It has been one year after the credit crisis took center stage last summer and heralded the market top that took place months later in October. Since that time the markets have begun to do something they neglected to do; begin to price risk into investments. The markets entered 2007 without a care in the world as evidenced by record low spreads in the credit markets. Over the last year, credit spreads have risen dramatically as the other side of the return coin, risk, resurfaces after being tossed aside. While most investors entered 2007 complacent, not everyone played into the euphoria as shown by prescient commentary from Stephen Roach.
The high priests of each of these risky asset classes all have very persuasive arguments as to why the fundamentals have changed — in effect, why the current assessment of risk is far more benign than in the past. Call me a cynic, but I don’t buy the theory of “riskless coincidence” — that the fundamental underpinnings have simultaneously improved for all risky assets at precisely the same point in time. If there’s ever been a visible manifestation of the excesses of the stock of global liquidity — despite an adverse shift in the flow — this is it. Like it or not, the excesses of global liquidity have created a profusion of “this time it’s different” stories. I might be persuaded that one or two of them are intriguing — it’s the profusion that kills me.
In a myopic rush to celebrate the immediate dividends of faster economic growth, the costs of what it has taken to achieve that outcome have all but been ignored. As long as global growth remains strong and the liquidity cycle remains accommodative, I suspect those costs will continue to be finessed. But when the tide goes out and the global growth engine slows for any one of a number of reasons, an increasingly integrated global economy and its tightly interdependent financial markets could well have to come to grips with these costs head on. That remains the biggest potential pitfall of 2007, in my view.
“Global Resilience”, 10/09/2006
Mr. Roach’s comments, made nearly one year prior to the peaking of the market, were dead on. The tide has indeed gone out in terms of global liquidity, liquidity that the markets were supposed to be awash in last year, with markets now grappling with the price of loose lending earlier in the decade. Financial institutional losses have been off the charts recently leading them to knock at the door of the Federal Reserve looking for cheap handouts. Indeed, financial institutions are not just knocking at the door but remain as their losses quickly eat away what they just borrowed, leaving them at the Fed’s doorstep asking for more. This is illustrated in the figure below that shows borrowings from the Fed at record levels and remaining there.
As seen above, previous crisis borrowing remains only as a blip on the screen as this credit crisis is of generational making, a truly 100-year storm. The storm’s winds have only intensified as the Fed’s Senior Loan Officer Opinion Survey released today illustrates. Credit was tightened across the board from consumer to corporate America, with commentary from Moody’s DismalScientist provided below (emphasis added).
The July Senior Loan Officer Opinion Survey dashed hopes that the credit crunch is ending or is about to end. Only foreign banks reported less tightening in credit standards to businesses and households from the previous survey. Domestic banks, both large and small, indicated that they are continuing to tighten standards on nearly all forms of lending. Standards for C&I loans, residential mortgage loans and consumer credit were all markedly tighter since the last survey in April. Only standards for commercial real estate loans did not worsen in the July survey…
This survey suggests that the end to the credit crunch is likely not in the cards for this year. Banks indicated that they would likely be tightening standards on loans to both businesses and households further through the end of this year and into the beginning of next year. The fact that banks are tightening standards on nearly all forms of consumer credit, even outside of the mortgage arena, is worrisome as well. With the job market expected to worsen through the end of this year, this lends a significant amount of downside risk to the forecast for a relatively speedy recovery by the end of this year or early next year.
The economy will continue to deteriorate until credit standards ease. One of the hallmarks of economic recoveries is improved willingness by the banks to lend, not a reduction in the Fed Funds rate as banks remain the credit transmission mechanism to the economy. The Fed pressing on the pedal (lowering interest rates) does nothing to move the car unless the power is transferred to the wheels (consumer, corporations) via the banks. This point is illustrated below in which the end of a recession is seen by bank willingness to lend once again.
The transmission remains locked up as credit is neither being transferred to the consumer or corporations. This is one of the main risks to growth in the second half of the year and into 2009, and is likely only partially factored into the Blue Chip Economic consensus forecasts that are still calling for 1.5% growth in real GDP for the U.S. in 2008, and 1.9% for 2009. While some economists see growth accelerating next year, others are not so sanguine with Jeffrey Saut from Raymond James going against the grain as his commentary below shows.
By our pencil, even if housing prices stop going down, which is doubtful in the near-term, the banking complex will continue to reduce exposure to real estate as it attempts to shore-up its balance sheets. Unfortunately, as long as this sequence continues to play, CREDIT for the economy will remain lacking and/or extremely tight, as is being telegraphed in the chart below. For a finance-based economy like ours, this is troubling since it now takes $5.57 in new debt to fuel $1 worth of GDP growth. And that, my friends, is why I remain more concerned about the economy in 2009 than I have been during 2008…
The call for this week: Friday’s date read “8-8-8,” which is considered by many to be a pretty lucky sign. Consequently, there were a plethora of Asian weddings, the likely reason why the Olympics began on Friday, and the stock market reacted accordingly with its own celebration of +302 points (DJIA). We think the “crazy 8s” will continue to party this week into our envisioned 1320 – 1330 target zone for the SPX, which is where we recommend selling your remaining trading positions and/or raising your stop-loss points. Is this the start of a new secular bull market? We doubt it because by our notes there have been 24 daily Dow Wows of 300+ points and NONE of them have been within the confines of a secular bull market. We continue to invest and trade accordingly…
“Painful Ups And Downs,” 08/11/2008
Until the banks start channeling the cheap funds they receive from the Fed towards consumer and company loans rather than replacing their losses, it's going to be tough goings for the market ahead. For instance, the performance of S&P 500 tracks bank standards for C&I loans with a six-month lag as shown below.
Recent bank tightening does not bode well for the market's performance for the remainder of the year. As such, the current market bounce is simply a rally within the context of a bear market and caution STILL remains the order of the day.