U.S. ECONOMY: PHOENIX RISING OR WOUNDED DUCK FLYING? - March 1, 2008

Economic expansion rises like a phoenix from the ashes of the preceding economic recession Well, that's been the pattern for more recent US economic booms. A US recession is underway. What is less clear though whether it will be followed by a bounce? Further, is this recession contaminative with respect to the global economy as a whole, as has been the previous pattern? Or, is the US economy now less sole trend setter and will relatively robust growth in most of the rest of the world keep the US economy from sinking deeper into depression? I suspect the latter, but this shifting of global economic currents has left most investors and analysts trying to interpret the paradoxical tides. Regardless, the US economic downturn has still not hit bottom, and this time around there maybe no trampoline waiting at the bottom. More likely, it is a bowl of Jell-O, or is it something more malignant, such as stagflation ?
 

THE SCAVENGERS' BALL

Keynesian relief applications and the still robust developing and other developed economies of the globe are keeping the US economy from tumbling out of the sky. The US economy has probably already experienced the most dramatic drops. There is no free fall, but neither is the US economy rebounding. There is no phoenix rising, but only a wounded duck still trying to fly.

  
Is this positive? Well, it depends on your perspective. In the capital markets, key players tend to wait for the bottom before committing their money. Part of it is fear and part the predatory psychology. If the bottom is not yet hit, then investors are concerned that even otherwise sound valuations may prove no match for gravity in a plunging economy. Other investors are more focused on trying to time the bottom in order to appear the shrewdest in a contest among predators and scavengers. Regardless, the great institutional wealth of past economic rebounds is reaped up front. After the tectonic bust of the savings & loan industry in the very beginning of the 1990's, unrivaled wealth was amassed by individuals and institutions, such as merchant banks and hedge funds, who waited until the US Regulators responsible for liquidation of those S&L's began to sell their assets at rock bottom prices. These mostly real estate assets then were rather shortly resold or repackaged with real returns in multiples of the investment made to purchase only a couple of years earlier. The rock bottom liquidations by US regulators had also been one of the key indicators of an economic bottom, besides feeding a scavengers' ball.

THE WOUNDED DUCK ECONOMY

With no clear bottom or bounce, which has signaled the beginning of previous recoveries, the US economy will find it difficult to draw new money, investors. On the other hand, a complete crash presumably should keep the US worker and homeowner from losing his job and home.

 
Well, maybe?
 

This US recession is being lead by the squeeze on the US consumer. Those businesses servicing or manufacturing or building for the US consumer are in for an extended malaise, even potential demise. US Federal Chairman Ben Bernanke, as I am concluding this article, has been testifying before the US Congress and now has also confirmed some of the more troublesome projections that we already anticipated in our article for the EuropeanCourier.org a month earlier, (January 27, 2008: How Far the Rumble Behind the Mortgage Debt Crumble. ) It's not that I was smarter or even more perceptive than the Fed Chairman. Rather, he could not admit the danger for fear of causing further panic. However, now the situation has continued to deteriorate with respect to US homeowners and consumers that greater urgency and earnestness is required.

     
There will be some potential winners, at least survivors, (particularly those businesses that will benefit from a falling dollar or rising exports or business serving other businesses); however the overall environment is at best uncertain. At least Mr. Bernanke has not yet uttered the word stagflation, the combination of economic stagnation and unchecked inflation. That may be a term from the late 1970's and early 1980's that has outgrown its application today. My definition is a distressed economy with no clear trajectory, the wounded duck economy.
  

The US worker on the whole will be struggling to maintain. Wages will not keep up with rising costs. Worse, the US consumer will be entering and most likely exiting this recession with historically the lowest savings and equity in his/her home. He/she will face a tightening liquidity crunch, as well as credit options. Consumer purchasing capacity is at recessionary levels. Still because no bottom has been hit, it will still appear that the US economy somehow is not crashing.

IT IS NOT JUST A SUB-PRIME MORTGAGE PROBLEM

A month ago in the above described article in the EuropeanCourier.org of January 27, 2008, we alerted then that the so-termed sub-prime mortgage collapse was not likely to be just about higher risk mortgages. Our initial assessment is being borne out by the statistics and, now, by the main stream media that is catching on the nature and depth of the problem.

      
Initially the main stream media focused on the lax, even abusive lending standards associated with some but certainly not all non-conforming mortgages. Fraud was purported in almost every US neighborhood were foreclosures were reaching unprecedented numbers. It was not so much the plague that had become the news but the presumably bad or even criminal behavior that was behind the heaps of bad mortgage paper. Maybe it made for dramatic news coverage or it conveniently placed responsibility upon those who were designated to face the greatest pain from the proposed remedy; however this did not altogether define the problem.

  
The default rates on so-called sub-prime mortgages are reaching 25% default levels. However, the problem is clearly all mortgages. Defaults on all mortgages, including prime, are at levels not seen for the last couple of decades, or more. Similar recessionary indicators abound for unsold housing inventory as well as new construction. Relevant US realtor and housing associations are now predicting that the home market is scraping the bottom, implying that the floor has been reached. Maybe the US housing market is close to the bottom, but it certainly will not be bouncing of a trampoline.

 
Maybe most telling is that 3 out of 4 Americans who were considering home improvements are now delaying those projects. This is certainly bad news for Home Depot and Lowe's, but it is a telling indicator of a substantively greater problem. US homeowners do not have the money to spend on traditional basics like home improvement: Worse, maybe most did not want to pour good money after bad, if their home values had gone below water, below that of the mortgage principal.

  
REMEDY EXASPERATING THE MALADY?
 

Home values are/have declined dramatically, and in some markets by 20% or more. Some would argue that this is just about a bubble bursting, and values declining to more reasonable levels. Housing values had been rising rapidly over the last few years, but it was also a reflection of a declining dollar and the appreciation of all real asset classes. Home prices were not leading the escalation but tracking.

 
Regardless of the cause of this presumed bubble, now many homeowners find themselves with mortgages higher than current values, and with no opportunity to take advantage of lower interest rates today being driven by Federal Reserve cuts in benchmark rates. Simply put: they are not eligible for the most conservative types of mortgages, conforming, the only types of mortgages generally available after the recent tightening of regulatory standards. This has also had the pervasive effect of pushing all home prices down to levels were most homeowners have been stripped of their equity, or worse. Lower interest rates are not reflected in home values; however the reflexive tightening of mortgage standards has had the effect of making substantively worse the plight of the US home owner. Liquidity has severely dried up in the housing market. Again, Fed Chairman Bernanke has also acknowledged this shortcoming, boomerang of recent sharp and reflexive tightening of mortgage lending criteria.
 

NEW WINNERS OF THE US ECONOMY
 

Housing and consumer spending has been the post WWII driver of the US economy. This will not change overnight, but the US economy will define new priorities and confirm the increasing role of fresh driving forces. Domestic consumer spending will retreat, but here are some of the industries that should fare relatively better as compared to the mean:

1. export driven, (US dollar competitiveness);
2. technology, (innovation and greater efficiencies);
3. logistics, (with emphasis on greater efficiencies);
4. oil and resource, (still feeding global development);
5. commercial real estate, (reflecting rise in real asset values, but only in certain industries. Example: warehouse and distribution secured by longer term triple-net leases from business but not retail space dependent on the retail consumer going on a shopping trip. Lack of new construction will also alleviate the risk of overcapacity).

 
Will this be enough to keep the US economy from a deeper and longer fall? Well, I must come back to the metaphor of the wounded duck.
 

RISKS TO US/GLOBAL ECONOMY
 

The global economic environment is still trending positively, relatively. The new economies, particularly China, India, Brazil, Russia, Indonesia and even the former Communist Europe, are all still geared in catch up mode. The traditional petro-Dollar economies are engaged in developing and diversifying their economies at unprecedented levels. This is all having a positive effect on the US economy countering other negatives.
However, there are some downdrafts, potentially at least:

 
- How much of the current global growth is driven by the Chinese Governments relaxed monetary policy ahead of the Beijing Olympics to maximize this as a showcase and minimize any risk of economic or social disruption within this timeframe? After the Olympics, will Chinese authorities over tighten monetary policy, development and economic growth in a reflex reaction to regain discipline?

 
- Lowering US benchmark rates has not yet translated into more capital/loans available to US consumers, homeowners and business.

 
- The breadth and particularly the term of continued housing mortgage defaults is likely to be broader and longer than now projected by most.

 
- The tumble is rapidly contaminating other consumer debt instruments including credit cards.

 
- US financial institutions, particularly those involved in residential and consumer lending, will continue to suffer from a housing market that will continue to hiccup due to sharp liquidity and valuation contractions and ongoing defaults even in the prime segment.
 

- Rating Agencies, critical to US and global debt markets in the US, are hamstrung by the perceived failures of the mortgage backed and other asset backed securities, and therefore will not be as inclined to facilitate existing or new products, innovations that may be a decisive part of a new capital growth cycle.
 

- The US trade imbalance is persistent at unprecedented levels, and petro-Dollars and other US import payments are not being repatriated, coming back to the US as investments, equivalent to previous levels, thereby further constraining US investments and liquidity. (Petro-Dollars are being reinvested more in the developing markets as well as at home. Regulatory conditionality, such as Sarbanes Oxley and tracking of funds in criminal/terrorism prevention contexts is discouraging the US as the safe haven for capital).
 

- The US Dollar is losing is status of exclusivity or even as preferred currency. (Some of this is economic driven, but it is also driven by political, regulatory and legality considerations. A significant advantage of capitalism has been the anonymity of money. People who may not share cultural, religious or political values or simply did not care for each other nonetheless could exchange money for goods and services. However, that becomes less realistic if money loses its anonymity and is associated with certain political, legal or moral agendas. As US authorities press their own priorities in controlling international fund flows, the US Dollar is likely to be increasingly avoided. US economic sanctions in cases like Belgrade in the 1990's or Sudan today may be at least somewhat effective when applied to relatively small economies. This may also deny funding to or implicate criminal and terrorist enterprises. Nonetheless, the tactic could backfire, especially against the US Dollar, if such sanctions and tracking are so broadly applied as to be the rule rather than exception. Ironically, this week ABN Ambro decided that it no longer will accept US based investment accounts due to the regulatory burdens).
 

JUMPING WITHOUT A PARACHUTE
 

Is that dangerous? Again, it all depends on how far is down. It can even be profitable if there is a trampoline waiting. The smart money though does not jump until it is certain that it will be met by a decisive upward draft. That was the case in the 1990's. However, this go-around the clear sign of recovery is not likely to be so clear The signs may be lost in contradictory tides that some will see as a favorable current and others a dangerous whirlpool.

 
Some positive indications are already dramatically moving the capital markets. The bond insurers, (as anticipated in our article of January 27, 2008 in the EuropeanCourier.org), appear on the verge of bailout. The markets have observed the bond insurers' fate as a leading indicator of liquidity as well as economic health. US economic stimulus measures are being enacted, although not yet effecting. A new US Administration, coming within this year, will carry its own economic risks and opportunities. A Democratic Party Administration could be expected to be more sensitive to average homeowners as well as wage earners and less inclined toward trickle down economics and remedies.
 

For many US and especially international investors, the best course may appear to be no action. However, that is not possible for institutional investors of size. Even traditional safe haven investments, such as Government bonds or commercial, overnight paper carry risks of market pricing or liquidity. They are also not an adequate source for return for most institutional investors.
 

CALIBRATING NEW EXPECTATIONS
 

There has been an investor tendency to seek out developing markets. It was a good bet, but will it continue? The returns now may also no longer be commensurate with risks in many of these new economies, (from political risk to economic sustainability). Regardless, America's economic opportunities cannot and should not be ignored, even if no longer benefiting from exclusive preference. While some will try to time the market in jumping back as investors, as had been the fashion, the opportunities are likely to appear more subtly. They could be more speculative, risky investments in the still growing new economy and innovations and reflected in higher returns. They may also be going back to more conservative businesses and enterprises now offering generous returns for relatively low risk.

  
Regardless, investor expectations may be the most difficult part of the analysis. From residential housing to private equity investments, investor expectations are now in as much of a market correction.

Muhamed Sacirbey

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Mr. Muhamed Sacirbey holds B.A. degree in history and J. D. degree from Tulane University in New Orleans. He also holds M.B.A. degree from Columbia University. Prior to becoming Bosnia’s Foreign Minister and Ambassador to the United Nations, he practiced as an attorney in New York City and worked for several years as an investment banker. He presently writes his book “A Convenient Genocide, in a fishbowl ” and is a commentator on human rights and political issues.

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