally push up P/Es and
10-year Treasury now yield 2.66%, and will probably be
even lower later while 30-year Treasury bonds are now at
3.0%, our long-held target, and also a low in recent
decades, but may drop further.
So a P/E of 15 at the stock bottom sounds reasonable,
but would put the S&P 500 index at 600 then, down
32% from here and 61% below its record close on Oct. 9,
2007. Wow! Earlier, we warned of the number 777, not the
Boeing airliner model but the low on the S&P 500 in
2002. If it were breached, we noted, then the bear
market that started in early 2000 would still be intact,
and all of the rally from the 777 low in October 2002 to
the peak five years later would merely be a rally in a
bear market. Last month, the S&P 500 fell below 777.
It has since bounced, but probably not for long as new
lows lie ahead.
There are other reasons to expect considerable
further weakness in stocks. High dividends can support
stocks at least to a degree, and dividend yields in
Europe are meaningful, averaging 5.2%. But not in the
U.S. where the S&P 500 yield is a miserly 2.5%. And
dividend cuts are coming fast and furious. In the U.K.,
dividends are constrained for financial institutions
getting government bailouts, while in the U.S., the
financial sector is slashing dividends.
Some 36 of the S&P 500 have cut dividends 46
times this year, axing $33.8 billion, with $30.8 billion
coming from financials. Among those S&P 500 firms,
about 20% of dividends this year are from financials,
down from 34% in 2007. Elsewhere, REITs are cutting
payouts, and GM eliminated its dividend. Only 202
S&P 500 companies have initiated or raised dividends
218 times this year, representing payments of $18
billion, with only $2.4 billion being from financials.
In 2007, 298 did so and only 12 reduced or suspended
dividend payments.
In troubled times, investors tend to withdraw from
foreign markets to concentrate on the home scene they
know best. That's why bear markets tend to be uniform.
U.S. investors sold a net $92 billion in foreign stocks
and bonds in the July-September period, a record flight
from overseas investments, while foreign investors
pulled over $100 billion from stocks in Japan, South
Korea and India so far this year. U.S. stocks are
actually falling less than most foreign markets.
Deflation
For years, we've been forecasting that chronic
deflation of 1% to 2% per year would start with the next
major global recession. Well, it's here! In October, the
U.S. producer price index fell 2.8% from September and
the CPI dropped 1.0%, the biggest decline since before
World War II. Sure, the big driver was the decline in
energy costs, but even excluding food and energy,
consumer prices dropped 0.1%.
The Fed worries that in deflation, offsetting
monetary policy is difficult since its target rate has
to stop declining when it reaches zero. Of course, the
Fed has other tools as witnessed by the quantitative
easing discussed earlier. Nevertheless, all these
measures amount to leading the horse to water, as
discussed earlier, and he may not drink. The deflation
in Japan in the 1999-2005 years worried the Fed when it
appeared imminent in the U.S. early in this decade, and
it still does. Japan again faces chronic deflation, and
the Bank of Japan forecast zero change in the CPI (ex
food but not energy) for the fiscal year ending March
2010. Fed Vice Chairman Kohn said the lesson from Japan
was that "we should be very aggressive in combating
deflation."
Deflation encourages saving since money is worth more
later. It also spawns deflationary expectations. Buyers
anticipate lower prices later by waiting to buy. That
sires excess inventories and capacity, which forces
prices down. Buyer suspicions are confirmed so they wait
even further to buy, generating a self-feeding downward
price spiral, as now seen in autos and houses. Deflation
also elevates the cost of debts and debt service since
both remain fixed in nominal terms but the revenues and
incomes used to repay them tend to fall with overall
prices.
Deflation fears and other forces have also reduced
reducing 30-year Treasury bond yields to our long-held
target of 3.0% and completed what we dubbed in 1981,
when the yield was 14.7%, "the bond rally of a
lifetime." The recent financial crisis has also helped
as investors abandon everything else -- stocks and fixed
income alike -- in favor of Treasurys.
Deflation results from overall supply exceeding
general demand. We have been forecasting the good
deflation of excess supply, as in the late 1800s and in
the 1920s, due to today's confluence of semiconductors,
the Internet, computers, biotech, telecom and other
productivity-soaked technologies. But we have allowed
for the bad deflation of deficient demand, as in the
1930s, if one of two adverse conditions develop --
widespread financial crises and worldwide protectionism.
Sadly, both are real possibilities.
Inflation?
Many, of course, worry not about deflation but
inflation due to all the money being pumped out by
central banks and governments globally. They no doubt
are biased since most have lived only in an era of
inflation and don't agree with us that inflation is the
result of excess government spending in wars, both hot
and cold. In peacetime, deflation reigns. Starting with
rearmament in the late 1930s, then World War II and the
Cold War with its hot phases, Korea and Vietnam, wartime
and inflation persisted for 60 years.
For now at least, all that money from central banks
and governments isn't getting outside financial
institutions. We're in a liquidity trap. The horse isn't
drinking, thank you very much. And if lenders do start
to lend, central bankers, with their congenital fear of
inflation, will no doubt reel in all that extra credit.
Even if the bank reserves stimulate the money supply
with the usual multiplier effect, the credit created
will pale in comparison to the destruction of
derivatives and other privately-created liquidity due to
persistent deleveraging and writedowns.
Finally, the consumer saving spree we're forecasting
will probably increase the saving rate by one percentage
point per year on average for the next decade. That
would generate a cumulative $5.5 trillion and go a long
way to offsetting the intervening fiscal stimuli, and
then some.
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