Financial Contagion and the Negative Feedback Loop

Alternative media sources contain some of the best information for investors. Such is the case with the podcast service, “Bloomberg on the Economy” with Tom Keane. In a recent podcast, which is available via iTunes, Mr. Keane’s guest was economist Nouriel Roubini.

The program format allows for the deeper exploration of a topic, which in the very capable hands of Mr. Keane enables a listener to learn about a guest’s views that go beyond the sound bite.

In the interview, Mr. Roubini describes the chain reaction that is at the heart of much of fears of the financial contagion swirling about the investment markets. Coupled with the potential negative feedback loop to the real economy, the dangers of the credit crisis are better understood.

The case made by Mr. Roubini flows as follows.

Mr. Roubini describes the current financial system as a subprime financial system, lacking transparency and one in which a contagion could readily spread from the subprime mortgage market to other areas of the credit market.

The flow looks something like this:

From

• Subprime to
• Near Prime to
• Prime to
• Consumer Credit to
• Auto Loans to
• Credit Cards to
• Student Loans to
• Commercial Real Estate to
• Leveraged Loans to
• LBOs to
• Corporate Bonds

Note: The last item listed (corporate bonds) dovetails tightly with the credit default swaps [CDS] of corporate bonds and the concern expressed by PIMCO’s Bill Gross, as noted last week on this blog (“Here Comes the Global Depression”, Jan. 22, 2008). Additionally, Mr. Roubini notes that the CDS market is a $45 trillion financial Frankenstein, which did not exist a mere ten years ago.

Investment Strategy Implications

Current valuation levels support higher stock prices. This is true if one believes, as I do, that earnings for 2008 will not collapse by 20% plus. However, the situation is still very fluid and risks of contagion and the negative feedback loop exist and are very real.

The positive equity market assumptions made on this blog and in my reports are twofold:

• Earnings for 2008 will be better than the bear case expects thanks to the global growth story and stimulative actions (fiscal and monetary) taken by government bodies
• Financial contagion outlined by Mr. Roubini will not unfold to greatly significant degrees thereby mitigating the negative feedback loop between the real and financial economies

The risks to these points rests in their interrelated nature, one that is mutual reinforcing. Moreover, it must be noted that even if my two points do hold, the danger point has not completely passed for equities as the special aspects of 2008 (electoral campaigns in the US and the China Olympics) give way to 2009, a year without such positive factors at work.

At that point, a second wave of earnings declines could stretch a 10% decline in earnings for this year (a much more realistic expectation) into another 10% decline, or more, in 2009. This, however, is not the consensus view and, therefore, should be noted but not stressed at this time.

Bottom line: good valuation levels, a more resilient global economy, an oversold stock market, and high degrees of investor pessimism should be strong enough underpinnings for an equity market that is almost priced for a financial contagion disaster.

Comments

[Victhom]

Well I guess you need an update....

Risk of a Global Recession Following the U.S. Hard Landing?
Nouriel Roubini | Jan 30, 2008
It is now clear that the US economy is already into a recession that started in December 2007: the data on December employment, retail sales, manufacturing ISM, housing and other macro variables confirm it. And the 0.6% growth for Q4 GDP confirmed that sharp slowdown of the economy in Q4 and its tipping over into a recession by December. It may take –as usual – almost a year for the NBER to formally declare that a recession started; but when that decision is made it will be clear that the great US recession of 2008 started in December 2007 or – at best – Q1 of 2008.

At this point it is clear that the debate has shifted to how deep this recession will be, a mild one lasting two quarters as the new consensus claims or a deeper, longer recession – lasting at least four quarters – as I have been arguing for a while.

It is also clear now that this US recession will lead to a global economic slowdown – short of a global recession that would occur if global growth were to be below 2.5% - and to actual recession in a number of individual economies.


www.bloomberg.com/avp/...
The main points:

- the US has already entered a recession and this recession will be protracted and severe, more so than the mild recessions in 1990-91 and 2001;

- whatever the Fed does will be too little too late as you cannot resolve problems of insolvency with monetary policy and as it takes years to clear a glut of housing, consumer durables and automobiles;

- the rest of the world cannot decouple from a US hard landing; when the US sneezes the rest of the world catches the cold; and this time the US will have a severe case of pneumonia; thus expect significant contagion to the rest of the world; thus, there will be a significant global economic growth slowdown.

en.wikipedia.org/wiki/...

[calvino]

Vinny, do you think California's 10% across the board budgetary cut and inevitable layoffs will have any sort of decelerating effect on the national economy. I do not think state budgetary constraints have a chance of spreading to other states, because other states did not depend on big cash infusions from the real estate boom. I am wondering if you agree with me and if you think the growing list of commercial vacancies in states like California and Florida as well as a growing number of residential vacancies will impinge upon tax revenues, or the value of some of the CMBS that you have at the top of your list. I am a bit of a worrier, so if you think I am just a nervous nelly, I can understand. Anyway, good luck with the value investing - i am going to buy some Salesforce. com aka CRM and Baidu, because they have come down into my value range.