Paul Castillo : Northwestern Mutual - Economic Commentary - November 2008 : Article: Economic Commentary

Economic Commentary - November 2008

Clare Zempel

Economic and Investment Strategies Consultant

Overview

Economic and market conditions have deteriorated sharply since mid-September. That is when Lehman Bros. failed and its problems spilled over to AIG (American International Group) and the Reserve Primary fund, which became the first public money market fund to “break the buck” – to allow its share price to slip below a dollar.

The latter was the shock that spurred investors to shift en masse into the safest available cash assets. That shift accelerated after the House rejected the Paulson plan to stem the mortgage-based crisis in the financial system. Paulson’s plan was enacted and evolved to include capital injections into banks. Meanwhile, the Federal Reserve redoubled its efforts to add liquidity and restore normality to the credit markets. Other governments and central banks took similar steps to stop what has become a worldwide panic. Modest declines in some short-term interest rates and in credit-risk spreads since mid-October indicate that these efforts have started to have modest positive effects.

Beneath and in response to the financial turmoil, households and businesses have curbed spending in order to conserve cash. The result is that economic conditions have weakened substantially since mid-September. The National Bureau of Economic Research (NBER) now seems certain to declare that a recession started sometime around December 2007 – the month when non-farm employment appears to have peaked. The consensus now seems to fear that the current recession will be long and deep, continuing well into 2009 and perhaps into 2010.

There are serious risks in the outlook but it is possible that the consensus overestimates them. In mid-March 1980, President Carter threatened to impose credit controls in order to contain inflation. Households and consumers stopped borrowing and spending overnight. The economy and the stock market went into freefall that spring but rebounded sharply once the credit-control threat was removed that summer. The current credit shock is much more serious in nature than Carter’s mere threat but it can be resolved – and sooner than feared.

Real interest rates have declined to levels that ended recessions and bear markets in the past. Absent the credit crisis, low real rates plus the steep decline in oil prices – an effective tax cut for consumers – would promise an imminent economic rebound. The credit crisis has undercut that promise but, in pointed contrast to their inaction in 1929-1932, nations and central banks worldwide have acted to contain the threat. Those actions seem to have started to produce some positive results. Fear remains extreme but that tends to happen just before conditions start to improve. Caution is in order but remain faithful to asset allocation plans.

Economic and Market Update: The Continuing Discussion

Credit-Market Crisis The credit crisis in evidence since summer 2007 accelerated in mid-September when Lehman Bros. failed. That failure spilled over to AIG and the Reserve Primary fund, which became the first public money market fund to “break the buck” – to allow its share price to slip below a dollar. This happened because the Reserve Primary fund lost a reported $785 million in commercial paper – a short-term IOU – issued by Lehman Bros. It was the shock that spurred investors to shift en masse into the safest available cash assets, primarily short-term Treasury bills. (Figure 1.)

Shifting assets into safer assets drove T-bill yields down and commercial paper yields up. Some commercial paper issuers had difficulty funding their needs and borrowed from banks instead. Banks held onto cash in order to meet their clients’ needs and curtailed lending to other banks. LIBOR – the London Interbank Offered Rate – soared.

As credit market conditions deteriorated, investors sold stocks and bonds to raise cash and reduce debt. Stock markets here and around the world plummeted. Stock market volatility measured by the VIX – the CBOE Volatility Index – reached unprecedented levels. (Figure 2.) (Figure 3.)

Confronted with such turmoil in the markets, the U.S.

Treasury, the Federal Reserve and their counterparts around the world redoubled their efforts to stabilize conditions, with a special focus on mortgage-related securities. The now well-known problem is that delinquencies and losses on lower quality (subprime and Alt-A) residential mortgage loans have soared.

These mortgages were “securitized” – combined into “pools” and sold to investors. These securitized mortgage pools were often used to create related investments that offered investors a lower interest return but promised less credit risk, a higher return but with more credit risk, and the like. As mortgage problems rose, it turned out to be more difficult than expected to determine just how much an investment “derived” from a mortgage pool was worth. Investors

who lost confidence in such investments sold them at deep discounts.

Under mark-to-market accounting rules, investors who held similar securities had to write their values down, incurring losses and reducing capital in the process. The reduction in capital made creditors less willing to lend and/or forced debtors to make additional asset sales at losses. To stem this downward spiral, the U.S. Treasury will now invest capital in banks and create a new market for mortgages, and the Federal Reserve will back up commercial paper, money market funds and other financial assets.

Depression Fears Policymakers have acted aggressively because they want to make sure that

credit is available to qualifying individuals and businesses that need it. The reason for this goes back to the 1930s – the Great Depression period. From 1929 to 1933, Nominal GNP (total spending) fell 46%, Real GNP (real or inflation-adjusted economic activity) fell 27% and the

GNP Deflator (prices) fell 26%. The unemployment rate soared from 3.2% to 24.9%. There were no “automatic stabilizers” – no FDIC deposit insurance, unemployment insurance or Social Security – in the early 1930s. Moreover, Congress raised taxes and imposed tariffs so high that world trade basically stopped. (Figure 4.)

Over this same 1929-1933 period, about 9,096 banks failed, and the M2 Money Stock fell 31%. According to

Milton Friedman and Anna Schwartz, mistaken Fed policies permitted the “great contraction” in the money stock, which was the principal cause behind the Great Depression. (Figure 5.)

Federal Reserve Board Chairman Ben Bernanke concurs and said this to Milton Friedman in 2002:

I would like to say to Milton (Friedman) and Anna (Schwartz): Regarding the Great Depression. You’re right, we (the Fed) did it. We’re very sorry. But thanks to you, we won’t do it again.

M2 has not shrunk now – it is up more than 7% over the last 52 weeks. The Fed has on balance done the right things well. The economy will weaken further but

probably much less than the headlines and the markets seem to expect.

Past and Present Pain The present is without question painful for investors. The stock market has fallen sharply for more than a year, and the credit crisis has not eased much if at all in response to extensive counter-measures. Numerous financial failures and the stock market’s precipitous decline in October draw our attention to 1929-1933 and the depression period, even though the evidence points elsewhere. The problems and risks we face are serious and unusual, but in broad terms we have been here – in uncertain and perilous times – much more often than we remember. (Figure 6.)

In 1973-1975, the stock market (S&P 500 Common

Stock Index) fell 48% over almost 21 months. The bank prime lending rate reached a record-high 12% in July 1974. President Nixon resigned in disgrace in August 1974. Franklin National Bank failed in October 1974 – then the largest bank failure ever. Oil prices quadrupled and people waited in lines to fill their tanks. Inflation soared to double-digits for the first time since 1948. Unemployment jumped to 9% – the highest since 1941. The 1973-1975 recession was the longest and deepest since the depression.

Inflation returned to double-digits in March 1979. Oil prices almost tripled after Iran seized U.S. hostages in November 1979. The federal funds interest rate reached 19.39% in April 1980, just after President Carter threatened to impose credit controls – a threat that

caused Real GDP to record its second-steepest one-quarter drop in the post-war period.

The economy rebounded when the credit-control threat was rescinded in July 1979 but it slid into another severe recession in 1981-1982. Inflation returned to double-digits and the fed funds rate reached 19.93%. The 10-year T-Note yield climbed to a record 15.84% in September 1981 and did not fall below 10% until 1985. The unemployment rate reached 10.8% in December 1982 and did not fall below 7% until 1986. (Figure 7.)

The stock market fell 34% from August to December in 1987. This “crash” was worldwide and associated with program (computerized) trading. More than a few observers raised the possibility that the stock market’s drop would lead to an economic depression but the economy kept on expanding and the unemployment rate kept on falling.

In August 1990, Iraq invaded Kuwait, and a bear market and recession started immediately. The stock market fell just 20% over three months and the recession was quite mild, but war-related fears were palpable.

We endured the Asian/PacRim Crisis in 1997-1998. Russia defaulted on its debt and Long Term

Capital Management failed in 1998. Technology stocks collapsed in 2000-2002 and the broader stock market fell 49%. A mild recession was underway when the terrorists struck on 9/11/01. The Enron and WorldCom scandals followed, as did the wars in Afghanistan and Iraq. The Federal Reserve lowered the federal funds rate to 1% in 2003-2004 due to fears about deflation that proved to be unfounded. (Figure 8.)

Some if not all these events from the past 35 years must have been very frightening to live through. The causes behind them were not well understood in their time, nor was there much confidence about their successful resolution. That does not prove that our current problems will be resolved, but it does provide reasons to be hopeful.

Implications Absent the credit-market crisis, low real or inflation-adjusted interest rates plus the sharp decline in oil prices would be solid reasons to expect economic conditions to improve soon. Absent the credit-market crisis, the low valuations placed on common stocks plus the elevated fears in evidence now would be important reasons to expect the stock market to rebound.

Governments and central banks around the world have taken well-calculated steps to repair liquidity and restore confidence. The credit-market crisis is still with us, but recent declines in some critical interest rates and credit-quality spreads support the hope that it has started to fade.

On September 27, 1974, the “WIN” or “Whip Inflation Now” conference was held at the White House. The purpose was to collect recommendations on how to subdue inflation which had reached double-digits in February. As it happened, before any recommendations could be implemented, inflation peaked on its own and fell in half over the next two years.

On November 15, 2008, leaders of the world’s 20 richest nations and biggest emerging economies will meet in Washington for an unprecedented summit on tackling the current global financial crisis. Perhaps this conference will confirm that the current crisis has all but ended. The odds are that it will.