As U.S. slows, so slows world

by Levi Folk | August 20, 2007

The recent lending strike in credit markets has been swift and severe. It threatens to have knock-on effects for global economic growth and exacerbate the downturn in the U.S. housing market. The weakness in stock markets has been most pronounced in the housing and financial sectors. The risks of these problems spreading to the broader markets and economy are real.

Banks are pulling in their horns in reaction to the losses on portfolios exposed to U.S. subprime mortgages that have been securitized and repackaged as collateralized debt obligations (CDOs).

The tighter borrowing conditions are affecting the most leveraged borrowers, typically hedge funds, which are finding borrowing conditions either more severe or non-existent. This could force a repricing of assets across the board as funds are forced to dump investments to meet redemptions and margin calls.

If some securities are being sold at attractive prices, that appraisal does not readily extend to the financial institutions that have seen share prices drop recently, by as much as a 40% in the case of Wall Street investment bank Bear Stearns. To focus exclusively on the banks’ losses on CDOs exposed to subprime mortgage securities may be to miss the point.

Investment banks will likely face an earnings rout in the coming quarters because so much of the business on which they have relied for commissions has dried up. This point is significant for equity investors given that financial stocks accounted for 30% of S&P 500 profits in the first half of 2007.

The securitization of mortgages has been a lucrative business for these investment banks, and this business has ground to a halt over the past couple of months. The value of the loan securitization and investment banking to U.S. commercial banks is estimated at 27% of 2006 revenues, according to Lombard Street Research.

Likewise, many of these banks may be left holding the bag full of leverage-buyout deals—$200-billion to $300-billion in all—which are slated to be financed over the next few months. Buyout group Black-stone recently issued a warning that private-equity deals are slowing. High-yield debt premiums have risen substantially in recent weeks, and that confounds the value of these deals over the long term as well as M&A activity in general on which these banks have earned substantial fees.

Market prognosticators have been suggesting the market is now undervalued based on corrected prices discounted for earnings based on analysts’ consensus estimates. The forward price-earnings ratio (P/E) is 14.4 based on forward earnings over the next four quarters, according to Thomson Financial, which is admittedly below average.

It is probably prudent at this juncture to question the strength of forward earnings, however.

Wall Street analysts are still calling for financials to increase earnings by 8.6% in 2007, reports economist Ed Yardeni. Those numbers are almost certain to be revised lower.

Turning to the epicentre of this crisis, the U.S. housing market, until this market stabilizes recent financial market volatility is likely to persist.

The backup in yields and retraction in lending standards over the past few months will only serve to exacerbate the problem: Confidence among U.S. homebuilders is at a 16-year low; housing starts fell 6% in July and building permits suggest starts are still headed lower; and the stock of unsold homes sits at nearly eight months of demand for new homes and 8.8 months for existing homes, well above the long-term average

This supply overhang will only be sold off with lower housing prices, given the rising and record rate of foreclosures on mortgages and the tightening lending standards for new borrowers. A recent U.S. Federal Reserve study shows mortgage lenders tightening the screws on would-be borrowers even on some of the more creditworthy prime borrowers.

All of these factors could eventually sap the U.S. consumer and ultimately the broader economy of its strength. Roughly US$370-billion in adjustable-rate mortgages (ARMs) are resetting this year; US$250-billion will reset in 2008 and 2009; and US$700-billion in 2010 "and beyond," according to First American CoreLogic, as reported by CLSA’s Greed and Fear. The implication here is that hundreds of billions in mortgage resets will put further strains on cash-strapped consumers.

Back in March I argued that falling house prices could have repercussions for U.S. consumption, which accounts for three-quarters of economic growth. The housing bubble aided and abetted consumption by allowing homeowners to borrow off inflated home-equity values.

Household financial balances (income less savings and investment) peaked at a deficit of 5.1% of GDP in 2006, or roughly US$900-billion, according to Ian Shepherdson of High Frequency Economics. This deficit will need to be at least partially unwound over the coming quarters unless it can be sustained with other means of financing. Disposable income, which has been growing at roughly 5.5% annually, may prolong the inevitable.

That aside, the consequences for economic growth and corporate profitability are therefore negative over the next few quarters, suggesting that cash is king.

Slower growth will have harmful repercussions even for commodity stocks and currencies of countries that are net exporters of commodities, such as the Canadian dollar.

Investors have borrowed in yen at low rates to invest in high-yielding currencies and commodities. As that trade turns negative, investors will be forced to unwind positions and gold and other commodities would also get hit.