The March 18, 2008 press release from the Federal Reserve states that “[r]ecent information indicates that the outlook for economic activity has weakened further. Growth in consumer spending has slowed and labor markets have softened. Financial markets remain under considerable stress, and the tightening of credit conditions and the deepening of the housing contraction are likely to weigh on economic growth over the next few quarters. Inflation has been elevated, and some indicators of inflation expectation have risen… [i]t will be necessary to continue to monitor inflation developments carefully”.
The first quarter has been difficult to put it mildly. In the fourth quarter last year many economists remained unsure if the US would be in a recession (defined as two quarters of back-to-back negative GDP growth) or a significant slowdown. Today almost everyone is talking about the duration of the recession and when the economy will be out of recession. Federal Reserve Chairman Ben Bernanke even mentioned for the first time that “recession is possible” during his April appearance in a Joint Economic Committee hearing. The final figures released by the U.S. bankruptcy courts show that 28,322 businesses sought bankruptcy protection in 2007, a 43% increase compared to a total of 19,695 in 2006. This is further evidence that US economy is likely contracting.
The Commerce Department in late February confirmed the nation’s 4th quarter Gross Domestic Product (a consumption base measure represented by adding up consumer, business and other spending and investments) grew at an annual rate of 0.6%. This is a significant reduction from the 4.9% growth rate reported for the third quarter. Consumer spending and business outlay were revised downward while confirming the drag from housing in the fourth quarter to be larger than first anticipated. In the meantime, the Gross Domestic Income (an income based measure including personal income and corporate profits) experienced a 1% annualized rate decline. Currently, the first quarter 2008 GDP is projected to be close to 0%. The Commerce Department will be releasing the first quarter report at the end of April.
Private payroll has declined for the fourth consecutive month. The March employment softness was broad based across industry sectors with the biggest losses in construction, manufacturing and temporary help. The construction sector shows weakness in both residential and commercial sectors. The weakening in the US job market thus far has been more attributable to weak hiring. This is evidenced by the steady climb in continuing jobless claims with initial claims remaining fairly low, but evidence is mounting that the pace of layoffs (i.e. fresh employment claims) is accelerating. The four week average of new claims in the last week of March increased by over 15,000 to 374,500 from 358,750. 400,000 is the critical worrisome mark according to most economists. For the week ending April 12, the Department of Labor (DOL) reported initial filing reached 372,000, a 17,000 from prior week.
Initial construction of US homes fell to a 17-year low in March. In February the revised reading was 1.07 million a 36% reduction from a year ago. For March this year, the housing starts fell to a seasonally adjusted 947,000 annual rate, an 11.9% decline from February. The rate for building permit applications also fell to a seasonally adjusted annual rate of 927,000 in March. The decline of new construction was not confined to any one region of the country. With this data it is clear that we have not hit bottom yet in the residential real estate market.
Housing construction is an important indicator of the US economic health and a significant contributor to US economic activities. Some economists do not expect any recovery in this sector until 2009, at the earliest.
According to the S&P Case-Shiller Index of 20 major US cities, house prices fell 2.4% in January from December and are down 10.7% from a year earlier. During the first three month of 2008, home prices have fallen at an annualized rate of 20% across the US with few exceptions. The Office of Federal Housing Enterprise reported a 1.1% drop in January and down 3% from a year earlier. This indicator tracks only houses with mortgages purchased or backed by the Fannie Mae and Freddie Mac. This means that it does not track high-priced homes nor homes purchased with sub-prime mortgages.
According to RealtyTrac, foreclosure fillings in February nationally were up 60% when compared to February one year ago. The drop in the foreclosure rate from January is due to seasonal reasons. The hardest hit areas are the ones that have experienced the highest appreciation during the prior three years (California and Florida for example). The rust belt states (Michigan and Ohio for example) are also experiencing significant problems due to the struggling manufacturing economy. In March, the foreclosure filings shot up 57% when compared to March 2007 and are up another 5% from February. At these foreclosure rates, lenders are repossessing homes faster than they can sell them. 2007 saw a doubling of inventory while sale of foreclosed homes went up only 4.4%. At the end of 2007, about 2% of all home loans were in foreclosure which is the highest rate since the Mortgage Bankers Association has been keeping track. The increasing foreclosures and bank owned inventory are putting further pressure on home prices.
The National Association of Realtors reported that sales of previously owned homes decline by 2% in March to a seasonally adjusted rate of 4.93 million. Last July it was 6.11 million, an 18.3% drop in activities. The inventory for unsold homes is now at almost 10 months’ supply. Although there appears to be some slowdown in price depreciation, the US housing market has not bottomed yet and will be a major factor in determining the length of the current economic woes. The depletion of real estate wealth across the country has both real and psychological impacts on home owning consumers which contribute to further economic malaise.
On Tuesday, the US dollar dropped to its all time low against the 15-country currency, the euro, at an exchange rate of $1.6018 per euro. This continues the multi-year retreat of the dollar. There are many factors that contributed to the shrinking dollar and the effects are beginning to affect the global economy. The main contributing factors are declining interest rates and economic slowdown in the US. The US dollar is not only declining against the euro but against almost all major currencies. As the following graph shows, since mid-2005 the US dollar has declined against a basket of foreign currencies of euro, Japanese yen British pound sterling, Canadian dollar, Swedish krona and Swiss franc (CHF) through yesterday. This decline is significant and is contributing to inflation here and abroad. The Malaysian ringgit hit an 11-year high and the Australian dollar a 24-year peak. The Singapore dollar reached a record high. While economic growth in Asia is expected to slow in 2008 partially as a consequence to the U.S. economy slowdown which dampens the region’s exports, rising consumer prices have made it difficult for central banks to ease monetary policy. This likely will keep their interest rates high and continue the pressure on the US dollar.
With currencies pegged to the dollar, oil exporting countries in the Middle East are importing inflation. The global commodity surge injected these countries with significant current account surpluses. This massive liquidity has stimulated domestic demand resulting in economic activities doubling and high inflation. Consumer price inflation in theses countries has jumped from 3.9% in 2001 to over 9% in 2007. A significant factor is the peg to the US dollar which has helped to import inflation. We do not believe this is sustainable in the long run and changes must be implemented.
According to Reuters, inflation in Singapore reached a 26-year peak and a 13-month high in Malaysia as Asian governments grapple with the problem of containing surging food and energy costs without choking off economic growth. Australian inflation accelerated to its fastest pace in 17 years. Indonesia and Vietnam raised their inflation forecasts, and the Philippine central bank said it would look at raising rates if commodity price rises began feeding into wages and other costs.
US consumer confidence has plummeted since the middle of last year. Increasing commodity prices, job insecurity, poor stock market performance and the reverse of the wealth effect have all contributed to a sense of financial insecurity. Consumers are feeling less confident about themselves and the economy. Starbucks, the ubiquitous coffee shop, reported their same-store sales fell from a year ago as customer traffic slowed, especially in markets hit hard by the housing bust such as California and Florida.
At the same time, inflation is beginning to pick up strength. DOL reported that the Producer Price Index (PPI) jumped 1.1% in March, exceeding forecasts for a rise of 0.6% after rising 0.3% in February. The “core” PPI, which excludes volatile food and energy prices, rose 0.2% after a 0.5% increase in February.
The Consumer Price Index, the government’s key inflation measure, rose 0.3%, compared to February when prices were unchanged. The gain matched the forecasts of economists surveyed by Briefing.com. The price of energy jumped 1.9% percent in the month.
The more closely watched core CPI reading, which removes the volatile food and energy costs, was up 0.2% in March after being unchanged in February. On a year to year basis, the increase was only 0.65% for March which is the second worst showing since 1992. There is no question that the inflation pressure is building and is slowly eating away consumers’ purchasing powers. Import prices pose a growing threat to US inflation and are running almost 15% year-over-year, thanks to the weakening dollar and the rising commodity prices. The sharp increase in gasoline and food prices are pushing up retail sales and give a false sense of security to the US economy that the consumers are still spending at the same pace.
So how did we end up here? Without trying to oversimplify global economics, we should start at the end of the 20th Century where we experienced an unprecedented stock market valuation (now referred to as the Internet Bubble) and high productivity. After the market crashed, investors went from blatant disregard for risk to high risk aversion. The Federal Reserve lowered interest rates to avoid a severe recession and stimulate growth by injecting liquidity into the market. With interest rates at historical lows, investors turned to the real estate market as the next investment target. After 3 to 4 years of seemingly endless appreciation, the economy is humming along with consumers feeling good with an escalating home equity. From Wall Street to Main Street, investors have once again got comfortable with risk, leveraging on the cheap became a sure way to make money. The Federal Reserve began to raise interest rates in 2005, but regardless of how often the rates were increased there seemed to be no impact on the real estate market or cooling investors’ enthusiasm.
In the meantime, with the significant trade deficit with importing countries, such as China and Japan, much of their surpluses were invested in long term US government securities which further prevented the US intermediate and long term rates to rise. This extended the low mortgage rate environment and the real estate bubble. Beginning in 2007, the environment began to shift and the risk dynamics began to tighten.
The contraction in real estate wealth and the choking of market liquidity happened quickly and severely. The most recent estimate is close to $1 trillion in write-off among global financial institutions. Although it started with the sub-prime mortgage debacle, the combined losses will far exceed the total value of the sub-prime loans outstanding. The rippling effect of extreme risk aversion is equivalent to throwing out the baby with the bath water.
We believe that the US is in a recession and we will not begin to recover until 2009 at the earliest. The US dollar has probably seen bottom against the currencies of the developed economies but will continue to adjust against emerging and oil export countries as they loosen or abandon their currency peg to the US dollar, but a meaningful reversal is also not likely until we enter the first leg of the next economic cycle since we are 6 to 12 months ahead of other economies. Commodity prices may remain high, but they will not likely continue their bull market for long as the rest of the world economies begin to slow. As the demand pressure is reduced, so will the commodity prices. This also does not mean that commodity prices will be significantly lowered in the near time since rising economies of China, India and Russia are growing their middle class and massively consuming commodities for domestic consumption. This will continue to apply pressure on all commodity prices.
We are not supportive of any further interest rate reduction. Further lowering is not likely to have more effect on the real economy since this recession is caused by liquidity contraction. With the bail out plan for Bear Sterns, we have witnessed new approaches by the Fed to intervene in the market and the economy.
The Fed is taking on credit risk by creating a number of new lending facilities in response to the credit and liquidity crisis: the Term Auction Facility (TAF), the Term Securities Lending Facility (TSLF), and the Primary Dealer Credit Facility (PDCF). Each facility permits financial institutions to borrow directly from the central bank at excellent terms and wide range of collateral, particularly the mortgage-backed securities. Rather than rate cuts under this current credit-driven recession, the Fed is and will use these facilities to meet its objectives. Furthermore, not lowering interest rates would further help to stabilize the US dollar. The Fed will be meeting next week, and the market is counting on a 25bp reduction.
Under the weight of an economic slowdown (recession) and other uncertainties, the stock markets took a beating during the first quarter and extended their losses from the prior quarter. The market correction was not confined to the US alone. Foreign markets retreated in an acknowledgement that we are truly in an inter-dependent global economy as well as the recognition that a global slowdown is on its way. The following table summarizes the performances of the major market indexes for the respective periods:
This quarter clearly demonstrates two important aspects regarding portfolio diversification: 1) There is a significant downside correlation among equities. Many investors operate with the understanding that spreading their assets among domestic stocks with various capitalization and investment style as well as investing in foreign developed and emerging markets would help them to minimize their portfolio volatility. This may be accurate on the upside but obviously not on the downside. 2) Using non- or low-correlated investments (i.e. the investment movements are more independent from one another) provides the benefit of risk management in a down market.