The Outlook Beyond “The Great Recovery”
We are standing by our constructive view on risk assets for now, as our best guess is that markets continue to rise alongside leading indicators through Q1-10, but the outlook quickly becomes murky, beyond the first half of 2010, where we see several major challenges for the domestic and global economy:
- Another wave of financial stress on the banking system driven by the impact of sharply rising delinquencies and foreclosures on newly reset Alt-A and Option ARM mortgages (not to mention major losses on commercial real estate assets yet to be realized). Note in the chart below that the first wave of resets, notably in subprime mortgages which caused the failure of several major financial institutions, peaked in the fall of last year and has since sharply declined alleviating the primary stress on the banking system. Unfortunately, just as our beloved banksters have been led into a false sense of security, an even larger wave of resets is set to flow through the banking system, which will pressure bank balance sheets through 2012. Note that the majority of these loans were written at the peak of the housing bubble and represent the greatest excesses in price and lending standards.
- As our administration continues to pat themselves on the back for the Great Recovery that policy has orchestrated in 2009, the prospect for additional stimulus deteriorates daily. As shown in the chart below, the fiscal tailwind driving this year’s growth, is set to become a massive headwind beyond the first half of next year. History shows that prematurely exiting from an accommodative policy setting in 1936, derailed the recovery in the late 1930s and led to another leg of the Great Depression. If auto sales post Cash for Clunkers are any guide, we wonder what economic growth will look like once the punch bowl is taken away from the party this time around.
- Coincident indicators of the domestic economy (GDP, Industrial Production, etc.) will begin to demonstrate substantial improvement in coming weeks and quarters. As the recovery shifts from a second derivative story to one of first derivative improvements, interest rates are likely to follow the trend in economic indicators higher, while investors begin to price in the likelihood of future rate hikes. Given, points one and two above, combined with extreme levels of indebtedness at both the private and public sectors, the overall economy’s ability to deal with higher rates is greatly reduced. The reason is simple – the larger the outstanding debt load, the larger the impact of rate hikes on debt-servicing costs.
We believe the relief we’ve experienced in 2009 has been driven solely by two temporary factors which will soon begin to fade – a predictable lull in the mortgage reset schedule, coupled with an unsustainable burst of deficit spending and explosive growth of the Fed’s balance sheet. These tailwinds will turn into significant headwinds in 2010 and beyond. Therefore, it is likely that the stabilization in house prices and rise in economic indicators investors are cheering today, will prove to be one of the greatest head fakes in history.