NEWS / Foreign Exchange

Misplaced Faith in the Fed and the Global Economy

The housing situation is still deteriorating, and it is slowly spreading to the rest of the economy while the credit crunch remains unresolved. We believe the lethal combination will deal the economy a knockout blow that neither the Fed nor the global economy can resolve.

The latest Case-Shiller index shows house prices continuing to drop significantly while inventories of homes for sale are exceedingly high and foreclosures are soaring. As we get into the period where mortgage resets are reaching their highest point, we expect these trends to worsen, placing even more mortgage debt in jeopardy of default, and throwing additional significant supplies of homes on the market.

Although we were early in recognizing the end of the housing boom and its highly negative impact, we are no longer alone as the consensus now recognizes the depth of the recession in the housing area. However, despite the housing downturn and its major role in engendering the current credit crunch, the stock market remains at elevated levels. The reason for this optimism is a widespread belief that the economy will undergo only a brief and mild slowdown as a result of Fed actions and a strong global economy.

The vast majority of economists and strategists believe that the housing woes will be contained and not spread to the rest of the economy. In our view this outcome is highly unlikely. Over the last 50 years every downturn in housing starts of 30% or more has led to a recession with only one exception, and none of those instances were associated with the kind of disastrous housing market that we are seeing today. The preceding economic expansion was not based on strong gains in employment and income, but was spurred by soaring mortgage credit, the housing boom and a decline in the household savings rate. Furthermore the economy has already slowed down considerably as evidenced by declining growth in employment (no matter what tomorrow??™s employment report shows), production, consumer spending and new durable goods orders.

The supposedly strong 3rd quarter growth in real GDP was a statistical anomaly. It started with a tepid nominal annualized growth rate of 4.7%. However, since the implicit price deflator was an unbelievably low 0.8%, real GDP came in at a completely unrealistic 3.9%. By way of comparison the average price deflator for the prior seven quarters was 3.1%. Had that been the case this time, real 3rd quarter growth would have been only 1.6%--and anyone living in the real world knows that inflation could not have been anywhere near as low as 0.8% in the period. Furthermore the liquidity crunch started only halfway through the quarter and preparations for a possible auto strike spurred inventory accumulation that will be undoubtedly taken down in the current quarter.

We also believe that the widespread faith in the Fed to solve all economic and financial problems is misplaced. The Fed has only one tool, and that is the ability to change the fed funds rate. It??™s an exceedingly blunt instrument and one that is not capable of fine-tuning and timing all of the complex aspects of a modern economy. The fed cannot create any real wealth, but can only encourage the increased use of credit, resulting in the issuance of paper money. If a central bank could guarantee steady economic growth with low inflation no nation in the world would ever have any economic problems. The current tug of war between inflation and economic growth and the parsing of every word in each FOMC statement, speech and testimony illustrates the difficulties involved.

Furthermore the widespread belief that the global economy is now immune to the domestic U.S. economy is an unproven thesis yet to be tested. The U.S., the EU and Japan are all showing signs of slowing down, and together they account for 70% of world GDP. The developing nations, which account for the remainder, have GDPs that rely heavily on exports to the other 70% for their growth.

In our view the U.S. economy is facing a hard landing or recession together with disappointing corporate earnings. As this becomes the mainstream view in the period ahead the market is likely to undergo a major decline.