Credit and the economy

The scale of the credit crisis is huge and current wisdom, and it is pretty convincing, is that there will be no way out for at least a couple of years more. On the other hand, US economic growth remains robust even as unemployment rises in certain sectors and retail sales falter. 

We already see that economic growth is not going to be driven by the consumer, by investment or by the government, primarily because all 3 groups have stressed cash flows and balance sheets. The one leg upon which any faster than expected recovery or softer than expected landing rests, is trade. 

How does the current credit crisis fit into this scenario? Spreads are generally wide. That makes it hard for consumers to borrow for consumption and hard for firms to borrow for investment. Libor has been very volatile indicative of the damaged integrity of the banking system. Fannie Mae and Freddie Mac are likely insolvent, and in any case are levered to extreme levels. With a combined market cap of less than 6 billion USD, 36 billion in prefs and 19 billion in sub debt, while backing over 5 trillion USD of mortgage debt, the insolvency of the GSE's is not improbable. That said, the fact that the banking industry is a large holder of prefs and that the banks themselves are large issuers of prefs, mean that any bailout will likely have to be a wholesale bailout across the prefs as well as common equity. The costs to the taxpayer, already 25 billion and rising. On top of the primary action, the CDS market, side bets if you like, total over 6 trillion USD. Aside from the scale of the financial impact, roughly half of 6 trillion since there are two parties to each swap, so 3 trillion, X whatever default rates X the residual value, there is the issue of locating the risk since CDS are over the counter, non exchange traded instruments. This could potentially create a domino effect as CDS triggers result in counterparty defaults. 

All this pretty much impacts the domestic economy, but what about trade? Trade decisions are based on relative demand and supply and comparative advantage. Trade finance while Libor based are relatively short term, fully secured against cargo and unlikely to see the extent of spread widening in corporate debt markets. While the BRICs are slowing as well, the nature of their demand is likely to evolve so that infrastructure investment begins to take centrestage. Even Socialist and Communists can be Keynesian. The high tech and capital goods and industrial supplies economies of the US and Germany are likely to profit from this, as long as the terms of trade are favorable. The Japanese solution throughout the 1990s was in part to depress prices, debase the JPY and export its way out of trouble. In the meantime, the Fed may hope that while they keep interest rates low, long term US government bond yields will rise creating a steeper yield curve and the opportunity for banks to reflate via another (risky) carry trade.

Time is what the US economy needs. For the weaker USD to take hold, for the trade balance to adjust, for tax receipts to stabilize government coffers, for export and (later) tax cuts to sow the seeds of growth in another evolution of the US economy. 

Will they be given that time?

Europe

The Eurozone recorded its first quarter of negative growth since 2003. Annual growth had peaked in 2006 at 3.3% and is currently 1.5% and slowing. The distribution of growth was not uniform with Spain and Italy clearly slipping towards recession. France and Germany continued to report stable albeit slowing growth. The UK also was slipping towards recession.

Domestic consumption saw a similar picture. Spain saw particular weakness, as did Italy, France and the UK. Germany registered robust growth. In retail sales, Spain has fallen off a cliff. Italy and France were also very weak. UK retail sales appeared to be holding steady while in Germany, retail sales accelerated.

In Exports, Germany, the UK and Italy registered steady growth. France saw some weakening. German trade balance has been in surplus and steady since 2000. In France the trade balance has been volatile, in Italy it has been steadily deteriorating while the UK has recorded a persistent deficit.

Economic confidence peaked in Summer 2007 and has since slumped across Europe. Business Confidence has been very weak in the UK and in Spain has nose dived. In Germany and France it declines but remains positive.

Consumer confidence tracked business confidence, collapsing in all except Germany where it is just beginning to turn down.

Employment numbers had been positive for the last 7 years averaging 7.2% unemployment in the EU and 5.2% in the UK. The current economic slowdown has not impacted employment yet but signs that it is beginning to are showing, particularly in Spain.

The one bright spot in Europe is Germany where a significant external sector fuelled by demand for capital goods from emerging economies continues to support the economy, this despite a strong EUR and disadvantageous terms of trade.

Already the German Ifo business climate and expectations lead indicators have fallen sharply in the last month. Construction holds steady but has never really been a source of strength, manufacturing, wholesale and retail indicators were all substantially weaker. Industrial production has fallen sharply from 5% to 1%.

The currency will be an important factor as the recessionary economies of the US and Europe vie for the emerging market dollar.

Twenty seconds into the future...

Investment Outlook 2008


Economic growth:


Despite expectations of recession, US economic growth remains fairly robust. Retail sales and personal consumption growth has slowed but remains in positive territory. Consumption is no longer viably financed by credit, and has to be financed by wealth creation or income. Asset values are falling. Personal income growth has slowed but remains in positive territory. The savings rate, however, has fallen to dangerous low levels. Growth in consumer credit is likely to slow as banks tighten lending standards. The connection between house prices and consumption is contentious. With credit availability being reduced for at least 2 quarters now, the impact would have been felt in retail sales. That it hasn’t may be due to the tax relief in the first quarter of this year. Unemployment has been rising for a year and is expected to rise further. Consumption is fragile.

Conference board business confidence and expectations indicators have been depressed. Given that consumer confidence is similarly depressed, the outlook for consumption is poor, consumer credit is likely to contract and asset values are declining, business confidence is likely to fall further. However, they are near historical lows marked in the late 1970’s, early 1990’s and 2000 recessions and are likely to bottom out when GDP growth confirms recessionary conditions. Until then it is unlikely that firms will undertake to increase investment. Investment is also driven by ROI hurdles defined by prevailing and expected interest rates as well as risk premia. With credit markets in decline, credit spreads widening and bank lending in decline, investment will need to be funded by cash flow and ultimately profits. Corporate profitability is likely to be squeezed from the inability to pass on imported inflation to consumers. Corporate revenues will face headwinds from weaker consumption growth. The overall outlook for investment is poor.

The external sector may provide some relief to output. A weak USD is supportive of trade and could reverse the balance of trade deficit. The trade balance with Japan is unlikely to adjust given economic growth in Japan. Europe is an important trade partner as well by size, however, weak economic growth in Europe will limit the potential improvement of the trade balance with that region. The likely areas for improvement will be with China, Pacific Rim, LatAm and OPEC. The US export sectors are concentrated in capital goods and industrial supplies. Consumer, autos, technology are unlikely to contribute much in any reversal. The infrastructure investment of Asia and OPEC is likely to play to the strengths of the capital goods and industrial supplies heavy exports of the US. The outlook for trade is favorable.

Overall, it appears that the US is headed for a protracted slowdown with weakness in consumption and investment. The government is not in a position to operate an expansionary fiscal policy in the face of rising inflation and a significant budget deficit. The external sector will likely provide some relief.

If inflation recedes as we expect it will this may allow the Fed to lower interest rates or at least keep them on hold.

In Europe, the picture is similar. Economic growth is expected to slow. Unemployment may take a longer time to adjust, upwards. Retail sales have fallen sharply across the Euro zone.

GDP growth in China remains robust although it has now slowed over the last 3 quarters (since 4Q 2007). Unemployment remains low. Average earnings remain robust. Inflation has been rising. Retail sales have been remarkably strong. At the same time, consumer sentiment is falling quite quickly. Economy was euphoric in the summer of 2007. Government policy has been hawkish on inflation in the past year. The recent slowdown in growth, albeit from elevated levels, has given policymakers pause. Rhetoric has been indicative of more accommodative policy going forward. Demand for exports, particularly from the US, will come from investment and to a lesser extent from consumption. In the meantime, China continues to diversify its trade from the US and Asia towards Europe and Africa.

India has been experiencing robust and stable economic growth. Inflation has been accelerating, however, and the RBOI has been actively raising rates to reign in inflation. Industrial production peaked in early 2007 and has slowed down substantially.




Inflation

Inflation has been trending up in most countries and is substantially higher than a year ago. On the demand side are the high growth emerging economies such as China, India, Lat Am. On the supply side, bottlenecks in the infrastructure in emerging economies are responsible for increased volatility.

In the US, PPI is rising at 14.5% per annum, a rate not seen since 1979, 1974 and 1951. Import prices are rising at 20.5% against export prices which are rising at 8.5%. CPI has been rising as well, albeit less rapidly, rising 5% year on year to June 2008. Core inflation is rising at a less robust 2.4%. The main source of inflation is from food and energy and from imported inflation. Energy prices are volatile and will likely recede quickly if economic growth slows globally. Food price inflation is driven by two forces, one is the competition for inputs from energy and the other is a emerging market populations such as China and India substituting to less calorie efficient diets (grains to meat). The latter will be a more persistent source of inflation. Inflation from poor infrastructure, the result of underinvestment in past years will also be more protracted. Given the composition of CPI in the US, while energy and food price inflation is a problem, we do not see it as a debilitating one.

Capacity utilization peaked in 2005 around the low 80’s and currently has broken below 80. There exists domestic capacity to relieve some of the inflationary pressures from a weak USD and rising external inflation. This may provide some economic justification for the otherwise misguided protectionist tendencies arising in the US. The economic impact of any protectionist policies may therefore not have as dire an impact as might be expected otherwise.

Note that with the US economy slowing, US bank bailouts are highly inflationary and the implementation of any bailout needs to be specific and temporary.

Unit labor costs, personal income and employment costs have not seen significant strength in the past 8 years. Wage inflation has not been in evidence although this is clearly an area of concern going forward. Wages have lagged profits and may have to adjust. If so, this may drive inflation.

The analysis of the US can be loosely extrapolated to the developed world.

Where inflation will be a serious problem will be in poorer countries where food and energy are a significant proportion of CPI. In the past 12 months the largest increases in inflation have been in
The rise in inflation has indeed been broadly negatively correlated with per capital GDP. LatAm, Eastern Europe and MENA have seen substantial inflationary pressures. Even agri economies have not been spared as open economies import inflation.

2007 has seen robust growth in infrastructure spend particularly in emerging markets. Inflation pressures will limit the extent to which these economies will be able to operate fiscally reflationary policies. This will put to test the theory that emerging markets domestic demand is rising as a driver of economic growth.



Policy

US: As the US is the world’s largest financial economy, the Fed is hostage to it. If as we expect, inflation turns out not to be as persistent a problem, the Fed will not have to aggressively raise interest rates. It is likely that it will delay any decision in the hope of receiving more encouraging news on the inflation front. One thing to note is that bank rescues are inflationary in nature and may require some balancing by the Fed. On balance we expect the Fed to hold steady. That does not mean that the current Fed Funds rate is signaling the appropriate market clearing interest rate. US interest rates are probably too low for normal conditions and are probably more appropriate to addressing flagging domestic demand. In any case the source of inflation is not domestic and it is unlikely that higher interest rates will dampen price pressures.

UK: The UK is broadly in the same position in the US in terms of interest rate policy. Inflationary pressures from economic bottlenecks are probably higher than in the US thus calling for a more hawkish stance. The BoE is similarly caught between slowing economic growth which is at risk of deteriorating further, and risks that inflation accelerates. Unlike the US, a good proportion of inflation is domestically generated and can therefore be addressed with higher rates. On In addition the BoE has explicit inflation targets. We therefore expect the BoE to raise rates rather than keep them on hold.

Europe: Euro area inflation has been rising substantially. Unlike the Fed and the BoE, the ECB has actually acted to raise interest rates by 25 basis points to 4.25% on 3 July 2008. Inflation has been particularly strong in Spain, Greece and Ireland. The ECB has been quite clear as to its intentions on the inflation fighting front and we can expect rates to rise further if inflation continues to rise. We expect, however, that inflation numbers will moderate and the need for further rate increases will abate.

China: Inflation is running at 7.1% YOY June 2008. Surprisingly the pattern of inflation across urban and rural areas is fairly balanced. As expected the price pressures were concentrated in construction costs, food and energy. Consumer non durables and services saw little if any inflation. It appears that China is a classic case of cyclicality in growth and prices with the expected lags. The PBOC is actively addressing inflation while trying to maintain stable growth. China is in the middle of a major infrastructure build out which in itself is highly inflationary. The PBOC will have to act to counteract the impact of this government expenditure. In a lower per capita GDP economy, marginal propensities to consume tend to be larger as consumer staples account for a larger proportion of expenditure. The PBOC has so far acted to restrict bank credit to minimize any multiplier effects from the financial system. It is not clear if the PBOC will try to impact multiplier effects on the consumption side. Increasing specific consumption taxes will go some way to mitigate these impacts.

India: The RBI is already hawkish as inflation is rising quite quickly. Currency volatility has been a concern recently as the INR weakened significantly this year. India is desperately in need of improved infrastructure but a substantial budget deficit is straining the government’s ability to fund it. At the same time, any infrastructure spend would be highly inflationary. There is overinvestment in the real estate sector and risk of a severe reversal.




Equity

US:
Corporate earnings have come in weak, as expected. Exporters are showing some signs of strength on a weak USD. Valuations are still elevated by historical standards. In the oil shock stagflation of the early 1970’s valuations fell from the 20’s to single digits. The current average PE of the S&P500 is still in the high teens. Under an inflationary scenario, this is likely to test the single digits. With earnings downgrades in progress, the outlook for US equities is quite unfavorable.


Europe:
Corporate earnings in Europe will similarly come under pressure. A strong EUR will further disadvantage Euro Zone companies. Valuations, however, have priced in inflationary conditions as well as weaker earnings. The Estoxx trades at an average PE of 10X, as does the FTSE. Expectations are for zero growth over 2009. The Swiss market, however, trades out of line in the high 20’s. Currently the European markets represent relatively good value.

Greater China, Asia:
The slowdown in the US and Europe will inevitably impact the earnings of China companies. Domestic inflation fighting policy will also dampen economic growth. The market is still expecting earnings growth of mid teens to mid twenties for China companies in the current year and similar growth rates in the following year. Valuations are in the mid to high twenties in China and low teens in Hong Kong. Greater China companies were acutely overvalued at their heights in mid 2007 but have retraced by between 40 – 50 % since then.

Japan:
The Nikkei 225 and Topix PEs are circa 16X. Growth is slowing and the economy is at risk of slipping back into recession. The difference this time is that inflation is actually rising, albeit from a low base.

India:
The market PE is circa 14 with zero growth expected in the current year and mid teen growth expected in the following year.



Corp Debt

Foreigners will be switching out of US treasuries. Some substitution into corporate debt. Valuations crucial and market always overshoots.
If someone is switching out of lending to the US government, unlikely they will want to lend to a US corporate. Ditto UK. Will only switch country. Or asset class.


Sovereign Debt

Japan, China together hold about 1 trillion in US sovereign debt. UK holds 250 billion USD, Oil producers hold 140 billion USD.

For China and Japan, buying US treasuries is the equivalent of a leasing business serving US consumers in aggregate. The BoJ has slowed its purchases of US treasuries and its holding of US treasuries has also decreased. China, however, continues to be a buyer and its holdings are still increasing. Part of this will be due to efforts to control the natural strength of the CNY. As inflation and credit market problems and bailouts debase the USD, foreign central banks and will not be as willing to accept US treasuries to fund US consumption. The US as a nation will likely find the cost of debt rising. Yields on US treasuries should rise. Taken together with our view on the Fed’s inflation and growth stance, the yield curve is likely to continue to steepen.

Foreign investors will not likely want to lend to US consumer. The may like to own US assets but at lower valuations.



Commodities

Industrial Metals – likely to be weaker, range bound in a new range, unlikely to retreat to 2003 levels, steel and infrastructure related resources likely to be supported.

Gold – inflation hedge and risk barometer is likely to weaken as risk becomes fully priced and inflation begins to ease off.

Softs and Ags – energy impacted crops likely to ease off, however, generally strong from changing dietary habits from developing countries.

Energy – highly cyclical and likely to fall from highly overbought territory, do not see a return to 2003 levels but expect significant short term weakness.



FX

FX is highly unpredictable. Notwithstanding, we expect FX to be driven as follows.
USD generally weak, big C/A deficit, inflation, need to be more export competitive,
GBP weak, big C/A deficit, inflation, need to be more export competitive,
EUR, generally weak, need to be more export competitive,
JPY strong, C/A surplus, may weaken as Japan slips into recession,
RMB strong, rising domestic demand, middle class, consumption, acquisition currency,
Asian FX strong in general,
INR weak, C/A deficit, Inflation
Latam FX strong, credit ratings upgrades, agri commodities,
CHF, SGD strong, flight to safety, will weaken as global risk pricing comes off,
MENA FX strong,
AUD, CAD, MYR strong, commodities impact, AU is running a very high C/A deficit and inflation is high, will likely come off as commodities rally peters out.

Inflation Comment

The US and Europe cannot fight inflation by raising interest rates because their domestic economies are not pushing against full employment. The source of inflation is from the emerging markets. The US and Europe need China and India to raise interest rates and fight inflation. If they get what they need, that means interest rates in emerging economies rising faster than USD and EUR rates. In terms of term structure, USD and EUR yield curves will only flatten if BRL, CNY and INR curves flatten first.

The more likely scenario is that China and India are facing serious inflation. China will act to slow inflation, India is slightly caught between a rapidly cooling economy and together, aggregate demand will slow. The implications for the rest of the world will be an easing off in energy prices, then food prices, albeit to a lesser extent, and thus lower risk of inflation. The US and Europe will find themselves less motivated to combat inflation.

The price of stable prices will be slowing emerging economies and thus demand for US and European exports. Taking the US as an example, consumption is likely to be weak from poorer consumer sentiment, rising unemployment and weaker income, investment is likely to be weak from scarcity of credit, poorer business expectations, weaker corporate profits, the government is broke, any spending might be inflationary. Trade is almost the last hope for any earlier or stronger than expected recovery. That requires export demand from countries other than those in similar financial health or lack thereof: the developing world. If that part of the world is slowing down, it doesn't leave much hope for a quick recovery.

What could change that is investment in infrastructure in parts of the developing world where inflationary pressures can be addressed by ad hoc and specific measures, i.e. where market prices do not apply wholesale to the economy and there is sufficient central planning, and where balance sheets corporate or sovereign still have the firepower.