11 Jan 2008 Will The Fed Act In Time?
The recession camp is growing as many large brokerage and bank economists toss their hats into the ring. Goldman Sacs yesterday joined Merrill Lynch and Morgan Stanley in projecting a possible recession in theUS. Goldman’s economists predicted the economy will shrink 1% in the next six months and grow 0.8% for the year as the economy did in the last recession of 2001.
David Rosenberg, Merrill Lynch’s chief North American economist said this week that at no time in the past 60 years has the unemployment rate risen as far as it has as of last Friday from the cycle low without the economy slipping into recession. He added that “back-to-back declines in total hours worked [as we saw last week] have always been associated with recession.”
Recessions are officially declared after the fact by the U.S. National Bureau of Economic Research on conclusive data. The recession dating committee waits for conclusive evidence before officially declaring an economic downturn, so it could be several quarters before we know for sure. But as we stated in last week’s Brief, the evidence, official or not, is becoming tougher to refute. In fact investors seem to be doing more than profit taking.
So far this year the Dow is down just over 3% and the Nasdaq 6.2%. Since the October 30th peak in equity markets the Dow is down 7.7% and the Nasdaq 13%. Market corrections are deemed to have occurred when they fall beyond 10%. The Dow had its 10% decline between October 10th and January 8th. Market corrections typically forecast economic slowdowns, and in some cases cause them.
Equity markets continue to be weighed down by the uncertainty over just how big the credit problem really is for banks. Until there is confidence that the huge asset write downs are in the past, there is no way of projecting how severe the economic downturn might be. Bank of America’s agreement to bail out Countrywide, the nation’s largest mortgage lender, for now anyway, removes a major potential bankruptcy from the marketplace. But it is by no means the end of the morass. Other mortgage lenders such as Washington Mutual and bond insurers such as Ambac and MBIA are equally in peril.
Jason Trinnert of Strategas Research Partners points out that on an historical basis, bottoms in financial crises do not generally occur until there is a major bank failure or something of the sort. He gives examples such as Continental Illinois, Penn Central, Long Term Capital, and Enron. These collapses led to dramatic Fed actions that were direct and substantial. An event of that magnitude has not yet occurred. He points out that the Countrywide acquisition removes it as a potential catalyst, but there are plenty of others.
But is a major collapse in these modern times really necessary given so much more information and market efficiency? We have a Fed chair in Ben Bernanke who can be preemptive. He has done so once already during his two-year tenure and seems willing to do so again. In a speech yesterday he clearly signaled that he and his FOMC have settled the debate over slower growth and higher inflation. He said the Fed was ready with “substantive additional action” to make deeper interest rate cuts to keep the economy’s expansion alive.
Fed experts have pointed out over the years that when there is a question of economic strength, employment is their primary area of concern. Mr. Bernanke’s comments yesterday were in stark contrast to the latest FOMC statement probably because of last Friday’s announcement by the Labor Department that unemployment jumped to 5%. Bernanke said the forecast for 2008 “has worsened” and risks to growth are “more pronounced,” effectively rewriting the FOMC statement of Dec. 11.
Bloomberg News points out that Bernanke did not refer to the “committee” when he expressed his views yesterday as he has often done in the past. “Bernanke chose to finally assume the mantle of leadership,” said Michael Feroli, an economist at JPMorgan Chase. “He has generally sought to avoid front-running the committee.” Brian Sack, a senior economist at Macroeconomic Advisers who used to work at the Fed, said the shift in Bernanke’s language indicated he and his colleagues may have conferred after the January 4th job figures.
It now appears that the Fed’s focus will be predominately on the slowing economy giving inflation a back seat. Bernanke’s 14-page speech contained only one paragraph on inflation according to Bloomberg. It referred to the Fed’s preferred measure of inflation being 2.6% which is outside the comfort range.
So if the Fed is primarily focused on the economy now we can expect further cuts and soon. Lehman Brothers added another half-point of interest-rate cuts to its forecast through August, saying today that the Fed will lower its rate to 3%, including a half- point this month instead of a quarter-point. Goldman Sachs Group Inc. economists predicted this week that the Fed will lower its rate to 2.5% by year-end. In contrast, the European Central Bank has left its key rate at 4% and President Jean-Claude Trichet yesterday signaled it may raise borrowing costs to contain inflation even as economic growth slows. The ECB’s Governing Council is “prepared to act preemptively” to prevent risks to price stability from materializing, Trichet said inFrankfurt.
Is Bernanke in time with rate cuts? The stock market seems to be convinced that the Fed is too late to prevent recession. There was only a brief spike in prices yesterday during Bernanke’s clear signal that he would be cutting rates. The market’s lack of enthusiasm could be taken that investors fear that the perception of recession on the minds of consumers and managers is ahead of the Fed cuts and there is little more policymakers can do other than make the recession less severe.
Our tactical asset allocations have shifted significantly in the past weeks to address the slowing economy. We have extended bond maturities across the board. We have increased our holdings in the utilities, telecom, and healthcare sectors. We have avoided consumer staples because their valuations appear high. We have reduced our weighting in technology and other growth stocks by half and may need to go further if it looks like the economy will recede faster than expected. Finally, in our growth models we took a position in the global financial sector yesterday. We believe we are near the bottom of the credit crisis. We believe that Fed rate reductions will begin to add confidence in bank stocks. We also like the dividend yield at 3.9%. It helps us to be patient is we are early.
Have a good weekend.