“Talk about a new paradigm,” says Merrill Lynch’s David Rosenberg: bad news boosts markets. Despite dearer oil, downgrades to subprime mortgage bonds and lousy US retail sales, the Dow and the S&P 500 have hit new record peaks, while the UK and European markets are close to new seven and six-year highs.
But what is there to get excited about? US second-quarter earnings are currently in the spotlight, and profit growth is expected to reach about 4.2%, the lowest growth rate in five years. What’s more, the proportion of companies that have lowered their forecasts for second-quarter earnings is well above the long-term average, says Peter Mackay in The Wall Street Journal. And as Ambrose Evans-Pritchard points out in The Daily Telegraph, profits are 25% and 30% above their historical trend levels in the US and Europe respectively. This means strong growth in the medium-term looks highly unlikely. In Britain, profit warnings by UK-listed firms are running at their highest level since the dotcom bust of 2001; 191 firms issued warnings in the first half, according to Ernst & Young, a sign that the economy may be starting to slow.
That’s the worry for the US economy in the second half, amid a darkening outlook for consumption. Overall retail sales dropped by 0.9%, the worst slide in almost two years. Disposable income has been falling for three months, energy costs are rising, and credit-card debt keeps growing while mortgage-equity withdrawal is slowing, says John Mauldin on Investorsinsight.com. “The consumer is clearly under pressure.”
Given the dismal outlook for the housing market, there will be scant scope for consumers to tap their houses to keep spending. Standard & Poor’s reckons property values will be down an average of 8% between 2006 and 2008, while rising real mortgage rates implies sliding sales for at least another year, according to Ian Shepherdson of High Frequency Economics. Nationwide, foreclosures are up 87% year-on-year to about 762,000 and the total will grow by another 1 million, says Rosenberg. That implies plenty more supply to depress prices which will “push an increasing number of overleveraged homeowners into negative equity”.
The slumping housing market doesn’t just threaten US consumption, but it is beginning to “undermine confidence in the global credit bubble”, says The Economist. “Far greater troubles” await the subprime market in the next two years, when homeowners face increases of up to 50% in their monthly payments as their low introductory interest rates expire, says Jonathan Laing in Barron’s. Around $800bn in subprime loans will be reset, sending foreclosures rocketing; investors in derivatives of loans backed by subprime mortgages could be facing $100bn in losses. Ratings agencies evidently made a mistake when they accorded some subprime CDO debt the highest credit rating. The worry is that downgrades of top-rated CDOs (last week ratings agency Standard & Poor’s was set to downgrade some mortgage-backed securities and will review CDO ratings) will prompt widespread selling by institutional investors forbidden to hold low-quality debt. This in turn may spur the selling of other assets to cover losses.
Other parts of the credit market have been tightening: the average interest rate attached to low-quality corporate borrowers has jumped by 0.5% in a week, says Evans-Pritchard, while private equity firm Kohlberg Kravis Roberts is having to accept more stringent conditions on debt to finance its Boots buyout, which points to tougher terms for private equity in general. The “spigot of cheap money” that has underpinned the merger boom is closing. The US economy is “close to falling out of the sky”, and we are facing a “drip-drip credit crunch”, says Albert Edwards of Dresdner Kleinwort. Irrational exuberance has made a comeback.