04/04/2008
Caught in a vice | Fund Strategy – March 2008
After two consecutive declines in US employment growth, more investors are coming round to our view that the US is in recession. The question then, ceases to be whether there might be a recession, and changes to the likely duration and depth of any downturn. The debate also moves on to the extent to which the authorities can resurrect the economy and mitigate the likely pain. The outcome is of more than parochial interest, as the US remains the dominant player in the global economy, and the rest of the world still ‘catches a cold when the US sneezes’.
Since the start of 2008, the economic news has worsened and the authorities have upped the ante, mobilising both a monetary and a fiscal policy assault to counter the developing recessionary forces. In January, the US Federal Reserve Bank cut interest rates by 0.75% at an unscheduled meeting. That was followed, barely a week later, by another 0.50% at a regular meeting, making a cumulative cut of 2.25% from the September peak. Surely that will get things moving?
Well, yes and no. Short-term interest rates have been savagely cut, but mortgage rates have barely budged since the Fed first started to slash interest rates back in September of last year. Moreover, the problem is not solely a matter of price: the most recent Senior Loan Officers’ survey revealed a marked tightening in loan standards across the spectrum of borrowers, as well as the increased cost of borrowing. So, despite the significant cuts in rates, the policy shift has so far failed to turn things around. Lenders are more circumspect about who they are prepared to lend, and how much they are prepared to lend – and the terms on which they are prepared to lend effectively rations the available funds.
Where rate-slashing is having an effect is in steepening the yield curve, improving margins and allowing the banks to recapitalise. To some, it might seem unpalatable to be seen to be bailing out those who brought much of the present woes upon themselves, and upon the economy as a whole. However, to have any prospects for a sustained recovery, it is essential that the banking system is ‘fit for purpose’. A speedy recapitalisation would improve such prospects. Unfortunately, history suggests a lengthy period of curve steepness (certainly a year or more) is required to get the job done.
Congress has also introduced a stimulatory package, to much acclaim. Sadly, this fiscal initiative is equally long on hope, and short of substance. The package only amounts to around 1% of GDP, and involves a one-off rebate. This is unlike the last fiscal package in 2001, which included a cut in tax rates, as well as tax rebates. Research has suggested that tax-cut beneficiaries are more likely to adjust their spending patterns if there has been a permanent boost to their incomes. Indeed, a recent survey suggested that only 25% of recipients would spend the rebate. The rest would either pay down their debts or boost the level of their savings. The overall impact will not be negative, but equally it seems unlikely to provide the hoped-for kick-start to the economy. Indeed, some analysts are considering the possibility of a double-dip recession as a result of the initiative.
Apart from these ‘traditional’ policy responses, the authorities have been attempting to improve the workings of the financial markets so that they can resume their lending role. For some time now, lending between banks has dried up, as players have been reluctant to lend unless they are 100% sure of guaranteed repayments. Consequently, many banks have been unable to raise sufficient capital to ensure the continued smooth operation of their business. A noticeable part of the problem has been in the mortgage market and, to its credit, the Fed has increasingly stepped in to try to improve liquidity between market players. Whilst this can never be a lasting solution, it may help to tide the markets through a period of impaired liquidity which threatens to ‘freeze’ normal market operations. Economic policies will certainly struggle to be effective if the underlying markets are dysfunctional.
Unlike the 2001 recession, this downturn will focus on the consumer not the corporate sector, and housing remains the key. Inventory levels are running at levels more than twice ‘normal’, and the industry is still starting construction of far too many new buildings. The necessary corrections to that market still have a long way to run – starts need to be cut back a further 20%, the prevailing inventory overhang needs to be worked off and house prices need to fall further to encourage demand. This whole process will continue to undermine business and household confidence, the workings of the financial system and the efficacy of economic policy. The authorities can aim to provide the necessary conditions for an eventual recovery in 2009, but there is little they can do to forestall the coming widespread economic pain.
Douglas Roberts, Senior International Economist at Standard Life Investments
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
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