My Diary 361 --- Section (1) Subprime changed the Outlook

My Diary 361 --- Section (1) Subprime changed the Outlook, Reading the Hard-to-read, The two forces play

December 5, 2007

My general impression after the recent China Forum held by Euromoney, ICBC and HSBC is that there is an obvious gap of understanding China between foreigners and domestic policy markers. It still needs more times for the rest of world to understand what has happened and what is going on in China. Foreigners should not bring their western experience to frame the roadmap and direction of China, while Chinese should open their minds to learn from external world and manage the pace of growth in sync with domestic development cycle.

I have a strong feeling that nowadays, the world is worrying the “China’s Competition”. Not too far in the future, the world may need to worry about “China’s slow-down”.  However, at this stage, the priority is to think about what will look like for the year of 2008.

So, let us take a close examine at the US economic outlook, subprime/credit pains as well as the market liquidity conditions. Before put down my ink, one thing to keep in mind is that forecasting the US economy is a challenging business at the moment. The impact of financial market turbulence from August continues to be felt in the real economy.

Section (I) Economy Outlook

Subprime changed the Outlook

For the world economy in 2008, the most important question so far is the impact of the current mortgage-based credit crisis and the consequent influence of US economic growth. If the Fed can respond quickly enough to the developing financial storm to prevent further contagion and sustain domestic purchasing power, then the US may have a reasonable prospect of avoiding a recession. In that case there would be a substantial rebalancing of growth and redirection of credit away from housing and consumer spending towards exports and non-residential investment spending by the non-financial corporate sector. So far this combination has kept US growth remarkably buoyant despite the credit crunch since August, but it is becoming less and less certain that this paradigm can be maintained.

A reality check is that the current downturn in the US housing market and the crisis in the sub-prime financing sector have radically altered the economic outlook both in the US and in Europe and the UK where consumers are heavily leveraged. At the mean time, the losses from the subprime debacle have extended more widely. The more financial institutions write down their assets to more realistic values, the less willingness to grant credit to borrowers as banks tighten their lending conditions. Thus, unless offset by steep declines in central bank interest rates, credit conditions will become much tighter. Typically this has a direct impact on asset prices and spending of all kinds in subsequent months…… The world is approaching that kind of tipping point just now.

Moreover, the recent squeeze in the money markets has shown that the risks are now substantially greater, and there is a further risk that central banks could, by failing to cut rates quickly enough to offset the spreading weakness, exacerbate the downturn. For example, in November 3M USD LIBOR moved above 5% (compared with a Fed funds target of 4.5%) and 2-year credit swap spreads rose above 100 bp compared with normal levels of 30-40 bp. These signs of stress in the money and credit markets imply further weakness ahead both for economic activity and inflation unless rapidly counteracted by central bank easing. Based on these readings and the current high degree of uncertainty, it is especially difficult to make single-point forecasts for economic growth and inflation at this time.

Reading the Hard-to-read

The economic signals have been hard to read for two reasons --- 1) the emerging market has been showing signs of decoupling so far, and may well continue to do so; 2) there was ample liquidity growth both in the developed economies and in the emerging market to ensure continued economic expansion and the avoidance of recession. In particular, US export growth and business investment spending associated with exports or with the non-residential sector would be enough to counteract the weakness in housing and related parts of consumer spending.

In the currency arena, the US Dollar has recently weakened sharply as foreign inflows to the US have slowed. The reason why the inflows have slowed relates directly to the subprime mortgage crisis : 1) there has undoubtedly been a decline in confidence in USD-denominated instruments, as well as increased concern about the health of some major US financial institutions; 2) the widespread expectation that the Fed will cut interest rates again undermines confidence in future returns in USD.

However, most people will have been astonished by the Q3 US real GDP data which produced an annualized growth rate of 3.9%, associated with annualized productivity growth of 5.3% for the business sector. How could it be that the US generated such high rates of growth in the midst of a credit crisis? The answer is that while consumer spending contributed a fairly normal 2.1% to growth (thanks to firm employment growth and decent wage growth), non-residential investment contributed 0.82% and net exports contributed 0.93%. Already the current account deficit has narrowed from 6.8% to 5.5% of GDP. Thus, it is reasonable to expect that a continued performance on this scale would mean that exports (which are 3X of housing in the GDP) would contribute more to GDP than housing subtracts from it.

The two forces play

In the other hand, in past cycles, consumer spending did not depend on HEW, the major drivers of consumption spending being job growth and wage growth. Similarly in this cycle, surveys suggest that not more than about 20% of HEW was ever used for consumer expenditures. These arguments remain valid. Thus, the key remains on whether the banks’ write-offs became large enough to curtail their willingness to extend credit, then the authorities would need to respond rapidly by cutting rates before credit tightness squeezed the overall economy. We are now at a point where the banks are indeed becoming capital-constrained, and there is a real possibility that one or several of the major banks will be forced either to cut their dividends or to raise additional capital in order to maintain their capital ratios

How these two forces play out over the next few months will be crucial to whether or not the US avoids a recession. On the one side exports are surging under ideal conditions: on the price front the US currency has weakened sharply, and at the same time on the volume front the strong growth of foreign economies promises a narrowing of the US trade gap on a scale only seen in the late 1980s, and therefore continuing powerful positive contributions to real GDP growth. On the other side, capital-constrained financial institutions, licking their wounds from mortgage-related write-offs, could contract or slow their balance sheet growth enough to curtail money and credit growth for the economy as a whole(Today, the 3M LIBOR is at 5.15 vs 3M UST Bill at 2.99). In this event steep cuts in rates would be needed from the Fed to maintain the growth of domestic purchasing power.

Bottom-line: The US economy will highly likely to grow below par caused by the housing-induced weakness, but may not slide into recession. Externally, strong growth in China and India and much of non-Japan Asia can be expected to continue, although given the extended state of asset values financial markets in these regions will almost certainly be affected by the slowdown in the developed economies…… keep in mind that economic decoupling does not necessarily imply financial market decoupling.

In the near-term, market focus will be on reports from retailers on the post-Thanksgiving sales performance. Beyond that, I still think that labor market data remain the single most important indicator (NPF report on December 7). Historically, the Fed almost always is easing when unemployment rises, and almost never cuts when it's not. It’s ironic that unemployment (the most lagged cycle indicators) provides such strong guidance to an ostensibly forward-looking Fed. In contrast, forward-looking indicators do not.

Good night, my dear friends!