Economic Trends and Risks

Self Sustained Downward Spiral

Questioning e*mails ask how this financial disaster continues to worsen.  The risk-savoring investments banks (now gone) and commercial banks such as Citigroup continue to fall in to the abyss.  The WSJ tied the Citi bailout to “toxic” assets as the government intends to "absorb" as much as a quarter trillion dollars of potential losses.

The worsening mess is largely the same seen for over a year and tied, you guessed it, to mortgage lending and the severe drop in home prices that continues to expand the toxic mortgage assets that are helping to take down the financial giants. 

Weak home sales, now further stalled by the recession, and the huge inventory of unsold homes keep downward pressure on home prices.  From its peak today’s Case-Shiller index of 20 cities home prices shows a -22% decline.  And that’s an average.  Las Vegas and Phoenix both show annual price declines of over -30%.

Existing home prices are down -20% from its peak.  Tomorrow’s new home data will continue the downtrend from the -17% decline of September.

 

As home prices fall, foreclosures rise.  The mortgage to home value ratio provides the rational.  Say even a comparatively healthy mortgage was financed a year ago with a 15% down payment.  Given the timing of the purchase that mortgage loan amount is now more that the house value and provides clear reason to foreclose.  It’s an old story but now as price declines exceed 20% a new, higher quality mortgage class is getting dragged in. It isn’t just sub prime anymore.

 

The mortgage effect is carried right to the holders of the mortgages, or more accurately the holders of the securitized mortgage backed securities (MBS) or other derivatives based on home mortgages.  The prices of the mortgage security assets are falling for this reason and financial institutions are large holders. 

 

The broader problem is that no one knows who owns what given the repackaging of mortgage loans in to MBS.  That heightens the risk of trading mortgage debt (unknown pricing, unknown delinquencies, unknown credit quality) and helps explain the freezing up of credit liquidity. 

 

Estimates suggest that almost a quarter of homeowners with mortgages have zero or negative equity in their homes.  Home sales don’t end this current sucking sound, steady home prices and reduced foreclosures will. 

Indicator of Recession End

I won't again review why I believe (and presume the National Bureau of Economic Research which is in charge of marking the dates agrees) that the economy fell in to recession near the start of the year.   See either the October 21 or June 19 posts for that detail.

The index of leading indicators is largely designed to foretell oncoming recessions as one of its components -- weekly unemployment claims -- provides a real time indicator of when the recession has ended.  The logic is simple, slowing layoffs add stability to income and spending growth.  No such indication has arrived yet.

Today's report on unemployment claims shows quarter century highs for the 4-week averages of initial claims and continued claims.  We prefer the averages given the volatility and potential false reads in the weekly reports. 

Initial claims best represent layoffs as continued claims better represent overall unemployment.  The end of layoff acceleration better marks the turn in economic growth than the start of new hiring which often is delayed.

The 2001 recession ended in November as initial claims peaked in late October (at 489K).  The 1990-91 recession ended in March as initial claims also peaked in that same month (at 501K).   Today's 4-week average of initial claims rose to 507K given a jump to 542K in the weekly measure.   Keep an eye on initial claims as an indicator of better times ahead.

Commodity Prices Plunge, Now Warnings of Deflation

The plunge in commodity prices has been impressive.  It almost seems silly to be echoing the forward whispers regarding deflation after the 27 year high in producer prices (PPI) just four months ago. 

The commodity price pressures peaked this Summer as crude goods PPI reached above a 50% gain from a year ago and core crude goods prices were at 36% annual growth.  Today's October PPI shows 12 month declines in both as metal and other key commodity prices add to the tremendous dive in energy prices left by the slowing global economy and reduced demand.

The resulting declines in finished goods PPI (what the press reports) and the consumer price indices will lag the plunge in commodity prices but the turn is very clear.  From the 27 year high of almost a 10% annual rise in PPI in July, October shows just a 5% annual gain.  Core PPI reached a 19 year high of 4.4% in October but the continued rise contrasts to the lack of pricing power that exists in a clearly recessionary economy.  Core direction should swing by year end.  

Significantly lower input prices for manufactured goods is just as clear in the ISM index which showed a 30 year high in June prices paid and a drop to a seven year low in October. 

The stronger dollar also pulls import prices lower as the annual growth in import prices has been cut by 2/3 in just the last three months.  Annual import prices excluding petroleum have fallen by 1/3. 

The clearest price drop from the consumer perspective is energy prices.   A barrel of oil is trading at $55 today from a high of $145 during the July 4th holiday.  Gasoline prices are about to edge below $2 from above $4 in early July.  That translates in to some real help for the economy if sustained.  A $90 bln plunge in oil prices translates to nearly a 3% positive contribution in economic growth. 

 

The early whispers of eventual deflation seem unlikely.  The Fed is as watchful (if not more so) of deflation than outsized inflation.  Any commodity based decline in prices will be short lived as service prices provide a more stable and clearer view of the inflation outlook.

Consumers Have Stepped Aside

The decline in consumer spending continues to worsen.  October retail sales fell -2.8% -- the largest of four consecutive declines.  Auto sales fell -5.5% and show a tremendous -23% plunge from a year ago. 

 

The near term outlook doesn’t provide much encouragement as consumer confidence reached a record low in October (yeah, lower than 9/11 or during the double digit levels of unemployment and inflation in the early 80s) and unemployment has jumped 1.5% over just the last six months.  In brief, no signs of near term stabilization despite the desperately low levels.

Stock market declines add to the lost wealth of falling home prices as income growth weakens under the highest unemployment rate in 15 years.  The financial crisis drove confidence sharply lower in October as the credit crunch adds to the problems in consumer spending, especially for higher priced durable goods.

Retail sales shows annual declines in all the durable goods components – autos, furniture, electronics/appliances and building materials.  The staples of food and health care are up from a year ago as even clothing and department store sales are lower.  Overall, retail sales are -4% lower than a year ago.  The accelerated decline over the last few months leaves a –9% annualized plunge over the last six months.

When does this bad consumer news turn better?  When home sales flatten and help push the stock market higher given its lead on the economy.  A lift in confidence, both from consumers and businesses, is  needed before a turn in consumer spending is seen.   A lower unemployment rate will eventually follow. 

 

Fiscal Rescue Costs Hit the Deficit

The Treasury’s new fiscal year began in October as the Congressional Budget Office expects FY09 to start with a massive $232 bln budget deficit.  The expected size is $175 bln larger than a year ago and larger than the entire 2007 fiscal year deficit.

 

The cause of the massive deficit is the first wave of the $700 bln financial rescue package -- the Troubled Assets Relief Program (TARP).  In October, the government invested $115 bln in preferred stock of eight large U.S. banks.  The capital was seen as a way to hold off, or preferably avoid, more bank failures and thaw the frozen credit markets. 

There is a chance that the Treasury may decide to use a net present value basis rather than a cash basis to record the stock investment which would reduce the $115 bln to just $17 bln and lessen the public outcry.  Disguising the rest of the $700 bln package shouldn't be as simple.

 

Fiscal spending will continue to balloon as FY09 budget deficit estimates stand above a record shattering $1 trillion (yeah, a million millions), at least given the already approved spending.  Expectations are for another fiscal stimulus package in the $150 bln to $200 bln range which would further enlarge the already ghastly immense deficit and taxpayer debt.  

 

Larger Employment Decline Expected

The trends on the labor front are only worsening and suggest an October payroll decline in excess of 250,000 as the unemployment rate is expected to match the high following the last recession.  The accelerated decline in employment leaves reduced income gains, spending and economic growth.

Today's weekly report on those filing for unemployment benefits showed continued claims above the peaks of the last two recessions as initial claims also near those recession highs. 

The record low in October consumer confidence (from its 1967 start!) included a sharp downturn in employment conditions.  The worsening employment measure and the high level of continued unemployment claims argues for an unemployment rate at or above the 6.4% high in 2003 from the 6.1% rate in both August and September.

The worsening trends in payrolls could provide the reports larger surprise.  Last month's -159K decline was the largest of the nine month string of declines.  A larger October decline near -250K seems likely given the indicators. 

The ISM reports included an 18 year low in the manufacturing employment index and the lowest since the start of the non-manufacturing employment index in 1998.

While the timing of the payroll effect is hazy, layoff announcements have become daily fare in the news.  Pepsi, Whirlpool, Xerox, Chrysler and the damaged financial companies have stepped up in the name of efficiencies.  Moreover, the ADP employer services company uses its own information to estimate the payroll change.  The October estimate doubles the size of the largest estimated decline this year.  And with a 105K average overestimate of payroll growth over the last three months, that too suggests a decline near 250K.

The Manufacturing Plunge

The severity of the plunge in the ISM manufacturing index is foreboding.  The index based on a survey of manufacturing purchasing managers fell to the lowest level since September 1982.  The quarter century low exceeds the lows during the last two recessions and stands just above the low at the tail end of the 1981-82 economic downturn (remember the Rust Belt recession).

The index reached 38.9 in October where a 50 reading distinguishes between a rise or contraction in manufacturing and a 41.1 level is consistent with a general economic decline. 

The key new orders component leads production, employment and the rest of the inputs.  New orders fell to the lowest since June 1980 -- lower that the bottom of the last three recessions -- and provides an ugly preview for the near term.  The employment index reached a 17 year low. 

A drop below a breakeven 50 in the export orders was the first in six years as the slowing world economy adds to the decline.  The benefit came from lowest prices paid level since late 2001 given the sharp decline in commodity prices.