United States: Critical Macro Investment Themes for 2008

For the first time in seven years, I approach my annual thematic forecasting ritual on a distinctly downbeat note. Small wonder: The downside risks in last year’s outlook morphed into the Crunch of 2007, which is still playing out. In contrast, at the start of 2007, I focused on the notion that a resilient global economy would promote higher real interest rates. While widespread complacency about risk premiums made me nervous, and I foresaw liquidity dwindling and market volatility rising, I relegated big market moves to ‘tail events’ that seemed unlikely.

That was then. Today, the tail events have moved to center stage and real yields have plunged 100 bp from their peaks in June. I think the crunch of 2007 will still influence markets and economic outcomes in the coming year. Several of our market conclusions may be surprising. In my view and that of our strategy teams, investors in 2008 should anticipate a stronger dollar, wider transatlantic yield spreads, and a further steepening of global yield curves.

These market conclusions flow from the confluence of four critical macro themes. The first two relate to growth: A mild US recession is coming; and US and global growth will recouple, with growth slowing abroad. The third theme is a key reason behind that slowing: The reintermediation of the US and European banking systems will continue, adding to financial restraint. Finally, a significant reregulation of US financial services firms is likely, adding to restraint. I’ll start with the four themes and work back to market conclusions.

Theme I: A Mild US Recession

Although it has yet to begin, our call for a mild US recession is intact: We expect domestic demand to contract significantly in each of the next three quarters, essentially no growth in overall GDP for the year ending in the third quarter of 2008 and corporate earnings to contract by 5-10% over that period. Three factors triggered our call: Global growth — for us, long the key bulwark against a downturn — is slowing, financial conditions continue to tighten, and domestic economic weakness is broadening into capital spending.

Even if the data do not immediately point to such weakness, we think the Fed will insure against these downside risks. Fed officials have indicated that they will continue the Term Auction Facility (TAF) launched in mid-December for as long as needed to realign interbank lending with policy interest rates. However, easing strains in money markets is only one offset to the tightening of financial conditions. To cushion the coming weakness in growth, we also think officials will reduce the Federal funds rate by at least another 75 bp over the next 7-9 months. Such easing will contribute to a steeper US yield curve, but it is important to note that much of this future policy action is in the price, according to Fed funds futures.

Theme II: Recoupling of Global Growth

The resilience of the global economy — and its “decoupling” from the US slowdown — was a major theme for investors in 2007: Divergent growth rates promoted wider short-term US-overseas interest rate differentials, a weaker dollar, a collapse of transatlantic bond yield spreads (and a move into negative territory), and outperformance of large-capitalization, globally-exposed US growth companies.

In contrast, global “recoupling” may well be the dominant issue for the coming year. Global resilience remains a key ingredient in our view that the US recession will be a mild one and the asynchronous character of the global economy will persist this year. However, our baseline global outlook includes a pronounced slowing this year, especially in Europe, the UK, and Japan, resulting in global GDP growth of 4.3% and thus the potential for lower interest rates than are currently priced into those three markets. As detailed below, recoupling is a critical ingredient in our calls for a stronger dollar and a reversal of transatlantic spreads.

Courtesy of the turmoil in global credit markets, the coming global downshift will likely mask considerable regional disparities. We expect growth in the industrial world to slow to only 1.4%, while the developing economies, led by China, will hardly miss a beat. But the credit turmoil threatens to cause even weaker growth outside the US as the US downturn spills over into other economies.

Critical to the global call is the expected resilience of Asian, LatAm and OPEC economies. Whether the knock-on effects on exports from China, Mexico, Canada, Japan, and other Asian economies tied to China’s supply chain will overwhelm their increasingly strong domestic demand remains uncertain. With China tightening into the teeth of this slowdown, the risks are on the downside of this baseline scenario. With policies in the industrial world turning stimulative, however, we expect a re-acceleration to 4.9% global growth in 2009.

Theme III: Reintermediation and recapitalization

The third theme is an extension of one begun this summer: The deleveraging and “reintermediation” of the banking and financial system and associated needs for capital that will last well into 2008. That process has reduced risk appetite, raised the price and reduced the availability of credit, thus tightening financial conditions. We see this tightening lasting through midyear.

Deleveraging means that institutions and investors are selling assets out of their portfolios or are being forced to take back onto their balance sheets assets previously funded off the balance sheet in Special Investment Vehicles (SIVs) and/or conduits. Issuers unable to roll over maturing asset-backed commercial paper (ABCP) beginning in August called on their bank sponsors to absorb the commitments they made to back them up. In turn, this ‘reintermediation’ of the global banking system is producing a contraction in credit and an increase in its cost — that is, spreads are widening as intermediaries prize liquidity or sell lower-quality assets.

Reintermediation promotes a pro-cyclical credit contraction in three ways. First, it forces a shift from a funding source that requires no or very little capital (the SIV or conduit) to one that requires considerable capital, reducing financial leverage. Second, in classic, pro-cyclical fashion, banks are raising the cost of new liquidity and credit facilities; they are now selling such options at prices more appropriate to the risk in today’s market. My colleagues Betsy Graseck and George Goncalves agree that this new pricing regime won’t evaporate any time soon. Credit rating downgrades on the structured products moving to bank balance sheets will also hike capital requirements and tighten credit availability. Finally, although European banks are well capitalized for now and can absorb further writedowns, our European banks team believes that these institutions will nonetheless defensively raise capital to show strong capital ratios in a troubled macro environment. Those moves will further limit credit availability.

The extent of this reintermediation process matters for both the cost of credit (as reflected in spreads) and its availability. US banks’ median Tier I capital ratio hasn’t dipped below the 6% “well-capitalized” level, but to prevent declines, banks still must either sell securities, raise new capital, limit lending, or some combination of the three. A proposed “Master Liquidity Enhancement Conduit” or “Super SIV” has been abandoned as banks decided that it was uneconomic, and they are bringing the bulk of SIV-held assets on their balance sheets. Significant capital injections from sovereign wealth funds and the aggressive actions by central banks to add liquidity to money markets have partly offset the effect on spreads of such reintermediation.

Beyond the banks, other intermediaries are also in asset-reduction mode; markdowns could contribute to a $500 billion contraction in balance sheets on Wall St. (see “Funding Pressures: More Fundamental than Turn of Year,” Global Economic Forum, November 19, 2007). Moreover, unlike the past, when financial markets and the Street could cushion deleveraging at the banks or vice-versa, this time they are deleveraging and shrinking together, representing a constraint on the supply of credit. This combination will continue to tighten financial conditions and weaken already-slowing US and perhaps global growth.

The result – even following aggressive action by five central banks to alleviate money-market pressures, plus the ebbing of year-end market pressures – is that money-market rates remain elevated compared with policy rates, and yield spreads over those money-market rates on loans have stayed high or widened. For example, although three-month dollar Libor-OIS spreads have declined from 108 bp over the past month to 63 bp, they are still 55 bp higher than they were in the spring, effectively reducing the impact of the 100 bp decline in the federal funds rate by half (see “Bold Action: Central Banks Likely to Succeed,” Global Economic Forum, December 14, 2007). In our view, it’s not that central banks have failed in their efforts to alleviate strains in money markets; rather, ongoing reintermediation likely will keep spreads wide — and possibly drive them wider again — at least through mid 2008.

Theme IV: Reregulation of Financial Services

The fourth theme is microeconomic in nature: The pendulum is swinging back to reregulation of the financial services industry. The subprime mortgage crisis has spurred new regulatory lending guidelines from the Fed and other bank regulators, and proposed amendments to Regulation Z (Truth in Lending) to protect consumers from unfair or deceptive home mortgage lending and advertising practices. The new rules, which the Fed would adopt under the Home Ownership and Equity Protection Act (HOEPA), would restrict certain practices and would also require lenders to provide certain mortgage disclosures earlier in the transaction. Parallel proposed legislation from both the House (HR 3915) and Senate (S 2452) is aimed at the same goal. The sponsors of the legislation — Barney Frank (D, MA) and Christopher Dodd (D-CT) — believe that deregulation fostered abuses and that the Fed’s proposals do not go far enough to correct them. These proposals may not be implemented quickly in the current political environment. But in my view, while their goals are in many cases laudable, the uncertainty surrounding significant regulatory change will ironically have adverse macroeconomic consequences: It will be one more factor that will keep financial conditions and willingness to lend tight as we go through 2008.

The broader context for reregulation is also important. Regulators are concerned that financial innovation has fostered laxity in risk management and due diligence by lenders and investors. Some want to beef up supervisory initiatives or capital requirements under the Basel II framework. Similar to proposals aimed at mortgage lending troubles, these initiatives are aimed at real problems, but the uncertainty surrounding them may also keep lenders wary and restrained. And for investors, reregulation probably means a downward re-rating of the longer-term earnings potential of financial services firms.

Market calls

Against this backdrop, we expect that the dollar will strengthen, especially against the major currencies; transatlantic yield spreads likely will reverse and widen again as growth in Europe fades; and global yield curves — not just in the US — will steepen. These conclusions from our rates, currency and credit strategy teams flow from our US recession call last month. All hinge on the important insight that a lot of the bad US news is in the price, but that the deterioration outside the US and the policy reactions to it are not.

The dollar call, articulated by Stephen Jen as the “dollar smile,” is a prime example of this logic. While near-term US economic weakness may well put additional downward pressure in the dollar, the downside surprises in the global growth outlook are more likely to come in Europe, the UK and Japan. And we think that neither Asia nor Latin America is immune from the forces depressing growth in the industrial world. Finally, the dollar in our view is grossly undervalued against the euro and sterling. As a result, we anticipate a moderate dollar rally in coming months.

Another example: Jim Caron and I believe that our US recession and "recoupling" calls imply a reversal of transatlantic yield spreads, which have gone from +120 bp in mid 2006 to -30 bp today. The logic is similar to that for our stronger dollar call: There is a lot of US recession risk priced into US yields but little recoupling risk in European yields. In our view, such spreads have bottomed and will move significantly higher; if we are right, spreads could move back to +20-30 bp or more. This dovetails perfectly with a trade we advocate: Sell EUR FX vol vs. Buy EUR vs. sell US swaption receivers as the EUR comes off and the US-EUR rate and volatility gaps narrow. The driver of this trade is that a move to lower policy rates in the US is already in the price, but lower European rates will be the surprise.

Risks

Lingering inflation risks may delay these moves in currencies and rates by keeping central banks on hold for longer. In fact, many investors fear that a new wave of inflation may emerge from the booming economies of Asia, OPEC and Latin America. But we think upside inflation readings in the industrial economies will put growth in the US and abroad at risk and ultimately will make these market moves even more likely.

The extent to which markets, policy, and economies are linked may also enter the debate, as tighter financial conditions require aggressive and/or unconventional policy responses, such as the one launched in mid December by five central banks to provide market liquidity. Indeed, there is talk of fiscal stimulus in Washington, as some lawmakers view monetary policy as incapable of dealing with the current economic malaise. While such talk may spur hopes for a quicker turnaround, fiscal policy action is unlikely as long as the President has the power to veto.

Finally, as was the case a year ago, the direction of liquidity and volatility are the biggest wildcards in the outlook for financial markets. Near-term, the direction of each seems clear to me: The risks that liquidity will remain in short supply and that volatility spikes higher are both significantly greater than 50%.

By Richard Berner New York
Morgan Stanley
January 4, 2008