Sunday, October 19, 2008

'So far no good' meets THE FUTURE

AN UNSETTLING ECONOMIC PICTURE - The economic data were very unsettling last week yet they took the markets’ mind off the financial sector woes. And while that let markets rise, it wasn’t because of any good news - just a different kind of bad news:

  • Retail sales fell again and are dropping at a 4% annual rate in the quarter.
  • Consumer sentiment fell by a record amount, month to month, and to a very low level (fifth lowest since January of 1978)
  • the current conditions index for consumer sentiment reached its lowest point since at least 1978 when the data series went monthly.
  • Inflation was well contained.
  • Housing starts fell to near a 40-Year low while permits hit a 25 year low.
  • Industrial output fell by 2.8% month-to-month.
  • The home-builders survey for October hit a record low, a series that goes back to 1985.
  • The Philly Fed index hit a point so low it has only been weaker 1.5% of the time in the last 38 years.
Any questions?

Putting weak economic signals in context

Recession Probability
Since Recession Mos Total Mos % Recession
2000 9 105 8.6%
1990 18 225 8.0%
1980 42 345 12.2%
1970 70 455 15.4%
1960 82 585 14.0%

Is it done yet or are we? Recently recessions have occurred about 8% of the time or so (see table above). But historically the incidence of recession is nearly double that. An eight percent chance of recession is roughly a recession lasting one year out of every twelve. A recession occurring 14% of the time implies a one-year long recession about every seven years. So when we are getting economic measures that are the lowest we have seen in twenty to thirty years, we are definitely seeing weakness that is recession-caliber weakness and probably deep recession caliber weakness.

CONTEXT!! Readings that are the weakest in eighteen years only get us comparison with the relatively mild or 'U-shaped' 1990 and 2001 recessions. In going back another decade we pull in the severe "V-shaped" 1980 and 1981 recessions. So when we are seeing reports that have never been weaker since 1978 or weaker only 1.5% of the time in 38 years we are really saying something in terms of the sort of weakness that is being felt today. This is not 'garden variety' economic weakens and it is not yet reflecting the worst damage from the financial crisis that has hit us. There is much worse stuff to come...

Just a heads up on that.

While there is a lot that has been written on the subject of credit crunches, I only wish to make the point that credit crunch recessions tended to be severe and were more associated with “V-shaped” rather than “U-shaped” recessions.

The hybrid recession - In 1980 with inflation surging and some of the market-changing end runs around credit-rationing from the interest rate ceiling era incomplete, the economy was in distress for an extended period. It was a very severe recession with the worst elements of the “V-shaped” and “U-shaped” recessions combined (a steep drop off in activity coupled with an extended bottom). The impact of the traditional credit crunch via dis-intermediation was being blunted by new vehicles for savings and capital markets that were changing rapidly under the crush of high interest rates and fast-changing deregulation. In this period a proliferation of new mortgage products some of which have since become familiar were offered up. One was the variable rate mortgage especially as 30-yr US Treasury bond yields touched 16%.

Bank reluctance to lend: What is relevant to our case is not the high inflation that kept the Fed squeezing interest rates so tight for so long in 1981 and 1982. Nor is it regulation that prevented (in the 1980s and before) markets from getting funds to lend into banks that could on-lend them. Rather it is an intrinsic reluctance on the part of banks to lend due to their weakened financial state and to the ongoing threat to their asset quality from a still-deteriorating housing market. The cause of the ‘crunch’ in 2008 is different but it is still palpable.

Risk is still present Some worry that banks will remain reluctant to lend to housing despite their recapitalization by the government. That argument seems correct. The Treasury Secretary has continued to warn that more banks could fail even after announcing there might be a capitalization plan and after the $700bln bail-out bucks were awarded by Congress. Sovereign Bank Corp. has decided to let itself be acquired by the giant Spanish bank, Santander. Previously Goldman Sachs and Morgan Stanley found refuge as commercial banks giving up on their independent investment banking status, while Merrill Lynch had jumped into the arms of B of A. There is reason to expect banks to remain wary of lending and of the potential for losses in such an environment.

Crowding out? Some also worry that the large government presence in the capital markets will lead to ‘crowding out’ of private sector investment. Here the calculus is rarified since the government is doing this to facilitate what it sees as a too-dormant private sector; one that if left to its own devices might even contract. It sees itself as stepping into the void, not crowding out the shrinking violets we now call banks. Nonfinancial corporations already have cut back on capital spending - they will not be tapping capital markets as much in this climate. It will be hard to disentangle cause from effect in this cycle for those wishing to prove the case of crowding out. Moreover, the elastic supply of funds from abroad makes crowding out less likely overall. But rest assured that there is a fertile ground of historic precedent to mine for possible percussions in this period. Just be careful how you apply the lessons of the past under the new rules of the game.

Things change and remain the same - In this cycle the international economy allows for a much freer flow of capital than it in the past, especially older cycles. And, bear in mind, too, that in 2008 the credit crunch is of a different sort, being imposed more by banks on themselves than by government through a pernicious interaction of market conditions with regulation. The impact on the economy may be nonetheless damaging for that difference, however. We have yet to see how deep the recession will be. That will be an important element in banks' deciding how much to lend again. At the same time the banks' decision's themselves will have an important impact on how weak the cycle is. It is precisely these sorts of interaction effects that make recessions potentially so dangerous. Nothing is set, established or sacred.

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