Friday, December 01, 2006
The difference this year is that construction-related unemployment won't reverse itself in the spring as it usually does. Earlier in the fall the economic Fed-CW was that commercial construction would pick up a good deal of the slack, but now both commercial and residential construction are slowing. We can expect that trend to continue, because banks are going to continue to exert more caution in lending, and because commercial construction is related to both manufacturing and residential construction. (New developments require new banks, supermarkets and shopping plazas.)
Manufacturing now is slumping. A weakened dollar in the coming months should help to offset this somewhat, but will be outweighed by the very significant drop in domestic demand for manufactured products produced by falling construction. (Consider Weyerhauser and Caterpillar, for example. The drop in demand for wood products affects Weyerhauser, and the drop in the demand for heavy equipment affects Caterpillar.) In terms of the GNP, it's of concern that exports of services are dropping.
By February consumer spending will be dropping significantly due to progressive limitations on available credit, and then the second-order effects of lower consumer spending, a tightening job market, rising foreclosures and contracting credit will become the main movers. At that point, the housing decline will begin to be fueled less by affordability and more by increased caution in both borrowing and lending, poorer job/earnings prospects and a procession of negative economic news. Most plumbing and contracting firms will still have relatively strong business for another year related to backed-up existing home demand, but their profits will drop quickly, due to a more competitive bidding process. They will, in turn, trim spending. Less pickup trucks, etc. The contraction is beginning in south California already.
I continue to think that the Fed will drop 50 basis points in the first quarter of 2007. Inflation signals will remain relatively strong, but those signals will begin to drop out when credit tightens. This will be a continuing, slow slide next year, but if the Fed doesn't get ahead of this domestic cycle they run the risk of a very severe downturn. I have read quite a bit about Bernanke's theories about the Great Depression, and I think he will be a strong advocate for earlier, rather than later, action. Eventually he will draw the inflation bugs with him as the "unprecedented" occurrences begin to mount.
Heating oil stocks remain higher than the five-year average. The Saudis claim that that world oil supply is in imbalance, but unlike the peak oil fanatics, their concern is centered on oversupply:
High oil inventories in the U.S. are keeping the global oil market "significantly" out of balance, Saudi Arabia Oil Minister Ali Naimi said Friday.What they really mean is that they are terrified of "Fortress America". They are desperate to keep us politically and militarily involved in the area through energy dependence. However, their efforts are going to produce the exact opposite of their intent; the real pain of this US recession will fuel a broad-based popular demand for increased energy generation inside the United States. Those with more historical knowledge view the prospect of being dependent upon the most dysfunctional corner of the world with dread and fear.
"The market is significantly out of balance," Naimi told reporters on arrival in the Egyptian capital ahead of Saturday's meeting of the Organization of Arab Petroleum Exporting Countries.
"Inventories in the U.S. are high, not low, that is why the market is out of balance," Naimi added.
When asked what would balance the oil market he said: "Take 100 million barrels out," without elaborating.
Inflation in this cycle is related to extremely lax lending standards and high fuel prices. Both will automatically correct going forward (foreclosures alone will force credit tightening, whereas a recession will reduce fuel demand), but the self-reinforcing nature of this credit binge/purge cycle will not. The variable here is extreme political upheaval in the ME Gulf region, but I think we won't see that for about another 9 months at the earliest. Edgy Adji does not yet have any nuclear arrows in his quiver. He would if he could, but for now he cannot.
There are two theories about what happens after the midpoint of 2007. The first is that the world economy decouples from the US economy, and continues to rise. The second is that the woes of the US begin to propagate to places like China. Weak spending at WalMart has a direct significance for Chinese exporters, so I would expect some weakness there over the next two years.
There has been a global housing inflation (in China, in India, in most of industralized Asia, in parts of Russia, and in Europe), and it is beginning to settle out in Australia, for example. Going forward, I expect something near to the US experience to begin to spread in Europe, Australia, and parts of China toward the end of 2007.
As for our domestic recession, we could reverse it within a couple of years by removing environmental roadblocks toward any sort of energy development project alone. However, recent political history suggests that illegal immigration and deranged environmentalism will be the determining factors of the 2008 election. Democrats have spent the last six years insisting that Bush alone refused to ratify Kyoto (he doesn't have the authority, the Senate has that), and that the Republicans, left unchecked would, within weeks, cover the country with an arsenic-laden cloud of oily smoke, killing cute chipmunks and babies, unless they happened to be fortunate enough to drown in the global flooding produced by global warming.
It will be difficult to reverse this politically. The deep misery of the lower-middle and working class will, however, especially when conditions on Wall Street get bad toward the end of next year and the first half of 2008.
Right now everyone's concentrating on sub-prime, but the problem runs much deeper. People have been refi-ing out of consumer debt post Christmas for years, but this year when they go in to do it, they will find that the automated valuation system parameters have changed and so have lending policies.
The key is that the final peak of the run-up was very steep, so it took a while this year for the year-over-year values to show a drop nationally. Those who are trying to clear the foreclosures are estimating 8% to 20% price drops nationally.
We are at the end of the lag, and in the next quarter OFHEO will show an absolute drop. Plausible deniability ended with this month's existing home average and median prices.
The 2006 vintage of mortgages is showing absolutely ghastly default rates already. I waded through an awful lot of quarterlies over the last month, and to make money writing and selling, it looks like you will have to write 8.5-9% loans in the next quarter. It's over for creative financing, because the yields the market will demand for the crud will be too high to write saleable loans.
The reason the big boys are buying subprime units is partially to cushion the impact of the junk they've got. The whole cycle has ended, but it takes a few months for the thud to be heard. I do expect S&P & Fitch to be revising.
You can already get 5.6 to 5.8 fixed 30 years in New York with excellent credit, a firm 20% down and a firm appraisal. Good borrowers are going to be gold and will be treated as gold, but this is where the inflation in housing prices gets stripped away, because the real ability of the borrower to pay the loan is the only actual protection against loss for the lienholder.
Watch the mortgage app refi index for the next few months. You'll see that most who could escape have escaped. From here on in it gets dreary and default rates and foreclosures mount inexorably. By next summer, places like Orange County, CA are going to look like several spots in Colorado now.
Yes, exactly. It's as if everyone is determined to run their vehicles right to the wall, thinking they can leap at the last moment. The Europeans really scare me.
As for spreads, I'm trying to avoid writing financese, because I want other types of people to be able to understand what's happening. For anyone else reading this, on the banking side spread = Net Interest Margin (NIM), and that's been off all this year. We are already seeing the hunt for real money, and real money is going to be hard to come by.
It's frightening. The overnight CD rates were:
And then you look at 5.6% traditional fixed 30yr mortgages.... The whole production side of the financial system seems to be in disarray. Corporate lending had already gotten out of whack by the beginning of the year, IMO. It was non-productive.
IMO the production side of banking and the MBS-holders of the funny-money loans are moving from chasing returns to chasing hard collateral or cold hard cash. There can be only one reason that the big boys are buying subprime units, and that is that they need to counterbalance by new production what they have. One leg at a time, this thing is folding up.
This is why I think the underlying trend is deflationary. When the finance system is so overloaded with risk that it cannot counterbalance with return, you get a cycle of contraction.
CF, normally I follow the European economies and markets more closely, but I've spent the last three months concentrating on this mess. I don't have any feel for the month-by-month EU pressures. I am sure that they will take it further than the US would, though. One factor is their subliminal belief that the governments will not let the bad stuff happen.
Materials? I can't get titanium plate to save my life (we're only an $8 B company) so I've had to substitute a superior material that happens to be 50% more expensive. And try to sell it.
Aluminum bronze? Doubled. Brass? Doubled. Stainless steel in all varieties? At least doubled. We update our own price list every 6 months to keep up with material cost increases and we're still not keeping up. I look at the Fed inflation numbers and laugh.
But, going forward, a deep recession would tend to reduce prices for most materials. Mining and refining are energy and labor-intensive operations. The cost of fuel contributes to what you are seeing.
A lot of these materials may remain somewhat expensive if worldwide demand holds up (the decoupling happens). A weakening dollar raises the costs of imported metals. Also, the geo-politically induced oil crunch, combined with the machinations of OPEC and others may tend to support oil prices. Distorting the market in this way could produce much more serious global problems. In the Asian countries, everyone's asking when the governments are going to reduce fuel prices.
I suppose it is possible that we could see a combination of inflated commodity prices and recession for a while, but I think it can't last for more than 3 quarters.
The quasi-protectionism of the oil cartel may produce a worldwide problem. There are elements of this situation that parallel the 20's, because markets are not being permitted to adjust naturally.
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