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Danger ahead: The prospect of recession again confronts America

January 04, 2008 | Financial Times

America has entered 2008 in greater danger of recession than at any stage since the collapse of the internet bubble in 2000-01, as the world’s largest economy struggles to maintain growth in the face of the credit squeeze, a housing slide and high oil prices.

Fourth-quarter growth for 2007 looks likely to come in at 1 per cent or less on an annual basis, while the current three months are unlikely to be much better and could even be worse. The only question is whether the economy will struggle through this sickly period and gradually regain strength over the course of the year – or succumb to its ailments and, with growth turning negative, fall into recession.

According to the latest NBC News/Wall Street Journal poll, more than two-thirds of Americans believe the US is either in recession now or will be in 2008. Some of the country’s most famous economists – including Alan Greenspan, the former Federal Reserve chairman, as well as Lawrence Summers, former Treasury secretary, and Martin Feldstein, president of the National Bureau of Economic Research – put the odds of recession at close to 50-50.

Editorial Comment: Bankers are fallible - Jan-02Poor Christmas sales leave stores hungry - Dec-27US manufacturers warned on insularity - Dec-18Data fail to dispel US housing gloom - Dec-18US consumer spending resilient - Dec-14US import prices surge by record rise - Dec-12This is striking, because economists say it is almost impossible to forecast recessions and, in the last quarter of a century, there have been only two brief and shallow periods of negative US growth. “We have had an awful lot of bad news,” says Mr Feldstein. “It is not a sure thing we are going to have a recession, but nor do I have great confidence that we are going to escape.”

Bill Gross, chief executive of Pimco, the world’s largest bond fund manager, goes as far as to say he – like many ordinary Americans – thinks a recession has already started, in December.

Ominously, the credit markets have started to price for recession, with risk spreads rising on securities that have no direct connection with the troubled housing or financial sectors. Yet the Fed and most economists still say the single most likely outcome is that the US will make it through a rough patch and regain strength by the second half of 2008. In addition, while credit markets appear to be pricing in an increasingly high likelihood of recession, equity markets and the oil market – while off their highs – are not.

Wall Street is divided: Morgan Stanley is forecasting a recession, joining Merrill Lynch and Goldman Sachs, which are long-time bears, but JPMorgan and Lehman Brothers are noticeably less gloomy. Business leaders are split, too, with finance and housing executives much more pessimistic than their counterparts in other sectors. “If you talk to people in financial markets, they see recession as a virtual certainty,” says Martin Regalia, chief economist at the US Chamber, a business organisation. “If you talk to people in economic markets, they see positives in the economy that tend to offset the negatives, so you get slow growth rather than no growth.”

Who turns out to be right will depend on a titanic tug-of-war between the forces dragging down US growth and the continued strength and resilience of key sectors of the economy. The result will be of great importance to a world that – for all the dazzling growth of China and other emerging economies – would struggle to absorb a full-blown US recession.

At the heart of the problems is the bursting of the housing bubble that helped to power American growth since this economic cycle started six years ago. The end of the bubble has brought a brutal slide in home construction, house price falls that threaten to undermine household wealth and consumer spending, and turmoil in the credit markets that are used to finance housing.

The US has endured financial crises before with little or no effect on the real economy – for example, in 1987 and 1998. But these were autonomous financial crises with little connection to the underlying US economy. This financial crisis is different. It is defined by the bursting of twin bubbles in housing and the credit markets – bubbles that were deeply interconnected.

Easy money and the collapse of discipline in the credit markets helped push house prices to unsustainable levels. But when the residential property bubble finally burst it took the credit market bubble with it – decimating the value of hundreds of billions of dollars of securities linked to subprime loans that were safe only as long as house prices kept going up.

Now the credit crisis poses a direct threat of its own to the US economy. The secondary market for mortgage securities is dysfunctional, throttling the supply of many types of home finance and thereby putting further downward pressure on the housing market. Meanwhile, banks are being forced to take tens of billions of dollars in housing-related assets, once held in off-balance sheet vehicles, on to their books, while incurring massive writedowns on these and other securities. Mr Greenspan says losses on subprime and related securities are likely to reach $200bn (£101bn, ?136bn) to $400bn, though the final extent will not be known until house prices stabilise.

For all the supposed benefit of securitised markets in distributing risk around the world, it appears that a large share of the ultimate risk remained with big US commercial and investment banks. So analysts fear that balance sheet strains will force these banks to pull back on lending both to consumers and to businesses outside the housing sector, creating a generalised credit crunch. “This is clearly happening,” says Mr Feldstein. “Banks are shepherding their capital. As they take these investment vehicles on board and realise they have got outstanding obligations where they provided lines of credit, they are going to be more cautious about extending credit in general.”

One sector that looks particularly vulnerable to any pullback in credit is commercial property, which has boomed over the past year, helping offset the decline in residential investment and keep building workers in employment. Housing construction continues to plunge, while the rate of decline in house prices seems to be accelerating, with some experts forecasting falls of 20 per cent or more in real terms over a number of years.

As late as the third quarter – when household wealth hit a record $58,000bn – house price declines were offset by gains on equities and other business assets. But in a tough macroeconomic environment it seems unrealistic to rely on equity gains to offset falling house prices from now on.

Most economists think consumers will respond to falling house prices by spending less and saving more. The question is, by how much? The Fed estimates that consumer spending rises or falls by $3.75 for every $100 increase or decrease in housing wealth. But some studies suggest the effect could be much larger. Moreover, if 2007 does not turn out to have broken the record, this is likely to be the first year since the second world war to see an outright annual decline in house prices. No one knows what sort of response actual house price falls would produce from homeowners.

“It is not all subprime,” says Jeff Frankel, a professor at Harvard. “Even without that, the magnitude of the fall in house prices itself is a prime candidate to cause a recession – [through] what it has done to the construction industry and household finances. Then there is oil.” The high price of oil and food is putting additional strains on consumer spending, reducing disposable income and eating away at real wage gains. Richard Berner, chief economist at Morgan Stanley, says the rise in energy and food prices between June and December alone “drained about $45bn or 0.4 per cent from consumer discretionary income”.

Traditionally, economists would expect the price of oil to fall when the US economy is weak, freeing up some disposable income and acting as a natural stabiliser. But strong demand in China and India plus geopolitical tensions in the Middle East are keeping oil hot – compounding the housing and credit problems.

Given the pressure from housing, the credit squeeze and oil, the interesting question, as Mr Greenspan puts it, is why the probability of recession is not much higher than 50 per cent. One reason is that the US had made some headway in dealing with the excesses in housing before the credit crisis erupted this summer. Home starts have already fallen from an annualised monthly rate of 2.3m units in January 2006 to 1.2m in November 2007. The construction sector has subtracted from growth for roughly a year.

Home starts may have to fall a good deal further. But the fact that the US economy has already absorbed a halving in home construction greatly improves the chances of avoiding recession. If it had to begin now, recession would be all but guaranteed.

Moreover, as Mr Greenspan pointed out in recent interviews and speeches, the business sector is quite insulated from the effect of the credit squeeze. Corporate balance sheets are unusually strong, companies have plenty of internally generated cash – as witnessed, for example, in share buybacks – and took advantage of low borrowing costs prior to the latest financial turmoil to lock in cheap long-term funds.

Indeed, there is still only limited evidence of the credit squeeze extending to non-housing-related sectors. Mr Regalia at the US Chamber says: “Banks across the board are tightening credit standards, but it does not imply a broad-based credit crunch for people and businesses with good credit histories and strong balance sheets.” He says surveys of small businesses show that funds are still available at decent rates.

This view is reflected inside the Fed where – contrary to Wall Street myth – the so-called “academics” on the board of governors have been willing to consider pre-emptive rate cuts based on forecasts of future spillovers from the credit crisis. But many regional Fed presidents – with strong ties to local business leaders – have been reluctant to ease too aggressively, pending more evidence of such spillovers outside housing.

The longer credit markets stay dysfunctional, the greater the likelihood these spillovers will eventually materialise. Put another way, either the credit markets will ultimately drag down the non-housing economy or the non-housing economy will ultimately drag the credit markets upward.

Indeed, the economy may be able to hang on long enough to win out. The export sector is booming, helped by the decline in the dollar over the past couple of years coupled with a slowing in US growth relative to that of other big economies. Looking ahead, the contribution from net exports to growth in gross domestic product will probably decline as growth eases abroad. But exports should still contribute something between a quarter-point and a half-point to growth in the coming quarters. This will provide a buttress at a time when domestic demand is very weak.

Strong overseas earnings, flattered in conversion by the weak dollar, are also propping up the stock market, guarding against a second blow to household wealth. Business investment is muted and the latest durable goods report raises concerns that companies may be pulling in their horns. But there is little sign that investment is falling off a cliff.

Ultimately, however, the fate of the US economy lies with the consumer. “The consumer so far is hanging in there but is not in great shape,” says Mr Feldstein.

Consumer confidence is weak: the latest University of Michigan survey puts sentiment only a fraction above its post-Hurricane Katrina low. Yet, for all the gloom in surveys, actual consumer spending remains quite resilient. November’s retail sales figures were much stronger than expected; the early data on December look a good deal weaker but still not disastrous.

Underpinning this is continued strong growth in nominal income in a still tight labour market, with unemployment at 4.7 per cent. If unemployment started to rise sharply and income growth slowed, the outlook for consumer spending would deteriorate sharply. But while the pace of job creation has slowed, there are few signs of a rapid deterioration in the labour market.

Moreover, there are reasons why companies may be reluctant to shed workers. Since the last recession ended in November 2001, businesses have been unusually cautious about adding employees – leaving them still quite lean in staffing terms. Slowing productivity growth also means that for any given increase in output, companies will need more workers – unlike in the early part of this decade when rapid productivity growth meant they could expand without adding more staff.

Fed analysis suggests that, given appropriate monetary policy, the economy can absorb falling house prices and keep growing – particularly if the decline is not too abrupt. All analysts agree that policy actions by the Fed – and the US government, in what is a presidential election year – could make the difference between recession and recovery.

Peter Hooper, chief economist at Deutsche Bank Securities, says the Fed’s latest move to auction loans into the money market and the administration-sponsored plan to freeze the interest rates on some subprime loans, reducing the expected number of foreclosures, made him cut his estimate of recession risk from 50 per cent to 40 per cent.

Almost all analysts’ forecasts for moderate growth, in the 2 per cent range for 2008 as a whole, assume at least one more Fed interest rate cut – some assume three or more downward shifts. However, if upward pressure on inflation increases – possibly from high oil prices or a weak dollar – the Fed may not be able to cut as much as the market expects, increasing the probability of recession.

Less conventional sources of support could prove decisive. The Federal  Home Loan Banks are funnelling loans into the banking system at an annualised rate of $746bn, according to Fed data for the third quarter. These loans – against housing-related securities – are allowing banks to continue offering mortgages, preventing a sudden stop in housing finance and, so far at least, the failure of any big lenders.

Meanwhile, sovereign wealth funds are pouring billions of dollars into the US financial system in return for equity, recapitalising banks and easing their balance sheet strains. If this happens on a large enough scale, it could ward off a generalised credit crunch.

Yet even in the most optimistic of plausible scenarios, the US will skirt along the brink of recession for a number of months with very weak growth. During this period, it could easily tip over the edge.

Some, including David Rosenberg, chief economist at Merrill Lynch, see it as difficult for the economy to grow at only about 1 per cent for any sustained period without stalling and falling into recession. Others including Ben Bernanke, Fed chairman, say economies do not stall merely for lack of sufficient forward momentum. But all agree that while the US works through a period of very low growth it will be particularly exposed to any additional shocks or an intensification of the existing problems in housing and the financial sector.

“The story of recessions is that unexpected adverse shocks – or a coincidence of adverse shocks – hit a vulnerable economy,” says Larry Meyer, chairman of Macro­economic Advisers and a former Fed governor. “This economy is vulnerable.”

When is it on and when is it over? The arcane art of cycle dating

The common definition of a recession is two successive quarters of negative economic growth. However, the formal definition is more complex.

The Business Cycle Dating Committee of the National Bureau of Economic Research in the US is charged with deciding when recessions begin and end. The committee is made up of top economists operating independently of the government and is chaired by Robert Hall, a professor at Stanford.

It regards growth in gross domestic product in real terms (adjusting for inflation) as the ”single best measure” of economic activity. But it does not rely exclusively on GDP statistics, for a number of reasons. The Bureau of Economic Analysis publishes GDP estimates only quarterly, while the committee works on a monthly basis. Moreover, the GDP estimates are extensively revised over a number of years.

So the Business Cycle Dating Committee uses other metrics as well. It puts “particular emphasis” on personal income (in real terms less transfer payments) and employment. In addition it looks at industrial production and wholesale and retail sales. It also weighs estimates of monthly GDP growth by private sector forecasters.

The last recession, according to the committee, began in March 2001 and ended in November of that year.

If the US falls into a sharp or prolonged recession this time, the judgment will be easy. However, if output growth stalls but jobs and incomes continue to grow, the committee could face a tough decision as to whether to term the slowdown of late 2007/early 2008 a recession or not.

Do not expect an answer soon. The committee normally declares the start of a recession six to 18 months after the event. Since recessions typically last less than a year, this means a recession can be over before it has officially begun.


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