- U.S. home construction shows signs of life
- Global inflation and growth woes remain
In the 1980s, economist and Nobel laureate Amartya Sen found that famines tend to happen not because of a lack of food, but because of obstacles preventing those in need from acquiring the existing stores of food. This juxtaposition is center stage across the globe right now – an ongoing famine for liquidity in many financial and housing sectors versus the flood of petro-liquidity driving consumer and producer inflation higher worldwide. We have liquidity in spades, just not in the sectors that welcome it or need it most.
Why so serious?
Remember April and May? The leaves were returning. The flowers were blooming. The credit crunch was over. Well, the spring fling is over and markets have come to the realization – which incidentally has been TD Economics base case scenario all along – that the credit crunch will continue to slowly bleed for some time. While the market roller coaster saw increasing optimism early this week, apparently markets forgot that the U.S. housing market remains in shambles. There is some light. For the first time since the spring of 2007, the 3-month trend in new home sales and starts is positive. New home construction is what is captured in GDP measures of residential investment, and this same signal preceded rebounds in U.S. residential investment in each of the last three downturns. Existing home sales, on the other hand, make up the majority of the U.S. housing stock and mortgage market, and sales there dropped another 2.6% M/M in June and are down over 15% over last year. Critically, at this current pace of sales, it would take over 11 months to sell the inventory of unsold homes already on the market. And this doesn’t include other homes dumped on the market in coming months through foreclosure or voluntary sales. In the second quarter, one in every 171 U.S. households was foreclosed on – with Nevada showing a staggering one in 43 households and California one in every 65.
This is the heart of the liquidity famine. As more homes are dumped on the market, home prices fall further, driving further mortgages underwater, leading to further foreclosures, further homes dumped on the market, and further home price declines. Lather. Rinse. Repeat. At some point, lower prices will entice buyers into the market, but not until the expectation for further declines recedes. Why buy today when you can buy next year for 10% less? In the meantime, liquidity in the housing market is nonexistent. This feeds directly into the current dilemma for the financial sector. The smaller and more regional the bank, the more exposed to the mortgage market. Real estate loans account for 1/3 of all assets of U.S. commercial banks – over ½ of all assets for banks with total assets less than $1 billion – and nearly 2/3 of assets of savings and loans. This puts these institutions in a vise, and those like Fannie and Freddie that have bought or underwritten about half of all these mortgages in a bind. As a result, commercial banks’ average daily borrowing of $16 billion from the Fed’s emergency lending programs last week was the highest ever.
So the issue becomes what can be done to get that liquidity flowing again? In a perfect world, we’d let the market work itself out. Prices would fall to the point that buyers would move in, and larger banks would recapitalize by attracting investors. But current regulations limit the ability of buyout firms to move into the banking sector – an issue the Federal Reserve is reportedly trying to address – while large foreign investors that bought into large banks earlier have since lost money on their investments and may be once bitten, twice shy. The bill moving through the U.S. Congress right now hopes to help stop the self-fulfilling prophesies of doom, gloom, and liquidity vacuum. The government would increase its debt ceiling by about $800bn – about half of which could cover the expected 2008 federal deficit and the other half would be there just in case. This “just in case” would help cover, among other things, the federal government insuring approximately $300bn in mortgage debt belonging to 400,000 American households who will refinance their subprime loans into 30-year fixed-rate mortgages, $4bn in federal transfers to the states, and the ability of the U.S. Treasury to buy stock in Fannie and Freddie up to the federal debt ceiling. As banks continue to struggle, these two institutions are key to helping the U.S. mortgage market grind on. While not ideal, a government backstop may be just what is needed to avoid their failure and the vicious cycle in the mortgage market. Earlier this week, the Congressional Budget Office estimated the cost of the Fannie and Freddie rescue plan at $25bn. As with most of the estimates placed on the cost of credit crunch, this seems likely to creep higher, but is still much lower than the cost of doing nothing. In the worst case scenario – or even just the next incremental step because let’s be honest, there isn’t much of a difference between the first step off the cliff and the second – the costs to the Federal government could be ten times higher.
A horse with no name
The current U.S. predicament is core inflation and GDP growth both running at about a 2.5% pace over last year. For those unlucky few who need to buy gas and food on a regular basis, total inflation is running at twice that pace. Still, this is well short of the near 15% pace of core inflation and 1% Y/Y contraction in U.S. GDP in 1980 that saw the invention of the moniker “stagflation.” Nor are there signs inflation will come unhinged in the U.S. to that extent so the “stag” part is much more likely than the “flation.” Similarly in Canada, headline inflation is now running at twice the pace of core inflation (3.1% vs. 1.5%). In fact, on a global scale, the most likely scenario is further stagnation in advanced economies and further inflation for emerging markets, with very few of either seeing both on a sustained basis. The U.S. consumer is quickly running out of stimulus checks to spend. In Canada, retail sales for May showed an ongoing sharp deceleration in everything not being bought at a gas station. In Europe, surveys of the manufacturing and service sectors showed sharper than expected decelerations in Q2. The U.K. economy posted its weakest quarterly GDP growth rate in three years in 2008Q2 and is likely to contract before the year is out. And, the pace of exports from Japan and Hong Kong saw precipitous declines in June. So growth is likely to slow in these regions and exert a downward pressure on domestic inflation.
On the other hand, broad-based emerging market resilience and inflation worries remain. The pace of inflation-adjusted retail sales in China is the highest in 12 years. Korea’s economic expansion stayed constant in Q2 while inflation remains at a 10-year high. And across the EM universe (or at least averaging 57 EMs), inflation has accelerated from a 5% pace in June 2007 to 12% in June 2008. So while Malaysia this week hiked interest rates for the first time since 2006, and Brazil surprised markets with a larger than expected rate hike, the average pace of inflation across EMs is rising faster than the average interest rate. This is pushing down real interest rates and helping to fuel both faster growth and inflation in these markets. The same is not occurring in advanced economies, with average real rates still above zero in the G-7.
So in the immortal words of the modern philosopher Axl Rose, “Where do we go now?” Sluggish economic growth in advanced economies is likely to keep a lid on growth prospects in EMs, but not unbearably so. Inflation in EMs is likely to place upward pressure on advanced economy inflation, but not uncontrollably so. And we are likely to see more mirages in the desert before we finally find paradise and bring balanced liquidity back to the global economy.
Richard Kelly, Senior Economist416-982-2559