The final act of this decade’s great credit bubble really got underway the morning of Jan. 21. That’s when Asian markets began selling off as investors worried that the fallout from the relatively obscure sub-prime sector had spread into the broader economy. A dramatic series of tremors rocked stock indexes from Tokyo to Toronto, where Canada’s national exchange plunged 605 points. In the weeks since, the U.S. Federal Reserve busted out a massive 75-beep cut in its fund rate between meetings and then slashed another 50 for a total of 125 basis points in just eight days. In the staid world of central banking, that’s as hot as it gets. The Dow Jones industrial average responded with a gain of more than 700 points, but don’t expect a big recovery. As this purge plays out, broker Merrill Lynch suggests the Fed will have to cut the fund rate down to 1% before the U.S. recovers. Indeed, the U.S. is likely already in recession, and investors can bet on a few more hits yet on both sides of the border.
“We’re just at the start of it in Canada. Canadians will be surprised in 2008 at how slow the economy will get,” says Randy LeClair, a senior vice-president and portfolio manager with AIC Investment Services Inc., a Burlington, Ont.–based money manager overseeing $6.5 billion in assets. “I’ve heard people say, ‘Well, we don’t have sub-prime, and Canadian banks are OK.’ But we rely on the U.S. for 80% of our exports.” Canada got off easy when the tech bubble burst in 2000, but it could now be facing a good old-fashioned consumer-led business recession.
LeClair, for one, is not the least bit surprised. He notes that the spread between 10-year and two-year Canadian government bond rates — what is known as the yield curve — has been either flat or slightly inverted for 18 months, a good sign of an impending recession. When short-term rates are as high or higher than long-term rates, it’s an indication markets think there is more risk in the short term than longer term. “The signs were there, but people shrugged them off,” says LeClair. “Even in June I thought this doesn’t make sense; it’s like nuns on crack. This just doesn’t happen without a recession.”
The likely result? There will be a slowdown, the Canadian dollar will drop and unemployment will have to rise, says LeClair. “It’ll be six to eight months before we see the light at the end of the tunnel.” He will be looking for the yield curve to steepen, with the spread between two- and 10-year bonds rising to 175 or 200 basis points, before he starts thinking we’re at a bottom — the spread is only 75 basis points now. He’ll also be watching consumer confidence indicators, looking for signs that people feel it’s safe to start spending again.
But let’s not get ahead of ourselves with talk of a recovery. We’re not even three months into this slump if, like David Rosenberg, North American economist at Merrill Lynch, you assume the recession began in December. American consumers are facing the largest postwar hit to their biggest nest eggs, their homes, since the 1970s, at a time when the middle class is drained after 30 years of stagnant wages and overspending. The world’s resources are already more expensive as a result of rising global demand for food and energy, but that’s especially true in the U.S. because of the dollar’s drop. “The problem is that people haven’t saved enough. We’ve just consumed and the Chinese have saved,” says Stephen Jarislowsky, the éminence grise of Canadian money management. “They’ll try to keep it from falling apart with rate cuts. But that only pushes off the day of reckoning. We’re going to sink gradually into the swamp.”
Rosenberg suggests home prices could drop 15% in 2008, and 10% in 2009 in the U.S., and that there could be “outright contraction in economic activity in the first three quarters of 2008.” American consumer spending will fall, and GDP will slow to 0.8% this year and 1% in 2009. The Baltic Dry Index, that obscure but perennial measure of global shipping rates, is down a troubling 45%, while the International Monetary Fund has slashed its forecast for U.S. growth this year from 2.2% to 1.5% (and from 7.8% to 6.9% for the emerging economies).
It’s tempting then to believe that there are some cheap stocks available. But investors should think twice before trying to find bargains in recovering stocks, says one hedge fund manager, Toronto’s Eric Sprott, “This is not the time to go bottom fishing. When I look at the banking system, I see way too much leverage. The balance sheets of the banks are littered with all kinds of derivatives, CDOs, LBOs and credit derivatives.” Some institutions are leveraged up to 30-to-1, and that’s worrying considering the state of the monoline or bond insurers that insure the paper held by the banks. If any more are downgraded, the banks holding that paper will have to raise more capital to get their balance sheets within regulatory requirements. “You can see where the stress is in the system. It’s in the fault lines in the credit market,” says Sprott.
As it is, a vast web of financial contracts and obligations exists between financial institutions, and the number of outstanding derivatives on the books of big banks is said to now be more than US$500 trillion. Sprott notes, however, that none of the firms at the center of this crisis have been allowed to fail. For example, ailing Countrywide Financial was quickly snapped up by Bank of America last month. At the time, some suggested the acquisition was a sign of confidence on the part of the bank. That may not be the right way to look at it. “Bank of America could be perceived as covering its ass in terms of counterparty risk to Countrywide,” says Sprott. “I suspect the reason these companies haven’t been allowed to fail is that no one wants to test counterparties.”
The banking sector has written off US$100 billion in sub-prime debt so far, which, according to Montreal’s respected Bank Credit Analyst outlook, is one-third to one-half of what has to be accounted for before investors “feel secure that the financial sector has owned up to its exposure.” The BCA believes that the rating agencies are about halfway through the rerating process, and the next $100 billion to $200 billion will be written off in the opening months of 2008. Investor sentiment was neatly summed up by Warren Buffett when he suggested there was some poetic justice in the idea that the firms that wrote, bought and sold the bad paper are now suffering as a result. “The people who brewed this toxic Kool-Aid found themselves drinking a lot of it in the end,” he told a Toronto crowd in early February.
But is this mess poetic justice, or just human nature? One of the distinguishing features of this credit bubble was the use of bundled mortgage securities that allowed firms to write loans but reduce their risk exposure by selling off the loans rather than keeping them on their own books as in cycles past. That put the accent on origination and fee-taking, not ensuring the loans were viable. “It was greed and short-term thinking,” says Jarislowsky. “But then there is always theft of capital from those who have it to those who don’t. It’s happened 50,000 times before.” And you can expect it to happen again. Fashionable talk in the U.S. is that the American economy isn’t so much cyclical as it is structured around asset bubbles that need to be manufactured every seven years to keep the 60-year postwar U.S.-denominated debt super-cycle from popping. Could an alternative energy and infrastructure boom be created by policy-makers and financiers to get the economy pumping again? That — and another bubble — is probably a good bet.