Fed Notes Indicate Economy's Troubles Aren't Over

Zacks’ Director of Equity Research, Dirk van Dijk, CFA, has pored over the recently released Fed Reserve notes from its March meeting. We were interested in getting his take on them, including what suggestions he would give to investors based on his findings.

So what is your initial take on the recently released minutes from the Federal Reserve’s March meeting?

All in all, not a pretty picture – especially seeing as since this meeting, the data has gotten worse. We are now on the fourth consecutive month of private payrolls declining, and the declines have turned out to be much steeper after the revisions than the data the Fed was looking at.

Well, it does mention that private payroll employment posted a third consecutive monthly decline.

True, but even still, it seems likely that the employment numbers are overstated – or job losses understated; take your pick – due to the Birth/Death [B/D] adjustment. Now, there is nothing nefarious about the B/D, it's just that it is trend-following and at inflection points tends to get things wrong. Thus, it overstates employment as things start turning south, and understates employment when things start to get better.

I would note that the unemployment rate is now up to 5.1%. Also, falling aggregate hours indicates that 1Q GDP is likely to be weak. Given the decline in real estate values and slowing retail sales, it seems quite likely that property taxes and sales taxes – the two principal sources of State and Local Government revenues – are going to fall. This will make employment gains in these sectors unsustainable.

What do you think about the notes on real consumer spending having stalled?

If wealth is decreasing and real incomes are not rising, it should not be a surprise that real consumer spending has stalled. Long-term, however, this is a good thing, since less spending means more savings – and the U.S. is a savings-starved economy. However, it does lead to slower economic growth. The consumer represents about 70% of the economy.

Do you feel we’ll see the end of the housing crisis at some point in 2008?

We might see an end of the decline in housing starts later this year, but a quick rebound is very unlikely. Housing prices are still way too high relative to historical measures like price to rent, home values as a percent of GDP, and median price to median income. Look for prices to continue to decline for the next few years – not months, years.

Are you of the mindset that the Fed is assessing the outlook correctly?

Seems to me that the projections from the Fed Reserve notes are indeed moving in the direction of reality. Although, I’m a little surprised by their statement about housing prices falling more than anticipated. Were they referring to the pace of the decline, in that it will be over more quickly?

If so, then the look ahead to 2009 seems to make no sense to me. Housing prices have to come down. Yes, we could have a "W-shaped" recession due to the effects of the stimulus package. But the effects of the housing decline will continue for a long time.

Where do you see housing prices going, finally, and what should investors do about this?

From the peaks, housing prices will probably come down 25%, which translates into about $5 trillion of lost wealth. A good portion of those losses will be borne by the banking system. To make it up, the banks will have to raise more capital diluting the existing shareholders and they will have to cut their dividends.

We see this process today at Washington Mutual (WM) and have seen it in many other financial institutions so far, including Fannie Mae (FNM), Freddie Mac (FRE), Morgan Stanley (MS) and Citigroup (C).

Of course, they are the lucky ones. The unlucky ones go belly-up the way New Century did, or get take-unders like Countrywide (CFC) and Bear Stearns (BSC). I would continue to avoid or underweight the sector.

The strength in net exports should be real, however. So, big exporters in the Industrial sector like Boeing (BA), Caterpillar (CAT), Joy Global (JOYG) and Honeywell (HON) could be well positioned.

Dirk van Dijk, CFA is the Director of Zacks Equity Research.

Comments

[chrism1962]

I agree with your analysis that we have not yet reached bottom for residential property and can see about another 20% of falls to come.

As commercial real estate tends to lag retail by about 18 months, at what level ( compared to todays price) do you think that they will stabilize, and when?

Regarding retail real estate in particular, they will be doubly hit by reduced asset values, and reduced revenues. Are you expecting company failures in this sector?

[SeriousBull]

You have estimated a decline in housing prices in the range of 25% or $5 trillion in banking write-downs. This is more in line with our analysis portends the immediate need to shore up the Treasury by taking aggressive action to salvage what we can to shelter the US taxpayer from the losses coming, not only from private companies, but from losses to be (one-day) realized at the government mortage agencies like Ginnie Mae. Time is of the essense as banks typically only hold 5% collateral on a home loan so we are agreeing that $100 trillion in capital reserve deposits (5 x 20 mulitple) will vanish.

[SoonerJoe]

I don't agree with the comment here that lower consumer spending means increased savings. While it may mean this for some people, it may be the case with many that rising prices + stagnant wages actually equates to an even further erosion of savings rates and totals.

[iThinkBig]

SeriousBull, your analysis is on. The $100 Trillion will be lost global investment and global contraction (especially the U.S. at some point). The taxpayers will bear most burden of the bailouts but it is the contraction of investment and subsequent job losses we see accelerating which will ultimately drastically lower the quality of life for most Americans. The solutions is to innovate now in energy and give the global consumer what it wants. This would continue to expand our global empire. If we don't, then we will contract into Depression, see a final global war (nukes would likely be used, YIKES). Do the American people have the collective will to push leadership into action and out of their Washington cacoon? That looks like a big negative to me, I see most Americans wanting bailouts, meaning a Socialist government until at least 2012 when the continued pain accumulates to creating necessary action.

[pockyclips 2020]

We have long a way to go before the housing/ sub-prime mess is cleaned up. At least the economists are admitting it is a $1 trillion problem, not $200 to $300 billion here in the USA.

There is roughly a 4/1 ratio between median income and average home price. Historically, this ratio should be 3/1. And this was before the days of the $400/month car payment, maxed out credit cards, and health insurance that covers only 65% of actual expenses.

Housing prices will have to come down another 20% before they
become affordable. It makes little difference how many choppers full
of money the Fed drops on the banks, other than to the bankers!