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For years, American households and financial institutions have pushed the limits of debt. More and more they borrowed, enjoying a giddying ride up. But now they've hit the ceiling, and the credit boom has turned to bust. The ride down will not be pleasant.
But that doesn't mean the U.S. stock market is doomed to a prolonged downturn. The market, which tends to anticipate future economic activity, typically bottoms in an atmosphere of pervasive gloom and negativity. Although we're not predicting a rip-roaring bull market this year, stocks could still end the year in the black, just as we forecast in January.
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The economy almost certainly has lapsed into recession. Cuts in short-term interest rates engineered by the Federal Reserve Board, the enactment of a $150-billion economic-stimulus package and the robust health of non-financial businesses may soften the blow and make this recession a mild one.
But recovery to the next business cycle will be slow and arduous, possibly taking two to three years, because of the severe damage inflicted on the balance sheets of banks and consumers. David Rosenberg, senior economist at Merrill Lynch, thinks the economy will struggle to grow 1% in both 2008 and 2009.
The distress began with the pricking of the bubble in residential housing prices, which were inflated by reckless lending and borrowing practices between 2004 and 2006. The National Association of Realtors says median home prices have fallen 15% from their peak in July 2006. But inventories of vacant and unsold houses are still bloated, and home prices are way out of whack compared with incomes and the cost of renting.
Goldman Sachs's chief economist, Jan Hatzius, says home prices ultimately need to fall 25% to restore balance, which could take until the latter half of 2009. A decline of that magnitude would erase $6 trillion of home-owners' wealth. Meanwhile, nine million homeowners (soon to be 14 million) have negative equity in their houses, says Moody's economist Mark Zandi. That helps explain the rising tsunami of mortgage delinquencies, defaults and foreclosures since last year.
Hatzius estimates that financial businesses will suffer $500 billion in residential mortgage credit losses. Because of financial leverage -- commercial banks, for example, typically have ten times as much debt on their balance sheets as equity -- he estimates that these losses will contract the supply of credit in the economy by $2 trillion. That shock and the huge drag from the negative wealth effect -- home equity is Americans' principal store of wealth -- are enough to shave more than two percentage points off economic growth this year, projects Hatzius.
So get ready for a nasty slump in consumer spending, probably the worst in three decades. After years of borrowing aggressively and spending far more than they produce, U.S. consumers will reduce their discretionary spending on autos, clothing, furniture, vacations and the like. The cutting has clearly begun. Goldman strategist David Kostin expects real growth in consumer spending of less than 1% in both 2008 and 2009, the first time growth would be so low for two straight years since World War II.
But at least the dimensions of consumer retrenchment -- repaying debts, cutting spending, rebuilding savings -- are known. The same cannot be said of the infirm financial system.
Financial uncertainty
We know that credit losses have impaired bank balance sheets and that the necessary write-offs will reduce banks' lending power. But because of the way Wall Street bundled and securitized mortgages and other assets into complex, murky derivatives, we still don't know the extent of the damage to the financial system. "No one understands how the tentacles reach out," says Jeremy Grantham, chairman of GMO, a money manager in Boston. "We're all flying blind."
Government regulation of the financial industry will likely increase significantly and the industry will be transformed -- but into what? Writes Pimco bond guru Bill Gross: "The private credit markets have forfeited their privileged right to operate relatively autonomously because of incompetence ... and excessive greed. Whether you know it or not -- whether you like it or not -- you are bailing out Wall Street."
Gross expects the government to force Wall Street to reduce debt-to-equity ratios -- currently a towering 30 to 1. Moves like that could reduce risk in the system but will mean less-abundant and higher-priced credit for borrowers.
POSTED BY: GregC (May 01, 2008 12:49 PM)
... article consists of expert opinion predicting a slow steady recovery supported by negative evidence pointing to substantially impaired potential for US economic growth compared to past recessions.
