Archive for January, 2008
Stock Market to the Fed: “It’s Insolvency, not Just Illiquidity, Stupid!”…and the Systemic Financial Meltdown Risk from the Monolines’ Crisis
The reaction of the stock market to the unexpected 75bps cut by the Fed last week and its reaction today to the further 50bps cut clearly shows that markets and investors are now fully realizing that the US economy is suffering from serious credit, i.e. insolvency, problems, not just illiquidity ones; and that Fed monetary policy can partly tackle illiquidity problems but cannot resolve insolvency ones.
Last Tuesday when the Fed unexpectedly cut the Fed Funds rate by 75bps the US stock market fell by over 1% in spite of that cut (but by less than the 5% that the futures had priced before that surprise cut). The next day – Wednesday – the S&P tumbled by another 2.5% for most of the day giving the market verdict on the Fed action: too little, too late and useless to resolve the massive credit problems in the economy, including the serious market concerns that a downgrade of the monolines would lead to massive financial write-downs and a financial meltdown. The late day whopping rally in the last two hours of trading on Wednesday last week – 600 points on the Dow and over 5% on the S&P – was triggered instead by the news that the New York insurance regulator had met with banks to try to work out a plan to recap the monolines and thus avoid a catastrophic downgrade of their triple AAA rating. So that day the market told the Fed (with a 3.5% stock market drop following the rate cut): your 75bps cut means practically nothing to us and unless the credit problems of the economy are resolved. And the 5% rally was indeed triggered by news that maybe the monocline downgrade could be avoided.
Same story – in reverse – today Wednesday after the additional 50bps cut by the Fed. The initial reaction of the stock market was a relief rally – with the S&P500 index up about 1.7% after the Fed announcement and its signal of more monetary easing ahead. But this rally totally fizzled again in the last two hours of trading as reality sank in that the rescue of the monolines is much harder than hoped for after Fitch revoked its top AAA ranking on Financial Guaranty Insurance Co, one of the bond insurers. So the S&P fell from its day peak by 2.2% and finished the day 0.5% below its opening level in spite of the 50bps gift by the Fed and in spite of the fact that the Fed had reduced policy rates by a whopping 125bps in eight days!
So both following the 75bps cut last week and the 50bps cut today the stock market told the Fed: “it’s not just an illiquidity problem; it’s most importantly a credit or insolvency problem we worry about, stupid!” And the market reaction on both occasions highlights the relative impotence of monetary policy in addressing credit problems.
Let me elaborate on these issues and also discuss how the problems of the monolines are now at the core of the markets, of the financial regulators and of the Fed’s concerns about the risk of a catastrophic financial market’s meltdown….
It is now clear that the US economy is already into a recession that started in December 2007: the data on December employment, retail sales, manufacturing ISM, housing and other macro variables confirm it. And the 0.6% growth for Q4 GDP confirmed that sharp slowdown of the economy in Q4 and its tipping over into a recession by December. It may take –as usual – almost a year for the NBER to formally declare that a recession started; but when that decision is made it will be clear that the great US recession of 2008 started in December 2007 or – at best – Q1 of 2008.
At this point it is clear that the debate has shifted to how deep this recession will be, a mild one lasting two quarters as the new consensus claims or a deeper, longer recession – lasting at least four quarters – as I have been arguing for a while.
It is also clear now that this US recession will lead to a global economic slowdown – short of a global recession that would occur if global growth were to be below 2.5% – and to actual recession in a number of individual economies. The economies most at risk of an outright recession are the following ones:
Newsweek: “The Road to Recession”, “The U.S. Economy Faces the Guillotine” and “Goodbye to the Bulls?”
The cover page on Newsweek magazine this week is titled ”The Road to Recession“. The fact that this cover story title is written without even a question mark is a signal of how far the consensus has moved towards the recognition of an unavoidable recession that has actually already started.
And if the cover title was not clear enough the title of the cover story in the magazine is ”The U.S. Economy Faces the Guillotine“. In this cover story the author not only discusses how a US recession is now unavoidable; he also dismisses the hypothesis that the rest of the world can ”decouple” from this US hard landing. The fact that yours truly is cited throughout the magazine is no surprise.
Indeed, as I expressed and fleshed out all week at the Davos’ WEF:
“The debate today is not any longer on whether we will experience a soft landing or a hard landing in the US; it is rather on how hard the hard landing will be. In other terms on whether the current recession will be relatively mild – say lasting two quarters until the middle of 2008 – or rather be much longer, deeper and uglier and lasting at least four quarters. My view is that the recession will be protracted and painful as a shopped-out, saving-less and debt-burdened consumer is on the ropes and now faltering; while the financial system is on the verge of a systemic crisis that will cause a severe credit crunch…
Indeed the delinquencies and losses in the financial system are spreading from subprime to near prime and prime mortgages; to credit cards and auto loans; to commercial real estate loans; to leveraged loans that financed reckless LBOs; to the losses of the monolines that are effectively bankrupt and at risk of spreading furher massive losses to money market funds and other financial institutions once they get properly downgraded; and soon enough to corporate defaults and junk bonds that will in turn trigger massive losses on credit default swaps; eventual losses in the financial system may add up to more than $1 trillion…
As for decoupling there is no way that the rest of the world can decouple from a US recession. When the US sneezes the rest of the world catches the cold; and unfortunately this time the US will not experience just a case of a mild common cold; it will rather suffer of a painful and protracted episode of pneumonia; thus the real and financial contagion to the rest of the world will be serious…
The Fed will ease aggressively but whatever it does now is too little to late; this easing will not prevent a recession as monetary policy can deal with illiquidity problems but it cannot resolve the deep credit and insolvency issues that plague the US economy; also when there is a glut of capital goods - in 2001 tech capital goods, today a glut of housing, consumer durables and autos the demand for these goods becomes relatively interest rate inelastic; it takes years to clean up this glut and monetary easing does not work as it is like pushing on a string…
U.S. and global equity markets will enter a serious bearish market as a US recession and sharpl global economic slowdown take a toll on investors’ risk aversion and firms’ earnings and profitability…all risky assets will be under serious pressure in 2008″.
Newsweek also asked 15 leading economists to comment on the likelihood of a recession and the recent market turmoil under the title “Goodbye to the Bulls? Fifteen key economists, policymakers and strategists weigh in on a week of volatility and economic turmoil”
Here is my contribution to this debate that opens this survey by Newsweek:
Here is Bloomberg’s columnist William Pesek commenting on my contrarian argument that we may have to worry more about deflation (more specifically “Stagdeflation”) than about Stagflation: Forget Stagflation. Stagdeflation Sounds Scarier: William Pesek Commentary by William Pesek, Bloomberg Jan. 25 (Bloomberg) — Nouriel Roubini isn’t known for subtlety. His pronouncements about the global economy have an [...]
Here is a piece from Time magazine:
Posted by Justin Fox, Time magazine January 24, 2008 12:41
Last year, when Time’s Board of Economists gathered for its annual debate in Davos (and no, Time doesn’t really have a Board of Economists on an ongoing basis, we just gather them together every year here at the World Economic Forum), economist and superblogger Nouriel Roubini was the only gloomy voice in the crowd. As Peter Gumbel recounted in Time last January:
“Goldilocks is threatened by three bears,” Roubini said — a housing recession, the beginning of a credit crunch and continued high oil prices. (He pointed out that, while it may be true that crude prices have fallen in the last few months, they are still high in historical terms.) Roubini was open in his use of language that others avoid: “I worry about a U.S. hard landing,” he said.
“The debate is not whether we’re going to have a soft landing or a hard landing in the U.S. but how hard the landing is going to be,” says Nouriel Roubini, professor of economics at New York University. He sees a sharp, possibly year-long U.S. recession and a global slowdown.
Nobody on the panel really disagreed with that negative assessment. Which got me thinking that, now that almost everybody agrees with the Roubinis and Steve Roaches of the world, it might be time to start discounting their opinions a bit.
This morning, as I sat on a comfy chair writing my post on Al Gore and Bono, I noticed that Roubini had settled in with his laptop a few comfy chairs away. So I sidled over and asked him if he thought maybe economic gloom had gotten too much in fashion.
He cited the five stages of grief (denial, anger, bargaining, depression, acceptance). “I think we’re getting into the depression stage, we’re going to go soon enough into acceptance,” he said. “The mood here is pretty depressed. That sets the stage for acceptance and fixing the problems and moving on.”
So are you turning bullish? I asked him. “At least we’re reaching the bottom point, or close to it,” he said. “It’s a start.”
So am I really turning “bullish”? Let me elaborate…
At a WEF session I contributed to yesterday in Davos a poll of the audience agreed – a 75% consensus – that sovereign wealth funds, hedge funds and private equity are the “new power brokers” in the global economy and the global financial system.
The current hype about SWF has an element of faddism. Three years ago at Davos all the talk was about hedge funds and how they would take over the world. Two years ago the hype moved to central banks and their accumulation of reserves. Last year at Davos it was all about private equity and its relentless rise and power. This year the stars at Davos are the heads of sovereign wealth funds who have been invited in mass.
Are these four economic actors the new power brokers as the Davos crowd believes and as a recent McKinsey Global Institute report recently argued?
Let us consider the actual facts…
Here is a link to a video of an interview that yours truly had with Bloomberg TV today in Davos. And here is a link to an hour long interview that I had with Tom Keene of Bloomberg Radio from Davos. The main points: – the US has already entered a recession and this recession will [...]
From the WSJ Blog today:
BearBlog: Goldilocks and the Three Ugly Bears
BearBlog takes a look at what Davos attendees say is in store for the global economy — and what they said last year.
Last year, Nouriel Roubini was the lone pessimist on Davos’ five-person opening economics panel. His colleagues predicted the world economy would continue to grow strongly without overheating, a rosy scenario economists dubbed “Goldilocks.” Mr. Roubini, chairman of Roubini Global Economics and a New York University economics professor, demurred. “Goldilocks is threatened by three ugly bears,” he said, predicting a subprime meltdown, an end to cheap credit and rising oil prices would bring U.S. consumer spending to a halt. At the time, Mr. Roubini’s “ugly bears” provoked more laughter than concern. But Goldilocks has already met two of those bears and signs are mounting that the third — in the form of a sharp falloff in U.S. consumer spending — could show up soon. “Sometimes people say about me that even a broken clock can be right twice a day,” says Mr. Roubini, who contends his habitually gloomy outlook has been, over the years, more nuanced than he’s given credit for.
Now, though, he’s unabashedly glum. “2008 will be an ugly year,” he says. The question of whether the U.S. will fall into recession is stale: “Now the debate is, how bad will it be? I think it will be extremely severe.” Financial-market conditions will get much worse: “When you add all the losses, not just subprime but also soon enough on auto loans, credit cards, student loans, leveraged loans and corporate bonds, we’re looking at $1 trillion of losses in the financial system.” These massive losses, he contends, mean “there’s a serious risk of a systemic financial crisis. Not just in the U.S., but globally.”He laments that his colleagues are still getting it wrong. “The consensus is behind the curve” on a host of topics, including the severity of the U.S. recession, the extent to which the rest of the world can continue growing as the U.S. slows, and the depth of the problems in the financial system. Global central banks’ massive liquidity injections last year helped grease money-market wheels but can’t tackle “fundamental issues of insolvency and regulation. [These problems are] systemic. They take much more than liquidity to resolve.”Pointing out that he’s been forecasting a global stock-market fall and that global markets slid sharply on fears of a U.S. recession this Monday, he predicts: “This is just the beginning of a serious bearish market in equities. Things will get much worse before they get better. I was right a year ago and I think I’ll be right again.”
— by Joellen Perry
Indeed, this morning I was again - like last year – a speaker in the main session at the Davos WEF on the global economic outlook. This year – in addition to myself – Steve Roach also presented a very bearish outlook for the US and global economy.
In summary here are the main points I made at this session:
The Coming Economic Recoupling and Financial Contagion in Global Stock Markets and Financial Markets: When the U.S. Sneezes the Rest of the World Gets the Cold
The scary free fall in recent days of US and global stock markets is no surprise to the readers of this column as it has been analyzed and predicted for a while now. The collapse of global equity markets on Monday January 21st is not just an episode of financial contagion from the US stock market to other stock markets.
It rather signals that global stock markets are now beginning to price the following things.
First, the US recession is unavoidable and has already started; and this recession will be ugly, deep and severe, much more severe than the mild 8-month recessions in 1990-91 and 2001.
Second, the rest of the world will not decouple from the US since – as discussed in detail below – many trade, financial, currency, policy, confidence links – lead to a transmission of negative growth shocks in the US to the rest of the world that will lead to a sharp global growth slowdown: 2008 will be the year of recoupling rather than decoupling.
Third, the US stock market has already started to reflect in the last few weeks the consequences on earnings and corporate profitability of a severe US recession.
Fourth, a growing realization that even aggressive Fed easing will not prevent this severe recession, i.e. that we are at the last leg of the stock market’s sucker’s rally and that the Bernanke put has very little value as massive financial losses will increase regardless of what the Fed does.
Fifth, now other global stock markets are now starting to price the effects of the US hard landing on the rest of the world growth, the phenomenon of recoupling.
Thus, the Monday Massacre in global stock markets is – more than a case of financial contagion – a revenge of economic fundamentals as investors are waking up from the delusion that the US would avoid a hard landing and that the rest of the world could decouple from such hard landing. A reality check is now occurring after stock markets remained for too long in the delusional triple dream of a US soft landing, of a Fed being able to ease and avoid the hard landing, and of a world miraculously decoupling from the US hard landing. As predicted here at the beginning of the year 2008 will be ugly bearish for US and global equity markets.
To understand this high correlation of equity markets that is now returning in this period of high financial turmoil and volatility one needs to consider in more detail why the world cannot decouple from a US hard landing. Already in June of 2006 this author wrote a paper and several blog items describing 12 reasons why the world would not decouple from a US hard landing. It is important to revisit these channels of international real and financial transmission to understand the current stock markets bloodbath and why the US recession will have severe effects on the rest of the world.
Let me discuss next in more detail these channels of recoupling of financial markets and real economies…
Will the U.S. Recession be Associated with Deflation or Inflation (i.e. Stagflation)? On the Risks of “Stag-deflation” rather than “Stagflation”
This author is on his way to Davos to attend the World Economic Forum (WEF) that starts this week. Many lofty issues will be discussed at the WEF including the recent turmoil in financial markets, the risks of a US recession, the possibility of a global economy slowdown if the rest of the world does not decouple from the US hard landing and the rising risks of high global inflation.
Indeed, the S-word (stagflation that implies growth recession cum high and rising inflation) has recently returned in the markets and analysts’ debate as inflation has been rising in many advanced and emerging markets economies. This rise in inflation together with the now unavoidable US recession, the risk of a recession in a number of other economies (especially in Europe) and the likelihood of a sharp global economic slowdown has lead to concerns that the risks of stagflation may be rising.
Should we thus worry about US and global stagflation? This note will argue that such worries are not warranted as a US hard landing followed by a global economic slowdown represents a negative global demand shock that will lead to lower global growth and lower global inflation. To get stagflation one needs a large negative global supply-side shock that, as argued below, is not likely to occur in the near future. Thus the coming US recession and global economic slowdown will be accompanied by a reduction – rather than an increase – in inflationary pressures. As in 2001-2003 inflation may become the last of the worries of the Fed and one may actually start hearing again concerns about global deflation rather than inflation.
Let me elaborate next why in the rest of this note…