With all eyes on traditional residential mortgages, analysts are now looking for clues in related asset classes for any signs of recessionary contagion. In his weekly review of the U.S. economy, Nouriel Roubini highlights the vulnerability of commercial mortgage back securities – which typically lag their residential cousins by 2 years – as well as plunging retail sales, a worsening inventory cycle, and the soaring fiscal deficit…
Focus on the U.S. Economy
The current U.S. and global economic conditions, remain at the very least quite challenging. The good news is that President-elect Barack Obama has unveiled a first rate economic team to drive the economy towards the recovery. Larry Summers, Tim Geithner and Christina Romer are certainly top rated experts and excellent choices to address this most severe financial and economic crisis. The bad news is that the recovery is not in sight yet and won’t be for some time.
The most recent set of events and the string of economic data are a clear sign that the crisis is not over, and the worst might very well be ahead of us. On the one hand, consumer confidence got a boost from falling oil prices and new leadership in the U.S. government. On the other hand, yesterday’s Conference Board report confirms that the economy is in a deep recession (the confidence index is still at the lowest level on record since 1975) and points to further consumer spending declines in the coming quarters. The release of preliminary Q3 real GDP growth in the U.S. (revised down to -0.5% from the initial -0.3%) displayed a downward revision to personal consumption from the original -3.1% down to -3.7%. Consumption is expected to be a significant drag on the economy for a while. Analysts estimate that the fall in energy prices – a reflection of falling U.S. demand and a by-product of the fact that this severe recession is a global one – will boost real U.S. income by roughly $200bn (1.5% of GDP) but it is also. On the back of this, U.S. home prices keep falling, equity prices may still be very far from the bottom and employment losses are mounting.
News on home prices is never good these days, but instead of getting better, it may still get worse. The U.S. housing sector is still far from stabilizing. Housing starts keep plunging, and demand keeps following supply downward. As a result inventories are not getting worked off and remain at record highs; downward pressure on home prices continues. Home prices (S&P Case-Shiller C-10) are down 23% from the peak and the pace of decline keeps accelerating every month. The fact that home prices have still a long way to go before reaching a bottom seems to be consensus at this point. Back of the envelope computations suggest that the wealth losses for households related to the fall in home prices are roughly $3 trillion so far, and are clearly bound to increase further – to eventually reach the $6-8 trillion range. With a negative wealth effect of 6 cents on the dollar, the reduction in personal consumption could amount to a whopping $500bn. Things would look even worse if we factor in the losses related to the decline in stock market prices. Retailers including chain stores, luxury brands and online merchandize are taking a hit from declining consumers discretionary spending. Retail sales were already down 15% during July-October period. Moreover, stores expect holiday sales to plunge by almost 50 % this year taking the slump way into 2009.
And after the residential real estate woes, commercial real estate could well be the next shoe to drop. Last week, news that two big commercial mortgages that had been packaged into securities in the past year, were likely to default spooked the $800bn CMBS market that usually follows the fate of the residential mortgage market with a lag of 2 years.
The worsening credit crisis has caused a sudden spike in job losses and filing for jobless claims in November. While a hiring freeze across industries began in late-2007, lay-offs started escalating in Q3 as the credit crunch and demand contraction spread from the housing and financial sectors to the corporate and service sectors, export and commodity industries. Being a lagging indicator, monthly job losses are bound to hit the 300,000-350,000 range in 4Q08 and early-2009, taking the unemployment rate to 8.5-9% by late-2009/early 2010. The slow economic recovery, massive erosion of consumer wealth and demand and double-digit decline in industrial activity could cause job losses to continue for a few years into the recovery. With mounting unemployment, we can expect the contraction in consumer spending to accentuate and defaults on consumer and auto loans, credit cards and mortgages to accelerate.
While easing oil prices provided a breather to the trade deficit, the recent boom in exports is fading in the face of the strengthening dollar, trade credit crunch and more importantly, demand and manufacturing slowdown in export destinations like Japan, Europe, Asia ex-Japan and Latin America. The contribution of net exports to GDP growth of 2.9% in Q2 and 1.1% to Q3 prevented the economy from contracting severely. But net exports will slow to 0.5-1% in the coming quarters led by declining oil and non-oil import demand amid slowing consumer demand and manufacturing activity even as real export growth continues to fall through 2009. This slowing, though still positive, trade contribution poses further downside risks to GDP growth.
After taking a hit from high oil and commodity prices, the manufacturing sector is facing tight credit conditions and slowing domestic and export demand, leading firms to lower the sales forecast through 2009 and scaling down inventories. Declining orders for durable and capital goods indicate that industrial production will decline significantly in 2009. Plunging demand and corporate earnings will also cause a double-digit fall in business expenditure, at least through 2009, given that business sentiment especially for small firms are near record lows. The auto sector is also in a perfect storm amid slumping vehicle sales and tight credit conditions. But the recession might help pave the way for the much needed auto industry restructuring to improve fuel-efficiency and competitiveness of the Big Three automakers.
Fiscal policy will play a pivotal role in 2009 as the Fed Funds rate approaches zero. Significant fiscal stimulus will be needed during these 4-5 quarters to prevent significant growth contraction and deflation. Since any boost from tax cuts to households and businesses will be temporary, raising government spending via grants to deficit states and infrastructure spending would be more effective. While spending on infrastructure and green technology as endorsed by Obama can provide some stimulus during this prolonged growth slowdown, the extent of job creation would largely depend on the reallocation of the unemployed labor between sectors. Democrats are also pushing for unemployment benefits and food stamps which are well-targeted and have the largest bang-for-the-buck. While Obama has prioritized a large fiscal package as soon as he comes into office in Jan 2009, delays in Congress approval and actual implementation will make the stimulus less timely. Meanwhile a $500-700 bn stimulus along with other Treasury bailouts will push the fiscal deficit in the $900bn to $1 trillion range in the next two years, especially as the recent revenue boom in corporate income and capital gains and dividend taxes are fading significantly.
The recent readings of both the PPI and the CPI are showing the beginning of deflation. Slack in goods markets with demand falling and supply excessive, slack in labor markets with sharp fall in employment and slack in commodity markets means lower inflation and actual deflation ahead – with a concrete risk of falling in a liquidity trap. And given the costs and dangers of price deflation and the deadly deeds of debt deflation, central banks have to recur to unorthodox monetary policy to address the liquidity trap and the severe liquidity and credit crunch. The Federal Reserve has reached further into the box of unorthodox tools by announcing direct purchases of $600bn in conforming MBS and agency bonds ($500bn and $100bn, respectively.) Simultaneously, the Federal Reserve is setting up a new $200bn Term Asset-Backed Securities Loan Facility (TALF) for investors of consumer loan-backed securities (i.e. credit cards, auto loans, home equity loans.) The U.S. Treasury will backstop the first $20bn in credit losses.
A few days ago the government was forced to provide a $306bn rescue package for Citigroup whose toxic asset overhang prevents a return to normalcy even after the government’s first $25bn capital injection under TARP. Under the rescue program, Citi will be responsible for the first $29bn in writedowns; after that the losses will be shared between the government (90%) and Citi (10%) who has recourse to a loan from the Fed for this purpose. In return, Treasury will get $7bn of preference shares with 8% dividend rate ($4bn to UST, $3bn to FDIC). In addition, Treasury will inject another $20bn in capital, buying further preference shares under the TARP program. Commentators seem to agree that action was necessary but worry that the terms are exceedingly lenient.
And going forward there is another problem: 8,000 banks that are not ‘too big to fail.’ Many regional banks have important capital concentrations in the next leg of this debt-deflation story, commercial real estate.
The backdrop to the renewed flurry of government interventions remains the completely frozen credit environment that is now gripping the non-financial corporate sector, both high-yield and investment grade. The spreads in the cash bond markets went on to exceed their CDS counterparts and reached new record highs on November 21 as the specter of bankruptcy looms ever larger for automakers and manufacturers around the world. Debt-ridden LBO companies are struggling to refinance or repay their debt while private equity companies face investor flight. Importantly, the record spreads are not only driven by firesales but find some justification in the deterioration of credit quality down the rating scale. Experts such as Edward Altman and also rating agencies predict a record default wave in the high-yield sector above 10%.