I think the debate is largely over. We are in a consumer recession. After years of unprecedented credit availability, driven by expectations for never-ending gains in real estate prices and relatively low interest rates, consumer debt exploded as a measure of household income, GDP, or overall net worth. In fact, the ratio of debt to income rose as much in the last six years as it did in the previous 40 years (source: Federal Reserve Board).
So what’s next?... Credit is and will be much more difficult to get, especially for individuals with marginal or suspect financial strength. Moreover, with housing prices continuing to fall, the ever-resilient consumer may finally be at a meaningful inflection point in terms of overall spending relative to income. Baby boomers who wrote off social security long ago, while banking on growing equity in their homes to support their eventual retirement, may now have to search for other options. Worse over, those who borrowed against their retirement nest egg through home equity loans may face serious financial challenges. For a generation who lived beyond their means is it now time to pay the piper? Can we really become a nation of savers after all these years of rampant consumption?
In the meantime, the write-offs will continue… Thus far the banks, brokerage firms, and insurance companies have written off approximately $150 billion in loans and debt instruments. Unfortunately this isn’t the end. Estimates for the total that will eventually be marked down or written off approaches $500 billion with some estimates as high as $700 billion. Yikes.
On the positive side, the yield curve is likely to steepen as the Fed continues to lower short term interest rates while inflation fears prevent the long end of the yield curve from falling as much. There is some good news in this. Banks tend to thrive when the yield curve is steep, as they generally borrow short and lend long. Over time, as long as the yield curve remains steep the banks will eventually earn their way out of the mess they are now in.
Home prices, how low will they go?... The average price of a home has fallen approximately 9% over the last quarter of 2007, the worst decline in the 20-year history of the housing index (source S&P). It is difficult to predict when the housing situation will turn around. On the positive side, Federal Reserve Chairman Bernanke thinks housing will bottom some time next year. Meanwhile, Congress is debating several bail-out programs to stem the tide of foreclosures.
On the negative side, there are estimates for further declines in housing prices of up to 25%. I don’t believe anybody really knows, since we are sort of in unchartered waters.
But here is an interesting question: Since the rise in housing prices lasted longer than many economists forecasted, why wouldn’t the down turn do the same? That is typically how bubbles form and how they burst. Moreover, any federally sponsored bail-out programs will only serve to worsen the credit tightening cycle. Despite the Fed’s 2.25% of interest rate cuts, the capital markets are more reluctant to lend, and understandably so in this context. Why would any institution lend if there is no penalty of not repaying? In a nut shell, we are not out of the woods yet and continue to maintain a cautious stance towards financials and consumer discretionary.
From a global perspective, a US recession is likely to weaken other economies around the world. If there is a global slowdown, my sense is that energy and commodity prices will correct, perhaps in a meaningful way. As a result, we are cautious on financials, consumer discretionary, commodities, and energy, for those of you keeping score at home.
Can the other sectors carry the load to keep stock prices moving higher?... Let’s take a look at each of them one at a time. First, technology stocks have lagged the overall market thus far in 2008 having fallen 13% vs. the 6% drop in the S&P 500, reflecting fears that problems in the consumer and financial sectors will cause corporations to pull back on spending as well. Additionally, in a tough market environment, high beta names tend to under perform, so we are not looking for leadership from the tech sector this year.
The next candidate might be the more stable growth areas like consumer staples and health care. On the former, there are a few respectable growth stories, but not many. As for health care, the threat of universal health care and a united federal government under Democrat control is enough to be cautious in general on the health care sector. Within health care, we do favor medical equipment and hospital supply over pharmaceuticals.
OK, back to the score card… Add technology, consumer staples, and health care to the uninspiring list. What does that leave? Not much. Industrials, perhaps. We are generally positive on companies that are paving the way for infrastructure growth around the globe, as well as companies that drive more efficient use of natural resources like water. Companies that make meters, valves, pumps, dispensers, and related products should have exciting secular growth stories. It is one area in which we are doing considerable research. We hope to have more thoughts to share on this topic in future editions of Willingdon Views.
