‘Brother, can you spare a dime?’
Or should it be, “Brother can you spare $53tr?” (yes, that’s $53,000,000,000,000 to you and me) We were drawn, inevitably given the dire state of the underlying US economy, to the latest musings of Mr David Walker, the man with the unassuming name but the important title.
Mr Walker is the US comptroller general, in essence the country’s chief accountability officer at the Government Accountability Office. Quoted in the Birmingham (Alabama) News Mr Walker, speaking to his home town Rotarians, likened that massive figure for total US unfunded liabilities (Medicare, Social Security, public pension debts etc) to being equivalent to a mortgage of $455,000 for each US household…but with no house to back up the mortgage!
If left unchecked Mr Walker believes that the total for liabilities and unfunded commitments could rise by c$2-3tr a year every year, placing an overwhelming burden on those future generations which will, ultimately, have to pick up the tab. According to the Birmingham News report, Mr Walker believes that if nothing is done to address the deterioration in the US fiscal position in the next five years the country faces an unavoidable economic catastrophe which could plunge the worlds largest economy into depression.
Not heard much on this subject from the US presidential hopefuls on the Primary circuit? We thought not! Hardly a surprise really given that the government is again mulling ways of throwing money at the slow motion “train wreck” that the residential property market and its traumatised victims have become. At the same time presidential wannabes on the campaign trails continue to push for additional help for the hard-pressed homeowner, while Cleveland City Council is busy bulldozing former sub-prime properties on the basis that it believes that the additional cost of policing potential ghetto areas will be disproportionately high!
“No magic bullet”
Hank Paulsen, US Treasury Secretary accepts that the Federal Reserve is “on the case” and is likely to keep cutting base rates aggressively through 2008. So aggressively in fact that it is entirely possible that in real terms, US base rates could actually fall into negative territory. There is nothing US authorities can do to offset recessionary conditions at this point. Base rate cuts may help boost sentiment but it takes between nine and twelve months for their impact to feed through to the real economy.
On fiscal policy, a tax rebate plan is proposed but here too the fact that Congress is no longer dominated by the Republican Party suggests that what ultimately gets proposed will prove both temporary and the product of a compromise between both sides…and all the weaker for that. In consequence we anticipate a stimulus package valued at no more than $100bn which sounds a lot but remember, in 2001 president Bush cut tax by $120bn and it made no difference either to the pronounced economic slowdown that ensued or to the anodyne recovery over 2002-03.
The $64,000 question
Or was it, in the context of the above, the $53tr question? Whatever the number is, the question is critical. It is too late, now, to be obsessing about whether or not the US is in recession. The key question is when will the upturn take place and how aggressive will that eventual upturn be. A quick glance at the US futures market indicates that futures are indeed pricing for a trough in US economic activity over Q2 / Q3 2008 at which point the aggressive base rate easing process, which began back in September will begin to kick in.
Although most independent economic forecasters are still mulling over the recession question, futures pricing indicates that market operators are looking for an aggressive “V” shaped recovery over the second half of this year and into 2009. Equity markets are likely to forecast the trough in the macro environment and then recover strongly. That seems to be where cosy consensus lies at present, with investors hunkered down with capital preservation, a focus on income generation, low beta defensives etc until the storm passes. At that point hedge funds will cover their short positions and high beta, cyclicals and financials will whirl higher again.
Whilst we agree that lower base rates will certainly help pave the way for a recovery we are far less convinced that the recovery will be anything other than a pretty feeble affair. Futures pricing pays scant, if any, attention to financial market history. What we knew all along and most are now waking up to is that this is not a mere mid-cycle recovery or “soft landing” this is an atypical recession the aftermath of which could leave the US growing at a sub-trend rate for many years to come. What we are now witnessing is the end to an unprecedented asset price bubble and the bursting of an equally unprecedented period of credit creation.
This is highly significant. The deleveraging process is quintessentially deflationary and whilst US banks are at last acting decisively to write-off exposure to exotic financial instruments, unlike their Japanese counterparts in 1989-1990, the tighter availability of credit, coupled with a much more risk-averse financial sector indicates to us that those sectors which benefited from the bubble eras for so long (financials, consumer stocks, housing and commercial property) could stay in the doldrums for a very long time.
Certainly we expect corporate activity. These sectors have been driven down to knock-down ratings by aggressive equity market action, probably to levels where industry bosses just cannot resist participating in consolidation. Whilst equity market speculators may prepare for that they should also be reminded that valuations are where they are for a reason and that reason could take a long time fully to dissipate.
Unlike 2000, this recession is being driven by weakness in consumer spending. We often hear why this time, due to lower levels of inflation and interest rates, it isn’t going to be like 1989-1990. We are not convinced. Certainly rates are falling but here’s the rub, many homeowners will not benefit because the value of their houses are falling in line with their credit scores. On the other side, buyers are struggling to achieve satisfactory credit scores and mortgage applications are being thrown out. This is happening in the UK and across Continental Europe, just as it is in the US.
The mismatch between sellers’ expectations and buyers’ ability to purchase is becoming canyonesque. Average holding periods on estate agencies books are lengthening and the residential property market in the UK is on the point of deflating aggressively, just as it is already doing in the US. Given that most people’s single biggest investment is their home and that much of their participation in the consumer binge of the past decade has been financed by increasing levels of indebtedness the outlook for that 66% of economic activity accounted for by consumption is bleak and likely to be under severe pressure for quite some time.
Our conclusion is that the debate should move on. We are no longer interested in whether or not the US economy is in recession (we are quite interested in any article indicating that the UK economy might be heading into recession if indeed such exists?). We are increasingly interested in the ensuing upturn. Will it be hot…or not? We are increasingly drawn towards the latter conclusion, given that we believe that the pressure on Western governmental and consumer finances has become intolerable.
We expect personal savings levels to be rebuilt, on both sides of the Atlantic and government spending to be limited by the constraints imposed by necessary fiscal orthodoxy. The combination of high personal debt levels, increasing aversion on the part of financial institutions to the exotic instruments which characterised the bubble of the past and rising pressures on Western governments all point to a long, hard, slog back from the abyss.
By Jeremy Batstone-Carr, Director of Private Client Research at Charles Stanley