http://www.rgemonitor.com/blog/roubini/227330
With the Recession Becoming Inevitable the Consensus Shifts Towards the
Hard Landing View. And the Rising Risk of a Systemic Financial Meltdown
Nouriel Roubini | Nov 16, 2007
It is increasingly clear by now that a severe U.S. recession is
inevitable in next few months. Those of us who warned for the last 12
months about a combination of a worsening housing recession, a severe
credit crunch and financial meltdown, high oil prices and a saving-less
and debt-burdened consumers being on the ropes causing an economy-wide
recession were repeatedly rebuffed the consensus view about a soft
landing given the presumed resilience of the US consumer.
But the evidence is now building that an ugly recession is inevitable.
Thus, the repeated statements by Fed officials that they may be done
with cutting the Fed Funds rate are both hollow and utterly
disingenuous. The Fed Funds rate will be down to 4% by January and below
3% by the end of 2008.
More revealing of the change in mood the financial press and some of the
most prominent market analysts are coming to the realization that a
recession is highly likely. The Economist has a cover story and long
piece arguing that a US recession highly likely (and citing this
author's work with Menegatti and our views on the inevitability of such
a recession).
More importantly, on Wall Street some of the leading analysts that had
been in the soft landing camp for the last year have now moved their
forecast in the direction of hard landing. It is not just David
Rosenberg of Merrill Lynch who has been informally in the hard landing
camp and is now explicitly talking about a consumer recession. It is not
just Jan Hatzius of Goldman Sachs who was always more bearish relative
to the soft landing consensus and is today explicitly talking about a US
recession and a credit crunch reducing lending by $2 trillion.
Even in soft landing houses such as Morgan Stanley and JP Morgan the
tone is completely different now. At Morgan Stanley Steve Roach was the
in-house bear while Richard Berner (a most sophisticated economist and
analyst) was the in-house soft landing optimist. With Roach now gone to
run Morgan Stanley Asia, the commentary by Richard Berner has become
increasingly darker. And the latest Monday piece by Berner is titled
“The Perfect Storm for the US Consumer” where his points on the headwind
forces hitting the US consumer are completely overlapping with my
analysis of such risks in my recent “The Coming US Consumption Slowdown
that Will Trigger an Economy-Wide Hard Landing. Berner starts with
“Serious pressures are mounting on the US consumer on five fronts: Job
growth is slowing, surging energy and food quotes are draining
purchasing power, adjustable rate mortgages are resetting, lending
standards are tightening, and housing wealth will likely decline. Do
these dark clouds finally and ominously herald the perfect consumer storm?”
And he concludes with:
“Risks to the consumer are rising, and the risk of outright US recession
is higher now than at any time in the past six years: Housing is in
sharp decline, consumers are vulnerable, and companies may cut capital
spending and liquidate inventories. A strong contribution from global
growth is still a huge positive, but spillovers from US weakness to
trading partners may hobble that lone source of strength. These
pressures could last longer or be more intense than I expect. And even
if the economy skirts overall recession, corporate earnings will likely
decline.”
An even more persistently bullish bank was JP Morgan that kept on
warning for the last year that the biggest risks to the US economy was
not a growth slowdown but rather a growth pickup and the risk that
inflation would surprise on the upside and force a behind-the-curve Fed
to raise the Fed Funds rate above 6%. This analysis obviously proved
wrong and now the very smart – but mistaken - Bruce Kasman has had to
throw in the towel and accept that the downside risks to grow are sharp
and that the Fed will cut the Fed Funds rate to 4%. As he put it in his
latest note:
US outlook change: More drag, more ease -- Drags from energy, and credit
tightening push GDP forecast to 1% on average for current and upcoming
quarter -- Fed is likely to recognize growing downside risk and ease
50bp, to 4% by end of 1Q08 -- December meeting outcome remains close,
but we now expect 25bp move from a proactive Fed As the US moves
through the fourth quarter, incoming economic news remains consistent
with our forecast of a growth “pot hole”. Powerful drags now in place —
from tighter credit conditions and an intensified contraction in
residential investment — are evident in the decline in output and
employment in the goods producing industries and in a slowing in
consumption spending…. …three developments over the past month look set
to increase downward pressure on growth.
• Oil on the boil. Global crude oil prices rose more than $10 dollars
during October, and has held at an elevated level this month. If current
levels are maintained, it would represent a drag on annualized household
income of approximately one percentage point between now and the end of
the first quarter. This drag, which has yet to have been felt, adds to
the forces weighing on consumer spending.
• Temporary lifts to fade. Although an upward revision to 3Q07 growth to
close to 5% now looks likely, this outcome is partly borrowing from
growth in the quarters ahead. Defense spending, which has grown at a 9%
annualized pace in the past two quarters, is almost certainly due for a
pause. And a significant upward revisions to inventory building in 3Q07,
points to an adjustment ahead. Indeed, the latest rise in ISM customer
inventory index, combined with auto production schedules pointing to
cutbacks through year end, suggests that stockbuilding is likely to
subtract from growth this quarter and next.
• Credit tightening broadens. Results of the Fed’s latest Senior Loan
Officers Survey indicates that credit conditions are tightening broadly
and that demand for credit is slowing. Most recently, credit conditions
have tightened significantly for commercial construction projects with
CMBS securitizations plunging over the past couple of months. While the
quantitative effects of this tightening is hard to measure, credit
conditions look set to remain tight for a longer period than anticipated
in our current forecast.
Taken together, these developments warrant a downward revision to an
already sluggish growth forecast for the coming quarters. The trajectory
of GDP growth is being lowered by one half percentage point per quarter
through the middle of 2008, with the path of consumption, stockbuilding,
and nonresidential construction activity shouldering much of the burden.
During this quarter and next, GDP growth is expected to be particularly
soft, averaging a meager 1% percent. The underlying resiliency of the US
corporate sector will be severely tested through a period in which
profits are expected to contract. While we continue to believe that
firms are unlikely to retrench in a manner that produces a recession,
the risks of a recession remain uncomfortably high. We currently place
the risk of a recession taking hold in the coming two quarters at 35%.
The Federal Reserve has made it clear that it is willing to act
preemptively in the face of elevated recession risks. Having moved 75bp
in two meetings, its October statement signalled that it viewed the
risks to growth and inflation as balanced — a message that the bar for
further easing was high. Against this backdrop, the Fed will need to
shift materially its perceptions of risks about the outlook in the
direction of our forecast change to produce ease. We now believe such a
shift will take place and produce 50bp of additional ease by the end of
the 1Q08.
When the most prominent and respected and sophisticated “soft-landing”
analysts on Wall Street turn this bearish and start talking about high
probability of a recession and downside risks to growth and of a
consumer recession you know that these are code words for admitting
implicitly – short of an official and explicit endorsement of such view
that very few analysts of Wall Street can afford to have because of
sell-side research constraints - that they believe that a recession is
highly likely.
So at this point the debate is less and less on whether we are going to
have a recession that looks inevitable; but it is rather moving towards
a debate on how deep, protracted and severe such a recession will be.
But the financial and real risks are much more severe than those of a
mild recession.
I now see the risk of a severe and worsening liquidity and credit crunch
leading to a generalized meltdown of the financial system of a severity
and magnitude like we have never observed before. In this extreme
scenario whose likelihood is increasing we could see a generalized run
on some banks; and runs on a couple of weaker (non-bank) broker dealers
that may go bankrupt with severe and systemic ripple effects on a mass
of highly leveraged derivative instruments that will lead to a seizure
of the derivatives markets (think of LTCM to the power of three); a
collapse of the ABCP market and a disorderly collapse of the SIVs and
conduits; massive losses on money market funds with a run on both those
sponsored by banks and those not sponsored by banks (with the latter at
even more severe risk as the recent effective bailout of the formers’
losses by theirs sponsoring banks is not available to those not being
backed by banks); ever growing defaults and losses ($500 billion plus)
in subprime, near prime and prime mortgages with severe known-on effect
on the RMBS and CDOs market; massive losses in consumer credit (auto
loans, credit cards); severe problems and losses in commercial real
estate and related CMBS; the drying up of liquidity and credit in a
variety of asset backed securities putting the entire model of
securitization at risk; runs on hedge funds and other financial
institutions that do not have access to the Fed’s lender of last resort
support; a sharp increase in corporate defaults and credit spreads; and
a massive process of re-intermediation into the banking system of
activities that were until now altogether securitized.
When a year ago this author warned of the risk of a systemic banking and
financial crisis – a combination of global liquidity and solvency/credit
problems - like we had not seen in decades, these views were considered
as far fetched. They are not that extreme any more today as Goldman
Sachs is writing today on the risk o a contraction of credit of the
staggering order of $2 trillion dollars in the next few years causing a
severe credit crunch and a serious recession. As I will flesh out in a
forthcoming note the risks of such a generalized systemic financial
meltdown are now rising. Hopefully by now some folks at the New York
Fed and at the Fed Board are starting to think about this most dangerous
systemic financial crisis that could emerge in the next year and what to
do to prepare for it.
