Prepare for subprime fallout

published 19 March 2007

Strange, perhaps, to begin an article on the crisis in the US sub-prime mortgage lending market with a quick look at the outlook for US corporate earnings but the two are related as dogged readers will shortly discover.

Two weeks ago we pointed out that consensus year on year Q1 EPS growth was down to 4.1% from 12% over Q4 2006. In the wake of further corporate releases and downbeat outlook statements that 4.1% growth figure has morphed into just 3.9% year on year growth, a decline of 55% from 1st January.

Looking at the sectoral breakdown it would appear that downgrades have coalesced amongst consumer-focused stocks (-9% annualised EPS growth V's +9.0% annualised growth penciled in just six months ago). Unsurprisingly, estimates remain robust for those defensive sectors seen as weathering the US economic slowdown best over the months ahead, i.e. Healthcare, Telecoms and Utilities (the latter may also be partly due to a reappraised outlook for Treasury bonds, see last week's Week In Preview). Critically, annualised EPS growth for the financials remains at 7% for Q1 and 5% for Q2 2007, pretty much unscathed through the latest bout of financial market jitters.

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Perhaps investors have been waiting for the Q1 reporting season, however, we find it impossible to believe that the financial sector will emerge completely unscathed from the sub-prime fall-out and would expect the knife to be taken to this sector too in due course. Lower corporate earnings, coupled with serious uncertainties regarding the longevity of the yen carry trade, carry the potential to remove a lot of liquidity from the market. Investors had better get used to further volatility over the months ahead.

We use inverted commas as this was the title of a whole section in a recent Wall St Journal (12th March). Naturally, the article was largely given over to the impending crisis about to engulf New Century Financial, the second largest US sub-prime lender, but concerns regarding the weakness in the US residential property market and its impact on the world's largest economy go much further than that. One likely indicator of ensuing stress might be the US payroll data.

How many people know that New Century employs 7,000 people? We didn't, but we do now! How many people know that the University of California economist Mr Ken Rosen believes that as many as 1.5m US home owners (out of 80m) could lose their homes through foreclosure and that sub-prime home values could fall by as much as 10-15%? We didn't, but we do now! How many people know that the US Mortgage Bankers Association predicts that the number of US mortgage lenders that are vulnerable to failure this year could be more than 100 (this compares with around 30 closing their doors since last December!), potentially throwing thousands more onto the employment scrap heap? We didn't, but we do now! How many people believe US Fed Chairman Ben Bernanke when he states that the US economy might actually be picking up speed by mid-2007? We didn't then and we don't now!

The US savings ratio remains in negative territory. This means that consumers are spending more than they are receiving in income. Some might be borrowing to spend, a risky strategy into higher interest rates (how many people can borrow at prime rates anyway?), others might be indulging in the folly known in this country as mortgage equity withdrawal. This particular house of cards has been shown to suffer from particularly unstable foundations as the weakness of the entire US residential property market over 2006 makes clear (unless you happen to be fortunate enough to own a farm in the mid-West and somebody wants to buy it to grow arable for ethanol production!).

Whatever the reason, we believe that a negative savings ratio is unsustainable over any period other than the shortest time and that a reversal of that ratio, back into positive territory must have adverse implications for consumption and, as we have argued before, business investment (the two are related) and, by extension, employment. All of a sudden the virtuous circle of the past becomes a vicious circle of the present, culminating in much slower economic output levels than had hitherto been expected.

Outstanding mortgages total around $1.3tr (for those who like comparisons, that's comparable with the size of the Californian economy!). Although the weakness in the US residential property market through 2006 was always likely to result in the greatest pain for those at the sharp end, amazingly, sub-prime loans accounted for fully 20% ($600bn) in the growth of the overall mortgage market last year, five times the level of growth of five years ago when rates were much more affordable! Business Week goes on to quote sources as saying that c40% of last year's loans are showing signs of distress. Hardly a surprise then to discover that a good proportion of total mortgages issued had no documentation regarding the borrower's financial circumstances, including their income levels!

Our forecast for 2007 US economic growth is 2.6% (against c3.4% for 2006), close to consensus. As weeks pass we increasingly think that the risk to this estimate lies to the downside. Although there are clear differences between the US housing bubble of 2003-05 and the tech bubble of 1998-2000 there are also clear parallels. The point is that both were/ are bubbles and both played a very major part in percolating down into overall economic activity. Also relevant is the fact that both are likely to end up in the same placewith lawyers in the courts.

Although a little too early to prejudge the ultimate outcome from the bursting of the property bubble, it is not too fanciful to suggest that regulatory reform, including the tightening of lending standards, is inevitable. If this then acts as an impediment to future housing demand (in an environment where, unlike this country and one or two specific hotspotslike midwestern farms, supply already significantly exceeds demand) then not only will it be harder for house prices, having slid, to recover, but also to assume that rising property values will underpin a continuation of the aggressive consumption patterns of the past.

The upshot is that these factors could shave as much as 0.5% point off Gross Domestic Product (GDP) growth already under downward pressure. Of greater concern is the fact that the baleful influence of the housing downturn is not a shortterm effect. Historically, housing cycles have tended to be quite long (c2 years) with a peak to trough decline in activity levels of approximately 30%. So far the US has lived through five of the ten quarters and activity levels are down by about 15%, so there's clearly much more to come. Indeed, there could be even more to come if the reversal following one of the most aggressive cyclical booms on record, does more than simply conform to historical norms.

So 0.5% off a forecast of 2.6% results in 2007 GDP growth of about 2.1%. Note that the Federal Reserve has a range of 2.5% - 3.0% growth pencilled in and judging by his recent pronouncements, Chairman Bernanke is in no mood to alter monetary course just yet. The clear inference from the above analysis is that by holding the line at 5.25% (and retaining the bias within monetary policy setting towards further tightening) a technical recession, if not an outright recession, becomes an increasingly likely outcome.

More recently, the Fed maintained its bias towards further tightening through the first part of the Nasdaq's plunge in 2000, only choosing to easy policy in a belated (and ultimately futile) attempt to steer the economy away from the inevitable recessionary rocks. On both occasions an inverted bond yield curve had been signalling the danger of risks ahead and on both occasions the Fed chose to ignore the message bond investors were sending. Now investors are well aware that the bond yield curve has been inverted since last July, effectively signalling the same message as before. Again, the Federal Reserve has chosen to ignore it, opting instead to suggest that the inversion could be as a result of overseas (mainly Asian) central banks filling their coffers with long-dated Treasury stock.

But hold on a minute, Asian central banks have been operating in such a way for several decades and if recent reports are to be believed, have been increasingly looking to diversify their reserves away from a perceived over-dependence on US treasury assets. No, the bond yield curve is inverted because bond investors suspect a recession. If we're right regarding the consequences of the fall-out from the US housing market, and the Fed chooses not to respond, a technical recession (at the very least) will follow. If we're wrong and the Fed does respond, then Treasury bond yields are going lower.

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