The Next Recession

 |  Includes: DIA, QQQ, SPY
by: Nicholas Cavallaro

The past two years has played host to some of the most eye-popping events in financial history. Wall Street titans and financial powerhouses that endured generations of battles have bitten the dust in this struggle for survival. Consumers that borrowed their way toward wealth are facing the reality of paying for the excesses of having lived outside their means. Elected officials and government entities that also borrowed from the future are finally making needed yet unpopular decisions, and they are still likely to come up short. Indeed, to study the rewards and consequences of actions made preceding to and throughout this paradigm shift have been fascinating.

Yet, many look forward to the breath of fresh air in the form of an economic rebound. Politicians, newscasters, and financial experts all trumpet the good things ahead, celebrate less bad news as turning a corner, and extrapolate trivial items as proof of a recovery.

And they are wrong. Some are motivated to sell good news; others are simply misinformed or not informed enough. Everyone seems to look at recent good news and accept as fact that good news breeds good news. This is surely not the case. The road ahead is filled with hazards, none of which have been addressed by the cheerful folks on TV. The economic pitfalls in front of us can easily cast us into another and deeper recession, lasting several months or even some years. Reasonably thinking, my arguments are as follows:

  • Deleveraging: Corporations across the board are still hesitant to meaningfully invest in capital expenditures. Think about it, given the duration of the recession, and the financial storm that is still whipping around in the rear view mirror, it makes sense that management will tend to preserve cash and defer expanding operational capacity. It would be illogical to pour money into (or challenging to secure financing for) new production plants, machinery, or equipment when an uncertain environment still lingers. This is why the cheerful folks dominate the media—if consumer uncertainty can be reduced, companies might actually invest in production. Because without these types of domestic investments, as the insightful economist John Hussman argues, there is nothing that leads economic recovery, and there is limited capability for other forms of economic activity.
  • Housing: The housing overhang has abated, but it is still oversaturated. It is very likely that many people are in houses that shouldn’t be. From the mid 1980s through the mid 1990s, the US home ownership rate was relatively stable at 64%. In the following ten years, the housing boom took off and home ownership increased to just shy of 70%. It has only fallen to about 68%.Renting more - owning less Although I do not offer a forecast on how much further home ownership will drop, or that it needs to return to the 64% area, but I imagine the drop in home ownership will (and shall) continue. There are still homeowners who cannot make the monthly payments. Interest rates on the loans could be zero, and if homeowners are unemployed, they will likely still be unable to make principal payments. Banks that own mortgage loans are in trouble. Credit quality will continue to deteriorate, and banks will make less loans (and rightfully so). This loan book issue could be even more amplified since relaxed mark-to-market accounting policies are likely masking additional losses, which banks will eventually be forced to take a loss.
  • Regulation: To borrow a phrase from Larry Kudlow, free market capitalism is the best path to prosperity. Government involvement usually ends up inhibiting economic growth, stifling innovation, causing inflation, or some combination of these or worse. In general, the following regulations hurt economic growth: quotas, tariffs, subsidies, minimum wage, rent control, consumer rebates, corruption, etc. These policies come to fruition because both sides of the aisle push agendas that favor reelection at the expense of its citizens. Recent stimulus efforts (Bush & Obama) create zero economic wealth; printing money is borrowing from and taxing future citizens while simultaneously provoking inflation. Protectionist policies (Bush with steel, Obama with tires) also raise prices for consumers while creating a disincentive for producers to create superior products. It further encourages rent-seeking activities (paying lobbyists), which also drains potential economic growth. And the one that irks me the most is Cash-for-Clunkers. Here, the government is incentivizing people to destroy something that is valuable and take on a sizable debt; nothing is produced that the economy itself naturally demands, resources are misallocated, and opportunities are forgone. Why not destroy houses that people live in, destroy schools where children are taught, and destroy malls where consumers spend—then rebuild it all to help the economy? It makes no sense. All this government wastefulness appears to be driving taxes higher, which further hurts the economy.

The problems of deleveraging, housing, and regulation do not take place in a vacuum; if they did, I would be less concerned. Each of these economic pitfalls has a trigger that may soon accentuate these problems.

  • Deleveraging has already started to unravel. As corporations are scaling down, the government is levering up at an astounding pace. The trigger event here is that our largest creditor nations, China and Japan, will decrease or stop buying US Treasuries (China is already increasing its gold purchases and discussion of an alternative reserve currency is abound). With interest rates next to zero, there is little incentive to continue loaning the US money, especially if repayment continues to grow in doubt (judging by treasury credit spreads). Though the Federal Reserve may need to raise rates to entice our creditors, doing so would choke this economic recovery, which is based on cheap monetary policy.
  • The housing trigger is more of a catalyst in that it is with high certainty of occurring: the increase in mortgage rate resets. To provide a brief background, the least creditworthy home buyers were issued subprime loans. Many of these included provisions where interest rates reset (to significantly higher monthly payments) a few years after they were issued. This is what happened in the subprime collapse—borrowers couldn’t afford the increased payments, and many subprime mortgages defaulted in 2008. The next group of homebuyers, those with credit just marginally better than subprime loans, were categorized as Alt-A or issued loans called Option ARMs. Alt-A refers to the creditworthiness being less than perfect, and the Option ARM is an adjustable rate mortgage (again with potentially higher rates). These mortgages had terms that delayed rate resets, until now, and the Alt-A Option-ARM collapse is just beginning since rate resets will continue through 1Q12. Though the Alt-A Option-ARM spike may not be as severe as the subprime mess, the duration looks to be worse.MonthlyMortgageRateResets
    Think of it this way: the subprime resets is like Hurricane Katrina blasting Louisiana; whereas the Alt-A Option-ARM resets is like Florida getting hit by Hurricanes Charley, Frances, Ivan, & Jeanne one year, then Hurricanes Dennis, Wilma, & Rita the next. There are no protective levies. Moreover, banks do not have an incentive to refinance borrowers that are behind since refinanced delinquencies generally end up delinquent again..
  • A similar case could be made for the regulation trigger as the deleveraging trigger in which regulatory policies hurts the US currency to the point of crippling the economy. However, the flashbulb moment—or shall I say, lights out moment—could come much sooner: social security will go cash flow negative much earlier than anticipated. Allan Sloan’s recent cover story in Fortune highlights this concern. Although, current projections have Social Security outlays exceeding inflows in 2017, Sloan argues that since unemployment has been unexpectedly worse, Social Security could go cash flow negative in 2009 (yes, this year). We will know if this happens in early 2010. Personally, I do not believe 2009 will be the turning point, but it’s not a stretch. If the Social Security cash flow negative date is pushed up to 2010 or 2011, panic could ensue.

Now, for those looking for some glimmer of hope, there are potential counterarguments that may provide flashes of mediocrity. First, multinational corporations are increasingly earning more dollars from overseas revenues. Second, the stock market could perform independently from the economy. Third, significant inflation may buoy stocks.

Although I admit that these could occur, I won’t be betting the farm. I at least offer the following refutations. First, a relative increase of foreign revenues may be the cannibalizing affect of companies pursuing healthier consumers in healthier economies; this could be signaling lost opportunity for the US economy.

Second, given time, there are always enough rational market participants that will align the market with the economy, as it is irrational to invest in overpriced future streams of cash flow. It is quite easy to profit from shorting bad stocks in an overpriced market or to even speculate in commodities and foreign currencies. Which leads me to my third rebuttal, in that inflation taxes everyone (and the poor the most). This surely impacts any economy.

The US economy is in trouble. Deleveraging, housing, and regulation each pose major threats to the economy’s viability. I don’t buy the advertisements for recovery because by next spring, there will be no recovery. The reluctance of foreigners to hold our debt, mortgage rate resets, and political maladies could all quicken the pace of an economic fall. And even though the past two years have been quite tumultuous, the next two years brings equal opportunity for pain.

(I endorse the arguments of others when I am unable to poke holes in them. The above is my beliefs, and I am thankful for the work and influence of John Hussman, Peter Schiff, The Economist, Forbes, Allan Sloan, and Bill Gross.)