Currently the equity markets of the world could use some Prozac.?Gloom and doom are everywhere. The broad group of sentiment indicators we monitor register a very high degree of investor pessimism. Hedge funds in the United States and Europe are as defensive as they have been at major market bottoms, and the media are full of sour commentary.
The unwinding of structured finance centered in the U.S. subprime-mortgage market is causing an intensifying global credit crunch that threatens not only U.S. consumption but also consumer spending around the world. Already major banks, insurance companies and investment banks have confessed to huge write-downs of loans, which reduces their capability to extend credit and makes them risk-averse. The apparent cause is the continuing decline of home prices in America, but the real villains are greed and gullibility.?The mortgage brokers,?real-estate developers, banks and the investors who bought the paper were greedy. The?buyers who assumed mortgages they couldn’t service were gullible and stupid.
As usual in such circumstances, the perma-bears are emboldened, raving about the biggest credit contraction in 70 years and the threat of a deep global recession. Some are even saying the rest of the world will go the way of Japan; in other words, 16 years and counting of stagnant growth and deflation. Japanese stock indexes today are still more than 50 percent below their 1989 highs. The bears point out that the U.S., European and developing-country markets have declined only 10 percent from their highs, so they could have a long way to fall. The pessimists foresee an engulfing tragedy, as the credit crisis spreads to take down highly leveraged companies, trillions in credit-default swaps, the junk-bond market and real-estate bubbles around the world.
The bears are prominent, intelligent people, and they have to be taken seriously. That said, I believe they are exaggerating the problem. The Federal Reserve began to raise interest rates three and a half years ago,?speculative activity in housing?peaked in mid-2005, and then a year later house prices began to fall.?In hot markets like California and Florida prices are now falling at about 7 percent year to year and are back to the levels of mid-2005.?When CNBC trumpets that “house prices?fell 7 percent in October,” it is misleading: what really happened is that prices fell 7 percent from the level of October last year.
As the stimulus from buying new homes and remortgaging old ones fades, consumer spending (which is two thirds of the U.S. economy) will be affected. The experts we pay attention to expect that in the adjustment process spending?will lag income gains by 2 percent or so, but will still rise by 4 percent to 5 percent in nominal terms in the coming?year. The next leg down in housing will reduce spending gains to about 4 percent—a drag on growth but not the end of the world.
Capital spending (another 10 percent of the U.S. economy)?is already fading fast, but with the dollar weak, the U.S. trade deficit is shrinking, and that will add 1 percent to real GDP growth.?GDP growth in America is going to slow to 1 to 2 percent for perhaps three quarters next year,?but I think negative GDP in the United States that triggers a global recession?and a doomsday is a low probability. Measures that would ease the subprime crisis by reducing the number of foreclosures could make the outlook even less dire.
The subprime-mortgage mess in the United States is one that the government is going to have to deal with. Politicians cannot stand by idly while?millions of voters are?ejected from their homes. Some form of interest-rate adjustment or principal guarantee will occur.?The guilty perpetrators of this bubble—the mortgage, commercial and investment banks—have been and will be punished with executive firings, job losses, write-offs and big stock-market declines. But as in the past, the system will be saved from a deflationary death spiral. Of course, the world economy will slow over the next year or so.
However, that isn’t necessarily bad. A slowdown reduces the risk of rising inflation. The popping of the housing and structured-finance bubbles had to happen eventually, so it’s better to get it over with. Big-capitalization, high-quality stocks in the United States, Europe and Japan are now downright cheap, and companies in the emerging markets continue to grow rapidly and are selling at reasonable valuations.
Don’t panic. A year from now my guess is that stocks, the dollar and U.S. inflation will be higher, and oil, gold, the euro and the pound will be lower.
