The winds of change are blowing harder than usual this year, perhaps gale-force by election day and it seems each presidential candidate is trying to upstage the other as ‘the” champion of real change, caught up as they are either in the romantic notion that he or she actually can initiate (instigate?) radical change, or, cynically, only exploiting a developing Social Mood becoming more amenable to such change.
In fact it is the current collective Social Mood, an admixture of fear about the economy and anger at our continuing involvement in Iraq which has been fermenting for about a year now and which is giving cover to the ordinarily more-restrained aspirants to public office. This mood has been ripening, fermenting, stewing in its own juices for about a year now, daring candidates to propose outlandish ideas to fix this problem or that program without fear of the attendant ridicule which normally would accompany such hare-brained schemes in times otherwise considered “normal.”
As usual, candidates are behind the curve. Less so the Democrats in 2008, as they currently are the “outs” and may load and reload again, hammering away with impunity, with all ideas, no matter how farfetched, remaining on the table. Here the Republicans must tread more softly, being the “ins,” and must float their ideas for change, mostly variations on the theme, without appearing to trash – too much – the policies of the current occupants of Washington, D.C.
But what about all this talk of “change” and what will we see this year? First we must differentiate the concept and degrees of change.
Change mostly occurs in minute packets, incrementally, over long periods of time. Think glaciers, evolution and your opinion of your daughter’s boyfriend.
Proposals for radical change, such as the sweeping reforms to health care proposed by the Clinton administration in 1993, fail miserably in the absence of a mass, public perceived needfor radical change (the status quo having been thoroughly and convincingly discredited), which, in turn, often must be triggered by extraordinary external conditions or events.
Think of the social safety net programs created after the Great Depression, our swift entrance into World War II in 1941 following the attack on Pearl Harbor, and the adoption of Great Society programs in the 1960s following the assassination of JFK.
More recently, think of the trickle-down economic policies based on tax-cuts and deficit spending in the 1980s following the oil shocks and Paul Volker-induced recession of the late 1970s and early 1980s, or the imposition of the USA PATRIOT Act immediately after 9/11 (the roots of which are The Antiterrorism and Effective Death Penalty Act of 1996, itself passed in the tragic wake of the Oklahoma City bombing in 1995).
Which is why, taking the issue of universal health care as an example, proposals this year to change health care all include the continued use of private health insurance as the primary means of reimbursing expenses and require all Americans to be insured. Hence, a variation on a theme as opposed to radical change, there being no extraordinary external event or evidence today, as in 1993, to compel such change.
As described below, however, the winner of November’s election may find, as his or her first term progresses, that wanting the presidency may be far different from what may be the difficult the experience of actually having it. We’ll explain.
Economic forecasters and observers finally are warming to the likelihood of recession in 2008. Less than a year ago, The Maestro, Alan Greenspan, sent global markets reeling with an off-the-cuff (?) observation the U.S. economy had a one-in-three chance of entering recession by year-end 2007, having become somewhat “long in the tooth” as economic expansions go.
Six months ago, as the first wave of the Subprime tsunami washed ashore when Bear Sterns announced it would have to contribute $3 billion to stitch up two profusely hemorrhaging structured investment vehicles (SIVs), were advised the Subprime problem was isolated and “contained.”
At year end, credible estimates now rank the Subprime problem as the likely most costly financial debacle in the history of the world, perhaps as much as $500 billion in eventual write-offs, but, again, those in the loop swear that’s the end of it and the global economic growth proceeds apace.
More likely, however, now that Social Mood is swinging toward a darker, less-contained, view, is the toxic subprime spillover pollutes other pools, and as a tsunami generally occurs in multiple waves, we have only seen the first of several.
The key is this: Social Mood drives markets and economic activity, not the other way around. When between half and 70 percent of survey respondents already, as of year-end, believe the U.S. economy is in recession, the actual recession never is far behind.
As humans we are hard-wired to expect a future similar to current conditions. When times are good, business is good, profits are good and markets are good, we naturally expect similar results in the future and make little effort to conserve resources. We build and own McMansions and gas-guzzling cars and altitude-record skyscrapers and our government initiates costly military adventures because we are told “deficits don’t matter.”
When times are bad, we see no end in sight and we act accordingly. We pull back, stop spending, stop investing, stop hiring, stop expanding. We buy used cars with better mileage, move into smaller dwellings, go on unemployment and go bankrupt. And we wait for the cycle to repeat. At the cusp, these variations in social mood often are quick and intractable.
And, at this moment, the mood has shifted unfalteringly to the dark side of recession and bad times.
Our nation’s current economic environment is deteriorating into a slow motion train wreck, viewed in slow motion, the effects of which will play out over more than a decade, in a similar fashion to what was witnessed in Oklahoma from 1982-1992. This is not a drill, but, as always, different parts of the country will be impacted unequally, with energy producing states faring best.
Compared to year-end 2007, home prices in major markets could fall another 10 percent to 15 percent in 2008 and 20 percent to 45 percent before bottoming, a process which will take another three or four years followed by another decade to recover to mid-2007 levels. Many speculators trying to “call the bottom” by buying properties on the way down will be burned as badly as those who bought on the way up but didn’t sell at the top, exactly as was the case with stock market investors in 2000 – 2002.
Subprime meltdown ultimately carries a $500 billion price tag worldwide. Bank, Brokerage and Insurance write-offs to date, about $80 billion, only the beginning. Public Accounting firms, in wake of Enron, will be in no mood for creative accounting which might otherwise shelter SIVs, derivatives, ABSs, CDOs, counter-party claims on balance sheets. “Marked-to-Make-Believe” becomes “Marked-to-Market.” Toxic financial waste is lurking everywhere, from Norwegian municipal investments to Florida government investment pool to large money market funds.
The U.S. stock market appears to be levitating solely on the hot air emerging from FIRE economy firms suggesting their remaining exposure to Subprime is “contained” despite an earnings recession which began in the Third Quarter and which will be confirmed by Fourth Quarter 2007 results. Dow and S&P, after trying to reclaim October record highs, top in mid-to-late-January, NASADAQ in early February. 2008 will be an ugly down year in many segments of the market (but not all).
Because of the significant risk of deflation, the Federal Reserve, in coordination with central banks of other industrialized countries, will focus first and foremost on fighting declining asset prices with liquidity to prevent a protracted U.S.-1930s or Japan-1990s style asset price collapse.
2008 election politics will exacerbate deteriorating economic conditions as candidates of both parties attempt to garner political gain by exploiting and distorting each economic report to his (or her) own advantage.
Stagflation will re-emerge as an economic condition and media buzzword from wherever it has been hiding since the late 1970s. Declining economic output will be coupled with rising commodity inflation – food and energy – initially, while other consumer and asset prices may begin to fall.
The pendulum of social mood, a far more accurate predictor of future economic conditions, now is swinging to perception of calamity from its previous, almost fixed position of prosperity, and has moved at least halfway toward feelings of impending doom in a scant six months.
A major financial institution failure will erode public confidence in financial markets, possibly inducing a “run” on banks, brokerage and investment firms, money market funds. (CitiBank, Washington Mutual, Fidelity, Bank of America, JP Morgan Chase, Wachovia, Wells Fargo, UBS, Merrill Lynch, Smith Barney, MBIA, AMBAC).
When it comes to the future, we just don’t know what we don’t know. History rhymes according to Mark Twain, and thus comparisons to 1929-1941, 1973-1974, and other long periods of depressed economic activity in various times and places around the world may not serve with crystal clarity.
The unpredictable and the serendipitous significantly will impact our present scenario, and indeed already has, to an extent obvious only in later years with the crystal clarity of hindsight (The Black Swan effect). A major bank, investment house or insurance failure, for instance, or a money market fund with losses so significant it “breaks the buck.” A terrorist attack in the U.S. or a foreign military attack on overseas U.S. bases or ships. And those are only a few of the unknowns of which we already know. The truly unpredictable event must remain nameless, but our inability to define it makes its occurrence no less likely. (reference 3Q2007 Morgan Stanley CFO “fat-tail” event causing $9B loss). Someone later will find an obscure reference to the exact event or condition in a novel or on the web.
Liquidity injections and money-supply increases (monetary stimuli) can become irrelevant, perhaps counter-productive in an economic environment in which lending activity has been vastly curtailed.
Fiscal measures such as tax cuts or “helicopter drops” of money (direct cash aid to homeowners with Subprime mortgages for example), or further increases in government deficit spending for defense, agriculture, energy and other programs will add to the national debt burden, further weaken the value of the U.S. dollar against other currencies, and induce additional direct U.S. equity and asset purchase investments by sovereign wealth funds which no longer care to hold as many U.S. Treasury obligations.
The Fed will worry about inflation some other day, despite early warning signs of actual inflation, principally in food and energy, which, conveniently, it omits from its focused-upon “core” inflation rates.
The next hull breech in 2008 will center around home equity lines of credit (junior liens on residential real estate), as banks, realizing that property values are declining and many lines of credit were made available right up to the (now-inflated) appraised value of the homes, begin to clamp down on once-liberal credit terms.
Unlike the traditional mortgage market, where banks and financial institutions for the most part are conduits, in the $1.1 trillion home equity loan market, 95 percent of these loans hare held on the books of the originating institution.
As banks start digging through their files, and begin taking a look first at all the home equity lines of credit extended at 90 percent to 100 percent of appraised value they will move quickly to freeze borrowings at current outstanding, and begin to require principal payments in addition to monthly interest.
The home-as-an-ATM concept quickly evaporates as homeowners begin to struggle to make principal and interest payments, and will divert funds from making payments on other debt, principally unsecured credit cards.
Public perception of recession becomes self-fulfilling prophecy as spending slowdowns trigger unstoppable chain of events.
A it becomes apparent in the big-bonus alchemists’ world of structured finance, derivatives, collateralized debt obligations and asset-backed securities that “marked-to-model” meant “marked-to-make-believe,” the process of marking to market will be exceedingly painful and require massive amounts of equity injection from – where else – the sovereign wealth funds.
So far in 2007, however, not all equity investments have turned out well for the SWFs. Remember in June when China’s SWF wrote a $3 billion check for a 10% piece of hedge-fund-gone-public Blackstone Group? It’s now worth about $2 billion or so, but, hey, one has to crack a few eggs to make an omelet.
The Saudi Prince Al-Waleed’s 5 percent investments in CitiGroup in 1991 and Apple in 1997 eventually paid off, to say the least.
Housing price declines in major markets likely will accelerate from the current nearly 7% October 2007 year-over-year drop (20 market composite).
Depending upon the market, we are only one year into the housing correction (Miami, peak December 2006) at the near end and two-plus years at the beginning (Boston, peak September 2005).
Considering the stock market correction lasted from March 2000 to October 2002, about two-and-a-half years, and despite the hype impacted only 20 percent or so of Americans, the housing slump will last far longer and impact far more people, hence the “slow motion” aspect and the far greater likelihood of a significant recession on par with 1973-1974.
Markets including Phoenix, Los Angeles, San Diego, Miami, Tampa, Las Vegas, New York, Seattle, Portland, San Francisco, Boston, Minneapolis, Chicago could see price declines of an additional 20% (Chicago) to 45% (Los Angeles and Miami) if housing prices in those area only revert to prices based on an historical annual rate of appreciation calculated from housing data from 1987-2000. (most of those cities already have seen 8% - 10% average price reductions since their respective residential housing markets peaked between September 2005 and December 2006.
Some bright spots: Denver, Atlanta, Charlotte and Dallas where annual appreciation since 2000 have averaged between 3.5% and 6.0%. Cleveland and Detroit actually have seen below average price growth since 2000, compared with the historical rate prior to 2000, though some would be hard-pressed to describe aspects of either city as a “bright spots.”
Compared to year-end 2007, home prices in major markets could fall another 20 percent to 45 percent before bottoming, a process which will take five years to hit bottom and another decade to recover to mid-2007 levels. (Remember the stock market required more than two-and-a-half years to bottom in late 2002 and four more years to recover to March 2000 levels, and involved less wealth and far fewer participants, and thus was more contained and spawning only a brief, mild recession.)
US Total corporate profits have entered recession, foreshadowing a general economic recession for 2008, after posting a second consecutive quarter of decline, based on 4Q earnings reports as of 12/31/2007 and 01/31/2008.
01/10/2008: Fourth-quarter profit at S&P 500 companies probably fell 8.1 percent from a year ago, the biggest drop since 2001, according to analysts' estimates compiled by Bloomberg. Earnings at financial companies probably declined 63 percent, the only drop among 10 industries
Once-“contained” Subprime, which has resulted in worldwide write-downs of $80 billion as of year-end (before fourth quarter reports), account for another $100 billion in charges to fourth quarter earnings in financial sector. Subprime write-offs will exceed another $200 billion for fiscal 2008. Institutions will begin reserving for legal costs to defend themselves from a landslide of lawsuits which begin erupting during the year.
US Housing prices will continue to fall in 2008, another 10% to 25% from YE2007 levels, varied by market. Total eventual decline from 12/2006 peaks, by market, range from 30% to 55% (regress to average), including Phoenix AZ, Los Angeles CA, Miami FL, Las Vegas, NV.
Some US markets less impacted by comparison, including Charlotte NC, Atlanta GA, and Denver CO. Some markets hold or see minimal decreases, such as Dallas TX and Oklahoma City and Tulsa. New York NY will see early 2008 gains but will peak at mid-year.
Automakers will see further sales declines from an anemic 2007.
Federal Reserve and foreign central bank activities in 2008 will focus solely on preventing viral asset deflation despite longer-term inflationary fallout from such policies. Central banks will continue liquidity injections and the Fed will continue lowering its targeted interest rates, perhaps to 2.0 percent for Fed Funds, with little impact as bank credit availability retrenches.
Banks will discover potential loan-loss exposure from junior liens on residential property (Home Equity Loans and HELOCS) especially loans and lines previously granted up to 80% - 100% of appraised values and unsecured credit cards, the balances of which have become concentrated among several large issuers following a decade of mergers and acquisitions.
Demand-driven commodity price increases in 2007 continue apace in 2008, with further inflation resulting from speculative activity finding fertile ground in commodities markets following abandonment of other scorched-earth investment sectors.
Oil and energy commodities will fall in 1Q2008 from seasonal demand declines but prices surge to record highs later in the year. Oil could see $160/bbl and natural gas $18/mcf.
Auto sales will decline further from 2007, and last year was the worst year for auto sales since 1998. Ford, which loses its 76-year hold on the number two spot to Toyota, saw 2007 sales fall 12%, GM 6%, while Toyota and Honda both gained more than 2.5%.
More than half of surveyed investment managers believe US stocks will gain at least 8% in 2008, making it the least likely outcome. More likely: US Stock markets peak 1Q2008 (mid-to-late January for Dow, early February for S&P 500 and mid-February, latest for NASDAQ) which become the highs for 2008, with full-year declines ranging from 10% - 20% for Dow/S&P, 15% - 25% for NASDAQ. European markets down 0% - 10% for 2008. Asian stock markets are roiled by US recession, but again produce big (50%+) full-year gains as Asian economies boom and money stays in/flows into these markets.
Commodity inflation apparent in 2007 in “Crude Foodstuffs and Feedstuffs” measure of PPI spills over into Intermediate and Finished Goods PPI, directly impacting CPI to produce highest consumer price inflation in years, greater than 6%.
One or more major banks, investment firms, money market funds or insurance companies worldwide will approach the brink of “failure” in 2008, accompanied by corresponding government bailouts and/or Sovereign Wealth Fund capital injections to insure none actually fail. Additionally, dominant entities may be forced to sell assets, business segments or markets, notwithstanding raising capital from overseas, to maintain regulatory capital positions.
Key Stats: 12/31/2008 (Est) / 12/31/2007
FF Rate: 2.0% / 4.25%
Prime Rate: 5.0% / 7.25%
3-Month LIBOR: 4.50% /4.75%
10-Year US Tsy: 5.50% / 4.25%
30-Year US Tsy: 6.50% / 4.75%
30-Year Mortgage: 8.00% / 6.125%
GDP 2008 0.6% (Q2-Q4 Negative) / 3.5%
USD/Euro: $1.60/Euro (1.72/Euro peak) / $1.45/Euro
CPI: 6.2% Full year, 4.4% Core / 2.4%
PPI: 7.0% Full year, 5.0% Core / 3.0%
Unemployment: 6.9% YE / 4.9% YE
US Budget Deficit: $450 Billion (09/30/2008) / $250 Billion (09/30/2007)
DJIA: 12,000 (-15% from14,100 peak 10/07) / 13,500 (-11% from 12/07 close)
S&P 500 1,320 / 1,475
NASDAQ 2,225 / 2,675
Crude Oil: 118.00/bbl (125 peak, 82 low in 2008) / 98.00/bbl
Natural Gas: 10.00 / 7.50
Gasoline 4.25 / 2.95
Gold 1,050.00/oz (1,200 peak) / 835/oz.
2008 Off the Wall:
January: A Republican not now in the presidential race decides to enter the race late in the month after early primaries result in no clear emerging candidate.
February: At a public speaking engagement, Alan Greenspan appears to choke while trying to say the word “disproportionableness” and later lapses into a coma. Financial markets swoon for no apparent reason other than it’s Alan Greenspan and despite his retirement from the Federal Reserve two years earlier.
March: A personal data security breach will occur at a major national bank involving records of more than 50 million individuals, paralyzing credit reporting agencies and credit scoring firms/models for months.
April: Florida real-estate taxpayers revolt in protest of high real estate taxes based on 2006-2007 fictitious appreciated values. Many homeowners simply pack up and leave, fed up with high tax and homeowners’ insurance rates and no remaining equity in the homes they are vacating. Florida legislators will enact an income tax to offset plummeting real estate tax collections, which will further the impetus to leave the state.
May: Immigrants, legal and illegal, will stage another day of protest, as happened May 1, 2006. More states have enacted stricter immigration laws, resulting in an exodus of illegal immigrants from state to state.
June: 2008 Olympics occur without a hitch but are judged to be an eco-disaster in pollution-choked Beijing, despite two-week shutdown of numerous nearby coal-fired electric generating facilities.
July: US runs out of gas, somewhere, if only for a day. The spot shortages will result motorist panic across the country with television images of Americans waiting in gasoline lines for the first time in a generation. National average gasoline prices briefly spike above $5.00/gallon.
August: A major hurricane will wreak havoc in the Gulf of Mexico, roiling energy markets and causing huge property damage losses.
September: Suburban crime rates surge in markets experiencing extreme housing dislocation as vacant, foreclosed McHomes awaiting sale or auction are targeted for looting (copper wire, etc.)and squatting, while occupied homes in neighborhoods are vandalized and burglarized.
October: A low-casualty/high profile terrorist attack will occur, primarily causing property damage and commerce disruption, but heightening fear factor. Global financial markets will seize in its wake as retail and corporate spending craters and plans for spending, including travel/vacation and big-ticket items, are cancelled.
November: Defying all odds from a year earlier, but boosted by fallout from the terrorist attack, a Republican not now in the race will win the White House in November. Ron Paul elected VP, his selection as running mate forestalling a run as an independent.
December: Iran tests a nuclear device and gains entry to an exclusive club, its resolve to build same having been hardened following years of US saber-rattling, and its research advanced by the purchase of technology from North Korea and an unnamed former SSR.
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