It's looking like 2007 will be the year that reality sets in for the financial markets. How many times were financial pundits calling for a housing bottom after we saw a brief up tick in various housing economic measures earlier in the spring? Too many! Now both the homebuilders and Wall Street are admitting to the fact that housing isn't likely to bottom this year and the housing recession is ongoing.
Next came the constant mantra that the subprime mess is 'contained' and that there will not be any resulting contagion into other areas of the financial markets. In fact, Mr. Bernanke, in a May 17th speech titled, 'The Subprime Mortgage Market,' had the following comments:
All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system (Emphasis added). The vast majority of mortgages, including even subprime mortgages, continue to perform well. Past gains in house prices have left most homeowners with significant amounts of home equity, and growth in jobs and incomes should help keep the financial obligations of most households manageable.
Anyone still arguing that the subprime mess won't spill over into the economy or financial sector and that it is 'contained?' The financial market volatility, hedge fund blowups and central bank liquidity injections over the past few weeks has clearly put to rest this debate.
Previous optimistic economists and portfolio managers are now shifting their views, as is Mr. Bernanke, that things are not as rosy as they once thought. Dr. Ed Yardeni, President & Chief Investment Strategist of Yardeni Research, Inc. has conceded that the mortgage mess has 'clearly not been contained,' and recently doubled his probability of a recession and bear market from 15% to 30%.
Data and commentary from Steve Cochrane from Moody's Economy.com demonstrates how widespread the fallout has been from the housing recession in Moody's Economy.com's most recent U.S. Regional Outlook entitled, 'Housing Hitting Everywhere.' Commentary by Mr. Cochrane is provided below:
No region is escaping from the impact of the housing market downturn and the mortgage meltdown. Employment growth continues to expand in each region, but at rates roughly one-half of a percentage point below one year ago. The only exception is the Northeast, where spectacular income growth in the first quarter has kept this year's job growth rather steady (No doubt influenced by Wall St. bonuses).Also, each region of the country is suffering deteriorating household credit quality. The breadth of this trend is remarkable. If there are exceptions, they are in the Pacific Northwest and parts of the Southeast. But the exceptions are few and far between.Figure 1
Source: Moody's Economy.com, DismalScientist
As housing was continuing to slide the financial press claimed that businesses, with their pristine balance sheets, would more than compensate for a weaker consumer to prop up the economy. This is quite a tough burden for the business sector (nonresidential fixed investment) to shoulder as it makes up a far smaller portion of GDP than the consumer sector (personal consumption expenditures (PCE) & residential fixed investment). The business sector makes up 11% of GDP compared to the consumer, which makes up 75% of GDP.
Figure 2
Source: Moody's Economy.com
A WrapUp earlier in the year (Who's Carrying the Economic Baton?) showed that businesses were not coming through as was predicted despite pristine balance sheets. The data showed that instead of funneling their profits back into their businesses through capital expansion, they were instead retiring stock. Retiring stock will not support the economy, nor will making manufacturing investments overseas as jobs are created there and not here.
Businesses are reining in their appetite for debt by reducing their demand for commercial and industrial loans at the same time banks are tightening standards on these loans. These were the same conditions that were seen preceding the last two recessions as businesses are taking their cue from the consumer as business loans (C&I loans) lag consumer loans. Weaker consumer debt demand leads to reduced consumption which is why business loan demand lags consumer demand.
Figure 3
Source: Moody's Economy.com
Figure 4
Source: Moody's Economy.com
Another argument being made is that the strong global economic boom will keep the U.S. from sliding into a recession through strong growth in U.S. exports. Basically, the engine that used to 'pull' other economies (U.S.) will now be 'pushed' by the caboose (Europe, China). Coupling that line of thinking is that the U.S. consumer will remain resilient and that retail sales will hold. Both these theories are beginning to sink as holes in these arguments are surfacing.
Paul Kasriel, Sr. Vice President & Director of Economic Research at The Northern Trust Company, reveals weakness in both as seen in his comments below:
Don't Underestimate the U.S. Consumer? The Global Economy Is Strong?These are two common refrains from mainstream economists who never foresaw a recession until it already had been declared by the NBER. Today we received some information that ought to give these mainstreamers pause for thought.Wal-Mart, the largest retailer in the world, reported a lower-than-expected quarterly profit and cut its full-year earnings forecast. Chief Executive Lee Scott blamed Wal-Mart's disappointing performance on economic pressure around the world. Said Mr. Scott, "It is no secret that many customers are running out of money toward the end of the month."Now, for the vaunted global growth story. Not 24 hours after the second-largest economy in the world, Japan, reported absolutely weak and weaker-than-expected second-quarter real GDP growth, the second largest economic region, the Eurozone, reported absolutely weak and weaker-than-expected second-quarter real GDP growth. Quarter-to-quarter annualizedEurozone real GDP growth slipped to 1.4% in the second quarter vs. 2.9% in the first. On a year-over-year basis, Eurozone real GDP growth edged down to 2.5% in the second quarter vs. 3.1% in the first. The unexpected weaker Eurozone growth calls into question two things--the policy rate increase by the ECB penciled in for September and the locomotive to pull the U.S. economy out of its funk.Evidence supporting that the subprime mess is spreading outside the U.S. economy can be seen in the present conditions diffusion index for Moody's Economy.com's Global Confidence Index. The index has recently plunged sharply down to levels not seen since the Iraq invasion in 2003. The correlation between the index and U.S. real GDP growth hints at further downside to the global confidence.
Figure 5
Source: Moody's Economy.com, DismalScientist
Figure 6
Source: Moody's Economy.com, DismalScientist
Are Retail Stocks Heralding a Recession as Homebuilding Stocks Did with a Housing Recession?
Paul Kasriel brings to light that the S&P Retail Index may be telling the same story the homebuilding stocks were in 2005, that a recession is imminent. His comments are provided below:
Don't Underestimate the U.S. Consumer? The Global Economy Is Strong?Although pointy-headed economists continue to be positive on the U.S. consumer, investors have soured on this space, as evidenced by the chart below that shows the behavior of an index of U.S. retailing stocks. The index is down almost 14% from its mid-February highs. I seem to recall in late 2005 when a similar index of homebuilder stocks was falling that these same pointy-headed economists couldn't see the housing recession forming on the horizon.The S&P Homebuilding Index peaked several months before new homes sales did, and the sharp plunge in the index in early 2006 indicated the housing market was likely to deteriorate sharply, and it has as new home sales have fallen considerably from their high in 2005.
Figure 7
Source: Moody's Economy.com
It is well known that housing is a leading economic indicator and that stocks discount the future, not the present. The decline in the S&P Homebuilding Index predicted a housing recession and the possible topping in the S&P Retail Index may be signaling a recession as cash-strapped consumers retrench their spending.
Figure 8
Source: StockCharts.com
As of yet, the S&P Retail Index is not forecasting a recession like it did prior to the 2001 recession when the index peaked ahead of the year-over-year (YOY) percent change peak in retail sales.
Figure 9
Source: Moody's Economy.com
However, it is possible that the rally in the index last summer was overdone and fueled by excess liquidity as the fundamentals for the retail sector did not warrant the price movement. Railcar shipment either lead or are coincident with retail sales, and railcar shipments have continued to plunge and are not yet showing signs of a bottom, indicating investors who bid up the S&P retail sector may have been on the wrong side of the trade.
Figure 10
Source: Moody's Economy.com
Recession on the Horizon?
With the unraveling in the markets, economists and financial pundits are shifting their thoughts to the prospect of a recession. It shouldn't have taken so long for optimistic economic projections by the financial media to turn more bearish on the economy considering the fact that we are in one of the worst housing recessions ever.
We are currently on par with the 1990 housing recession, with this bearishness in the housing sector well documented for nearly a year now. Just take a look at the National Association of Homebuilders Housing Market Index components below, which are equal to the lowest numbers for any month over the last 22 years.
Figure 11
Source: Moody's Economy.com
A retrenchment in consumer spending and both business and consumer debt demand is raising the probability of a recession. In fact, Paul Kasriel has developed a recession-warning indicator, which he calls the 'Kasriel Recession-Warning Indicator' (KRWI). His description of this indicator and updated results are given below:
Recession Imminent? Both the LEI and the KRWI are Flashing Warning (March 22, 2007)
To corroborate the recession-warning signal being sent by the LEI, I have developed another recession-warning indicator. I have found that every recession starting with the 1970 recession has been immediately preceded by the following combination - a negative spread between the yield on the Treasury 10-year security and the federal funds rate (hereafter referred to as 'the spread') on a four-quarter moving average basis and a year-over-year contraction in the quarterly average of the CPI-adjusted monetary base.
You Know Things Are Bad When The WSJ Trots Out Malpass and Wesbury In The Same Week (August 9, 2007)
As the chart below shows, since 1970, whenever the four-quarter moving average of the yield spread has turned negative and, at the same time, the year-over-year change in the quarterly average of the CPI-adjusted monetary base has turned negative, a recession has occurred. Guess what? In each of the first two quarters of 2007, this combination of a negative yield spread and contracting real monetary base has obtained.Figure 12
Source: Paul Kasriel, Northern Trust Company
With the housing recession ongoing, consumers retrenching, business sector funneling their funds into their stock and not capital expenditures, and a current credit crunch in the markets, a recessionary probability might turn into a recessionary reality.
TODAY'S MARKET
The Dow Jones Industrial Average and Nasdaq hit four-month lows despite another injection by the Fed worth billion. The markets traded in a narrow range before undergoing a consistent decline in the last few hours of trading with the Dow falling below the 13,000 mark as reports surfaced of trouble at Countrywide Financial Corp. with Merrill Lynch issuing a 'sell' rating on the stock.
The Dow lost 167.456 points to close at 12861.47 (-1.29%), the S&P 500 fell 19.84 points (-1.39%) to close at 1406.70, with the NASDAQ closing at 2458.83, down 40.29 points (-1.61%).
Treasuries rallied with yield on the 10-year note falling 2.6 basis points to close at 4.706%. The dollar index was up on the day, rising 0.38 points to close at 81.87. Declining issues represented 82% and 68% for the NYSE and NASDAQ respectively, reflecting a broad sell off in the markets.
Oil prices were up on the day after a bullish petroleum inventory release, with Brent crude rising .13/barrel to .64/barrel. Henry Hub spot natural gas was up 6.56% to close at .31. Precious metals were down slightly with gold falling .60/oz to close at 7.60/oz (-0.24%), and silver was down __spamspan_img_placeholder__.20/oz to close at .50/oz (-1.57%).
The sell off in the markets was broad based as all ten of the S&P 500 sectors were down on the day, with the materials (-3.13%), energy (-2.18%), and the industrial sector (-2.09%) showing the greatest declines. Defensive sectors such as the health care (-0.30%) and consumer staples sector (-0.79%) faired better with smaller declines.
Overseas markets also sold off with Asian and Latin markets down more than 2%. The Taiwan Taiex index led the decliners, down 3.57%, followed by the Brazilian Bovespa (-3.19%), Mexico Bolsai (-2.61%), and Japan's Nikkei 225 index (-2.19%).
