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By Richard Berner, Morganstanley | 20 May 2008
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Investors and issuers alike are pushing back on our bearish calls for economies and markets. Small wonder: They are relieved that the economic slowdown has so far been mild both here and abroad, and they hope that a rebound in US and global growth is coming. In the US, the hope is that tax rebates will sustain consumers until the lagged impact of an easier monetary policy bolsters credit-sensitive outlays, especially housing. The rebound in global equity markets over the past two months— ranging from 12% in the US to more than 20% in Japan and some emerging markets— has gone beyond typical bear-market rallies. Thus, it’s critical for us honestly and objectively to acknowledge and vet the bullish case.
But I want to emphasize downside risks for two key reasons: First, my level of conviction in a darker outlook than what seems to be in the price remains high. And second, markets seem priced to a just-right, muddle-through outcome— one that will limit the damage to earnings and also keep the Fed from tightening. Indeed, the view now in the price dismisses some essential ingredients for our base case as mere low-probability tail risks. Thus I agree with our strategy team that it’s time to take some money off the table, perhaps until the economic fallout gains pace.
The bull case has some legitimate props; indeed, we’ve cited some of the factors that underpin it as reasons we expect only a mild downturn. In particular, we have long thought that global growth will hold up relatively well in the developing world; it is primarily the industrial economies that are at risk (see "The Year of Recoupling," Global Economic Forum, February 11, 2008). And an aggressive policy response will limit the downside risks in the US case. Thus, in the wake of the events of mid-March, our strategy team correctly expected bear-market rallies, as officials ensured that the financial firestorm would not spread out of control, even if the economic fallout had yet to arrive (see "The Eye of the Storm," Global Economic Forum, April 7, 2008).
Several factors seem to suggest that the bull case has legs. First, despite all the headwinds, economies are holding up better than expected. Economic activity in the US, Europe and Japan appears to have accelerated in the first quarter, to 1% (revised), 3%, and 3.3%, respectively. Likewise, non-financial US companies reported healthy earnings (10% year-on-year), and the gains were broad based: 8 of 10 sectors rose, 6 of them by double digits, and 62% of S&P 500 firms surprised positively.
In the US, moreover, consumers have slowed spending but haven’t retrenched, capital spending dipped only slightly in the winter quarter, and net exports continue to provide strong support for output. That resilience for US net exports is echoed in domestic demand in many developed and emerging market economies in Asia and Latin America. Indeed, as our global economics team has emphasized, inflation in those economies is by far the bigger problem than growth, and policymakers welcome some slowing to help cap inflation.
Looking ahead, tax rebates for US consumers are arriving in bank accounts and mailboxes, promising at least a one-time lift for consumer spending. At this writing, roughly $30 billion has been distributed to about 30 million households since late April, or nearly one-third of the total to be distributed in the current fiscal year. At that pace, the tax rebates will boost disposable income by roughly 14 percentage points annualized in the second quarter, and may well give a lift to spending sooner than we expected. Inflation, moreover, has remained subdued despite the acceleration in food and energy quotes; we estimate that headline inflation measured by the personal consumption price index (PCEPI) ran at an estimated 2.9% annual rate in the first four months of 2008.
Investors hope that slower growth will help further to offset inflationary forces [[incredible that anyone is still quoting 'official' inflation numbers! : normxxx]] In addition, the credit markets are healing[!?!], hinting that tighter financial conditions may not cripple growth. Moreover, the dollar is stabilizing, potentially helping to cool off commodity prices and arrest their assault on discretionary spending power.
In my view, however, the downside risks outweigh those positives. Financial conditions are still tightening and are only beginning to affect credit-sensitive demand. In housing, the prospective further declines in home prices and associated rise in foreclosures means that writedowns at financial institutions have further to go. We estimate that, measured by the OFHEO purchase-only index that home prices may decline by another 7-10%, and broader indexes likely will show even larger declines. As evidenced in the Fed’s April Senior Loan Officer Survey, those factors are making lenders broadly more cautious; banks tightened lending standards across all loan categories, not just in mortgages.
And as Morgan Stanley Bank analyst Betsy Graseck points out, such lender caution will make it more difficult for borrowers to refinance, implying that bigger losses are coming into 2009 (see Sr. Loan Officer Survey: Less Credit Today Means More Losses Tomorrow, May 8, 2008). Likewise, our credit strategy team thinks that banks and broker dealers in the US and Europe are perhaps two-thirds of the way through the writedowns they will need to take, while provisioning at many banks is only beginning (see A Writedown Writeup, May 13, 2008). Although yield spreads have narrowed significantly in investment-grade debt and leveraged loans, small businesses are reporting that credit is harder to get than at any time since the early 1990s.
Moreover, supply-induced increases in energy and food prices are lifting headline inflation and eroding discretionary income. Indeed, the resulting loss in discretionary income from the start of the year nearly offsets coming tax rebates. With crude quotes at $127/bbl and gasoline apparently headed to $4/gallon, we now estimate that the rise in energy quotes between December 2007 and September 2008 will absorb an annualized $85 billion in US consumer discretionary income, or $15 billion more than two weeks ago, while price hikes in food— a much bigger share of consumer budgets— will drain about $50 billion from wherewithal.
By comparison, the tax rebates that started going out to consumers at the end of April will amount to $117 billion by year-end. Despite stronger-than-expected April retailing results, the combination of falling home prices, tighter credit, slipping employment, and rising food and energy quotes leads us to think that cautious consumers are likely to spend less of their rebates than many assume. Indeed, those April results may indicate that some strapped consumers spent the checks even before they arrived. The recent plunge in canvasses of consumer sentiment hardly seems consistent with buoyant fundamentals.
In addition, cautious businesses, who are beginning to see operating rates slip and profit margins erode, are apt to cut back on capital spending. In that regard, the 180 bp decline in manufacturing operating rates since August (taking out motor vehicles and high-tech industries to remove the influence of the strike in automotive parts) is strong evidence for a weakening in a time-honored support for business investment. Moreover, sources of capex funding are drying up. Slower US and global growth is just starting to hit margins, with a contraction in nonfinancial earnings the most likely outcome.
That will undermine corporations’ ability to use cash flow to fund capital spending. Indeed, nonfinancial corporate external financing needs (capex and inventory accumulation less cash flow) had already risen to 4.3% of comparable GDP in the fourth quarter of 2007. With tighter financial conditions curbing their ability to finance outlays, downside risks to companies’ capital spending are rising. The evidence: Revised data now show an 11.1% decline in nondefense capital goods orders excluding aircraft. Finally, US state and local officials are also turning cautious, tightening their belts in several regions.
This debate on the fundamentals probably won’t be resolved soon. So what should investors do? For risky assets, I think the bulls’ strongest case is that equity valuations don’t seem stretched, debt seems reasonably priced, and with cash on the sidelines, appetite for risk in debt and equities is substantial. The bear case now is that there is a fair amount of good economic and earnings news in the price, so any downside surprises now pose risks. I see that as a recipe for taking profits.
In that context, the muddle-through scenario is the biggest risk to our bearish market call, but it is delicately balanced. In particular, there are a couple of catch-22’s out there for the bulls. If growth fades further, and operating rates continue to slide, that might offer some relief from soaring commodity price hikes. But under those circumstances, operating leverage, pricing power, and profit margins may also crumble. Conversely, if the bulls are right and growth does prove more sustainable, there is a risk that the inflation and interest-rate backdrop will prove significantly less benign than investors believe. Higher inflation and/or interest rates will not be kind to multiples in either US or overseas equity markets.
M O R E. . .
Normxxx
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