Rudi's View | Sep 06 2007
This story was first published two days ago in the form of an email sent to registered FNArena readers.
By Rudi Filapek-Vandyck, editor FNArena
September is by far the worst month for US equities. It is the only month that has on average generated a significant negative return since the start of the twentieth century. The good news is, however, that September doesn’t always spell trouble, and this year may be such a year.
Two factors support the case for a less troubled September month this year. One is we already experienced two sell-offs in 2007; the first in February and the second only a few weeks ago in August. Another supportive factor is that the US Federal Reserve is widely expected to start cutting official interest rates in about two weeks.
History shows that whenever the US Fed starts lowering interest rates shortly after a major crisis the share market often responds with a rally. This is making the bulls in today’s market very excited.
US market strategists at Credit Suisse drew a parallel between the current global credit crisis, the October 1987 stock market crash and the August 1998 LTCM/Russia financial crisis.
Both previous crises similarly sparked concerns about their impact on global economic growth and in both cases the US Federal Reserve decided to cut interest rates. The end result was that economic growth swiftly recovered to the point where it was before the crises occurred, while US equities had a wonderful time until the Federal Reserve started tightening again. Various other historical analyses by other experts have come to similar conclusions.
But will the Fed cut interest rates at its next meeting in two weeks?
Though not everybody is yet convinced, the answer can only be yes.
What many skeptics seem to forget is that the world is currently facing two crises in one, and they both originate in the US. There is a credit crunch caused by the widespread exposure to various leveraged and packaged investment products which, in essence, were built upon too loosely accepted mortgage applications in the US, and there is the aftermath of the US property boom which is now creating headaches for both consumers and businesses as house prices are falling, defaults rising and inventories building.
None of these problems will go away with lower interest rates. But it is the potential impact on the broader economy, both in the US and worldwide, that is now at the heart of internal discussions by central bankers in the US.
It is probably fair to state that most economists and financial experts have underestimated the severity of these two problems, until now. Right until August 9th many experts were still adhering to the line that it would all turn out a storm in a cup of tea as subprime mortgages only represent a small fraction of the total housing market in the world’s largest economy. The next day BNP Paribas announced it would freeze three of its hedge funds because of subprime difficulties causing a global awakening to the true extent of the problem while forcing central bankers in Europe and other major economies into action.
Though share markets have recovered rapidly following the initial scare, the problem is still inside the global financial system. Lenders are tightening their rules and practices, the cost of attaining money has increased and many businesses, and consumers, with less than solid credentials or assets are simply excluded from taking on any debt. Meanwhile, banks and investment funds are trying to assess what the potential damage is. In the US stock brokers and wealth managers are picking up quotes from their clientele such as: “There are a lot of players out there who are insolvent, they just don’t know it yet”.
As far as the US housing market goes, an increasing amount of experts is using the term “bear market” these days. Prices of houses will come down further, mortgagees will default on their monthly payments, jobs will be lost, while a significant inventory in houses is already building. And some say the worst is yet to come as a large amount of mortgagees faces the prospect of rising monthly payments over the next 18 months.
So far, none of the above dangers and implications has shown up in economic data, but common sense dictates this should only be a matter of time. Until then, any impact on the US economy remains pretty much guesswork.
UBS economists in London have tried to find some answers through economic modeling. While economic models tend to be too static compared with the vibrant undercurrents in every modern economy, UBS’s exercise could nevertheless serve as an indication of why global interest rates need to be cut this year.
UBS found that if US interest rates were to remain stable both problems would likely reduce global GDP growth by one full percentage point next year. The economists argue that US interest rates will have to come down by at least 50 basis points (0.50%) and potentially by 25 basis points more (0.75% in total) to prevent the US economy from falling into recession. UBS also believes central banks in Europe, the UK and even Japan will likely have to cut interest rates as well to cushion the flow-on effects on their own economies.
Market researchers at highly respected BCA Research have done some estimates and calculations too. They believe some US$650bn in mortgages will default between now and 2011. This will inflict some US$200bn in losses for investors. (The basic assumptions behind these calculations have been derived from the 2000-2001 down turn in US housing).
While all this looks like a lot of money lost, and it is, BCA points out it still only represents about 1.5% of today’s US GDP. As a comparison, BCA offers the savings and loan crisis in the late 1980s/early 1990s cut 2.5% off US GDP at the time.
An increasing amount of experts has recently publicly demanded decisive actions by central bankers and the US government, including influential US senators and Bill Gross, managing director of PIMCO, the world’s largest dealer in debt instruments.
Skeptics can still argue the current two crises have many different characteristics compared with all the previous ones. Both UBS and BCA acknowledge, for instance, that US economic growth was already slowing without these two problems while many previous crises hit when the US economy was intrinsically stronger. This made the recovery through lowering interest rates easier.
BCA counters the skeptics by stating US authorities will be determined to face off a recession and they will simply do whatever it takes. Don’t forget US presidential elections are looming.
It nevertheless remains important that the anxiety in the global financial system is being addressed as quickly as possible as the impact on the wider global economy is likely to grow the longer this problem remains unresolved.
A special note should be made for China. While most experts acknowledge Chinese exporters will feel some impact from any slowing in the global economy, some experts such as Credit Suisse believe China will remain largely insulated from the global credit crunch as the country is a boiling pot of excess liquidity in itself.
This should secure that the Super Cycle for commodities remains largely intact, even if the US economy would be poised for sub-par growth in the near future.