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Taking Doom And Gloom To A New Level

FYI | May 13 2008

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By Greg Peel

The Californian city of Vallejo, population 117,000, has filed for bankruptcy. A city has never filed for bankruptcy before in the US. Vallejo’s tax income has been shattered by a 26% fall in house prices. There are other cities on the brink in California. They’re lining up to file.

The Dow Jones Industrial Average has gained 7.7% since the Fed pulled out the “nuclear option” of Article 13 (3) on March 17 and ensured no more Bear Stearns events. With the Fed watching its back, Wall Street has decided, for the most part, that it’s time to look ahead to the promise of the financial market crisis easing and economic growth returning. The Australian ASX 200 has risen 14.5% in the same period, driven by the supposedly safer Aussie banks and a greater proportion of corporate exposure to rising commodity prices. The question now, as many are asking, is: Is this a bear market relief rally or the real thing?

The UK Daily Telegraph’s Ambrose Evans-Pritchard has been among the most bearish commentators since the whole credit crisis began. But in his latest missive, published on Monday, Evans-Pritchard reaches new levels of doom and gloom. Central to his view is the US housing crisis, and he cites analysis by Lehman Bros and Goldman Sachs suggesting prices will fall across the country by an average of 25%. While some states, such as California and Florida, have already seen such drops in value, the national average fall is still only about 10%. We’re not half way there yet, but already Americans collectively have more debt in their houses than equity.

Under such circumstances one might expect Americans would begin reining in the fantastic plastic, but the opposite is true. Credit card debt jumped by 6.7% in the first quarter to US$957bn. That’s US$6,000 for every working American. The cash rate may have fallen to 2%, but credit card rates are at 20%. High food and petrol prices are forcing average Americans to turn to credit cards to survive. One money market trader suspects many simply intend never to pay them off.

At the corporate level, a groundswell of bankruptcies has also begun in the US.  In the last two weeks, six US “companies of substance” have gone down the tubes owing between US$142m and US$2.5bn. Evans-Pritchard notes the total in all of 2007 was seventeen. Standard & Poors notes defaults are rising at almost twice the rate of previous downturns.

The problem is this time companies have a much more toxic mix of equity and overstretched debt. Margin for error is razor-thin as the US heads into recession. Two-thirds of companies are rated by the agency as “speculative”, compared to 50% before the dotcom bust and 40% before the last big recession of the early 1990s. Debt was ramped up to dangerous levels in the 18 months prior to the credit crunch. There were deals being funded, says S&P, that should never have been funded. S&P suggests some 174 US companies are now trading at “distress levels”. This number only includes those companies large enough to score a rating of any sort.

Thankfully, suggests Evans-Pritchard, the Fed’s actions have avoided another Great Depression. With the cash rate down from 5.25% to 2% those potentially catastrophic mortgage reset rates are more manageable. However, the outlook is thus hardly positive, according to many.

France’s Societe Generale – the bank rocked in January by the world’s second great “rogue trader” affair – has, for the first time ever, reduced its exposure to equities to the minimum 30% allowed under its articles. SocGen is expecting equities to fall globally by 50-75%. It has moved to a 50% weighting of government-issued AAA bonds. “Nowhere and nothing will be immune,” said SocGen global strategist Albert Edward, “We are on the cusp of an equity meltdown that will slash and shred portfolios”.

The rising oil price had been seen as a friend to equity markets as it pushed up to US$110/bbl, notes Evans-Pritchard, fuelling strong rallies in the energy and energy services sectors. But at US$125/bbl it has become the enemy. The average US home is now spending 8% of income on fuel.

The oil spike will burn itself out, he suggests, as China hits the buffers on 8.5% (and rising) inflation. China has repeated Japan’s mistakes of the 1980s – too many factories shipping too many goods at slender margins into a crumbling export market. Lehman Bros analyst Sun Mingchun says China will tip over in the second half of the year. “With so much latent overcapacity,” says Sun, “an export-led slowdown could trigger a chain reaction which, in the worst case, could threaten the stability of [China’s] financial and economic system”.

Current evidence suggests Britain, Europe, and Japan will slump before America returns to growth, and China can possibly be added to the mix as well. Says Evans-Pritchard, “The Global Slump of 2008-09 is underway”.

Well that’s heartening, isn’t it? Of course, for every Evans-Pritchard there’s a Jake LaMotta – a raging bull who sees a US recession as shallow and temporary, the credit crisis as behind us ever since the Fed saved Bear Stearns, the housing crisis as nearing an end, and the US export economy as surging along on a lower greenback. Look out Dow 14,000, we’re coming back!

The reality is that every bear market has a relief rally, and never does a market drop 20%, turn on a dime, and then return directly. The euphoria soon runs out of puff as those investors who missed out on selling on the way down take the opportunity to sell on the bounce. And just as the down-move may well have overshot, so too will the bounce likely overshoot as well. As to what the correct levels and timing are is a matter of conjecture, and that which ensures a market exists. But at the very least, dooming and glooming aside, global equities will need to do some more work to form a more solid base before investors can start to worry that they’ve missed out on the next great rally.

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