Whatever your opinion of the health of America’s economy last week, “it should now be a lot gloomier”, says The Economist. Last Friday’s news that 4,000 jobs were lost in August – the first monthly fall in employment in over four years – fuelled fears of a US recession, wiping almost 2% off the Dow Jones index and leaving the FTSE 100 marginally in the red for the year.
The employment report was shocking. June and July’s payrolls were revised lower, showing that the job market has been weakening for months. What’s more, the August report merely reflects the first part of the credit squeeze. The housing sector is nowhere near bottom while financial sector pink slips will proliferate over the next few months. Moreover, many employers will be feeling the pinch as they struggle to raise money from “nervous banks and frosty credit markets”, says Gerard Baker in The Times.
Weakening employment undermines (already weakening) consumption, which in turn has been propped up by higher house prices; John Mauldin on Investorsinsight.com notes that spending financed by mortgage equity withdrawals has added about 2% to GDP every year for the past five. “That is now evaporating.” The bottom line? A recession looks all too plausible. John H. Makin of the American Enterprise Institute sees weakening consumption and slowing business investment amid tighter credit conditions pushing growth into negative territory in the fourth quarter. Merrill Lynch’s David Rosenberg puts the probability of a recession at 65%.
No wonder, then, that markets are hoping for an aggressive rate cut of 0.5% at next week’s Fed meeting. But will this help much? For starters, the credit tightening of the past few weeks amounts to a 1% rise in interest rates, as Rosenberg has pointed out. And a lower interest rate won’t bail out the housing market, says Mauldin. The 20% of homebuyers over the past two years who snapped up houses thanks to poor lending practices, a key driver of the market, aren’t coming back. Nor are lower rates a panacea for the credit crunch. They won’t change the fact that liquidity isn’t the problem, but trust. Financial institutions are loath to lend or borrow because they are unsure of each other’s subprime exposure; hence the spike in short-term interbank rates.
The potential knock-on effects of cash hoarding at banks are now in the spotlight: about £70bn of European commercial paper is up for renewal this week. If the banks can’t refinance the loans, they will have to swallow them. “If, as seems certain, the banks are forced to honour all these obligations at once, it could make the financial earthquakes of August look like mere tremors,” reckons Dan Roberts in The Sunday Telegraph. The trouble is that “even if they find room on their increasingly stretched balance sheets, there will be precious little money left over to lend to anyone else”.
Amid all this doom and gloom, however, European equity strategists at Morgan Stanley (who presciently recommended selling in June) have been thinking big. If markets pull through the current financial crisis and an uptrend resumes, as they expect, then equities are likely to embark on “a mania of epic proportions” akin to the tech craze after the 1998 jitters subsided. Optimism will spread as the uptrend will be seen as “unbreakable”, having survived the credit crunch; emerging markets will be the next big thing; and retail buyers will pile into markets. The MSCI Europe index would gain another 21% from here.
The strategists would turn more cautious however, if the US appears to be heading for recession, which they currently don’t expect. “It will all end in tears eventually”, but not before a final spurt of the bull run. It’s an interesting idea, but given the darkening outlook, markets seem unlikely to bounce back from this crisis as they did in 1998 anytime soon. The bull run, in short, is already ending in tears.