My Diary 365 --- 2008 Market Outlook (I): The New Year Hypothesis, Looking Beyond Housing, Bond Sitting on Bombs
January 6, 2008
The exciting year of 2007 ended with a sad note of Lady Bhutto’s assassination. With the start of a new year, fundamentals seem to point to a challenging environment.
Looking around, not only have asset prices come under strain (thanks to trouble in the housing, mortgage and credit markets), but stocks and bonds have also swung wildly. Overnight, US stocks had the steepest weekly loss since July after unemployment increased to a 2-year high (+5.0%) and ISM manufacturing declined (47.7), bolstering speculation that a recession will stymie profit growth. The 2yr UST yield (2.73%) declined 15bp, while the 10yr was about flat. There are something more than US equities and bonds … BDI opened up the year with a 4.2% dropped below 8,800 levels. The everyday living expenses have soared as the cost of crude oil hit record highs (100$/bbl) and prices for gasoline, fuel, and other commodities rose. Escalating prices for wheat and other agricultural products have also contributed to a jump in food prices this year. In addition, gold price surged to a historical high of US$859/oz. The Dollar continues to be undervalued against most free floating major currencies (EUR1.47; JPY 109).
Thus, judging by recent price moves of major asset classes, it is going to be a challenge year and the key question is how much will all these feed through to the
Anyway, at the beginning of the Year of Rat, there are a lot of questions and issues to be discussed …So first thing first and I will start with
The New Year Hypothesis
The markets have been talking about recession for a few Qs, and now we are here with Dec jobs report which exposed weakness in many sectors, with employment contraction (ex. government) the first time since 2003. The large increase in the unemployment rate and the pace of growth in continuing unemployment claims figures are even more problematic when taken in the context of the difficult housing and consumer credit environments. Along with the start of political season, the street is expecting corporate profitability to decline in coming quarters, with financials now at heightened risk of being under-reserved against consumer credit assets. Despite the New Year, 'fresh' balance sheets and recent Fed and ECB actions, market liquidity remains problematic as trading credit continues on a very skinny basis. The first wave of broker earnings has been solid so far, but Citi and Merrill may break this trend in coming weeks. Troubled financials have successfully attracted capital from a variety of sources; however more is needed despite the reduction of dividends and share repurchase activity. Overall, equities remain vulnerable and credit is unlikely to behave well in this environment.
The key to this view is the belief that the full impact from the housing correction has yet to be felt. The recent housing boom was driven by easy credit and greed, extending the housing price/income ratio from its typical 2.5-2.9x to roughly 4x. (the previous peak of this metric since 1950 had been approximately 3x in 1982). This metric is in the midst of correcting and as calculated by the NAR now resides at 3.7x. This metric combined with current consumer sentiment toward housing and the supply/demand imbalance in housing suggests that housing prices have much more to fall (15-25%). Assuming median income remains on its current trajectory, this correction will be sufficient to return the house valuation metric back to its historical norm. To date, multiple data sources including existing home data, Schiller, and Radar Logic suggest housing price have already fallen 3-6% yoy, making the current correction, the 1st nationwide yoy decline since the depression..... The US markets are creating another wave of No1s in its history... Sad? Proud?
The direct impact on GDP is material as housing starts have already fallen 48% from its peak in Jan 2006 declining to 1200K units at an average price of 290K subtracting $350 billion from the US economy over 2 years or 1.6% annually. However, the secondary effects are potentially the most detrimental as many expect that discretionary spending from the consumer will slow materially which represent 70% of GDP. These declines will stem from three sources: a drop in HEW, resetting interest rating in arm loans, and decline in spending from a fall in consumer confidence. Furthermore, higher energy cost at the home and at the pump have further pinched middle and lower income consumers. HEW has already fallen to $507 million in the 3Q07 down from it cycle peak of nearly $1 billion in mid-2006. and expected to fall to less than $100 million ... Can US consumer bear a life with daily live expenses similar to its Asian fellows? Seems NOT... They quit from Kyoto Accord....
Looking Beyond Housing
Moreover, rising home, auto, and credit card delinquencies are signs of a stressed consumer and indication on sales from retailers, restaurants, homebuilders, automakers, etc all suggest that the consumer is beginning to rein in spending. The 15 largest US homebuilders have lost 56% of their market value this year as home prices declined for the first time since the Great Depression, according to the National Association of Realtors in Chicago. Retailers in the US, mired in the worst holiday season since 2002, posted their smallest weekly sales gain in two months. Management teams are suggesting a material amount of sales have only been generated through the use of incentives or discounting which have further lowered margins, profit, and free cash flow. In addition, macroeconomics indicators are suggesting weakness in economy with the manufacturing ISM falling below 50 and claims data breaking out to the mid-300's. Beyond this fundamental economic backdrop, companies are struggling to meet EPS guidance will feel pressure to increase leverage to buy back shares rather disappointing equity investors... I do have some sympathy to those CEOs at this moment...:)
Risks to this New Year hypothesis include massive liquidity injection by the fed or a surprise rate cut as this could be the catalyst for a short term rally. However, the Fed will be cautious given inflation and dollar concerns and hopefully realize the US economy primarily has a credit issue not a liquidity issue. In fact, what happened in 2007 is in sharp contrast to the Fed's last rate-cutting cycle. In mid 2001, a survey of private-sector forecasters put the odds of recession at 35%. But by that point the Fed, under then-Chairman Alan Greenspan had already slashed its target for the FF rate by 200bps to 4.5%, while declaring weak growth to be a bigger worry than inflation. The economy ultimately did experience a mild recession in part because of 911 terrorist attacks, and the funds rate ended the year at 1.75%. Nowadays even though private-sector economists put the odds of recession at 38%, the Fed has cut the funds rate only 100bps since August and has yet to say weaker growth worries it more than inflation. But there is no doubt that a contraction in the labor market would jeopardize consumer spending, which is the lynchpin of the expansion.
Meanwhile there are few signs of this U.S. weakness affecting Europe, with the exception of the UK. Euro area data show that bank loan growth remained robust through November at 11% yoy (similar to the United States) due to the possession of loans from structured vehicles and increased banks funding in the wake of the security market disruption. But the market is in the process of re-rating (downgrading?) economic prospects for the UK, a process consistent with weakness in the housing market and the slowdown in some consumption measures. It is also consistent with the BoE rate cut last month. Japan and the rest of Asia is yet to show firm symptoms of being significantly affected, though some are starting to become concerned with the weaker than expected US growth....Hold on, there may have more bad news to come....
Bond Sitting on Bombs
There are a lot to say about bond markets. Over the year of 2007, 2yr UST fell 174bps, 10yr fell 68bps and the Curve steepened. In addition, there is an new “corundum” that even after Fed had cut 100bps of benchmark policy rate, the 30yr fixed mortgage rates fell only 1bp, on the back of higher realized volatility.
It appears that 2008 is picking up where 2007 left off. Issues that need to be addressed are: liquidity, banks repairing their balance sheets and economic/credit deterioration. These pressures, together with negative wealth effects emanating from falling real house prices, are likely to keep US GDP growth on the soft side through most of 2008 at below 2%. The weak economic data out of the US and the looming discussion of high inflation have underpinned the school who believes in “stagflation”, or discussion of “recession” or “depression”…Guess what, I feel the bond markets are still sitting on “Bombs”…For sure, the markets have moved one step forward, with the central banks stepping up to show their continued commitment to provide all the liquidity required to ensure that banks are functioning normally, together with Sovereign Wealth Funds.... my question is how many more Angel Funds we need to save the markets from crisis....
Having said so, it will be a very challenging task to predict the path of rates for the next few months, as the markets deal with slowing US growth, coupled with elevated, commodity driven inflation (Core CPI=2.3%, Core PPI=2.0%, Core PCE=2.2%, Import Price=2.7%). Relatively strong global growth will continue to put upward pressure on commodity prices and headline inflation numbers, creating a true dilemma for the Fed. Further potential international diversification away from US Dollar assets also has potential to limit further decreases in rates further out the curve. Beyond that, there are clearly going to be more write-downs. Merrill and Citi are the prime candidates, but I believe that we will continue to see losses pop up in unexpected places (a side effect from the risk-diversification of structure finance). We are just now starting the CDO unwinding process and a few days ago, I saw somewhere a $3.5 billion of MBS liquidations that were a result of a CDO unwind. It seems that the market is heading back towards the big problem of last fall, named by the fear of "what's next"?"
Finally, the most important indicator is still corporate default rate. In the midst of market volatility and uncertainty in '07, the Moody's global HY default rate stood at 1% at the end of Nov07, the lowest level since Dec1981 (0.7%). If the economy weakens, I can't see how default rates stay at these historically low levels. The key, of course, is when the default cycle will turn. Adding some flavor to the soup is that yesterday’s BBG reported that S&P expects HY borrowers in the
Bottom-line: The LIBOR and credit spreads will begin to widen out again in the
Good night, my dear friends!
