Stocks still vulnerable as U.S. economy sinks

by Levi Folk | March 29, 2008

The global financial system is undergoing a period of rapid deleveraging. Risky trades that were made when credit was last cheap are now being unwound, and many securities that were bought at the peak of the credit cycle are now being sold at losses. Despite unprecedented efforts by federal authorities to stem the crisis, this process will continue to unfold over the next year, and the economy will continue to contract.

A cycle of credit contraction is self-perpetuating and will undoubtedly exacerbate the weakness in the economy. Investment banks that have endured losses on securitized mortgages and leveraged loans to private equity funds are being forced to shore up their balance sheets.

As their asset bases shrink, so too must their portfolios of loans. Goldman Sachs recently estimated that the US$200-billon in sub-prime loan losses translate to US$2.3-trillion in loan contraction. In other words, every dollar of assets supports roughly US$10 in loans.

All told, Goldman is forecasting US$460-billion in total credit losses before the cycle turns. These losses will amount to nearly US$5-trillion in credit contraction over the course of the cycle, and this process of deleveraging will have important implications for global economies and financial markets.

Without full disclosure of the losses, banks are hoarding money rather than lending to each other. Witness the recent collapse of Bear Stearns, a major U.S. investment bank, due to a liquidity crisis that saw short-term lending channels dry up.

The U.S. Federal Reserve Bank has been writing new chapters in its book on monetary policy in its bid to clear the clogged lending channels. Despite numerous policies aimed at pumping money into the market, banks remain reticent to lend to each other.

The Fed is auctioning up to US$200-billion in Treasury securities to its 20 primary dealers with loans that are collateralized by these toxic mortgage-backed securities. The Fed is also taking the unusual step of allowing non-bank, non-deposit-taking securities firms to borrow at their discount window using the same dubious collateral.

The U.S. housing sector is at the epicentre of the current crisis and the prognosis here is still dire.

House prices continue to decline—at a 10.7% annual pace in January—according to the S&P/Case Shiller home-price index. The supply of unsold homes remains high at 9.6 months for existing homes, so a near-term recovery is unlikely.

Efforts to put a floor under house prices are being made by federal authorities. Government backed mortgage financiers Fannie Mae and Freddie Mac have been granted greater powers, to buy another $200-billion in mortgage securities. Federal Home Loan Banks will also be allowed to increase purchases of mortgage-backed bonds by roughly US$150-billion.

The U.S. consumer is retrenching largely because of falling home prices and will continue to do so judging by the latest reading in the Consumer Confidence Index, which fell to a five-year low of 64.5 in March. A one-time tax rebate totalling US$140-billion, aimed at reviving consumer spending, is now being put into effect.

The rise in stock market volatility reflects uncertainty in the market, but absolute index levels are not reflecting the severity of the credit crunch. The S&P 500 index in the United States has fallen roughly 14% since August, which is a shallow dip given the severity of the crisis.

Financial stocks have finally sold off to levels that are better reflective of the recent catastrophe, but other sectors have been largely immune. Consensus (analysts) estimates for financial earnings are for a 50% fall, year over year in the first quarter of 2008, according to Thomson Financial. Analysts are finally catching up with reality. More recent estimates are even lower.

The financial sector will undoubtedly be the biggest near-term beneficiary of the Fed engineered steep yield curve. Banks can now borrow freely at the discount window at 2% interest and lend long term at 6% or higher.

The stock market ex-financials is the shoe that is yet to drop. Excluding financials, recent consensus estimates are for a 9% gain for the first quarter of 2008. Profits are cyclical and will undoubtedly decline with the economy over the near term. Therefore, equities remain at risk to further weakness as the U.S. economy continues to grind down.