Thanks to Supercycle

HICCUP WARNING

Calling short-term market moves is not my forte, but several on the Morgan Stanley team now see the chance of a short-term consolidation/correction in equity markets. Note, however, that none of these colleagues is bearish on the medium term, and all see any near-term pullback as a chance to reload for further gains.

The common theme is that after the recent sharp gains, a pause is warranted:
DUD071004.pdf

DOWNUNDER DAILY : ERROR COUNT - October 21, 2007 GMT (6 pgs/ 76 kb)

Gerard Minack +61 2 9770 1529 Morgan Stanley Australia Limited+

I remain bearish on the prospects for 2008, despite the recent strength in equity markets (Friday aside). But I'm always on the look-out for how I could be wrong. Let me count the ways:

DUD071022.pdf

DOWNUNDER DAILY : PAST AN INFLECTION POINT - October 22, 2007 GMT (7 pgs/ 74 kb)

Gerard Minack +61 2 9770 1529 Morgan Stanley Australia Limited+

It's now well appreciated that this equity market cycle has been driven predominantly by earnings, rather than valuations. The E, not PE, has moved markets (Exhibit 1 shows the picture for the global MSCI index). This is a critical point, in my view. In particular, it suggests that the key threat to the bull market is material downgrades to growth and earnings, rather than rising rates.

DOWNUNDER DAILY : COPPER CUM CROPPER? - October 23, 2007 GMT (6 pgs/ 99 kb)

Gerard Minack +61 2 9770 1529 Morgan Stanley Australia Limited+

Slower US growth appears to have had an imperceptible impact on the rest of the world - except, perhaps, for industrial commodity markets. For now, investors haven't noticed or cared - the mining sector has surged through the past year - but there are warning signs of a serious set-back if we see a broader global slowdown in 2008.

The first point to note is that commodity prices are now being flattered because they are priced in US dollars. Prices are more muted in other currencies. Exhibit 1, for example, shows the LME base metal index priced in dollars, euros and a basket of Asian currencies. The noteworthy point is that in euro terms metal prices are around the bottom of the range seen over the past 15 months.

DOWNUNDER DAILY : DECOMPRESSION - October 24, 2007 GMT (6 pgs/ 113 kb)

Gerard Minack +61 2 9770 1529 Morgan Stanley Australia Limited+

One hallmark of the four-year rally in risk assets was the compression in returns and asset pricing. Never has the cliche been truer: The rising tide did lift all the boats. This year, however, has been different, with performance and pricing becoming more uneven - something I expect to continue. DUD071025.pdf

DOWNUNDER DAILY : AMERICA'S TOP MODEL - October 28, 2007 GMT (6 pgs/ 83 kb)

Gerard Minack +61 2 9770 1529 Morgan Stanley Australia Limited+

There are a number of commonly used indicators designed to pick turning points in US growth - and hopefully provide early warning of recession. The good news for economists is that none of them is perfect (that is, they don't put us out of a job). The bad news for investors is that the message now is mixed, confirming that it is right to be uncertain about the outlook. Here's a review of what they're saying:DUD071029.pdf

DOWNUNDER DAILY : GROWTH DOESN'T MATTER (AS MUCH AS YOU MAY THINK) - November 05, 2007 GMT (6 pgs/ 76 kb)

Gerard Minack +61 2 9770 1529 Morgan Stanley Australia Limited+

The 1990s tech bulls at least got one thing right: real demand for technology products has consistently outstripped GDP growth. Of course, buying tech in the late 1990s was still a lousy investment. Conversely, mining sector output has consistently disappointed forecasts over the past few years, with supply estimates repeatedly pushed out. Yet mining equities have been a stellar investment.

All of which hints that there is no close link between real growth - in both these cases, at a sector level - and investment returns. There are two missing pieces to the puzzle:DUD071106.pdf

DOWNUNDER DAILY : DOWNSIDE RISKS GO UP - November 06, 2007 GMT (7 pgs/ 100 kb)

Gerard Minack +61 2 9770 1529 Morgan Stanley Australia Limited+

The downgrades to growth keep coming - and the downside risks increase. Morgan Stanley U.S. economists Richard Berner & David Greenlaw, who were already on the low side of consensus, have reduced their through-the-year 2008 US GDP forecast to 1.7% from 2.1%. At the start of the year, they were expecting 3.0% growth for 2008. DUD071107.pdf

DOWNUNDER DAILY : A THREE-PACED BEAR MARKET - November 07, 2007 GMT (6 pgs/ 106 kb)

Gerard Minack +61 2 9770 1529 Morgan Stanley Australia Limited+

Developed-world credit has entered a bear market. However, the degree of stress is uneven across three areas: 1) short-end financing; 2) housing-related credit; and 3) corporate credit. Here are some thoughts:

First, there's general agreement that credit risk was under-priced earlier this year. While policy makers have worked to settle dysfunctional markets (particularly the short-end funding markets), they are not aiming to restore credit pricing to any particular level - and specifically not aiming to restore pricing to the levels seen earlier this year. DUD071108.pdf

DOWNUNDER DAILY : ANOTHER STUMBLE - November 08, 2007 GMT (6 pgs/ 64 kb)

Gerard Minack +61 2 9770 1529 Morgan Stanley Australia Limited+
Another stumble in equity markets so, as a big-picture bear, I have to ask: is this it, the start of a bear market? My answer is 'no'. I expect this will be another buy-the-dip opportunity. Here are some thoughts:

First, markets seemed ripe for a bout of profit-taking after the electrifying recovery from the August lows. Our Emerging Markets team has noted that corrections are likely when the MSCI emerging markets index is 20% above its 200-day moving average - last week the index was almost 30% above that average (Exhibit 1).

Second, it's noteworthy that recent gains had run ahead of earning forecasts in most markets (particularly EM). That meant that PE ratios were rising. Average valuations are not stretched by late 1990s standards, but they are now high compared to recent history. Exhibit 2 shows how stock prices have out-paced consensus earnings forecasts for the global ex-US MSCI index. (The chart is drawn so when the lines intersect the index is on a prospective PE of 15x.)DUD071109.pdf

The Widening Debacle Gerard Minack +61 2 9770 1529 Morgan Stanley Australia Limited+

The credit debacle is getting both wider and deeper. Obviously, this means more pain for those directly involved. Moreover, the unraveling of the great credit bubble is becoming the single biggest threat to growth - and hence equity markets - for next year.

The stress signs that roiled markets in August are returning, but they are broadening. Prices for residential mortgage backed securities (RMBS) are now almost in free-fall (more on that below). As noteworthy is the contagion: Commercial mortgage backed securities (CMBS) are now under pressure (Exhibit 1).DUD071113.pdf

DOWNUNDER DAILY : FROM A CREDIT SCARE TO A GROWTH SCARE - November 13, 2007 GMT (6 pgs/ 95 kb)

Gerard Minack +61 2 9770 1529 Morgan Stanley Australia Limited+

Last Friday (Another Stumble), I argued that markets were in another buy-the-dip setback to the global risk trade. I thought it would be buy-the-dip because the focus was on credit, rather than growth. Taking a second look, however, there are signals that growth is starting to become an issue. If these signs intensify, it would bode ill for equities. Indeed, it would increase the risk that the end-October highs mark the peak for the bull market.

Our strategists are also more cautious. Toby Walker went neutral Australian equities on 30 October (Moving to Neutral Australian Equities); Jonathan Garner clipped his Overweight in emerging markets on 8 November (2008 Outlook: Reducing Equities OW to 2%), and Teun Draaisma went neutral European equities on Monday (Too Much Uncertainty - Taking Profits in Equities).
DUD071114.pdf

DOWNUNDER DAILY : THE BIG DISAPPOINTMENT - November 14, 2007 GMT (6 pgs/ 65 kb)

Gerard Minack +61 2 9770 1529 Morgan Stanley Australia Limited+

Japan gets my vote for the stand-out disappointment of 2007. It has the world's worst performing major equity market (down 10% year-to-date, and the only market down even in US$ terms), and the economy has slowed despite signs last year that it was shrugging off the structural problems that dogged it through the 1990s. More worrying, some leading indicators are pointing to worse to come.

In fact, some indicators are pointing to much worse to come: The OECD's leading indicator for Japan now points to a recession-type fall in operating profits (Exhibit 1). The leading indicator has an excellent track record, so this warning should be taken seriously.DUD071115.pdf

DOWNUNDER DAILY : BACK IN THE KENNEL - November 15, 2007 GMT (6 pgs/ 101 kb)

Gerard Minack +61 2 9770 1529 Morgan Stanley Australia Limited+

"Bankers are like dogs." Not my view, that's from Guy Hands, CEO of buy-out firm Terra Firma Capital Partners. Mr. Hands continues: "They hunt in a pack and go into a feeding frenzy. When hit, they whimper, and hide in their baskets. The bankers have been hit very hard, and they're not going to come out of their baskets." Banishing bankers to their baskets has a number of implications:DUD071116.pdf

DOWNUNDER DAILY : No So Happy Year - November 19, 2007 GMT (6 pgs/ 101 kb)
Concerns about end-of-year funding pressure are contributing to renewed stress in short-end funding markets. The end-of-year turn used to be a big issue in short-end markets, with short-term LIBOR rates often spiking 50-100 basis points over the funds rate (compared with a more usual spread of 10-15 basis points). This seasonal pattern has not been evident over the past few years, but now - with markets more than usually fragile - it seems that this year could be different. DUD071119.pdf

DOWNUNDER DAILY : E Bubble case study - November 20, 2007 GMT (6 pgs/ 101 kb)

The financial sector is a case study in the earnings-driven nature of the current cycle. Until recently, the financial sector broadly matched the performance of the overall market through the past four years, building on a decade-long period of substantial out-performance in Anglo markets. Exhibit 1 shows the relative performance of financials in the US and in the rest of the world. DUD071120.pdf

The decline in metal market is becoming more serious. The LME's base metal index is now down 20% from its May peak. That's in US$ terms; in terms of other (stronger) currencies, the decline is even more pronounced, and in euro terms the index is now at an 18-month low (Exhibit 1). DUD071121.pdf

We no longer have a sub-prime credit crisis: in our view, we now have a global credit crisis as one of the greatest-ever credit bubbles painfully deflates.This is critical for all investors: low rates, plentiful liquidity and loose lending were pervasive supports for risky assets everywhere - and the businesses that made money creating, trading, rating, financing or owning them. A few points about this:

First, easy credit was very important to all risk assets, including equities. Easy money contributed to very strong economic growth. Rising asset prices have also directly contributed to reported profits. To give one example: Jerry Lou, our China strategist, has estimated that investment and non-operational income contributed 42% to reported EPS growth for China's A-share index over the past year. Reported EPS growth was 75%, while 'core' earnings growth was 33%. (For details, see China A-share Strategy: 1H07 Result, Super Growth or Super Bubble?, 3 September.) While this may be an extreme, my hunch is that earnings in most markets have been helped by the rise in asset prices. In short, the rising P directly boosted E.

Second, the tightening of global liquidity conditions is creating stress in many markets. This week saw notable problems in three areas: 1) America's mortgage agencies; 2) the monoline insurers; and 3) the covered bond market in Europe. A brief word on each:

Freddie Mac is one of the big two mortgage agencies in the US. Combined, they own or guarantee around $4 1/2 trillion of mortgages. Freddie Mac's losses mean that its scope for balance-sheet expansion is very limited. The broad picture is one where these agencies are likely to have limited capacity to provide finance at a time when other lenders are becoming far more restrictive.

This underscores the point that America no longer has a crisis in sub-prime mortgages, it has a problem in mortgages, full stop, in my view. This is now how markets see it. Exhibit 1 shows that most mortgage lenders were initially resilient in the face of the sub-prime implosion, but the mortgage finance index has now almost halved since June.

It's rare that markets are as dismissive of Fed rhetoric as they appear to be now. The tone of recent Fed commentary has been cautious, but even-handed, with several members still concerned about inflation. Certainly, there's little evidence that a rate cut at the upcoming FOMC meeting is a done deal, let alone that the Fed is preparing for a sequence of cuts beyond that. Yet that is what short-end markets are pricing with increasing confidence (Exhibit 1).

First, short-end futures markets have an imperfect record as Fed policy forecasters. (That's not to say that the market is better or worse than anyone else - I haven't done the comparison.) But it's noteworthy that, on a six-month horizon, the market gets easing cycles more wrong than tightening cycle. Markets get them wrong by under-estimating the extent of the rate cuts. Exhibit 2 shows the gap between the six-month-ahead Fed fund future and the Fed fund target that eventuated. It's not uncommon for the Fed to cut by 100-200 basis points more than is in the futures price six months' prior. In contrast, the typical error in a tightening phase is significantly smaller. DUD071126.pdf

The essence of a credit crunch is lenders being less willing or less able to provide finance. We are seeing both in the US. This arguably matters more than usual, as the household sector, for the first time in 70 years, is running a cash-flow deficit - that is, it needs finance to maintain current spending.

Measuring lenders' willingness to lend is difficult, but the Fed's regular survey of senior loan officers provides a time series of bankers' reported attitudes. It's clear that the past year has witnessed a sea change in bankers' stance, at least regarding housing. Exhibit 1 shows the net balance of respondents who are tightening mortgage lending standards. This net balance measure now surpasses the restrictive readings seen in the early 1990s recession. (To be fair, this is a qualitative measure designed to capture changes; it's not clear whether lending standards in an absolute sense are tighter now than in the early 1990s.)DUD071128.pdf

DOWNUNDER DAILY : To the Rescue
The usual Pavlovian reaction: Hopes for easier Fed policy have again lifted equities. Of course, perhaps not all the bounce can be attributed to Wednesday's signal from Donald Kohn that the Fed may ease at the forthcoming FOMC meeting. The S&P 500 index had been sitting on technical support, the rally had started the day before the speech (after news of ADIA's investment in Citigroup), and short-end futures had for some time been confidently pricing in a Fed cut (and, as a result, were basically unmoved by the Fed comments - see Exhibit 1). DUD071130.pdf

It's true: the best thing the US has going for it now is the rest of the world. That's clear from the GDP data - where exports have contributed 1.1 percentage points to GDP growth over the past year - and also from the profit data:

Growth in top-down profits (aka the NIPA data) has stalled over the past year (and fell outright in the September quarter), but it would have been far worse if not for the contribution from earnings made in the rest of the world. Exhibit 1 shows that the total profit share (relative to business-sector GDP) remains around all-time highs. However, the domestically sourced component, which never exceeded the late 1990s peak, is now in decline. DUD071203A.pdf

The political response to America's housing finance crisis has started. Authorities are encouraging greater 'mortgage restructuring' - largely delaying the re-sets on adjustable-rate mortgages (ARMs) - and US Treasury Secretary Paulson has proposed "temporarily" waiving taxes on state and local government bonds issued to help refinance sub-prime borrowers. The details on these initiatives are not clear, and some (such as the tax exemption on the bonds) require Congressional approval. But here are some broad thoughts:

First, the heart of the problem is simple: Too much money was lent to people who couldn't afford it. That implies that someone will have to take a loss. There are no costless ways to fix this problem, and, for now, it seems that most of that cost will be borne by the private sector.
DUD071204.pdf

Bear markets are not simply bull markets where prices go down rather than up. The 'rules' are different. Morgan Stanley's European strategy team has just set out its very cautious views on 2008 (please see Teun Draaisma, 2008: Regime Change), and highlights the characteristics of a bear market. Here are my thoughts on how a bear market would behave:

First, bear markets tend to be more volatile than bull markets. Moreover, the bull market that started in 2003 was notably unvolatile, so the contrast heading into 2008 may be particularly noteworthy. The yield curve - which may again prove its value as a leading indicator for growth - leads volatility (Exhibit 1). It is pointing to sustained high volatility in 2008.
DUD071205A.pdf

The credit crisis is asphyxiating corporate activity, at least in developed markets. M&A volumes have fallen sharply over the past three months (Exhibit 1). This has a few implications, in my view:

First, the turn in the M&A cycle reduces one support for equities. Moreover, while stock-based bids may continue, M&A is bringing less fresh cash to the market. That's because the cash component had relied on LBO financing, and LBO volumes have collapsed (Exhibit 2). This LBO cycle had dwarfed its predecessors and, relative to market capitalization, had surpassed the grand-daddy of LBO booms, the late 1980s. But now, without LBO-funded cash, M&A is increasingly just investors swapping paper for paper.

Investors have been fretting about a US recession for months, but I don't think it's priced into markets. We may soon find out: Richard Berner and David Greenlaw, our US economists, are now forecasting a recession in 2008 (please see Recession Coming, 10 December). Their 2008 GDP forecast, 1.1% in yearly average terms, is the lowest in the market (at least amongst the 41 forecasters who submitted to the 10 December Blue Chip Economic Indicators survey). Here's what I see as the implications of a US recession:

First, the Fed always cuts aggressively in a recession. Exhibit 1 shows the real Fed funds rate over the past 50 years. (In this chart, and others that use 'real' rates, I've deflated the nominal rate by a five-year moving average of CPI, which now stands at 2.9%.) The real funds rate has fallen to zero or below in every recession. That suggests to me that the minimum target for the funds rate in this cycle is 3%.

The US is now approaching - possibly already in - a recession. This will be the only thing that will matter for investors over the next few quarters. As a result, the bear market in risk assets, which in hindsight started two months ago, has much further to run, in my view. In short, it's time to sell.

I've continually pointed to employment as the single most important indicators for investors to watch. The labour market now appears so weak that it would be extraordinary for the US to avoid recession. Annual payroll growth has fallen to 1.0%. US employment growth has not fallen this low outside a recession period since the early 1950s (Exhibit 1). In soft landings growth has held above 1.6%.

Slowing growth in 2008 is not just a US story. I'm skeptical about whether markets could decouple from US weakness, even if the economies could - but that increasingly looks like an academic debate as the growth slowdown broadens through the developed world.

There are a couple of forces at work here. First, the US remains the world's largest economy, so weakness there will, unsurprisingly, have an impact on other economies, although often with a lag.

The second, more important (and under-appreciated) point is that economic coupling is more than just a follow-the-leader story: Cycles are synchronized because policy is often synchronized, business confidence is correlated, and financial flows tend to go through global mood swings. In other words, trade flows are not the only important transmission mechanism for economic coupling, and economies can be synchronized even if trade linkages are small.

These other links have been important in this cycle. Monetary policy has followed a similar pattern through the developed world: easing sharply in the aftermath of the TMT bubble bursting, and tightening over the past three years. Not every economy eased policy to the same extent, nor has policy been tightened to the same extent, but the fact is that just as the past few years reflected the generally easier policy of the 2001-03 period, 2008 is likely to reflect the generally tighter policy implemented over the past two years.

The turn in official monetary policy has been magnified by the swing in lending practices. The change in lender attitudes - and market pricing of credit risk - has clearly occurred throughout the developed economies.

The change in global credit conditions is one facet of what seems likely to be another synchronized swing, at least in the developed world: a turn in business confidence.

Finally, currency movements are by definition a zero-sum factor, but it's notable that dollar weakness over the past few years implies that currency movements are a headwind, in net terms, for other economies.

The signs of a synchronized turn in the developed world are starting to appear. The OECD's leading index is now signaling a period of contraction in developed world industrial production (Exhibit 1).

Last year's credit problems came in several areas. The good news is that one problem - stress in short-end funding and inter-bank lending - seems to be on the mend. The bad news is that other stress symptoms are not. Worst, last year's credit stress occurred against a broadly healthy economic backdrop: Things will get worse if there's a US recession.

Action to settle inter-bank markets seems to be working. The raft of unconventional measures - which boiled down to central banks offering funds at rates that banks have been unwilling to provide to one another - now seems to be settling things. Exhibit 1 shows that US$ LIBOR rates are now falling towards the Fed funds target and the overnight indexed swap rate (which reflects investors' expectations for the funds target). The spread remains unusually wide, but is much narrower than in December.

There should be no more uncertainty about one important issue: Mr. Bernanke seems as willing to cut rates on signs of cycle weakness as Mr. Greenspan. He signaled more easing to come in an overnight speech; our US team now looks for the FOMC to lower the funds target by 50 basis points at its 30 January meeting (see David Greenlaw, Bernanke Speech More Dovish Than Expected). Markets are now pricing a decline in the funds target to 23/4% by year-end, from 41/4% now (Exhibit 1).

There was always going to be a policy reaction to signs of economic weakness and market distress. But the response over the past fortnight has been more aggressive than I expected, forcing investors to confront a crucial issue sooner than I thought. That issue is simple: how effective will policy be in moderating the downturn and promoting recovery?

The first point to note is that recession is still likely (indeed, the arbiters at the NBER may subsequently tell us that it's already started). That means markets still face the broad-based earning downgrades and rising credit defaults that always come with recession. But investors will be much more able to cope with that bad news if they are confident that the policy response will lead to a relatively mild recession.

My view, however, is that policy will be much less effective in moderating this recession than is usually the case, and notably less effective than in 2001-02.

Policy will struggle to gain traction because the two sectors in most distress are the financial sector - the transmitter of monetary policy changes - and the household sector, which provided the most vigorous response to policy stimulus in the last recession.

Moreover, policy makers have less room to move in this cycle. The starting point for fiscal policy in the last downturn was a budget surplus of around 2% of GDP; now the deficit stands at 11/2% of GDP. The funds rate peaked at 61/2% in 2000, this time the starting point was 51/4%. More importantly, the average interest rate on the stock of outstanding mortgages was 91/4% in 2000, now it is 7%. As Exhibit 1 shows, the average mortgage rate remains at cycle lows. In short, there was no 're-loading' of the policy holster in terms of what is arguably the single most important interest rate.
DUD080204.pdf

This will be an unusual bear market because, unusually, it is a deflating earnings bubble. Just as equity markets were led higher by earnings, they will be led lower by earnings. More to the point, just as equities appeared cheap throughout the boom, they may appear cheap throughout the bust.

Exhibit 1 illustrates the US story: It shows the S&P 500 index and consensus 12-month ahead EPS forecasts. The index is on a prospective PE of 15 when the two lines overlap. The late 1990s was a PE bubble; this cycle has been an earnings bubble.

Having briefly - but violently - reconnected, asset markets again disconnected in response to looser fiscal and monetary policy in the US. Wall Street bounced almost 10% from its intra-day January lows, led by sharp rallies in some cyclical sectors. Credit markets, by contrast, barely responded.

Just as it becomes clear the US is entering recession, there are more signs of softer growth elsewhere. In other words, it seems that economic weakness will not be ring-fenced to the US, so investors will face softer conditions in many markets.

Exhibit 1 shows the 12-month change in the OECD's leading indexes for a range of economies, as at November (latest available), six months prior, and 12 months prior. All are decelerating. There are outright declines in the developed economies (although that does not imply GDP contraction). THe Asian leading index is also slowing, although it remains very strong by Western standards. Incoming Asian data had consistently surprised on the upside through the second half of last year, supporting the view that economic decoupling was occurring. However, the data are now falling short of forecasts (Exhibit 2).

Will falling long-end yields lead to a consumer-supportive mortgage refinancing boom in the US? There will be some response, but I think the boost will be much smaller than in the last cycle.

It's now attractive for a large number of mortgages to be refinanced, given the fall in long-end yields. Exhibit 1, courtesy of colleague Janaki Rao, shows the distribution of outstanding agency mortgages (prime, conforming mortgages). Over 40% of these mortgages can be refinanced at current rates.

The bursting credit bubble will likely lead to stable-door slamming by regulators, just as the bursting of the TMT bubble did (such as tightened corporate governance, thicker Chinese walls in investment banks, changed accountancy regulations). The force of the policy backlash will probably depend on how bad the bubble pops, but here are some likely areas for change:

The obvious fall guys – and there are already changes flagged by regulators. The International Organization of Securities Commissions last week proposed a code of conduct prohibiting “advice on the design of structured products which an agency also rates.” The US Securities and Exchange Commission (SEC) on Friday said it is considering new regulation of the rating agencies. This cycle has underlined the fundamental potential for conflict where customers pay for-profit organizations to rate them.

Investment banks may take some heat as developers, originators, and promoters of the new mortgage menagerie and rocket-science structured products. Market forces may do much of the work here – my hunch is that it will be many years before investors will be as willing to buy products as opaque, illiquid, and badly structured as was the case over the past few years – but there may also be tighter regulation. The SEC has formed a ‘sub-prime taskforce’ that will review the role of investment banks and how they manage risk.

Sub-prime lenders have been decimated, but expect moves to put lenders on the hook for borrower distress. Minnesota has already passed a law requiring mortgage lenders to act in a borrower’s best interest (which, according to Bloomberg, may make some ARM's illegal). Congressional leaders Chris Dodd and Barney Frank are looking at legislative measures to restrict ‘predatory’ lending. Prudential regulators last year issued new guidelines on sub-prime and adjustable-rate mortgages.

The introduction of new accounting standards (IFRS) – notably the banishing of general provisioning by lenders – seems particularly ill-timed. Every experienced banker knows that x% of the loans written at the top of a credit cycle will go sour – he just isn’t sure which x it is. It makes no sense not to let banks recognize that reality.

Several of the changes noted above would act as headwinds for the rise and rise of securitization. Exhibit 1, from colleague David Greenlaw, shows the dramatic rise of securitization in US financial markets. The securitization trend offered a number of advantages for lenders: It provided a funding alternative as household saving slowed, it provided liquidity for loans, spread risk, and allowed better use of capital (banks’ capital could effectively be recycled over and over, as loans were written, then passed on to capital markets).

I expect two bearish trends to intensify this year: The growth slowdown will likely go global, and the credit crunch will intensify. Many financial variables will be affected by one or the other of these trends, but there is one financial variable that looks particularly vulnerable to both: the A$.

Historically, the A$ has been viewed as a barometer of global growth, and has been correlated with industrial commodity prices. That correlation has fallen in recent years (Exhibit 1), but the link - actual or perceived - remains important within currency markets

Credit distress and collapsing securitization seem set to dramatically slow bank balance-sheet repair - and therefore delay the transmission of easier monetary policy to the real economy.

Credit remains in distress, with pressure even returning to short-end spreads. Inter-bank rates are again widening to policy-rates (Exhibit 1). In the US, banks are again tapping the Fed's temporary auction facility (TAF), borrowing US$30bn at yesterday's auction.
DUD080214.pdf

I'm not worried about inflation, at least not this year. I'm not worried about inflation because I'm worried about growth. A material slowdown in developed economies should ease global inflation pressures even if emerging markets keep growing.

Part of the story is the surprisingly low inflation seen in this cycle. If I had known in 2003 that the globe was about to average four years of 41/2-5% real growth, and that commodities prices would rise by several hundred percent - including oil going from US$20 to $100 per barrel - then I would have expected hair-raising inflation rates by now. Instead, the expansion has simply brought to an end the disinflation that started with the Asia crisis a decade ago (Exhibit 1).

I get strong pushback on my cautious view from asset allocators: where else, they ask, can they go, aside from equities? They think Treasury yields are unsustainably low, credit has no appeal, the Fed's rapidly lowering the returns on cash, so equities - despite the jitters - remain the best house on a bad street.

Relative value indicators support that view. The much-watched bond yield-prospective earning yield model says that equities have never ever looked this cheap relative to Treasury bonds. Even allowing for the fact that the centre of gravity seems to move, the equity yield/bond yield ratio is now below the level that has signaled strong equity outperformance over the past few years (Exhibit 1).

If you believe the message of the equity earning yield/bond yield model (aka the Fed model) it seems that equities are braced for recession. In fact, as discussed yesterday, they look cheap (Exhibit 1).I don't buy it. I don't like the earnings yield/bond yield (EYBY) model. Here's why:

The risk is obvious, but my sense is that a US recession is not seen as a fait accompli by all investors, nor is it fully priced into markets. Indeed, some recent price action - rising commodity prices, higher bond yields, out-performing cyclicals - is consistent with a cycle turn. Moreover, while the flow of economic news has worsened, not every lead indicator is in recession territory

Financial institutions' investment losses matter not only for shareholders, but also because those losses (and the institutions' response to them) can clog the transmission of easier monetary policy to the non-financial sector. The losses and their impact are the focus of a paper from a group of financial market experts, including Morgan Stanley's David Greenlaw. [David Greenlaw, Jan Hatzius, Anil Kashyap, and Hyon Song Sun; Leveraged Losses: Lessons from the Mortgage Market Meltdown, US Monetary Policy Forum Conference. Available at http://www.chicagogsb.edu/usmpf/docs/usmpf2008confdraft.pdf]

Exhibit 1 provides an overview of the US mortgage market. US financial institutions (aka 'leveraged institutions') hold almost exactly half of the US$11 trillion stock of outstanding mortgages. Sub-prime mortgages account for around $1.4 trillion of the total. (In 2006, when $3 trillion of new mortgages were written, sub-prime accounted for 20.1%; conforming mortgages 33.2%; jumbo 16.1%; Alt-A 13.4%; and home equity loans 14.4%.)

I'm bearish - really bearish - but even I admit that credit markets are now pricing in a very pessimistic outlook. This raises two issues that our strategists are grappling with: first, when to re-enter credit markets; and second, how to play the apparent discrepancy between credit and equity market pricing.
DUD080305.pdf

Remember that last year's credit distress occurred against a backdrop of a broadly healthy US economy: Not a single job was lost in net terms, and growth (outside residential construction) was reasonable. Things will get worse in a recession.

In particular, job losses will mean that delinquencies and foreclosures will spread from the mortgage exotica to the heartland: prime mortgages. Mortgage stress always rises when unemployment rises. Yes, the remarkable point about the 2002-06 expansion is that mortgage arrears rose even as unemployment fell (Exhibit 1) - a clear warning sign of how low lending standards fell - but there is likely to be a new wave of credit problems caused by economic weakness.
DUD080307.pdf

Mounting evidence of US recession - combined with signs of slowdown in other economies - could change the bear market. What has to date largely been a financial-sector sell-off could spread to sectors and markets driven by the growth cycle.

Friday's payroll report was further important evidence that the US is in, or heading towards, recession. Our US team expects outright declines in GDP in the current half year, which points to accelerating job losses (Exhibit 1).

The outlook keeps darkening. Our US macro team has made material downgrades to its US growth and rate forecasts, and our US strategy team has slashed its S&P earnings forecasts, led by big downgrades to the financials. (For details, see Richard Berner and David Greenlaw, A Darker US Outlook; Abhijit Chakrabortti, The Bank Job - Slashing Financial Sector Earnings; and from our US bank team: Betsy Grasek, Lowering EPS on Weaker Markets and Credit; Probability Higher of More Cuts Coming.)

The outlook's dark, in my view, because the sky is thick with chickens coming home to roost. As I've noted before, the US is entering this downturn with the most dangerous combination of high leverage and low rates seen in decades. Private sector leverage (debt relative to GDP) is at an all-time, exceeding even the peak seen in the lead-up to the Great Depression.