Purchasing

Robert J. (Bob) Garino

Headwinds: The cause of many questions about the direction of the business cycle
December 28, 2007

“Headwind” is generally defined as a wind blowing in a direction opposite to a course. Aircraft pilots and ship captains know all about head winds as a force of nature. Economists also use the term to describe certain fundamental factors that may be acting upon the larger economy. In both instances, it’s the relative strength of the "wind" that determines the course of a craft or the direction of a business cycle.

As 2006 was drawing to a close, the global marketplace seemed in flux. Analysts hinted at a potential slow start to 2007 but a more robust second half, with Asia and Europe offsetting assumptions about a relatively sluggish domestic economy that year. The principal worries at the time included increased inflationary pressures, higher-than-expected energy prices, a greater-than-expected slowdown in the U.S. economy (triggered by the changing housing market), and commodity price volatility—head winds all, but the consensus was that none of these items was strong enough to prevent the economy from enjoying another positive year.

In the end, 2007 will be remembered as the year of the subprime mortgage credit crisis--a head wind that few considered a year earlier but one that morphed into a financial and economic tsunami, affecting both the domestic and global economies. Initial projections pegged the financial losses by U.S. lenders around $50 billion to $100 billion based on the assumption that the subprime mortgage market was a small piece—about 12%—of the $10-plus trillion U.S. mortgage market. As additional revelations surfaced, however, the financial losses snowballed, ultimately taking down several high-profile banking/investment CEOs.

Now, the projected domestic write downs for collateralized debt obligations, collateralized mortgage obligations, structured investment vehicles, and unsecured loans are closer to $300 billion to $500 billion. As of November, several large banks had written down some $40 billion to $50 billion, according to stories on the Bloomberg.com news service and analyses by Global Insight of Waltham, Mass.

The Federal Reserve responded to the gathering storm by decisively injecting money into the financial system, lowering interest rates and the discount rates in September, October, and November. Those moves sought to ensure market liquidity and restore financial confidence, even though most sectors of the domestic economy—except manufacturing—already were expanding at a faster-than-expected annual rate. Along with the lower interest rates came an even weaker U.S dollar and its subsequent inflationary effect on commodities, especially in the energy and precious metals arenas.

Equity markets initially applauded the Fed’s decisions, but the Dow Jones Industrial Average exhibited considerable volatility, trading around 13,000+ but unable to shake the credit worries that permeated the investment community. The Dow stubbornly remained some distance from the record 14,165 level it reached Oct. 9, 2007, with most financial professionals expecting the economic fallout to remain in the forefront as 2007 wound down. Some 2 million subprime adjustable-rate mortgage loans valued at $600 billion are due to reset at higher amounts in the next eight months. All of these mortgages are not in trouble, of course, but homeowners who default or fall behind on payments could cause an unprecedented economic shock.

Thus, the combination of rising inflation expectations, higher energy costs, the weakening U.S. dollar, and an overly anxious investment community offered compelling evidence that the U.S. faced serious impediments to its ongoing economic growth. Some even envision a “perfect storm” in 2008 in which inflation pressures continue to threaten, forcing the Fed to raise interest rates and all but assuring a stagflation-type environment for the domestic economy.

Although the U.S. gross domestic product grew at a reported 2.4% to 2.5% annual rate in 2007, according to the Fed, it is expected to grow only 1.8% to 2.5% in 2008—lower than the 2.5% to 2.7% rate projected this past June. A number of factors led to this lower growth projection, including the tightened terms and reduced availability of subprime and jumbo mortgages, weaker-than-expected housing data, and rising oil prices.

The International Monetary Fund (Washington, D.C.) projects 1.9% U.S. GDP growth in 2008, almost 1% lower than its previous projections and the same rate as its 2007 U.S. forecast. While not calling for a recession--defined as two consecutive quarters of negative growth—IMF sees a housing-led lowdown dominating the domestic economic landscape this year. “Ongoing difficulties in the mortgage market are expected to extend the decline in residential investment, while higher energy prices and weaker house prices are likely to dampen consumption spending,” IMF says. Standard & Poor’s also forecasts U.S. GDP growth in 2008 at 1.9%, placing the risk of a recession at 40%.

Last month, the White House also lowered its 2008 economic forecast, predicting that unemployment would rise as the housing slump and tight credit weighed on the U.S. economy. The Bush administration’s forecast calls for GDP growth of 2.7% next year, down from its previous projection of 3.1%, and a rise in the unemployment rate to 4.9%, up from the previous forecast of 4.7%. Inflation, however, should decline, the administration predicts, with consumer prices increasing only 2.1%, down from its previous forecast of a 2.5% rise.

The contrary view holds that there are inevitable business cycles, but the U.S. and global economies are in the midst of a “super cycle” that began around 2001 and could continue for several decades. Any economic forecast should not dwell on a U.S.-centric view of the world, according to super-cycle proponents. After all, they argue, China, India, and Russia accounted for half of global growth in the past year, all fueled by rapid industrialization. What’s more, they note, U.S. GDP growth continues to make a strong showing, with final third-quarter 2007 GDP posting a better-than-expected 4.9 percent annual growth rate. That performance provides proof, they say, that the U.S. economy is far more resilient than people acknowledge.

Nevertheless, there are significant questions for 2008: Have the economic head winds gained velocity? If so, what will they do to the U.S. and global economies this year—specifically to those business sectors closest to the scrap recycling industry? And what are the ongoing as well as emerging worries this year? According to IMF’s October forecast, global growth will slow from 5.2% in 2007 to 4.8% in 2008. China will continue to lead global economic growth, with its GDP and industrial production again expected to post double-digit growth rates this year.

Finally, offering a more conservative view, Lynn Reaser, chief economist for the investment strategies group at Bank of America (Boston office) sees global GDP expanding 3.1% in 2008, down from an estimated 3.4% rise in 2007. Europe’s economy will face significant deceleration this year, she says, with Japan, Latin America, and Asia slowing at more moderate rates. Although the United States continues to be an international economic driver, internal economic demand in such powerhouses as China and India will continue to provide a “significant independent thrust,” Reaser notes.

Posted by Robert J. (Bob) Garino on December 28, 2007 | Comments (3)