Thesis: Expect contiuned weakness in the market, the Fed is left with a single sided choice of maintaining loose credit standards until housing regains footing. Oil continued to fall even though fundamentals remain in tact.
The single most concerning piece of information this week was the Federal Reserve’s quarterly Senior Loan Officer Survey of Bank Lending Practices. Respondents to the July survey revealed that their banks ratcheted credit conditions yet tighter in recent months, suggesting more “stag” ahead. The credit crunch has now spread into all areas of lending, with more than 80% of banks reporting a tightening in lending standards for mortgage loans, and more than 60% for consumer and business loans--levels far above those seen in the 2001 recession and even in the 1990-91 recession (graph below). Lending officers asked about their willingness to make consumer installment loans reported the biggest negative shift in attitudes towards lending to households since early 1980.
Also very disappointing were weekly data on jobless claims. New claims edged down slightly to 450,000, but remain well above levels just a few weeks ago, while the total number of claimants topped 3.4 million for the first time since 2003. With credit conditions tightening, the labor market weakening, asset prices down substantially, and fiscal stimulus now a thing of the past, households are likely to cut back on spending over the next several months. Consistent with this gloomy outlook, core retail sales in July--excluding autos, building materials, and gasoline were up only 0.3%, the third consecutive month of slowing. This suggests that the impetus from fiscal stimulus is rapidly fading.
The “flation” half of the stagflationary data came with the monthly reports on import prices and the Consumer Price Index. Import prices continued their climb in July, accelerating to a 21.7% year-over-year increase overall, 8% excluding petroleum products (the highest inflation rate since the depreciation of the dollar in the late 1980s following the Plaza Accord). For those of us who aren’t business history buffs, The Plaza Accord or Plaza Agreement was an agreement signed on September 22, 1985 at the Plaza Hotel in New York City (hence the name, I know politicians are really creative). The agreement was signed by 5 nations - France, West Germany, Japan, the United States, and the United Kingdom. The focus of the agreement was to depreciate the US dollar in relation to the Japanese yen and German Deutsche Mark (remember what was going on in West Germany right now) by intervening in currency markets. The exchange rate value of the dollar versus the yen declined 51% over the two years after this agreement took place. Most of this devaluation was due to the $10 billion spent by the participating central banks. The reason for the dollar's devaluation was twofold: to reduce the US current account deficit, which had reached 3.5% of the GDP (FYI as of 2007 it was at 5.3%), and to help the US economy to emerge from a serious recession that began in the early 1980s. The U.S. Federal Reserve System under Paul Volcker had overvalued the dollar enough to make industry in the US (particularly the automobile industry) less competitive in the global market. Devaluing the dollar made US exports cheaper to its trading partners, which in turn meant that other countries bought more American-made goods and services (sound familiar?). The Plaza Accord was successful in reducing the US trade deficit with Western European nations but largely failed to fulfill its primary objective of alleviating the trade deficit with Japan because this deficit was due to structural rather than monetary conditions. US manufactured goods became more competitive in the exports market but were still largely unable to succeed in the Japanese domestic market due to Japan's structural restrictions on imports. The recessionary effects of the strengthened yen in Japan's export-dependent economy created an incentive for the expansionary monetary policies that led to the Japanese asset price bubble of the late 1980s. But I digress….
Consumer prices leapt higher yet again, with headline inflation accelerating to 5.6% year-over-year on sharp increases in energy and food prices. Perhaps more concerning, core inflation rose 0.33% on a plethora of upside surprises strewn throughout the index, e.g. apparel +1.2% (likely related to the acceleration in import prices), tobacco +1.2%, public transportation +1.1% (probably driven by higher energy costs), lodging away from home +0.7%, education +0.5%.
The main bright spot of the US economy isn’t in the United States it’s the rest of the world, which is increasingly turning to US manufacturers given their steady productivity gains and more favorable exchange rate. In volume terms, the trade deficit has been narrowing since early 2007 (wait, this seems eerily familiar!).
Beyond the fundamental drivers of a weak dollar and weak US domestic demand, high commodity prices have been a factor behind this dramatic improvement. They encourage conservation by commodity-consuming countries like the United States (hence fewer imports) and stimulate more spending by commodity producing nations (including spending on US exports). Essentially all of the acceleration in real exports in recent months has been in commodity related goods.
Mortgage deterioration has spread beyond subprime. Early policy efforts e.g. modification of adjustable rate loans and a government-backed refinancing program generally focused on subprime borrowers, but defaults are accelerating in Alt-A and prime mortgages as well. Even among the government-sponsored enterprises (GSEs), recent mortgage vintages appear to be deteriorating at a faster pace. Thus, programs targeted to a more limited subprime population may be less effective as defaults broaden.
The federal government is likely to bear an increasing share of losses going forward. Financial institutions have now announced over $500 billion in losses over the last year, but have managed to raise $367 billion in capital, largely through issuance of common and preferred stock. However, as some institutions find it difficult to raise capital, additional exposure is likely to fall on the government (can someone say higher taxes?). Also, because a substantial portion of the early losses was related to securitized products, institutions with the most direct link to the government deposit-taking banks and the GSEs did not face immediate risk. This has now changed, as a result of widening losses and government action. As the federal government bears a greater fiscal burden, there is the potential for increasing conflict between policy objectives and political realities. Individual lenders have an incentive to reduce risk to limit losses and preserve capital. While policymakers aim to maintain credit availability, there is pressure on politicians to resolve financial disruptions in the least costly manner possible, as well as a desire to take incremental steps in the hope that more aggressive action will not be necessary.
Apart from the initial steps taken to date, what more can policymakers do? Congress plans to return for one month in September and then adjourn until early 2009. The Bush Administration may take additional action before next January, but without further legislation this would be limited to working within the existing authority that Congress recently granted. The incoming administration and the next Congress face three important questions: first, will the federal government devote more money to cleaning up the mortgage mess? Second, will lawmakers compel greater participation from lenders? Third, how will policymakers balance longer term reform against medium term stability?
So what does all this mean with regards to potential trades? The recent emergence of wider corporate credit and commercial mortgage spreads, GSE worries, and the potential contagion to the rest of the financial sector all do not bode well for the market. Getting above 1,300 required a great deal of inflation worry to be resolved, painfully so for the supposed “growth” areas, but having wrung out that fear and facing the specter of another wave of seemingly imminent financials damage, a pullback to previous lows is far easier to envisage than any break back to the tops of the recent range. The most proximate upside catalyst might very well be government intervention in the GSE space. Over the last year the market has come to respect the power of government action to spark short-lived market rallies, but it may take more damage from here to get that to happen.
A GSE bailout is certainly damaging for equity holders in that space. But as we have seen in the recent past, government intervention may be a market and sector positive, at least in the short term. Getting there may entail some serious pain and, while the nearly explicit GSE put may limit broader contagion in the financials space, it is worth remembering that a capital injection that just repairs balance sheet damage does not mean that GSEs will be open for “business as usual,” and mortgage activity will likely continue to be impaired.
Against this backdrop, though GSEs themselves face the most direct pressures and the entire financial sector is likely close second, housing equities look vulnerable too, with housing activity meaningfully related to GSE fortunes. Mortgage rates are rising despite a bond market rally, pushing mortgage spreads up even more sharply, and bank de-leveraging means further constraints on consumer credit and mortgage lending.
The XHB has outperformed the market by more than 20% since mid-July, as some tentative signs of firming in the data emerged (An uptick in permits, a slowing in the pace of house price declines, and some sequential improvements in the inventory of new homes relative to sales). But there has been little data follow through in the form of continued stabilization, and mortgage centered concerns ought to be the dominant force here, at least for now, with significant room for housing equities to run lower.
One of the symptoms of the weakening economic growth outlook (at least in the market’s estimation) has been the sharp pullback in oil prices. This has led to some significant sector rotations. Consumer areas of the market have been supported, while the energy sector has been damaged. As previously written, I view this rotation as extreme on both counts: Consumer discretionary stocks have taken too much credit for the potential boost to spending from a pullback in oil prices, and energy equities have taken on too much damage. Relative to the market, the broad consumer discretionary sector (XLY) and the retail space (RTH) have rallied; the underlying indices are both up around 5% relative to the SPX since mid-July. With oil price relief the likely catalyst, the magnitude of these rallies looks overdone, exceeding historical “betas” to the oil price move, and in the face of still significant underlying consumer headwinds. The weekly unemployment insurance data point to further labor market damage commensurate with an unemployment rate well into the 6% range, confidence remains at recessionary levels, and consumer balance sheets continue to be de-leveraged as banks cut back on lending.
On the oil side, even if oil prices only stabilize here, energy equities, which have looked inexpensive relative to crude oil all summer long, ought to benefit too. Even after taking into account the sharp pullback in oil prices themselves, the energy sector (relative to the market) looks undervalued.
Given all this data it would appear as if the choice is simple, we are left with only one option (hence the title, A Hobson's choice is a free choice in which only one option is offered, and one may refuse to take that option. The choice is therefore between taking the option or not taking it, colloquially formulated as "take it or leave it.") Expect equities to continue turbulent times and seek safety in wide moat companies, energy specifically is looking appealing given the recent pull back, avoid consumer stocks until future spending looks more promising.