Sunday, 19 October 2008

Economy vs Credit Markets

Back in late September I recommended that investors pay close attention to the credit markets. At that time I said that if stresses in the credit markets persist, the equity market would be in for tough times and as you know, October has been no picnic for equities.

However since the measures announced by European and US governments to guarantee overnight lending markets there have been some noticeable improvements in credit markets as demonstrated below by the reduction in the TED Spread.

Also of note, the 2 year swap spread has fallen from over 150 bps earlier in the month, back down to 124 bps as of Friday.

The flight to safety trade in 3 month treasuries has also eased from a low 0.20% earlier in the week to 0.78% as of Friday. Whilst these metrics are far from happy days are here again type readings they show significant improvement from a week ago levels.

However the flip side to this story is the latest economic data spilling out from the US. I noted some of this earlier in the week, Retail sales and the Empire State Manufacturing survey falling off a cliff. Housing starts and permits are hitting new cycle lows and builders sentiment is at its lowest ever. Also out during the week, the Philly Fed manufacturing index recorded it's sharpest ever 1 month decline to an 18 year low whilst consumer confidence also plunged the most ever in a single month in October.

On the earnings front there has been some decent reports from some tech and materials companies whilst some surprising negatives from the likes of Pepsi. However, I believe that earnings in the current quarter will be somewhat of a headfake given that things didn't really start to fall apart until September and the stimulus package was also still at play early on in the quarter.

4Q08 earnings are currently expected to be higher than 3Q08. That will just simply not be the case. The latest data from Zacks shows that for every earnings upgrade there are five downgrades.

So what will dominate? The repair of the credit markets or the gloomy economy? As usual, I have no strong convictions about short-term market direction. No doubt the progress being made in the credit markets is a positive, however I believe the economic fundamentals will prevail in the medium term.

Much of the economic growth and prosperity of the last decade has been built on cheap credit and rising asset prices. Inflated asset prices are no longer available to borrow against to fuel excess consumption. The change in social mood towards a recognition of frugality instead of excess should also not be underestimated.

These will be good long term developments however they will bring about short to medium-term economic pain. Consider a chart from John Maudlin's weekly column showing the sharp decline in US Mortgage Equity Withdrawl (MEW). MEW's hit an irrationally exuberant high in 1Q06 when $223.6 billion was extracted, just two years later and that figure has plummeted to $9.5 billion in 2Q08 as shown below.

How is the consumer, faced with higher unemployment, no prospects for wage growth for those with jobs, nothing to borrow against and tighter lending standards across the board supposed to keep spending at the pace of just 12 months ago? On the subject of tighter lending standards, also from Maudlin's weekly note, GMAC has said it won't lend to anyone with a credit score under 700, that rules out more than 40% of Americans. Welcome to the new reality.