Recession Threat Receding?
09/30/07
Alan Greenspan estimated on Friday during an interview with BCC radio that the chance for the U.S. to sink into a recession is less than 50%, although he is more uncertain of how strong world economies are. During this interview the ex-central banker said he sees a serious downturn as more likely than he did before. Previously, he had guessed that the odds of a recession were one in three. Whether a recession will come in 2008 is of course hotly debated. The bears naturally quote the looming adjustable mortgage loan resets that are going to occur in 2008. What they are referring to is the fact that 30% of all outstanding mortgages (about $11.5 trillion) are adjustable rate mortgages. These adjustable rate mortgages usually adjust their interest rate upwards after two years. These $3.45 trillion worth of ARMs will not all re-adjust in 2008, but about one third of them might and that gives the bears their arguments. They calculate that these readjustments will reduce the amount of discretionary dollars available for spending. Diminished retail spending will decrease profits in the retail sector and in turn will drag down other sectors, thus causing a recession. The dollar amounts involved are staggering, no doubt. This combined with declining collateral (home) values caused some serious dislocations in the credit markets, which in turn required the Federal Open Market Committee (FOMC) to lower the Fed Funds rate by 0.5% two weeks ago.
The result was that the dollar reached all time lows because of shrinking interest rate advantages compared to the rest of the world. This also caused gold to increase in price and to approach all time highs in September. You can see the respective charts above. I am sure that you can guess which one is gold and which one is the dollar. Even Warren Buffet is making money on his short dollar position now.
For the last 3 years the bear case essentially has rested on the argument that the consumer, having to endure upwards ratcheting mortgage payments, will lack spending power thus causing the recession. So let's shake the bears down and see whether their arguments are valid:
Total adjustable rate mortgages (ARMs): $3.5 trillion
Average upward adjustment: 3% or $105 billion
That's it???? That is the argument? Big Deal! Today we learned that seasonally adjusted personal income rose between August 2006 and August 2007 from $11,028 trillion to $11,774 trillion. Difference: $746.5 billion
I know, the increase in mortgage payments probably hits those consumers, who could otherwise not have afforded a home purchase and therefore - as usual – hits the ones that can least afford higher mortgage payments. In turn the bulk of the wage increases is probably benefiting the high income earners disproportionately. Be that as it may. The drag on the consumer sector pales against the income gains realized by American consumers last year. The rise in energy costs of course constitutes an additional drag on the consumer, but these numbers are also not enough to make a real difference. This weeks GDP data showed that personal spending on gasoline, fuel oil and other energy costs increased only about $10 billion over the year ended June, and personal spending on electricity and gas increased $17 billion. As for the inflation data, the small 0.1% monthly gain in the PCE core deflator brought its year-over-year gain to just 1.8% from 1.9% in July, its lowest level since February 2004 and within the Fed's comfort zone. It seems to me that the possibility of a recession in 2008 has increased yes, that dislocations in the credit markets are real and need to be carefully watched, but the economy is not showing any signs of an imminent recession yet. On the contrary:
The chart above shows the condition of the American corporation in terms of after-tax profitability, cash flow and capital investment. Cash flow is leading capital investment by a comfortable margin, which is essential for a certain amount of business confidence which in turn influences future business and investment decisions. The after tax corporate profitability has essentially quadrupled since 2002.
This chart shows the Baltic Dry Index (BDI), a key gauge of shipping rates in the world's busiest shipping routes. It reached a new record high yesterday at 9,259, a level much higher than in June when it was as low as 5,254. Two months ago, the index was at 6,838. The BDI tends to correlate well with commodity prices, at least in terms of direction of change, owing to its correlation with economic activity.
Let us summarize the arguments:
1. Rising incomes far outpace potential increases in cost of living through mortgage resets, higher energy costs or inflation
2. The average American corporation enjoys rising profitability and cash flow
3. The international markets are booming and shipping companies have become gold mines
Goldilocks environments can come crashing down on you in the blink of an eye; we know it and many of you might have experienced it. It behooves us to remain circumspect, but the current environment does not lead me to suspect that our economy is teetering on the brink of a recession. Whether the Goldilocks mix of strong growth and low inflation lasts is more debatable than normal, as there are factors pulling both growth and inflation in two directions. It is a situation in flux, and we, like the Fed, need to focus on the "timeliest indicators" for clues.
The current bullish picture might change for example next Friday, when we hear about the employment situation. Rising consumer incomes depend on a strong labor market. If the labor market weakens due to a crash in the home building sector and a concomitant loss of jobs then the bears might get another, better argument.
Hermann Vohs
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
