Thursday, January 17, 2008

Mr. Bernanke Goes to Washington

Yesterday, Bernanke made a presentation to Congress about the Fed’s outlook on the economy. Below are the major points (in italics and offset).

Since late last summer, financial markets in the United States and in a number of other industrialized countries have been under considerable strain. Heightened investor concerns about the credit quality of mortgages, especially subprime mortgages with adjustable interest rates, triggered the financial turmoil. Notably, as the rising rate of delinquencies of subprime mortgages threatened to impose losses on holders of even highly rated securities, investors were led to question the reliability of the credit ratings for a range of financial products, including structured credit products and various special-purpose vehicles. As investors lost confidence in their ability to value complex financial products, they became increasingly unwilling to hold such instruments. As a result, flows of credit through these vehicles have contracted significantly.

Let’s start with the charts (where else).

The SPYS have dropped from 156 – 134 – a drop of about 14%. And the chart is terrible: prices are moving lower, prices are below the 200 day SMA, the lower SMAs are below the longer SMAs etc…

The QQQQs have dropped from about 55 to 46, or a little more than 16%. That is not good.

And the Russell 2000 has dropped from about 84 to 68, or almost 19%.

No matter how you slice the market performance since their peaks, the overall performance is bad.

Here’s a graph from the latest FDIC quarterly survey (End of September 2007) of banking of loan charge-offs:

And here are two more pretty scary graphs from the same report:

And this was before this week's news -- which so far as stunk.

And we can expect another terrible year, given the number of problem mortgages in the system.

To date, the largest effects of the financial turmoil appear to have been on the housing market, which, as you know, has deteriorated significantly over the past two years or so. The virtual shutdown of the subprime mortgage market and a widening of spreads on jumbo mortgage loans have further reduced the demand for housing, while foreclosures are adding to the already-elevated inventory of unsold homes. New home sales and housing starts have both fallen by about half from their respective peaks. The number of homes in inventory has begun to edge down, but at the current sales pace the months' supply of new homes has continued to climb, and home prices are falling in many parts of the country. The slowing in residential construction, which subtracted about 1 percentage point from the growth rate of real gross domestic product in the third quarter of 2007, likely curtailed growth even more in the fourth quarter, and it may continue to be a drag on growth for a good part of this year as well.

While the absolute amount of existing home inventory has stabilized:

Months available for sale has continued to increase:

This indicates the rate of home sales is still dropping.

Recently, incoming information has suggested that the baseline outlook for real activity in 2008 has worsened and that the downside risks to growth have become more pronounced. In particular, a number of factors, including continuing increases in energy prices, lower equity prices, and softening home values, seem likely to weigh on consumer spending as we move into 2008. Consumer spending also depends importantly on the state of the labor market, as wages and salaries are the primary source of income for most households. Labor market conditions in December were disappointing; the unemployment rate increased 0.3 percentage point, to 5.0 percent from 4.7 percent in November, and private payroll employment declined. Employment in residential construction posted another substantial reduction, and employment in manufacturing and retail trade also decreased significantly. Employment in services continued to grow, but at a slower pace in December than in earlier months. It would be a mistake to read too much into one month's data. However, developments in the labor market will bear close attention

Energy prices are still high, although they have been coming down recently.

See the charts above for the stock market problems.

And home prices as measured by the Case Schiller index are starting to drop. Also note that home prices have increased considerable over the last 7 years. Assuming the home prices move back to the historical norm/mean (which prices usually do) the price correction could get really ugly.

The increase in the unemployment rate is very important; it took the wind out of a lot of bulls’ sails. Now bulls are pointing to the decline in unemployment insurance claims – especially the drop in the far more important 4-week average. However, I think that argument isn’t that strong considering how many other bullish indicators are dropping hard.

In the business sector, investment in equipment and software appears to have been sluggish in the fourth quarter, while nonresidential construction grew briskly. In light of the softening in economic activity and the adverse developments in credit markets, growth in both types of investment spending seems likely to slow in coming months. Outside the United States, however, economic activity in our major trading partners has continued to expand vigorously. U.S. exports will likely continue to grow at a healthy pace in coming quarters, providing some impetus to the domestic economy.

Above is a chart of the percentage change from the previous quarter in non-residential structures’ investment. This has been one of the few pieces of good news from the economy as a whole. However, I have to wonder if this pace can continue considering the problems in the credit market.

The chart for software and equipment investment -- which is the percentage change from the previous quarter -- was OK for the last few quarters. The fourth quarter's number is very important.

Financial conditions continue to pose a downside risk to the outlook. Market participants still express considerable uncertainty about the appropriate valuation of complex financial assets and about the extent of additional losses that may be disclosed in the future. On the whole, despite improvements in some areas, the financial situation remains fragile, and many funding markets remain impaired. Adverse economic or financial news thus has the potential to increase financial strains and to lead to further constraints on the supply of credit to households and businesses.

Translation – the financial sector is still taking it in the teeth. The chart confirms that analysis:

Note the following:

-- Prices are below the SMAs
-- The Shorter SMAs are below the longer SMAs
-- All the SMA are headed lower

Bottom line: this is an incredibly bearish chart.

Even as the outlook for real activity has weakened, some important developments have occurred on the inflation front. Most notably, the same increase in oil prices that may be a negative influence on growth is also lifting overall consumer prices. Last year, food prices also increased exceptionally rapidly by recent standards, further boosting overall consumer price inflation. The most recent reading on overall personal consumption expenditure inflation showed that prices in November were 3.6 percent higher than they were a year earlier. Core price inflation (which excludes prices of food and energy) has stepped up recently as well, with November prices up almost 2-1/4 percent from a year earlier. Part of this rise may reflect pass-through of energy costs to the prices of core consumer goods and services, as well as the effects of the depreciation of the dollar on import prices, although some other prices--such as those for some medical and financial services--have also accelerated lately.1

Wow – you mean this chart of oil

And this of agricultural prices

Is important? I thought only core inflation mattered? Seriously, it’s good to see the Fed Chairman acknowledging that food and energy prices are important and are incredibly high right now.

The bottom line is Bernanke painted a pretty grim picture. And with good reason -- the picture is pretty damn grim right not.