No Pain, No Gain: The Price Of Avoiding A Recession

| About: American International (AIG)

Yes, we did hear about the possible $3.2B hit that AIG (NYSE:AIG) might take on the 'subprime' issue. Yes, we did see an angry Jim Cramer on CNBC yelling how Big Ben Bernanke has no idea what is going on. Yes, we all know that a Standard & Poor's BBB credit rating is junk status. News flash for Jim Cramer; this coming Tuesday, Big Ben will ignore all the hoopla and for several good reasons.

Now we are not saying that Cramer isn't correct. The contrary is true. A day before (08/02/2007) Cramer blew his top on CNBC, I wrote this article that clearly calls for a rate cut. The issues are complex and somewhat perplexing. In order to try and make sense as to what is going down, we are going to try and put the latest developments into perspective.

The Economy

All in all, the economy has not blown up and we are still on track for a soft landing. There is an adage that says that when half the people are happy and half are not then things are about right. The same goes for the economic indicators. Half the indicators confirm an excessive slow-down and half the indicators demonstrate a strong economy. The obvious conclusion regarding the contradiction is that conditions are about right for a soft landing. Too many positive indicators would spell an ongoing boom. Too many negative indicators would spell a recession. 'Half this way and half that way' spells a soft landing.

The same holds true for Jim Cramer. If Cramer is positive all the time, this is not good. So perhaps it is time to get used to Cramer complaining a little more in order to balance out the general sentiment! We all know that a healthy market should not go up in a straight line. Hitting speed bumps along the way is part of driving in the marketplace, even when it is a big speed bump that makes you feel like yelling oh s**t (sugar) - there goes the tail pipe - and you have to pull over for a repair. Apparently repair time it is indeed.

Inflationary Induced Recession (Energy + Food + Housing)

Energy

Few noticed that when oil was approaching the new highs around the $78 mark, all of the oil majors, without exception, went into retreat mode. Well everyone noticed the reversal, but how many noticed that even the champions of this last earnings season were losing ground? In fact, reviewing the stock prices today, one would conclude that the majors need not have bothered to report at all. It made no difference whether they had a good, bad or mediocre quarter.

This defied all apparent logic and many erroneously concluded that the markets were foretelling the tale of an imminent recession. Otherwise, as the argument would be, the oil stocks should be rallying to new highs instead of reversing and sliding as much as 10% or more.

Hold this thought for now as we will come back to the energy component in a moment.

Food

Inflation data normally excludes the volatile food and energy components. This does not mean that the Fed doesn't notice the data. Food prices have soared in the first half of 2007. Milk and milk products are up 6%-10%. Coffee (Starbucks (NASDAQ:SBUX) included), bread, meat & poultry have all gone up over 2% with the average household cost increase at 3.1%. Well actually the increase is more than 3.1% but shoppers are switching more and more to off brand names in an attempt to lower their grocery bills.

Housing

The numbers are all over the place. For arguments sake we will take Jim Cramer's numbers and place the number of adjustable rate mortgages [ARM] to be in the vicinity of 14 million. Now Jim didn't say that 14 million would default on their mortgages. Jim did insinuate that about half (7 million) would have difficulty in repaying these loans. In reality only the top 10% income earners (which are not 1.4M mortgage holders but closer to 2M) won't feel the pain. Approximately 12M will feel the pain of the rate adjustment, some more and some less. A certain percentage will default. Default is not the issue. The issue is the pain.

The Pain

With energy, food and housing all going up at the same time, the only way to avoid a full blown recession is to increase wages. Now this is the last thing in the world that anyone wants. First, a massive wage increase would impede the U.S. attempt to mitigate the ever growing trade deficit. Second, what has tamed core inflation until now is the fact that wage growth has been sluggish. This of course is due in part to globalization. Third, if you think the dollar was losing ground against all major currencies until now, just wait and see what happens if inflation picks up a few clicks!

If the dollar falls too far too fast, you can bet your bottom buck that Mr. Greenback will lose its status as the world's reserve currency. Needless to say that all world powers throughout history have met with their demise as soon as their currency was no longer acceptable. Need we spell out the rest?

Since increasing wages substantially is not an option, Big Ben has his work cut out for him. In the meantime, the Fed is not alone in this game as all participants both at home and abroad would very much like to ensure a soft landing. A U.S. recession hurts all and more troubling is the ripple effect. Even countries that are seemingly immune from U.S. markets know that the domino theory has been proven to be destructively correct throughout recent history.

In summary, the average household is being squeezed on three fronts simultaneously; Energy (gas for the car, electric bills in the summer and heating in the winter), food and mortgage payments. So far the only small temporary relief has come from natural gas which is not a key component in the average energy bill during summertime.

The true danger is that the collective pain from all three inputs could derail the soft landing. It is a well known fact that the U.S. economy is still consumer driven. It would take at least a decade to transform the U.S. economy to a production/export based economy. Should consumers start to cut back extensively, many other sectors will decline rapidly, beginning with the consumer discretionary segment.

The Gain

As mentioned above, we come back to the oil markets to explain the bigger picture. Under current macro economic conditions, oil at around $85 will cause the U.S. economy to head into recession. Some of you may have noticed that several prominent OPEC oil ministers have been calling for $60 oil. Normally these comments are dismissed as lip service or other niceties, yet this time they really mean it. The objective is to move the price of oil back to a $51 to $65 trading range. The alternative is to let the price float upwards, send the U.S. economy into a recession and then get stuck with lower demand and oil at $45 or below for a prolonged period of time.

As the price of oil entered the realm of hitting the $85 mark, investors correctly concluded that this was the beginning of the end. Hence, the oil majors started adjusting downwards. Likewise this created a no win situation. If oil stays above the preferred trading range, the U.S. heads for a recession. If oil reverts to the preferred trading range then the oil stocks would have to adjust accordingly. Either way, the direction was south.

If you think that OPEC or Russia want to bail out the U.S. economy out of the goodness of their heart, you are mistaken. This has to be a joint effort to the benefit of all as no one wants to be a patsy. All want to maximize their profits for as long as possible and inflict as much pain as is bearable without killing the client. This is a delicate balance that Big Ben has to contend with.

On the one hand food prices increased in part due to the ethanol related corn demand. This should self correct over the next six months or so and prices could come down in 9 to 12 months. The problem is that the volatility to the downside is slower than to the upside. For now the U.S. consumer is stuck with higher food costs.

On the other hand both energy and housing expenses are readily fixable. The irony of it all is that the two are intertwined…

No Pain No Gain

The Fed doesn't want the housing recession to go away just yet as many first time buyers still cannot afford a new home. Until the market corrects the starter housing prices to be aligned with current wages the Fed has no interest in lowering rates to a level that could set off another housing boom. Likewise, the Fed wants everyone to remember that if the price is too high - don't buy. This in turn will help the Fed keep a lid on interest rates and inflation in general as well.

As mentioned above, the key to all that is transpiring is keeping the U.S. consumer healthy enough to avoid a recession. Out of the three components impairing the consumer, two are now in play. The objective is to give back enough to the consumer so that he/she can live another day. OPEC and other oil producing nations will do their part, but only their part. The oil producers want to see corporate America do their part first.

Part of this is the 'subprime' and 'Alt-A' loans outstanding. Assuming that the 'give back to the consumer' price tag is currently at $450B, corporate America is looking at taking a $150B 'hit' (giving back some profits) over the next 3 years. Likewise, OPEC et al will take a $150B 'hit' (lower profits) over the next 3 years. Only after corporate America does its part will OPEC et al do their part. Likewise, once oil is back in the trading range the Fed will control the mortgage fallout by lowering rates. Lowering rates while energy costs are high is a recipe for uncontrollable inflation. OPEC et al understand this.

As an aside, there are many different feasible ways that this can be implemented. Just one possibility is corporate America taking a $225B hit and being reimbursed through Freddie Mac (FRE) for $75B. Currently, the numbers indicate that the Fed via Freddie Mac has allotted for only $75B out of its $150B share. This doesn't mean that the Fed won't do its share. What this does mean is that the Fed does not intend on using Freddie Mac as the sole medium to do its part. The Fed may opt to bypass Freddie Mac altogether. The options are endless and naturally politics and appearances will dictate the format.

It is actually quite easy to control the extent of damage from the 'subprime' shenanigans by manipulating the prime rate. Cramer was on the mark in stating this and is probably why he is so frustrated. The problem is that Big Ben has to get his timing just right. Until oil is back in the preferred trading range, forget about a rate cut. First corporate America and affiliates, then OPEC et al and then the Fed come to the rescue of the consumer, or should we say the economy.

AIG, Insurers, Bankers and Prime Brokers

The biggest problem right now is how to divvy up the 'hit' amongst corporate America and overseas affiliates. All those who benefited in the past from the mortgage business can expect to be called upon. Recently Credit Suisse (NYSE:CS). Of course this was out of the goodness of their hearts! We will be able to figure out the allotments only after the fact. This is why investors are nervous.

We know that Cramer gives Big Ben Bernanke a BBB rating; however, in this scenario BBB is quality strategy - not junk.

Disclosure: No direct conflicts, though we do care about the secondary fall-out effects.

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