27 Jul 2007 Credit Woes Stir Volatility
Banks and other credit issuers took it on the chin this week with growing uncertainty in the credit markets. Citibank is down over 4% for the week while the S&P Global Financials Sector Index is down 4% over the past two weeks. The news of continuing declines in housing fueled worries that the broader credit markets would be damaged by a growing rate of sub-prime mortgage defaults and foreclosures. Wednesday, the National Association of Realtors reported that existing home sales fell more than expected by 3.8% in June to a seasonally adjusted annual rate of 5.75 million units, the lowest level since November 2002. Yesterday the Commerce Department reported that new-home purchases in June fell by 6.6%, the most since January.
Yet, today’s report from the Commerce Department shows that the US economy grew last quarter at the fastest pace in more than a year, propelled by rising exports, commercial construction and government spending as reported by Bloomberg. This follows a .6% gain in the first quarter of the year. Spending on commercial construction projects rose at the fastest pace in 13 years mitigating the recession in homebuilding. Factories also showed new strength as exports improved.
And if the growth news was not good enough, the report showed that prices increased only 2.7%, down from 4.2% in the first quarter. The Fed’s preferred inflation gauge, which is tied to consumer spending without food and energy costs, rose 1.4%, down from 2.4%. Fed policy makers have said a 1% to 2% increase is preferable.
The consumer who has supported the economy these many years took a break in the second quarter. Consumer spending, which accounts for about 70% of the economy, slowed to 1.3% annually, the weakest since the last three months of 2005, from 3.7% in the first quarter. Economists project that this quarter may be the strongest of the year, given the slowdown in consumer spending.
Global stock markets have been driven lately by mergers and acquisitions. The Dow Jones Industrials rocketed to a new all-time high of 14,000 earlier in the week. However, higher interest rates and tighter credit policies will effectively curtail the ‘urge to merge.’ Easy credit practices that lead to today’s sub-prime problems may soon be a thing of the past. Today, Cadbury Schweppes, PLC became the first company to delay the sale of a unit saying that “extreme volatility” in debt markets hampers leveraged buyouts. According to Bloomberg, “more than 40 companies have reworked or abandoned bond offerings in the past three weeks as investors, stung by losses from sub-prime mortgages, balked at absorbing more risky debt. The tougher borrowing environment also threatens to curb capital spending at a time when companies are already showing signs of turning more cautious on investment.”
Numerous questions remain. Is the US economy’s growth sustainable? If it slows significantly can the global economy continue its historic growth without US demand? Will the Fed reduce rates to stimulate the economy? Can the US consumer withstand rising gasoline prices and falling home prices? The short-term answers to these questions are provided weekly and monthly as the government reports its latest tabulations. But one has to make a subjective judgment beyond the data to chart a course of action. So far, those taking the pessimistic view of the economy have been wrong, but will they be right given a little more time?
Anecdotal information seems to suggest aUSslowdown may be in the cards. Honda,Toyota and Nissan all lost over 2% yesterday as investors worried that as much as 70% of annual operating profits could be in jeopardy if theUSconsumer stops buying cars. We have already seen retailers such as Home Depot and Lowe’s report significantly lower than expected earnings as consumers have curtailed spending in the home sector. Copper prices have been falling as inventories in the US have risen (a sign of slowing demand). Stockpiles of copper have more than tripled in the past year. Today, a friend who works with a national executive placement firm said that while their activity locally is quite good, nationally it is falling off. He said these trends are usually good predictors of future economic growth.
If it is becoming more probable that the US economy will slow, the question remains whether it will drag down the global expansion. Given that there are so many new dynamics with extraordinary growth of China, India, Russia, Brazil and others, it is difficult to predict what will happen if US demand diminishes. What may be most likely is that the US slowdown (if it happens) may be brief and shallow enough to avoid significant damage abroad. Each benign inflation report from the government gives the Fed a little more room to reduce rates should they see the need. The best indicators that such a move is coming are provided by corporate earnings and jobs. So far these trends are mostly positive, except for the obvious industries associated with housing and sub-prime lenders.
We hold around 10% cash in each of our models now and have positioned our capital preservation models more defensively. We have scaled back our risk positions in the growth models to manageable levels should volatility increase from here (which we do not expect). In short, we are maintaining a long-term positive outlook, but a slightly pessimistic intermediate term view, particularly in the US. The ability of Europe and the rest of the global economy to sustain a trajectory of growth will be proven over time.