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Friday, February 09, 2007


more on impending recession

via yahoo -- the latest rbc report on consumer confidence shows that, while overall confidence has swelled to a new cycle high and current conditions are at 114, future expectations continue to diminish.

Another index tracking peoples' feelings about economic conditions and their own financial prospects over the next six months dropped to 69.2 in February, suggesting consumers are somewhat apprehensive about what the future may hold. This expectations index had surged to 83.8 in January after a long period of weakness.

the differential of future and present is thus (-44.8). this report is not the conference board report which i generally follow, which has been indicating growing odds of a severe consumer recession for some time.

i also sat in on a presentation yesterday of an event-driven/distressed manager who runs a $600mm fund and is raising capital. the difficulty she has found in finding effective hedges for her style has led her to an economically-sensitive position -- the experience of 2001-2 is still fresh in her mind, and she further exhibited a reactionary nervousness in 2005 by going to a 40% cash position (though that intuition clearly did not pan out, despite very convincing signs that it would -- quite possibly in retrospect the petrodollar put can be the explanation of the markets refusal to yield, as it was from a december 2004 low of ~$40/bbl that oil shot up to $60 by july 2005 and the high 70s in july 2006).

her pessimism was more understated than my own, but she too explicitly understands all too well that yield curves do not remain inverted forever, and the process of unwinding them is not pretty. beyond noting that spreads are so narrow that they cannot really get narrower in a pragmatic world, she is also seeing increasing nervousness among financiers in the distressed, m&a and private equity fields -- for example, refi deals that were getting done last year to keep companies out of bankruptcy by extending their debt obligations out over several years are simply not finding bankers now -- and interprets this to mean the onset of a general credit contraction.

yesterday was also another red-letter day in the subprime market.

HSBC Holdings PLC, Europe's biggest bank and a major player in the U.S. subprime mortgage, disclosed it would need to set aside almost $10.6 billion to cover loans the bank expects won't be repaid.

Separately, New Century Financial Inc., a subprime lender based in Irvine, Calif., said it lost track of how severely the loans in its portfolio were losing their value.

Investors who buy the company's mortgage loans in the secondary market have been selling the loans back when borrowers default, New Century said. The company said because of accounting errors it underestimated how many loans would be resold and how much value those loans would lose before ending up back in New Century's portfolio.

New Century's stock closed down more than 35 percent Thursday, dragging the entire industry with it. Insurers like PMI Group Inc., Radian Group Inc. and MGIC Investment Corp., which write policies covering mortgage debt, also fell.

in conjunction with the havoc being visited on the subprime mortgage market, these are important signs of an economic rollover.

the stock market is so far showing few signs of slowing, with participation remaining relatively broad. but bond yields may have made an important top in june of 2006, which pimco's bill gross subsequently identified as a bond bull opportunity. in his latest missive, he remains quite wary while noting that economic fundamentals aren't driving bond prices anymore -- leverage and financial flows are, while the stock market is getting further support from buybacks.

In effect, despite the chicken and egg aspect of why the trade deficit exists – because foreign investors want to invest in the U.S. or because U.S. consumers want to buy things – there is likely near unanimity that it is now responsible for pumping nearly $800 billion of cash flow into our bond and equity markets annually. Without it, both bond and stock prices would be much lower, the $800 billion for instance representing 3 - 4x our current federal budget deficit. Almost perversely, then, an increasing current account deficit supports and elevates U.S. asset prices as the liquidity from it is used to buy stocks and bonds.

Notice that in 2001 a monthly trend reversal of $10 billion ($120 billion annually) neatly coincided with a 20% decline in stock prices and a flat bond market despite a developing recession. While the real economy was certainly influencing stocks and corporate profits, the effect of financial flows was also becoming apparent, certainly in the bond market and suspiciously so in stocks as well. The draining of $120 billion from the foreign cash flow pump appeared to have magnifying, “it’s different this time,” effects on both. The trade deficit resumed its downward trek in 2002 and as it did, stocks recovered and a strange phenomena began to be observed in the bond market – what Ben Bernanke was to call a global savings glut – which because it was recycled primarily into U.S. financial markets via an accelerating trade deficit – resulted in artificially high bond prices and low interest rates. Bernanke’s “glut” effect appears to have continued up until the present day as unusual and persistent negative yield curves in the U.S. have had little of their normal cyclical dampening effect on asset prices and the real economy.

Combined, the total rise in corporate share buybacks and the financing for bond and stock markets via the increasing trade deficit have injected an average of perhaps $1 trillion annually of purchasing power into our asset markets since the end of the 2001 recession. Because hedge funds and levered players of all types have been aware of this trade deficit/share buyback “put” and have acted upon it, the incalculable but conservatively estimatable pump from these two sources alone have poured in several trillions of purchasing power per year. Take that money and use it to invest in further high powered and levered financial instruments such as CDOs, CPDOs, and 0% down funny money mortgages of all varieties and you can understand why asset markets have done so well in recent years, and why, as my initial Outlook sentence suggested, it is so hard to analyze “value” in asset markets these days. Prices are increasingly being determined by value insensitive flows and speculative leverage as opposed to fundamentals.

gross is indicating that the music will stop when the contributors to the current account deficit -- petrodollar and asian import recycling -- falter. and this is an end which gross too, like our friendly distressed manager, now sees signs of.

there’s an ill wind blowin’ this time around, or to put it another way perhaps, many of our proverbial 100 bottles of beer on the wall may have been taken down, drained, and have totally inebriated the asset markets to the point of preventing further significant price advances. Drunks do, after all, at some point stagger home, roll into bed, and at least sleep it off for a good number of hours. The suggestion of no more bottles of beer on the wall comes from several sources, the first of which appears in Chart 1 as a recent reversal in the trade deficit. While some of this improvement is due to the standard dollar weakness of the past 12 months and its dampening impact on imports, much of it is due to the decline of oil since August/September of 2006. ... [T]he recent $20 reversal in per barrel oil prices results in a reduction of $100 billion or so in the annual trade deficit, and a like amount of liquidity extraction from bond and stock markets, much more if associated leverage is unwound. Granted, some would claim that there will still be $700 billion or so of purchasing power coming into our markets, but higher asset prices in a levered economy are dependent on greater and greater injections of liquidity, not less. Should oil hold in the $55 range, this extraction of high powered 100+ proof alcohol from the markets will be noticeable.

that is, a stanching of the petrodollar put can break the markets.

The second source of vulnerability comes from the corporate buyback stash, a trend itself as Chart 3 points out that is beginning to level off and reverse. Peter Bernstein, in a recent January missive, suggests that corporate profits as a % of GDP cannot continue to grow at the same pace. “Everybody else” he writes “is going to want a piece of that juicy action. Employees will demand higher wages, customers will demand lower prices, and the government will levy higher taxes.” ... Corporate profits are significantly influenced by the growth rate of real and (importantly) nominal GDP. As Chart 5 hints, should nominal GDP decline into the 4-5% range over the next several years as discussed in last month’s Investment Outlook, corporate profits and ultimately the juice for share buybacks will be affected as well. Chart 5, points to the possibility of reducing profits as a % of GDP by as much as 2% over the next several years if 5% nominal is where we are headed. If so, then share buybacks could be cut back by a good $100+ billion in the near term future.

that is, recent disappointments in q406 profitability are just the beginning of a gdp growth decline that will gradually end the stimulus of share buybacks.

UPDATE: big picture cites the slowdown in earnings growth.

timing is everything, of course, but one can look at the predictions of gdp growth and the dependency of ever-larger current account deficits on $80 oil and know that there isn't much more room for this cycle to run up. paul mcculley notes that the markets have priced fed easing into this year -- thus doing the work of easing preemptively -- without much assurance that the fed will actually ease in 2007. the easy money condition already in place requires fed justification soon to avoid being withdrawn.

Thus, we have a paradox: the Fed doesn’t want to signal ease, because the data are looking better, but the data are looking better because the market is explicitly betting on Fed easing. In fact, I believe that it is not just the yield curve that is making that bet, but “risk assets” more generally, notably ebullient stocks with low volatility and tight corporate credit spreads (which are linked, of course, by the Merton thesis1).

This paradox will not long endure, in my view: either the Fed will “validate” the markets’ pricing of easing, or the markets will un-price that easing, tightening financial conditions. In the former scenario we will all live happily ever after, or something like that, sometimes labeled a Goldilocks soft landing.

In the latter scenario, we will all live happily ever after, too, but only after an unnecessary interlude of melancholy, where the markets undo the easing “work” they have done for the Fed, re-opening downside risks to economic growth that provide justification for the Fed to do its own easing work.

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