It's a recession but does anybody care?

The most frequent topic of financial commentators the past few weeks is whether the US is going to enter a recession. The question is: Does it matter? If you knew we were entering a recession what would you do differently? What is a recession? Does the President of the United States come on television and address the nation? Read further to address all of these questions but the answers really don't have anything to do with your finances.

All year in this newlettter the favorite phrase for 2007: "We only see life through our own experiences".  Markets are supposed to anticipate economic events and yet this year it has done just the opposite and been the caboose for the economic train that is crashing and will soon resemble a scene from the early 1930's.

The term recession is used to designate an economic slowdown and is generally, but not always, accompanied by two consecutive quarters of negative real (inflation adjusted) GDP (Gross Domestic Product). The NBER (National Bureau of Economic Research) ( http://www.nber.org/cycles/recessions.html ) is the "official" arbiter of this overused description of the economy. Due to massive revisions of government data it is often a couple of years before the term recession is attached to a past economic cycle and is of no use to anyone except historians or those seeking a term to describe their own personal financial pain. If you are in the residential real estate market you realize recession is too soft a term and the word depression is more appropriate. If you are in an export business recession is not in your business model as you dream of finding more workers.

The next time you hear a financial commentator ask his or her guest whether the US is entering a recession feel free to scream at the TV: "Why does it matter and what would you do about it?" You won't get an answer but it will help you realize that the answer is irrelevant to you and the future course of the US economy.

Markets decline on confusion and rise on certainty

Last Friday morning Fed Chairman spoke (via teleconference) to a St. Louis Fed financial conference. ( http://www.federalreserve.gov/newsevents/speech/bernanke20071019a.htm ) The title of his speech tells us everything we need to know about current Fed thinking, "Monetary Policy and Uncertainty." His remarks were generally about Fed history but he chose the title knowing world financial markets would easily see his current state of mind. Friday's stock market decline of 366 Dow points was caused in part by the realization that the Fed doesn't know what it will do on October 31st (next FOMC meeting) and is having difficulty forecasting where we are going.....total confusion just like the 1970s Temptations hit song titled "ball of confusion".

Monday evening (10/15) Mr. Bernanke told the Economic Club of New York ( http://www.federalreserve.gov/newsevents/speech/bernanke20071015a.htm ) that the Fed was concerned about an unusually high Libor borrowing rate (today at 5.15% for 3 month Libor).  The Fed lowered the Funds rate by 50 basis points on September 18th but that only assisted banks as most corporate and real estate variable rate loans are tied to Libor which is normally 10 bp above the funds rate. The Fed was hoping to reduce the market based Libor rate but so far that has not occurred and was noted by Mr. Bernanke with the following quote: "Interbank term funding markets have improved modestly, though spreads there remain unusually wide." The US economy also has Mr. Bernanke confused as we heard with this comment: "It remains too early to assess the extent to which household and business spending will be affected by the weakness in housing and the tightening in credit conditions." It is no coincidence that as world financial markets began to realize the most powerful central bank in the world was seeking direction bond prices rose and stocks fell.

Markets always rise when the information flow is clear and understood even if the news is bad but confusion creates fearful sellers and that is why Friday's action was so violent. (Dow down 366 and 10-year interest rate down 10bp to 4.39%.

The fight at the Fed

One of the main reasons Fed monetary policy has been behind the curve for most of 2007 comes from the enormous data their staff analyzes on a daily basis. Early in the year they told us the mortgage mess was temporary and would not spill over to the general economy. The stock market's decline in February was short lived and buyers stepped in with both hands driving the market to new highs. Always have faith in the Fed was a mantra we learned from the Greenspan era (1987-2006) and it always paid off well at the cashiers window. Since we only see life as we experience it stock investors are only too happy to be rewarded from buying on weakness and seeing immediate profits. In the summer we again saw a nasty stock decline that was again met with buyers with hopes that the Fed was always right and if needed would lower short-term rates that would support the economy and stock prices. This again turned out to be prescient as stocks recovered quickly and rose to new highs a couple of weeks ago. Two for two is 100% and this week's stock decline should again bring out the buyers whose memories are high on success and low on fear.

Is it really that easy? Maybe not as the Fed is confused and faced with a dilemma that has no easy solution. Normally when interest rates fall we see the economy slowing and inflation falling but this month we have a fight with no clear winner (yet) to drive the Fed in the correct direction. Last Thursday we saw the price of oil reach $90 per barrel in Asian trading as demand from hedge funds, speculators betting on turmoil in the Middle East and those caught on the wrong side of the market propelling this most precious commodity to new daily highs. We have not seen a similar rise in the price of gasoline but if oil holds at these levels for a few weeks it is a certainty that a gallon will surpass $3 and then rapidly ascend to $4. Consumers don't buy oil they purchase gas for their cars and that is why there has not been an outcry from Congress which always reacts too late to fix the problem. Could Congress create a realistic solution but with next year's election it is certain every candidate will try and fix the problem with an impossible solution. Gasoline is a non-discretionary purchase for most consumers and price increases generally don't move buyers to cut back unless the price levels remain for many months/years. We have virtually the same situation with grain prices as a drought in Australia and strong demand from China and India have sent wheat prices to record highs. These commodities are also non-discretionary and these price rises have many fearful of a rise in inflation. A falling dollar that has our exports rising and trade deficit narrowing has others worried about import price inflation.

But, and its a big but, we now have asset prices declining (stocks, mortgages, etc.) and this is deflationary leading to credit contraction as the mortgage mess has investors worried about the value of securities that were market to model instead of market to market. As a side note the Financial Accounting Standards Board announced this week they will not delay the implementation of FAS 157 which will require companies to value their investments based on market value even if they are going to hold until maturity. ( http://www.cfo.com/article.cfm/9985407?f=most_read )

The Fed is caught between two strong forces and is trying to straddle between them but that is causing confusion in world markets. They must make a bold move and acknowledge that the economy is weakening fast and with a declining stock market and an upcoming rise in gasoline prices they will have the cover they need to show the world they are back in the drivers seat of their Humvee and will make sure passengers will arrive safely at their destination.

Stress in the credit card sector

Capital One announced a loss for the third quarter of $81.6 million due to closing Greenpoint Mortgage. These results are not surprising but inside the report was a disturbing report that gives us a clue about future consumer spending. ( http://www.washingtonpost.com/wp-dyn/content/article/2007/10/18/AR2007101802454.html?nav=rss_business ) They reported an increasing number of delinquencies and defaults in both the credit card and auto finance sectors.

A rising apartment vacancy rate

From Phoenix, Arizona comes the report that third quarter apartment occupancy rates fell to 91.2% from 95.4% a year ago due to a glut of single family homes that aren't finding buyers so the sellers are attempting to rent at any price. ( http://www.azcentral.com/business/articles/1018biz-renters1018.html ) In Shasta, California we see RE developers taking homes off the market and turning them into rentals. ( http://www.redding.com/news/2007/oct/15/its-not-a-good-sign-when-the-home-builders-start/) It's called deflation and will soon show up in lower owners equivalent rent in the monthly CPI.

Lower house prices = lower state tax revenue

From Sacramento and San Francisco we see stories about pending lower property tax bills for homeowners. ( http://www.sacbee.com/101/story/434423.html )( http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2007/10/14/BUDGSP2P3.DTL). From Maryland we have the Governor proposing a legalization of slot machines to cover a $1.7 billion shortfall in the budget. ( http://www.washingtonpost.com/wp-dyn/content/article/2007/10/12/AR2007101201609.html ) Looking for a solid bet in the next couple of years? Watch gambling companies as states try to out do each other in a race to the casino.

This Week

The big story will be on Monday as the world watches the US stock market to see if last Friday was a one day drop in prices. For those that are interested in short-term trading (we are NOT an investment newsletter) the last ten years the day after the October option expiration (last Friday) the stock market has risen all ten times. Economic news will be sparse but Treasury Secretary Paulson will be speaking about US-China trade relations and which will include rhetoric about the dollar-Yuan relationship. Wednesday at 1:15pm Fed Governor Mishkin will speak on Financial Instability a very timely topic. Thursday at 6am the Fed's Consumer Advisory Council will discuss mortgage loans and this should receive a lot of attention from Congress and the press. Unfortunately this will again be too little too late as the lenders have already reacted to this year's meltdown with much tighter underwriting guidelines.

Summary

Early in the year you read here that interest rates would fall after July 1st and the economy would not be able to withstand the fall from the mortgage market. The US 10-year closed last Friday at 4.39% and is headed lower with a final destination around the 3.70% level. The Fed will be forced to ease again as the Libor rate must decline and the Fed's only weapon is a lower Fed Funds rate. There is not much else they can do and we will really see panic when the world realizes that lower rates are not going to prevent the most serious economic setback since the early 1930's. No one believed it early this year and no one believes it now because we only see life from our own experiences and 99% of the world wasn't around during that time period. Fasten your seat belt, the ride is going to be very bumpy over the next couple of years and when you've never lived through that experience it can be frightening.