Economic Apocalypse Soon?
Nouriel Roubini – professor at NYU and noted blogger on the global economy – tends to the gloomy but is now seriously worried about where we are headed. With the Economist now out with a front page story on the likelihood of a serious US recession, his views seem to be entering the mainstream.
http://www.rgemonitor.com/blog/roubini
With the Recession Becoming Inevitable the Consensus Shifts Towards the Hard Landing View. And the Rising Risk of a Systemic Financial Meltdown
Nouriel Roubini | Nov 16, 2007
It is increasingly clear by now that a severe U.S. recession is inevitable in next few months. Those of us who warned for the last 12 months about a combination of a worsening housing recession, a severe credit crunch and financial meltdown, high oil prices and a saving-less and debt-burdened consumers being on the ropes causing an economy-wide recession were repeatedly rebuffed the consensus view about a soft landing given the presumed resilience of the US consumer.
But the evidence is now building that an ugly recession is inevitable. Thus, the repeated statements by Fed officials that they may be done with cutting the Fed Funds rate are both hollow and utterly disingenuous. The Fed Funds rate will be down to 4% by January and below 3% by the end of 2008.
More revealing of the change in mood the financial press and some of the most prominent market analysts are coming to the realization that a recession is highly likely. The Economist has a cover story and long piece arguing that a US recession highly likely (and citing this author’s work with Menegatti and our views on the inevitability of such a recession).
More importantly, on Wall Street some of the leading analysts that had been in the soft landing camp for the last year have now moved their forecast in the direction of hard landing. It is not just David Rosenberg of Merrill Lynch who has been informally in the hard landing camp and is now explicitly talking about a consumer recession. It is not just Jan Hatzius of Goldman Sachs who was always more bearish relative to the soft landing consensus and is today explicitly talking about a US recession and a credit crunch reducing lending by $2 trillion.
Even in soft landing houses such as Morgan Stanley and JP Morgan the tone is completely different now. At Morgan Stanley Steve Roach was the in-house bear while Richard Berner (a most sophisticated economist and analyst) was the in-house soft landing optimist. With Roach now gone to run Morgan Stanley Asia, the commentary by Richard Berner has become increasingly darker. And the latest Monday piece by Berner is titled “The Perfect Storm for the US Consumer†where his points on the headwind forces hitting the US consumer are completely overlapping with my analysis of such risks in my recent “The Coming US Consumption Slowdown that Will Trigger an Economy-Wide Hard Landing. Berner starts with
“Serious pressures are mounting on the US consumer on five fronts: Job growth is slowing, surging energy and food quotes are draining purchasing power, adjustable rate mortgages are resetting, lending standards are tightening, and housing wealth will likely decline. Do these dark clouds finally and ominously herald the perfect consumer storm?â€
And he concludes with:
“Risks to the consumer are rising, and the risk of outright US recession is higher now than at any time in the past six years: Housing is in sharp decline, consumers are vulnerable, and companies may cut capital spending and liquidate inventories. A strong contribution from global growth is still a huge positive, but spillovers from US weakness to trading partners may hobble that lone source of strength. These pressures could last longer or be more intense than I expect. And even if the economy skirts overall recession, corporate earnings will likely decline.â€
An even more persistently bullish bank was JP Morgan that kept on warning for the last year that the biggest risks to the US economy was not a growth slowdown but rather a growth pickup and the risk that inflation would surprise on the upside and force a behind-the-curve Fed to raise the Fed Funds rate above 6%. This analysis obviously proved wrong and now the very smart – but mistaken – Bruce Kasman has had to throw in the towel and accept that the downside risks to grow are sharp and that the Fed will cut the Fed Funds rate to 4%. As he put it in his latest note:
US outlook change: More drag, more ease — Drags from energy, and credit tightening push GDP forecast to 1% on average for current and upcoming quarter — Fed is likely to recognize growing downside risk and ease 50bp, to 4% by end of 1Q08 — December meeting outcome remains close, but we now expect 25bp move from a proactive Fed As the US moves through the fourth quarter, incoming economic news remains consistent with our forecast of a growth “pot holeâ€. Powerful drags now in place — from tighter credit conditions and an intensified contraction in residential investment — are evident in the decline in output and employment in the goods producing industries and in a slowing in consumption spending…. …three developments over the past month look set to increase downward pressure on growth.
• Oil on the boil. Global crude oil prices rose more than $10 dollars during October, and has held at an elevated level this month. If current levels are maintained, it would represent a drag on annualized household income of approximately one percentage point between now and the end of the first quarter. This drag, which has yet to have been felt, adds to the forces weighing on consumer spending.
• Temporary lifts to fade. Although an upward revision to 3Q07 growth to close to 5% now looks likely, this outcome is partly borrowing from growth in the quarters ahead. Defense spending, which has grown at a 9% annualized pace in the past two quarters, is almost certainly due for a pause. And a significant upward revisions to inventory building in 3Q07, points to an adjustment ahead. Indeed, the latest rise in ISM customer inventory index, combined with auto production schedules pointing to cutbacks through year end, suggests that stockbuilding is likely to subtract from growth this quarter and next.
• Credit tightening broadens. Results of the Fed’s latest Senior Loan Officers Survey indicates that credit conditions are tightening broadly and that demand for credit is slowing. Most recently, credit conditions have tightened significantly for commercial construction projects with CMBS securitizations plunging over the past couple of months. While the quantitative effects of this tightening is hard to measure, credit conditions look set to remain tight for a longer period than anticipated in our current forecast.
Taken together, these developments warrant a downward revision to an already sluggish growth forecast for the coming quarters. The trajectory of GDP growth is being lowered by one half percentage point per quarter through the middle of 2008, with the path of consumption, stockbuilding, and nonresidential construction activity shouldering much of the burden. During this quarter and next, GDP growth is expected to be particularly soft, averaging a meager 1% percent. The underlying resiliency of the US corporate sector will be severely tested through a period in which profits are expected to contract. While we continue to believe that firms are unlikely to retrench in a manner that produces a recession, the risks of a recession remain uncomfortably high. We currently place the risk of a recession taking hold in the coming two quarters at 35%. The Federal Reserve has made it clear that it is willing to act preemptively in the face of elevated recession risks. Having moved 75bp in two meetings, its October statement signalled that it viewed the risks to growth and inflation as balanced — a message that the bar for further easing was high. Against this backdrop, the Fed will need to shift materially its perceptions of risks about the outlook in the direction of our forecast change to produce ease. We now believe such a shift will take place and produce 50bp of additional ease by the end of the 1Q08.
When the most prominent and respected and sophisticated “soft-landing†analysts on Wall Street turn this bearish and start talking about high probability of a recession and downside risks to growth and of a consumer recession you know that these are code words for admitting implicitly – short of an official and explicit endorsement of such view that very few analysts of Wall Street can afford to have because of sell-side research constraints – that they believe that a recession is highly likely.
So at this point the debate is less and less on whether we are going to have a recession that looks inevitable; but it is rather moving towards a debate on how deep, protracted and severe such a recession will be. But the financial and real risks are much more severe than those of a mild recession.
I now see the risk of a severe and worsening liquidity and credit crunch leading to a generalized meltdown of the financial system of a severity and magnitude like we have never observed before. In this extreme scenario whose likelihood is increasing we could see a generalized run on some banks; and runs on a couple of weaker (non-bank) broker dealers that may go bankrupt with severe and systemic ripple effects on a mass of highly leveraged derivative instruments that will lead to a seizure of the derivatives markets (think of LTCM to the power of three); a collapse of the ABCP market and a disorderly collapse of the SIVs and conduits; massive losses on money market funds with a run on both those sponsored by banks and those not sponsored by banks (with the latter at even more severe risk as the recent effective bailout of the formers’ losses by theirs sponsoring banks is not available to those not being backed by banks); ever growing defaults and losses ($500 billion plus) in subprime, near prime and prime mortgages with severe known-on effect on the RMBS and CDOs market; massive losses in consumer credit (auto loans, credit cards); severe problems and losses in commercial real estate and related CMBS; the drying up of liquidity and credit in a variety of asset backed securities putting the entire model of securitization at risk; runs on hedge funds and other financial institutions that do not have access to the Fed’s lender of last resort support; a sharp increase in corporate defaults and credit spreads; and a massive process of re-intermediation into the banking system of activities that were until now altogether securitized.
When a year ago this author warned of the risk of a systemic banking and financial crisis – a combination of global liquidity and solvency/credit problems – like we had not seen in decades, these views were considered as far fetched. They are not that extreme any more today as Goldman Sachs is writing today on the risk o a contraction of credit of the staggering order of $2 trillion dollars in the next few years causing a severe credit crunch and a serious recession. As I will flesh out in a forthcoming note the risks of such a generalized systemic financial meltdown are now rising. Hopefully by now some folks at the New York Fed and at the Fed Board are starting to think about this most dangerous systemic financial crisis that could emerge in the next year and what to do to prepare for it.
That is for sure one gloomy report. Hidden within all that, is the trigger for it all. At least from my perspective, the housing wealth that was fueling the boom over the last few years.
The trigger point is the lending strategies that helped fuel the boom. Low rates helped push it along, but ultimately it was the culture of shaky lending practices. And then the subterfuge in the externalizing of these sub-prime money lending through giving everything a triple ‘A’ rating and pushing it out into the global space. (these rating agencies should be held accountable and investigated by a global task force) The markets failed, both in lending practices, and the rating of the risks. So in the end the invisible hands do not work and again the financial system gets thrown into turmoil. Who is holding what kind of debt is anybodies guess. I can imagine with the millions of transactions and the now meaningless ratings of these debts, that there are some pretty busy accountants out there. The key is the regulation of these markets was left up to regulatory regimes located within the business world and they failed miserably. So all those out there in the Friedman world take note- there is no such thing as invisible hands, somebody has to regulate the machinations of the financial system. And it had better be a regulatory regime that can be trusted and does not have profit as its motivation. The question is when will we learn this lesson. These are some fairly expensive lessons we have been through in history, and given the impending ecological crisis, it is time we learned and moved on. If only it were that easy. Maybe the next bubble will occur within the eco-friendly industry, at least some of the spin-offs may have some positive externalities when it all comes falling down.
Scary stuff.
I disagree with the first commenter. Shaky lending practices would not have happened had interest rates not been so ridiculously low. When the Fed lowered the overnight rare to 1% and left it there for two years, the writing was on the wall. How could they possibly expect anything but a mountain of bad debt and insolvencies from such a reckless monetary policy?? Just because excessively loose credit does not immediately trigger consumer price inflation does not mean it is doing no harm. The inflationary effects of “printing too much money” are channeled instead into the equity market, the housing market and other asset price bubbles. Like all bubbles, they eventually pop. Until central bankers learn some discipline and quit looking for an easy fix in loose money, we will continue to see this type of thing. Instead of just riding out the 2002 recession, Greenspan felt the US could inflate its way out of it. Well, that just delays the inevitable. Now, because the economy was not forced to undergo the structural changes it would have had the fed allowed the 2002 recession to run its course, we are now faced with a much more severe recession. The worst thing we can do now is react with a bunch of onerous and unecessary regulations in financial and consumer lending markets. Until the feds learn that there really is no such thing as easy money, all the regulation in the world won’t help.
Dear Rage,
You have posted some quite good comments, so I will not go into my raging rant on you. I will simply say I do agree that the low rates were a contributing factor, however I am unsure of the root causation that you attribute to them. Potentially some kind of residual intervening causation but not root causation. THe rates were lowered to stimulate the economy. These rates are lowered with an intended estimated effect on demand. (at least in Canada anyway from my experience within the process). However, these estimates cannot withstand or factor in any notion of the amount of error that a bias such as the types of lending practices that were unleashed by both a suspect lending culture guided by profit motives and the self regulated money lenders in the US. I guess with the logic your are using, the government must know ahead of time that large proportions of the lending institutions must be operating in such a fashion, and they must also know a priori that debt rater’s rubber stamps below triple “A” have been dry for years.
If they did have this knowledge then I am assuming they would have stepped in to prevent such a calamity. Of course we do have to factor into the equation that you have some interesting choices in leaders down south. And that is something that I am sure any model could never factor in the idiotic mentality (opps ranting sorry) of that regime.
Paul Tulloch
“the government must know ahead of time that large proportions of the lending institutions must be operating in such a fashion”
Shouldn’t they know? I’m no central banker who is paid to know such things, but I’ve been reading about it for years.
One would like to think that the Central bankers were aware of what was going on and could have enacted some regulatory powers to prevent he situation. However, given the response by the House and Senate in the US to concerns that lending was not properly regulated, and both are now considering bills to regulate lending practices, I would conclude that they were not aware of how wide spread the culture of sub-prime lending had become. It is estimated that over 20% of mortgages in the US are or were sub-prime. That does not include other sub-prime lending in the form of car loans, credit and others. I am in no way defending the Federal Reserve in the US, in fact I am implicating them in the whole mess. They should have been regulating the industry and not standing by on the sidelines with the their ideologically driven invisible hands stuck in their pockets. The same ideologically driven force that is allowing our dollar to go through the roof and needlessly strip so many people in the manufacturing sector of their livelihood.
It is a twisting story there is no doubt and it is only the beginning. It is kind of like living on a pacific island and your have felt the earth quake but you are now wondering how big the potential tsunami will be. It seems there is some kind of wave coming, because those closest to the action have already jumped into their helicopters and headed for the hills.
pt.
Friday Humour-
A big company offered $50 for each money-saving idea submitted by its employees. First prize went to the employee who suggested the award be cut to $25.
another look into the abyss by an economist article, seems to be the discourse has quite a demonic tone to it all.
“At the Gates of Hell”
http://www.economist.com/business/displaystory.cfm?story_id=10181281
As soon as the USA’s annual debt servicing obligations became higher than the productivity gains accrued by a one decade trailing annual R+D investments (R+D spending times 1.7X or so), this impending reflexive credit crunch became inevitable.
I hate to be partisan but all the best counter-cyclical policies are the opposite of what the Republicans have done: military spending is incredibly inefficient compared to education or boomer-adled healthcare. And wind-turbines are the most employment friendly energy source; Bush is big-oil. For housing, the best defense is building a middle class, but Mexican labourers are still treated like crap and immigration to the USA has shot down now that the country is a fortress (whose airport staff don’t adhere to even mild anti-pandemic protocols). The US dollar was a mild bubble for fifty years. Considering the way mid-21st century civilians are being treated by the Republican Party’s environment policy, excuse me for not caring if the USA’s banks all get bought out. Maybe Hillary will change my mind but she won’t have the demographics and surplus Bush had (and used to *really* recession Iraq).
Should all these predictions come to pass I think that Milton Friedman (were he alive today) would dance for joy. Unhappily for the American public his Chicago Boys are still an a credible presence financial policy making. One may reasonably expect that whatever social protections that still exist within the American public sector will be vulnerable to privatization and the dismantling of the US middle class will advance dramatically. Not good news for average Americans.
As a Canadian, I worry that such an economic meltdown south of the border will have very significant impacts here. Our current federal government is very sympathetic to undermining the social programs that have historically been a pillar of Canadian domestic economic policy. A recession of the magnitude describe maybe the leverage needed by the Harper government to move aggressively against the social safety nets. Not good news for average Canadians
I apologize for flooding this thread, but what we are witnessing in the US financial community is nothing short of one of the greatest economic disasters in modern history. So I wanted to add the following article for those with an interest. Just to verify a few points I made above.
http://www.reportonbusiness.com/servlet/story/RTGAM.20071127.wlevitt1127/BNStory/robNews/home?cid=al_gam_mostview