The market is assuming that since energy prices are declining and mortgage rates are drifting down consumer spending will continue to grow at a steady pace and the housing industry decline will end, resulting in a soft landing. Investors are also confident that the decline in auto sales will be an isolated event as well. This view is typified by today’s Wall Street Journal front-page article by Greg Ip titled, “Housing, Auto Slumps May Defy Usual Role as Recession Harbingers”. The article, while conceding that weak housing and auto markets usually lead to recessions, tries to make the case that this time it’s different. In our view this outcome is highly unlikely. The argument that “this time is different” is the same refrain we hear prior to every recession, and it is always wrong. Furthermore the record of strategists and economists—including the Fed--in forecasting recessions has been downright abysmal.
Contrary to the consensus, we think it is probable that the end of the housing boom will ripple through the rest of the economy, resulting in at least a hard landing and quite possibly a recession. This will be transmitted through the housing industry’s impact on overall employment and the sharp drop in the conversions of elevated home prices into ready cash through mortgage equity withdrawals (MEW).
Although new housing starts directly account for only 5% of GDP, the indirect effects are far greater. Some studies show that the housing industry and its related activities has accounted for 30% to 40% of the entire employment growth in the current cyclical expansion. So far employment in residential construction is down 110,000 from the February 2006 peak, reversing only 15% of the rise over the past 5 years. Keep in mind that although housing starts are down 35% since January 2006, housing completions have barely moved—and employment in residential construction is far more closely related to completions rather than starts. With a substantial decline in completions probable in the year ahead, the bulk of the drop in related employment is still to come. This does not even include such items as furniture, appliances, mortgage finance and real estate brokers. It is likely, therefore, that employment will weaken significantly in the period ahead, putting a debt-burdened and low-saving consumer in a precarious position
In addition it has been well demonstrated that mortgage equity withdrawals (MEW) have been a cash cow providing home owners with hundreds of billions of dollars that have gone into consumer spending. On an annualized basis MEW soared from about $100 billion in 2000 to $780 billion at the peak in the 3rd quarter of 2005. From that point it has already dropped by about 55% to $350 billion in the 3rd quarter of this year. Estimates as to how much of this went into consumer spending vary between 40 and 60%. This so-called “wealth effect” has been an extremely important prop to consumer spending as real consumption growth has far outpaced real income growth in recent years. With MEW no longer providing households with a substantial amount of extra cash and jobs not rising as fast, consumer spending growth is likely to slow significantly.
Unlike the consensus, we believe that capital spending and the global economy will not take up the slack. Consumer spending accounts for 70% of the GDP, and capital spending growth usually trails consumer spending by about 2 quarters. Therefore when consumer spending weakens it is probable that capital spending slows down 2 quarters later.
We also believe that the global economy will not decouple from the U.S. Exports comprise 35% of China’s GDP, and the U.S. is its biggest market. Japan gets 17% of its GDP from exports, with China and the U.S. its largest customers. Any weakness in China and Japan has huge ripple effects through the other nations of East Asia. Growth in the EU is likely to be hampered by rising short rates, an impending increase in the German VAT and the continuing burden of excessive regulation.
The weight of the evidence already indicates that the U.S. economy is slowing down, although the picture is still mixed, as is typical of a transitionary period. Softness is indicated by sluggish payroll gains, a rising trend in jobless claims, an ISI manufacturing index below 50, declining construction outlays, dropping auto sales, an overall deceleration in consumer spending, weakness in housing and sluggish durable goods orders.
With housing already in a hard landing, it will be extremely difficult to avoid a hard landing in the economy as well. In our view the stock market is in the same kind of denial it was in 2000 when the vast majority of strategists and economists already knew the dot-com bubble had burst, but mistakenly thought it would have little impact on the rest of the economy or on stocks. This was true of the Federal Reserve board as well. The FOMC statement of November 15, 2000
said “..softening in business and household demand and tightening conditions in financial markets over recent months suggest that the economy could expand for a time at a pace below the productivity-enhanced rate of growth of its potential to produce. Nonetheless, to date the easing of demand pressures has not been sufficient to warrant a change in the Committee’s judgment that against the background of its long-term goals of price stability and sustainable economic growth… the risks continue to be weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future.”
Only 7 weeks later on January 3, 2001, the FOMC held a special interim meeting where they reduced the funds rate by a full 50 basis points, pointing to “further weakening of sales and production” and “lower consumer confidence.” In a complete reversal of the statement issued only 7 weeks earlier, they said that “the risks are weighed mainly toward conditions that may generate economic weakness in the foreseeable future.” As former Fed governor Edward Gramlich recalls the situation in late 2000, “Everything was pointing up and, all of a sudden, everything started pointing down.” This brings home the point that the FOMC’s forecasting ability, despite the largest group of PH.D economists anywhere in the world, is no greater than economists in general. In the vast majority of cases the fed’s first move toward ease comes just prior to or even after the onset of recession.
In our view the market rally is based on reasoning that is seriously flawed and not at all reflective of the overall macro environment. Unlike some other observers, we do not believe that the market is being pushed up by a group of conspirators. Nor do we believe that excessive liquidity is behind the strong rally. What is behind the perception of excess liquidity is the strong belief that risks are minimal. When the perception of risk increases, the so-called excess liquidity will rapidly disappear as it did in 2000. While the economy remains in a transitionary period and there is no smoking gun, investors can assume a soft landing as they usually do before a downturn becomes more obvious. However, the leading indicators are in a pre-recessionary mode, and the actual economy is already softening. The easing of inflation is only a sign of this weakness, while the Fed’s first interest rate cut will typically come too late. The result is likely to be a hard landing or recession accompanied by a severe market decline.
