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“The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.”
- Rudiger Dornbusch, MIT Economist
Diversified manufacturer 3M Co. (NYSE:MMM - News) posted a weaker-than-expected quarterly profit on Tuesday and said global economic growth was slowing, sending its shares down 4.7 percent and weighing heavily on blue chip stocks overall.
... 3M executives cited the U.S. housing market as a drag, resulting in lower demand for products ranging from its optical films used in liquid crystal display televisions to roofing granules used in shingles for houses.
....Another diversified manufacturer, Illinois Tool Works Inc. (NYSE:ITW - News), had previously cut its outlook and Tuesday pointed to moderating demand and even declines in some of its North American markets, specifically citing the housing sector and production by the Big 3 domestic automakers.
The primary driver behind the slide into mild recession five years ago was the squeeze on company profits and the pressing need for business to run down borrowings, which led to sharp decreases in investment spending. As companies reduced their debt, households were persuaded to take on more. The Federal Reserve took steps to bring this about, by cutting interest rates from 6% to just 1% – where they were held for more than a year. The Bush administration played its part with an unprecedented programme of tax cuts, which amounted to around 6% of GDP between 2001 and 2004.Predictably, American households responded by stoking up spending and borrowing. As in the UK, the housing market was at the centre of the action. As the number of transactions rose, so did prices and increased borrowing was the obvious consequence. Outstanding mortgage debt of $5.1 trillion at the end of 2001 had virtually doubled by June 2006. In addition, an estimated $1.3 trillion of additional borrowing came through in the form of mortgage equity withdrawal.
While boosting the pace of economic activity, the policy also held the seeds of its own destruction, and the day of reckoning is now looming. Steadily rising inflation was the most obvious sign of an overheated consumer sector and a balance of payments deficit that is now around 7% of GDP is a clear sign of an unbalanced economy. The long-term result of the US acting as the world’s ‘consumer of last resort’ has been a surge in the dollar assets held by Asian central banks.
Given its remit, the Federal Reserve could not be complacent about the rise in inflation, which topped 4% at one point. Inflation was already edging up when oil prices moved rapidly north. Since fuel taxes are proportionately lower in the US, higher oil prices had a much bigger impact on living costs than in Europe. So, at each of its 17 six-weekly meetings between June 2004 and June 2006, the Fed added 0.25 percentage points to its benchmark rate, taking it from 1% to 5.25%.
This was clearly going to hurt and the pain is now being felt. Growth slowed to a more modest 0.7% in the second quarter (following an unsustainable 1.4% in the first three months of 2006) and the pace of job creation has slackened. The non-farm payrolls measure of employment (closely watched and published on the first Friday of every month) slipped from an average of 175,000 per month in the first quarter to just 51,000 in September.
But it is the housing market that has most felt the pinch, with confidence draining away as affordability gets stretched. In a ‘bubble zone’ of 18 states and Washington DC (which accounts for about half of US GDP), housing is now less affordable than London. From the second quarter, prices have stopped rising, the volumes of transactions has slowed and the number of new homes being built and building permits granted have fallen. To call it a tailspin is probably an exaggeration, but it is certainly a sharp correction.
This downturn in the housing market has coincided with other strains and stresses on households’ disposable incomes. After adjusting for higher debt repayments, higher taxes and general consumer price inflation, an apparently healthy 7% growth in nominal incomes translates into a mere 1% increase in discretionary spending power.
Faced with the prospect of an imminent slowdown (GDP is likely to rise by around 2% next year, the slowest for five years), the Federal Reserve stopped hiking rates at its last two meetings and there is a growing view that the next move in rates will be down. This, in turn, will further undermine the dollar, thus making life harder for British exporters to the US. On the plus side, weaker growth in the US will take the froth off commodity markets, including oil and, therefore, ease the inflationary pressures for British companies.
It may no longer be true to say that when the US sneezes, the UK catches a cold, but we will certainly feel the impact of a US slowdown. This will come via a weaker dollar, tighter export markets and weaker returns to British companies on their US investments.
Mere mortal investors and their professional colleagues are (at least if they are honest and have a modicum of sense) a bit confounded as to what to do at this juncture. By all measures, inflationary pressures are gaining strength, and yet recessions lower aggregate demand and with it, price pressures. Ah, but what about the Chinese? Even if things get bad here, they aren't fully in lock-step with the US economy and have plenty of firepower. And what happens when Helicopter Ben throws cash at the problem? Won't lots of money creation debase the currency and by definition produce inflation?
It's very easy to get a headache from this sort of thinking.
Michael Panzner offers a useful post, "The Wrong 'Flation" on this topic, arguing for the deflationary outlook. The most powerful evidence for this view comes from the fact that the monetary authorities have lost control of credit generation (broader money, the old M3) as observers ranging from market mavens like Michael Shedlock to Serious Economists like Mohamed El-Erian have pointed out. The credit crisis means credit contraction, a process the Fed will likely be unable to staunch. That in turns points to deflation.
However, "unlikely" does not necessarily mean "unable". Bernanke is a well known expert on the Great Depression, and well schooled in the dangers of letting contractionary processes feed on themselves. So he and his colleagues will be doing everything in their power from keeping a vicious circle from setting in. The Term Auction Facility was a creative measure that managed to stave off a crisis in the money markets. Perhaps he will be able to use a combination of novel measures, liquidity injections, and smoke and mirrors to keep confidence at a reasonable level (confidence and willingness to extend credit are what really is at risk here).
The problem, ultimately, is that credit extension (witness no-doc loans, mezzanine CDOs, speculative real estate lending, and "cov lite" LBO deals) went well beyond sustainable or sensible levels. There will need to be a reduction in credit, which will inevitably lead to a contraction. But what shape will that take? How far down is down? While I think a financial meltdown is a real possibility, I guesstimate the odds at 30%. That is dangerously high by any standards, but also says the greater likelihood is that a crisis will be averted.
While I am still generally pessimistic about the near-term prospects, the powers that be may be able to forestall a crisis (and by that I mean a credit crunch a la 1990-1991, not a real calamity) and instead engineer a fairly ugly recession (I'd prefer a short and very nasty one, but given the housing crisis, we are more likely to get a prolonged sluggish period). Not pretty, particularly for middle and lower middle income consumers, who will take the brunt of it, but the alternative (most likely a Japan-style deflation due to refusal to realize losses on inflated asset values) would be even worse.
From Panzner:Those of us in the very small group that has correctly anticipated that past excesses would eventually come home to roost generally fall into two camps: the deflationists, who believe that another Great Depression is on the cards -- at least initially -- and the inflationists, who argue that hyperinflation -- where prices spiral rapidly higher -- is the most likely near-term outcome.
While there are more than a few reasons for the contrasting perspectives, in my view it largely comes down to a difference of opinion about how the U.S. reached the "tipping point" to begin with. That is, was it "printing presses" that fueled the housing and other bubbles, the malinvestment and imbalances, and the widespread belief in "something for nothing," or was it excessive credit creation?
If the answer is the former, then the dollars that were and continue to be created remain in circulation, stoking inflationary expectations and exerting a relentless upward push on prices. As economists put it, there is too much money chasing too few goods.
If the answer is the latter -- which is what I believe has been and is the case -- then logic and history suggest that when the jig is finally up, it leads to relentless, liquidation-driven downward pressure on asset and other prices. As opposed to paper currency (or even digitally-created "money" that did not come about as a result of central bank buying and selling of government and other securities), much of the credit-money that was created out of thin air ends up "disappearing" (e.g., through default), diminishing overall demand.
In "Worried about Inflation? Just Wait," Reuters columnist James Saft lends further weight to the deflationist perspective and puts paid to growing worries over rising commodity and consumer prices.Never mind inflation, the powerful and long-lasting effects of the credit crisis will rein it in soon enough.
With oil, gold and other commodities at very high levels and U.S. producer prices up 6.3 percent last year -- the most since 1981 -- fears have risen that an aggressive round of rate cuts by the Federal Reserve will embed inflation.
Consumer price inflation for December was up 0.3 percent and has risen 4.1 percent since a year earlier.
But these are likely to prove lagging indicators, even if demand from emerging markets remains strong for raw materials.
If credit is being strictly rationed and asset prices falling -- as they are in housing and in stocks -- investment, consumption and just about anything else that can be put off will be put off.
"The strong probability is that we will get at least disinflation in 2008," said George Magnus, senior economic advisor to UBS.
"I'm not aware of any banking crisis in history, almost without exception, that was not accompanied by falling inflation.
"When balance sheets are shrinking and credit restriction is being applied, the whole effect is to cause people either to not be able to make spending decisions or to defer them. It puts a downer on aggregate demand," Magnus said.
A round of poor data, notably unexpectedly weak retail sales, prompted rumors of a highly unusual inter-meeting rate cut by the Federal Reserve, whose next scheduled meeting is January 29-30.
The Fed declined to comment. Traders were roughly evenly split on Wednesday in betting on a 50 basis point or a 75 basis point cut this month in the Fed benchmark, currently 4.25 percent.
But even aggressive cuts in interest rates will have a limited and painfully slow impact on demand under these circumstances, according to Magnus. He contrasts the current crisis, which is fundamentally about the solvency of borrowers and the banks that lent to them, with other crises, such as 9/11 or the stock market crash of 1987.
"When solvency is involved and asset prices are declining, monetary policy can help but can't solve the problem."
Yen carry trade and credit cards next?
Ominously for the economy, the Baltic Dry Index BADI of shipping capacity suffered its biggest one day drop since records began on Wednesday, down 5.74 percent and following similar heavy falls on Friday and Tuesday. The index is down almost 20 percent since January 1.
Because trade travels on ships, the Baltic index is often a good indicator of forward demand, both for natural resources and finished goods. Interestingly, the Baltic index continued to climb as the credit crisis unfolded through the summer, supported by strong economic growth in emerging markets.
Tim Lee of pi Economics in Greenwich, Connecticut, thinks prices of many assets and commodities will fall strongly in what he calls an "incipient deflation".
"Ignore gold, ignore oil: they are lagging indicators of the excessively loose central bank policies we had in the past," Lee said.
"The leading edge that is really telling us what is going on is the government bond market and property prices."
Yields on 10-year U.S. treasuries have fallen as low at 3.69 percent, down almost a half a percent since late December.
The credit crunch is breeding new areas of concern, such as credit cards and commercial loans. Another round of losses in a new area would further dampen credit.
Citibank has more than doubled its loan loss reserve ratio on U.S. consumer debt since the end of the second quarter, with the sharpest move in the past three months.
Then there is the risk that cuts in U.S. interest rates will unravel what is perhaps the world's biggest leveraged bet, the use of carry trades, according to Lee of pi Economics.
Estimated at as much as $1 trillion, carry trades involve borrowing cheaply in yen or other currencies such as Swiss franc that have low interest rates in order to invest in higher yielding currencies, or indeed in anything else the borrower hopes will go up.
Both the yen and the Swiss franc have rallied sharply against the dollar in recent days driven by expectations of much lower rates in the U.S.
If funding currencies like the yen and franc continue to rise, borrowers could sustain big losses. For example, many Hungarians have taken out mortgages in Swiss francs and many Korean corporations have funded in yen. Strong moves upward in the currency they borrowed may leave them unable to carry the debt.
"As the carry trade unwinds, liquidations and asset sales will push prices (down) further," Lee said.
It seems clear that, as with the credit-fuelled boom that preceded it, the bust has taken on a life of its own.
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