Economic Calamity? Calm Down
There has been a great deal written since the US subprime mortgage crisis burst onto the global financial scene in the second quarter of 2007. The vast preponderance of the press is expecting a deep United States recession, which ultimately would spread to Asia because of the US consumer’s role as the world’s economic engine, leading, finally, to a global meltdown.
There will no doubt be further subprime hits, but the evidence suggests that the global economy can sustain them. Supporting this view is the fact that there is a five-one balance of market participants, weighted towards the positive. The outlook remains good on anything but a short-term basis. But the reality is that nobody knows for sure as the risky credit default swap (CDS) market has grown from US$6.5 trillion to US29 trillion in just two years. Fears of the unknown are also being compounded by the high cost of getting it wrong. The risk also exists that recession fears could become a self-fulfilling prophesy. Nevertheless, while further choppy waters lie ahead, our investment ship seems set to weather them.
The “World is Coming to an End”: There are vast black holes in the credit markets. US consumers are overburdened with debt. As credit tightens, the subprime crisis will turn into a full-blown housing debacle and worse, with homeowners no longer able to take equity out of their houses in the form for other consumer purchases. Banks, already provisioning for existing bad debt, will be increasingly reluctant to extend new loans. Without new housing coming onto the market, consumer durables and other household goods sales will fall sharply. Car sales will fall. With 25 percent of China’s exports now going to the US, the contagion spreads to Asia.
The “We Can Take the Hits” Theory: Economists have had enough time to reduce their forecasts in the light of higher oil prices and subprime problems. Forecasts have been reduced but few are calling for a US recession. Even the BoE and Fed, while increasingly gloomy, are not forecasting such. For analysts, profit forecasts 18 months out over the past six months have been upgraded, not downgraded. In other words, a whole raft of pretty smart guys have looked at their various industries and decided that their forecasts are too low generally despite the subprime mess. There are recent indications that earnings momentum is moderating, but much of this reflects downgrades in those areas that one would anticipate (such as housing) with some of the cyclical industries also showing signs of slowing (such as technology). Despite this recent claw-back, earnings forecast are still up (nearly 17 percent in the case of China) since the subprime issue surfaced.
Bond markets: After their initial sell-off, high-risk bonds stabilized even as investors rushed to safety (a flight from risk is entirely different from a rush to safety). In short, the bond markets signalled that they would provide money to good-quality companies, even high-risk ones, once the initial fear had subsided. The housing and related areas suffered, as one would expect, but some mortgage-backed paper is already trading at distressed levels. The higher-risk markets have subsequently retreated a tad and wider yield gaps have reappeared, but, again, it must be emphasised that this is due to a flight to safety and not a run from risk. Overall, the bond markets have signalled that the "companies will be starved of cash" argument has feet of clay.
Companies: One of the characteristics of this recovery has been the low level of US bond issues. The reason? Significant restructuring and rising profits have kept US companies’ external cash requirements low. The result? US companies are paying historically low levels of their cash flow on interest payments, which is in stark contrast to the average debt-laden US household. Companies globally are in similar shape, with low or falling relative debt levels and rising profits (this is something analysts have generally been underestimating, with the notable exception of the US). While some stress cracks are appearing, none of this smacks of an imminent recession.
Moreover, things are picking up for the US corporate sector. The order backlog is rising strongly (and will likely do so as the dollar continues to fall). Expectations of new orders are rising, according to recent Federal Reserve Board of Philadelphia surveys. And, the rise in non-residential construction is now counterbalancing the collapse in housing construction; the real hit to US construction occurred in the first half of 2006.
Equity markets: No panic here. Instead, in the first flurry of subprime fears, they pushed valuations down based on the existing profits forecasts. They thus removed, in one stroke, a major valuation uncertainty and placed the onus on the analysts, effectively telling them to look at their forecasts. In the event, the forecasts (apart from the obvious ones) were upgraded as we have noted. With the global equity valuation well below its 20-year average, low valuations will likely cushion any further earnings downgrades.
On Balance, Positive
The markets are edging towards the conclusion that the world economy is sufficiently strong to take the subprime hit. The risk of a greater-than-expected US slowdown remains foremost on investors’ minds. But amid the negativity, the economy is continuing to grow. Third-quarter growth came in at 3.9 percent, stronger than the second quarter’s 3.8 percent. Two powerful drivers of US growth are the rising backlog of corporate orders and rising non-residential construction. A sharp reduction in both trade and budget deficits (as a percentage of GDP) has occurred; the trade deficit fell to its lowest level in 28 months, spurred by a falling dollar. This “twin deficit” has a powerful impact on the dollar (albeit with a variable time lag).
The US is an economy in transition, not recession, it seems. Until this becomes apparent, investors will likely react sharply to any poor US jobs, payroll and retail sales data.
Rising inflation could be a problem, but the consensus view is that while it will rise, it will not run away. Again, the economists have had sufficient time to look at the ramifications of higher oil prices, the falling US dollar, rising Chinese inflation etc, in coming to this conclusion.
The shortage of global liquidity could also be an issue. A shortage was already apparent a year ago; but many investors overlooked it because as the liquidity tide went out, huge lakes of liquidity were trapped in the rock pools. One of these lakes was Japan's yen carry trade. The liquidity seepage was sufficiently large to blind investors to the already receding tide. When subprime hit, many investors were thus blind-sided not just once, but twice.
The China contagion argument is also shaky. Since 1997, the percentage of China’s exports destined for the US market (including those routed through Hong Kong) has actually fallen from 37 percent to 25 percent. Enough said!
Today’s fears seem rooted in the facts that the subprime problem size is large and no one knows where the ultimate debt lies. Fear of the unknown usually results in a deeper discount to build in a greater margin of safety. The amazing fact is that the financial participants, apart from the credit markets, remain, if not exactly sanguine, then cautiously optimistic that the world can weather the storm.
It is too glib to argue that these markets do not fully understand the depth of the problem ‑ they too have participants, and have come to the conclusion that they are in good shape to live long and prosper.
Robert Rountree is head of Investment Marketing for Prudential Asset Management.