The fallout from the ongoing credit contraction is clearly much worse than anyone had initially thought. The OECD financial system, led by the banks, has already taken write-downs of over a $100 billion, and most observers expect another wave of bad news to hit in the next couple of months. Experts think that at the minimum, the total write-offs will eventually exceed $300 billion, and could go up to even $700-800 billion. There are many rumours swirling around the market place of the SWFs (sovereign wealth funds) renegotiating the terms of their already announced capital infusions, and were it to happen this would be a clear negative. The question is also asked as to where the banks will get their next chunk of capital. Even if the losses are ultimately $300 billion, the banking system in the west needs a huge slug of new capital, who will provide this? Nobody wants to provide capital when the eventual losses are still a moving target, and everybody wants to participate only in the final round of capital raising, as any investment prior to the final round will inevitably incur a hair cut.
Also given the complexity of the whole world of structured finance, and the degree to which financial structuring had permeated the financial system, most market participants are still unable to get a handle of how the crisis will spread and who will get affected next. Take the case of the issue around preserving the AAA rating of the monoline credit insurers, this has now become critical to stabilising the whole financial system, or the crisis around term auction securities, due to which even local government authorities are facing a steep hike in funding costs. Basically nobody is sure of which shoe can drop next, and where all the infected stuff is residing. In such an environment, risk aversion is but natural.
The other related problem is that despite the pace of the Fed easing, 225 basis points already and counting, it is at least till date having very little impact on actually easing costs and access to credit. Debt spreads have continued to blow out and are higher today across most products compared to when the Fed began easing. Even in absolute terms, credit costs for the person on the street have hardly dropped. Merrill Lynch has created a composite debt measure, taking into account actual borrowing costs for mortgages, auto loans, credit cards, etc, and calculated that for consumers, borrowing costs have only dropped by about 45 basis points, despite 225 basis points of Fed action.
On the mortgage front, because of the use of "teaser rates", and option-payment mortgages, which enabled mortgage originators to keep initial interest rates low, despite the Fed cutting, the average mortgage rates consumers are resetting into are 300-400 basis points higher than what they were initially paying. This is something that the Fed can do very little about, as a very significant number of loans will reset over the coming year.
In addition to the costs issue, we also have the reluctance of both lenders and consumers to increase leverage. In the latest Fed senior loan officer survey, the percentage of banks willing to extend new consumer loans was basically zero (last time this happened was in the recession of 2001), and a record 17% of banks are now tightening consumer lending standards. Apart from costs, only about 5% of reporting banks are actually seeing increasing demand for consumer credit. As Merrill points out in a recent report, not one bank in the loan survey reported positive demand for either subprime or non-traditional mortgages, and only 2% of reporting banks have seen increased demand for even prime mortgages.
Just because Fed easing has not worked till date in either lowering the costs or increasing demand for consumer credit, it does not of course mean the Fed will not eventually succeed, as its policy actions do have lags. However, seeing the limited impact the Fed has had till date in loosening financial conditions, one can understand the bears "pushing on a string" thesis of how the Fed has very little ability to cushion the coming consumer-led retrenchment.
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It is now pretty clear the US is going into a recession, the shocking Philly Fed survey numbers and other data points seem to confirm this, and the debate now is to the length and severity of the coming retrenchment. If we have a typical slowdown, the economy should start improving by the end of the year, and the equity markets bottoming out by May-June.
The worry is that we get a much more severe consumer retrenchment, and all the excesses built up over the years in the US need to get washed away. In such a scenario we could have a very slow and gradual recovery, which may mean significantly below trend economic growth in 2009 as well. If this were to play out, markets may bottom out much later. In either case, more downside for equity markets seems likely from here as markets have never bottomed out in the first months of a recession, and thus calling for an equity market bottom today seems premature.
As for India I think we seem to be in a trading zone, where we are too expensive for new money to flood in, but have decent enough fundamentals to avoid another big leg down. We may need to consolidate at these levels for a while and let earnings catch up and reduce the market multiples. Investors are currently shying away from the growth markets of India/China, partly due to valuations and partly due to concerns/uncertainty on the severity of the US recession and its impact on global growth.
As for India, investors are still convinced that growth will not drop below 7.5-8%, but seem unwilling to pay more than 14-15 times forward earnings. Thus either we have to wait 6-9 months for earnings to catch up or drop the markets by about 10-15%.
I still believe this secular bull market is not over, we are going through a cyclical bear phase, a pause that refreshes, so to speak. This correction will set us up for a strong and sustained market rise post the consolidation phase.