I. Introduction:
Fear and Loathing in the Credit Markets The financial crisis that erupted in August as a result of the subprime mortgage debacle has proved anything but transitory. In fact, it has broadened and deepened even if so far it has not spread more widely in the credit markets or materially infected the real economy beyond the housing market, whose woes are arguably more cause than effect. Its human casualties, beyond thousands of foreclosed homeowners, surprisingly include a number of defenestrated Wall Street CEOs (others hang by their fingernails outside their top-floor office windows) as a wide swath of elite investment and commercial banks have announced staggering losses—some $50 billion in total so far. Fed chairman Ben Bernanke recently raised his mid-summer estimate of $50 billion in write-offs to $150 billion. Other, less sanguine observers, including Goldman Sachs (which itself commendably managed to dodge the bullet), peg the number at more like $400 billion. As a percentage of GDP, that would roughly match the damage inflicted by the savings and loan crisis nearly 20 years ago.
Of course, the subprime market itself (in the peak years of 2004-06 some $1.3 trillion of such dubious mortgages were written) and the dangers that it represents have been magnified by what The Economist magazine recently called “the baroque superstructure” of related derivatives and other forms of leverage. At a minimum, almost certainly the “new architecture” of securitized subprime mortgages and perhaps other forms of consumer debt has imploded.1 1 The undersigned, who has nearly 40 years’ experience in the capital markets including the origination of publicly-held securities, finds the CDO (“collateralized debt obligation”) phenomenon, as dissected in such publications as The Wall Street Journal, simply appalling and fully agrees with the respected investment adviser and commentator Jeremy Grantham that those who created, rated and then sold them displayed a “shocking lack of responsibility”. CDOs were, as another observer remarked, “fur balls of risk”, and if they were not criminal (especially many of the underlying subprime mortgages themselves), they should have been. The fact that so many wound up being held by specially constructed, supposedly off-balance sheet vehicles associated with major investment and commercial banks is truly astounding. It is as though Enron rose from the dead and mutated into dozens of such sponsors, all under the unseeing eyes of regulators, auditors and rating agencies. What were they thinking? Could it have had something to do with stock options and bonuses?
II. The Economy
Despite the credit crunch precipitated by the subprime debacle (as analyzed in our last essay), the economy continued to grow in the third quarter at an annualized rate of 4.9%. The collapse of the housing construction industry subtracted approximately 1.1 percentage points, but the export sector, with the wind of a declining dollar at its back, added nearly that much. In part because of the credit crunch and in part because of the inevitable slowing of a mature economic expansion, the economy’s growth rate clearly decelerated in the fourth quarter, perhaps to 2%. Most observers believe that an outright recession (generally defined as two or more successive quarters of negative growth) will be avoided but that growth will slow to the point that unemployment will rise, which will constitute what is known as a “growth recession”. (A more worrisome version would add growing inflation to the mix, leading to “stagflation”.) Still, even if unemployment rises
from its present 4.7% to, say, the consensus-predicted 5.2%, that will hardly be painful by historical standards and ordinarily should be readily resolved by the Fed’s usual (and now ongoing) ministrations of monetary policy medicine. After all, in the last 25 years there have been only 16 months of actual recession (and each episode has been getting shorter and shallower) in large measure because the Fed helmsmen have so successfully averted the shoals and rapids of macro-economic recession and hyperinflation or deflation. Alas, these may not be ordinary times as the banking system may yet freeze up. Thus, the most prominent interbank lending rate, known as LIBOR, still hovers some 200 basis points above the Fed funds rate, more than three times the usual spread2. That shows that banks are afraid—of each other—and they have to hoard cash to preserve capital. Also, the Fed’s monetary remedies (essentially, cutting short-term interest rates)
seriously risk igniting inflation, which is already secularly stoked by global commodity price rises (as so well illustrated by oil’s hitting the $100 mark yesterday on an intra-day basis) and in the U.S. by a declining dollar (making non-oil imports more expensive). Yet the Fed cannot be unmindful of the risk that clearly undercapitalized banks (not to mention the proliferated, and unregulated, non-banks of what has been called “the shadow banking system”) will radically restrict credit (by as much as $2 trillion, according to a widely remarked Goldman Sachs estimate). Basically, at this point the question is whether the banking system has a problem of liquidity or one of solvency. If the latter, rate cuts will not avail, and giants may fall. Already a
goodly number have taken their begging bowls to Asia and the Gulf and returned with some $25 billion in generously priced capital from the new “sovereign wealth funds” that are swollen with the dollars earned from our monster (if declining) current account deficit. On the other hand (to recall Harry Truman’s famous two-handed economist), the business sector is in fine fettle. Balance sheets (excluding banks’) are lean, and cash flow is fat, especially for those companies with large operations abroad or major export businesses. Though business confidence has slipped, the sector is primed to lead if the consumer finally falters. The government sector, too, is relatively healthy as the federal deficit has declined to a tolerable 1.2% of GDP. Finally, global growth remains nearly 5% and may prove our lifesaver.
III. The Capital Markets
As the subprime debacle and the wider credit crunch unfolded in late 2007, the stock market displayed a degree of volatility not seen in years. In the fourth quarter itself, both measured and predicted volatility rose, and the overall stock market actually recorded—albeit quite briefly—its first correction (a decline of at least 10%) in six years, an extraordinarily long period of calm.
At year end, the broad market (as represented by S&P500 stock index) had marked a total return of a modest 5.5% (weighed down largely by the swoon in the financial services sector) though the doughty old Dow, which has much less exposure to banks, was up 8.9%. Smaller-company stocks, as represented by the Russell 2000, languished, as they posted a -1.6% total return. Buoyed by a weakening dollar, foreign stocks (as measured by the MSCI EAFE index) rose smartly, with a total return (in dollar terms) of 11.2%. Meanwhile, the emerging markets had another bang-off year for the fifth in a row, as the MSCI Emerging Markets Index clocked an
astonishing 36.5% in dollar terms. Putting aside all the sturm und drang in the credit markets, the stock market’s tepid rise represented a sober reflection of the waning strength of the overall economy and, in particular, the inevitable decline, registered in the third quarter, of corporate earnings growth (as represented by the S&P group of companies) to less than double digits for the first time since 2002, actually falling 8.5% year over year. Looking forward, Wall Street analysts remain (what else?) bullish, with a consensus forecast of a 10% rise in 2008. A more sober view would say that in a world of 2 to 3% inflation, corporate earnings generally will grow only 3 to 5% in nominal terms for the next decade or two. More soberingly, corporate profits are at a 40-year high (and 60% above trend), while wages are at an all-time low relative to GDP. One senses the pull of gravity taking hold as meanreversion exerts its inevitable toll, taking both back to historical levels, which is unlikely to be good for stock prices. Looking forward for 2008, stock market valuations are reasonable, as the S&P500 trades at 18.2 times reported earnings, slightly ahead of its level of 18.0X a year ago, reflecting those declining levels of earnings growth. Still, in an environment of a slowing economy and declining earnings growth, that leaves stocks somewhat pricey on an absolute basis. However, with interest rates across the yield curve still moderate, stocks are relatively attractive compared to bonds as their earnings yield (5.3% for the S&P500) remains comfortably above risk-free bond yields. The other gauge of stock-market health that professionals watch closely, so-called “sentiment”, remains fairly positive as well. Compared to valuations, it represents a more varied and elusive measure. Still, put broadly, there is a fair amount of gloom-and-doom among capital market participants and pundits, and generally that is—in the paradoxical way of things—a good sign for stocks’ chances to rise in the near term. In addition, there are those who see telltale signals of a final bull-market leg up in the coming year.
Jerome W. Anderson
April 9, 2008 |
