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28 February 2024

Sub-prime casts a bearish shadow

By Julian Bene



As 2007 becomes a memory, wary prognosticators have an array of evidence to sift and chew over as they try to determine the course of the economy and of corporate earnings and stock prices. Among these are the latest readings on the holiday’s retail sales and on consumer durables sales and on unemployment. There’s more news on house prices. Then we have the latest bailouts of big banks and of money market funds. Each of these indicators allows us to check whether parts of the story that the bears are telling seem to be coming true, or whether the bulls have the better of it. Most of these very recent signs have been more consistent than we have hitherto seen with a common-sense economist’s gloomy expectation of the after-effects of the housing glut and credit crunch – which is to say that they seem to bear out the bear story.

This common-sense expectation is based implicitly on a cause and effect model – of believed linkages in the economy – that runs roughly as follows. Cheap and very available money fed an asset price boom around the world, and especially in the United States pushed house prices beyond their normal relationship with incomes, and at the same time caused more houses to be built than “needed” in steady state. Innovative lenders found ways to put folks into these homes who really could not afford to own, and it all looked like a super deal to everyone as long as house prices went on rising. Americans borrowed against their inflated home values to consume, and US growth benefited from a double effect: the excess house building and real estate lending activity accounted for a large proportion of the jobs created and incomes earned in the past few years and thus paid for a lot of consumer spending in itself.

This fed consumer growth, as did all the home equity loans that the rest of America used to go shopping. When the music stops, one would expect these effects to reverse. So how is the dismal science’s story doing at the beginning of 2008?

Apparently, Americans binged a little less at the shopping malls over the holidays than has been their wont. This was a shoe that seemingly failed to drop in late November, when Thanksgiving sales reportedly managed a modest advance on 2006. In view of inflation, especially of higher gasoline prices, it seemed possible that retail consumption growth had already halted in real, inflation-adjusted terms even in late November. In late December the data seem to be sending a message with less nuance.


MasterCard Advisors, who tally retail sales on a preliminary basis, said that sales were flat year over year in the month to December 24. Take out inflation and that really means consumption went down. Another measure, this time of shopper traffic in the malls in the week before Christmas, was down by a whopping 10 per cent from 2006. To what extent traffic translates to spending remains to be seen, though almost certainly sales will not have dropped as dramatically as by 10 per cent.

Yet not all consumption-linked signs are down in recent days. The consumer confidence index from the Conference Board is up a little for the first time in four months. The bulls have to have something to cheer about! And the chaos theorists can take comfort from this contradictory move in the confidence index. The fact is that small moves up or down in any of these indicators may be pretty meaningless, which is why official declarations that an economy is in (mainly shallow) recession often come long after the event. We certainly do not yet have a definitive reading on retail sales or consumption for late 2007 and we cannot say that there has been the big drop that would give serious grounds for worry. If consumption stays about even with last year, for example, that should hardly be cause for complaint, and the same would even be true of a mild consumer recession.

At the factory level there are more signs to ponder. November durable goods orders rose by only 0.1 per cent, after four months of decreases, but excluding volatile aircraft these orders were down by 0.7 per cent, showing that this segment of the economy is pointing slightly down. The capital goods component of the durables result was down by 0.4 per cent, which may reflect business investment slowing down, but again hardly dramatically.

A rise in numbers claiming unemployment benefit, from 348,000 to 349,000 was worse than expected, but what can we make of a change in a data that requires a calculator to compute? This is the art of the economists’ story where the bulls can gloat the most: if overheated housing explained the decade’s job gains, why has not the end of the boom led to a big spike in unemployment? The best answers so far are not very good: immigrant workers falling through the measurement cracks and going home to Mexico when the jobs dry up, or significant flaws in the measurement of jobs and joblessness making the data meaningless.

The big news for our model concerns US house prices, because it does seem safe to assume that these will drive any consumption and lending slowdown. They seem to be falling at an accelerating pace. October house prices were down by 6.1 per cent compared to the previous year, whereas the September drop was only 4.9 per cent, all based on a respected Standard and Poor’s / Case-Schiller index that covers the major US metropolitan markets. There were stories that at least in Manhattan, foreign visitors flush with cash were plunking down money for condos that seemed inexpensive to them. Quite what nouveau riche Dubliners want with an apartment in New York City is unclear: it is a very long commute. When they find that New York bank staff cannot afford the rent for these condos – some of them are inevitably losing their jobs as the banks cut back on expenses – our Irish friends may reassess their property valuations. But still, in the meantime, foreign splurgers could be cushioning the blow of the housing readjustment.

And what of the lenders in this asset bubble that the US has been enjoying? Merrill Lynch had to join the ranks of the loss-making major banks running to sovereign investment funds for capital in late December. Merrill’s saviour was Singapore, supplemented by an American investment fund, for a total infusion of $6.2 billion. However, a bearish Goldman Sachs analyst on Thursday predicted that the misery is not over and that in the coming quarter Citigroup, JPMorgan and Merrill will all write down almost twice as much as Goldman’s previous forecast for them and more than the current consensus of analysts. Since Goldman is about the only major player who has so far come out of the credit crunch smelling of roses, perhaps we should listen to their analyst a bit more carefully than we listen to the rest of them. Yet since investment banks are always telling us that they have Chinese walls between all of their departments, the Goldman analysts and the guys who make the big trading bets may not talk to each other or share models and assumptions. So bulls can, if they wish, dismiss the idea that Goldman’s analyst is more reliable than his rivals.


The latest news of credit infections, while not especially dramatic, simply confirmed how widely the sub-prime mess is spreading. Janus, once high-flying mutual-fund managers, had to inject more than $100 million to keep one of its boring money-market funds from “breaking the buck” because some of the supposedly safe, very short-term paper in which it invested was less credit-worthy than it needed to be. T Rowe Price, a very large fund company, said some of its assets also were less pristine than desired. And BlackRock, who have a reputation for being good at sorting out the credit game for others, have some troubles of their own: Moody’s downgraded one of its money funds that froze its payouts a short while back. All this will leave some cautious investors wondering: “If money market funds can’t be trusted, are Treasuries the only safe place to be?”

On the whole, the latest signs are that the end of the housing boom is slowly having the expected effects on the US economy. What we don’t know is how deep the correction is going to be and how well the rest of the world will get along, as and when US consumers finally cut back. For that, we’ll just have to keep watching the indicators over the next weeks and months.