Wednesday, January 7, 2009

Return of the good old days...

What won't happen...
The stock market will not jet back to normal. No one will wave the magic wand of repair. The recovery will be halting and erratic. Those who expect a quick recovery will have to endure something more painful and episodes of false hope.

What will...
But there will be recovery.

The Fed has flooded the markets with liquidity and the treasury has injected capital into the major financial institutions. Actions to stimulate the economy are afoot, including a new fiscal program from the new president that will include the kitchen sink. I call it an Obamathon.

Some are wary of the future because they can see no drivers for growth. I make the opposite argument: what are the drivers of weakness?

A known, but treacherous, path
We know that corporate layoffs are in train and more job losses lie ahead. But that is true in all recessions. We have now entered into the 'plain vanilla' part of the recession after passing through the gates of Hell. By that I do not mean it is not painful or that the recession will be average. This recession will be severe. But we know what happens and we know weakness will run its course. Manufacturing is already at the sort of lows we see at the worst of recessions. Auto sales at 10mln units or so are scraping the bottom. Want recession? You got it. But conditions do not deteriorate forever. Recessions do end.

Argument for optimism

We expect services demand to remain as a drumbeat of growth and for the goods sector weakness to moderate as auto sales recover in part due to GMAC financing. Housing starts are so low there is little weakness left there. New household formations are about 1.5mln/Yr so housing demand is already making a dent in the overhang of new home supply that is running at 0.4mln units per year.

The main residual risk
Inventories are up relative to sales because sales have fallen, more than because inventories have grown. Government spending will advance. The main downside risk is from the business sector where construction has so far held up. Equipment and software spending could still fall sharply too. The main risk of setback is in the corporate sector. Unfortunately all the extended tax credits will not encourage much new spending there, if the economy is still contracting. So this remains a risk to further weakness. But if the consumer re-starts, that will mitigate the risk of corporate sector implosion.

Tug of war between forces of good and evil
The already extreme weakness in consumption will undergo the two way tug, lower from job losses, and upward, from the coming stimulus plan. On balance, it appears that much of the downward economic momentum is being spent in 2008-Q4 and in 2009-Q1. With stimulus coming on line quickly, perhaps late in Q1 and in Q2, the fundamental negative forces on the economy will have played out. Auto and home sales can hardly get much weaker. As long as the Fed/Treasury keep the financial sector intact the prospect for a return to growth in the second half is quite good. This a positive outlook but also a reasonable one. There is nothing 'natural' about continuing economic contraction.

Just how far can consumption fall in the face of countervailing stimulus?

Growth is natural
Economies have natural forces that propell growth like population expansion. And although unemployment is set to rise even at 8% most people have jobs. Pull backs in the economy stop when the domino effect runs out. The Fed/Treasury have stoppered the financial sector and blunted the risk for those dominos to continue to drop. The stimulus program will put a floor on consumer spending drops- that sector already has key sectors in what should be regarded as 'worst case scenarios' (autos and homebuilding).

With some sort of plan in place to help the mortgage market the scenario for recovery is complete. Already the Fed's low interest rates and mortgage purchase plan are reducing mortgage rates and that helps to support home prices. Prices already have taken a big hit. Each 50bp drop in mortgage rates allows a buyer to purchase a home that is 6% to7% more expensive so the Fed has already cut rates obviating the need for home prices to fall by a further 6% to 7%. With 20% declines already a reality, housing must be close to the price levels needed to sustain it. I am an optimist on housing. The problem for housing will be credit scores...

The good becomes the bad, the bad becomes the about in reverse?
There is a danger in thinking that the bad can't get worse. Still, I think a recovery is by and large the most reasonable path after the end of 2009-Q1. The deficit will expand sharply and the economy will get back on its growth path. What I do not understand is the logic for continued declines- what is the engine for that? Much of the weakness now is reverberating through sectors hit by the excesses in the commodity markets, in housing, and in retailing. Banks have already seen the worst of it. So What I find less plausible is that the slippage under these circumstances would continue to snowball. With a large fiscal plan underway the turning point seems to be cemented.

For markets the situation is different. There are many investors with funds trapped that want to release them and this potential selling stands in the way of a rapid fire market recovery. A rising market will get hit by waves of hedge fund selling. This will help to restrain the rebound in markets. Ultimately that will make the rebound more enduring. As always, having funds set to sell will not stop the market's rise if the rise is based on a positive shift in fundamentals.

Recovery phase two
After recovery is in gear there will still be a lot of work left to do. The financial sector will have to be weaned off of its support. The Fed will have to withdraw its excess liquidity and do it fast. So rates might rise quickly in the early recovery phase. There are many risks and inflation is one of them. But I throw my lot in on the side of betting on recovery to start and to endure.