Economic Update
Nothing is certain but death, taxes, and financial crises. Periods of relative stability encourage complacency, which can lead to loose lending standards and negligible risk premiums. Some sort of an economic shock then occurs, which exposes the accumulated risks and starts a deleveraging process that can culminate in a crisis. The crisis purges the system and exposes risk management and regulatory flaws. Legislators then point fingers and demand change. While this catharsis will eventually result in a healthier system, financial crises are painful for almost everyone involved, including those who have been prudent in their actions.
We hope that the apex of our newest crisis was reached last quarter, when panic blanketed all sectors of the fixed income markets, sending bond prices to levels so divorced from fundamentals that it paralyzed rational investors with irrational fear (see Figure 1). Confidence is an essential ingredient in market-based financial systems; without it, capital will not flow. Indeed, it was fear that caused Bear Stearns counterparties to recall their repo lines with Bear Stearns, nearly depleting its liquid capital base of $18 billion in just a few days and making it insolvent.
A bankruptcy, had it occurred, could have triggered systemic failure and crippled the financial system. Had that happened, economists would be talking about a depression rather than a recession. This is why the Fed not only agreed to provide JPMorgan Chase with financing to purchase Bear Stearns, but also extended liquidity to all its primary dealers, despite the obvious risk this represents for the Fed's balance sheet. Indeed, if something goes wrong, and the Fed experiences substantial losses, the Fed risks losing its independence.
The Fed has clearly demonstrated its willingness to act as lender of last resort. Lending facilities now in place offer depository institutions and primary dealers a number of ways to improve liquidity. Depository institutions can tap the discount window, or they can participate in regular auctions that price longer-term funding. Primary dealers can now access facilities that offer daily funding at the discount rate and term funding at an auction-determined rate. A variety of collateral can be posted by both depository and primary dealers in exchange for this funding. The Fed has also initiated a series of 28-day repos with primary dealers, and it has extended swap lines with foreign central banks to provide dollar liquidity abroad. To encourage borrowing, the Fed reduced the discount rate last quarter by 225 basis points to just 2.50%. Last summer, this rate was 6.25%. These actions have appreciably reduced the level of stress, but the system is still impaired.
In addition to shoring up the financial system, the Fed has sought to stimulate the general economy by lowering the federal funds rate by 200 basis points to 2.25% (see Figure 2) The impact of this stimulus was muted, however, by financial market stress, which has widened the spread between consumer lending and Treasury rates. The Fed's goal is to get long-term borrowing rates down, but short of outright purchases of mortgage bonds, the Fed has to do this indirectly by lowering short-term interest rates and offering liquidity facilities.
Other regulators are lending them a helping hand, though. The Office of Federal Housing Enterprise Oversight (OFHEO) lifted portfolio caps on Fannie Mae and Freddie Mac last quarter, which will allow these institutions to expand the number of agency loans they purchase or guarantee. OFHEO also reduced the capital surcharge on Fannie and Freddie from 30% above the regulatory minimum to 20%.This has also freed up capital that can be used to buy or guarantee loans. Furthermore, the Federal Housing Finance Board increased the authority of its member banks to purchase mortgage bonds. These actions have helped reduce conforming mortgage rates (see Figure 3), but nonconforming mortgage rates are still elevated.
These actions come too late to stave off a recession, but they could be in time to help stabilize the housing market. A few housing market indicators suggest that conditions are starting to improve: home sales have generally moved sideways for the last four months; the affordability index has jumped; homebuilders' sentiment and stock prices have risen; and, when asked in surveys, consumers say that now is a good time to buy a house. If home sales stabilize, then the huge overhang of homes available for sale can be worked off at a faster clip, and we might be able to forecast the bottom in home prices with surety. Increased confidence in home-price forecasts could lead to significant improvement in the financial markets because it would help solve two key mysteries: the value of the collateral backing bonds and the cumulative size of write-downs likely to be taken by financial institutions.
The big caveat attached to this optimistic view is that we are now in a recession, and we could experience a substantial decline in payroll and income growth that would undercut housing-market improvement (see Figure 4). That scenario, unfortunately, bodes poorly for the financial markets because it would not only reduce clarity about collateral value but also result in still higher estimates about financial market write-downs.
Chairman Bernanke, in a recent appearance before the Joint Economic Committee, danced around a question on whether the economy is in a recession. He admitted that economic growth might contract in the first half of 2008, but he expects economic growth to strengthen in the second half of the year and to grow "at or a little above its sustainable pace in 2009." We think that the Fed is too optimistic. We believe that economic growth, after contracting in the first half of the year, will enjoy a policy-induced rebound in the second half that fizzles into a sluggish growth rate persisting well into 2009. On the bright side, this period of anemic growth should keep inflation under control.
Our view is more pessimistic than the consensus forecast because we are concerned that real consumption growth will expand at a slow pace for an extended period of time, and that this will keep investment spending in check. We think consumers are on the verge of reducing their propensity to spend as they focus on paying down debt and rebuilding savings accounts (see Figure 5). We are also concerned that weak U.S. growth, surging commodities prices, and the credit crunch will weigh heavily on world output and will slow export growth. Two events that could improve our outlook would be a sharp reduction in commodities prices and an end to the credit crunch. Even under those conditions, our revised forecast would probably still be lower than the Fed's. For this reason, we think the Fed will continue to ease monetary policy in future meetings, lowering the funds rate to 1.75% or possibly lower.
For investors, it has been a very rough period, as exhibited by Figure 1, but the markets are now discounting a very dire outlook. Some would argue that the markets have priced in the end of the world. Investors with capital and a long-term horizon can selectively take advantage of bargain-basement prices with the knowledge that the basement will, at times, feel like a dungeon.
- Market Conditions & Dwight Porfolios
- Credit Crisis Leaves No Sector Unscathed—Fixed Income Sector Review
- Economic Update
- Investment Performance
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