Labor Day, 2008
Article 1.21
GLOBAL, CREDIT-BUBBLE UNWIND + PEAK OIL = RE-PLANNING
Now that
the enjoyable distractions of summer time and the Olympic Games have passed, we
return to a business environment that is hard to predict. This note summarizes
some news and personal, best-guess views (which will, no-doubt, shift) that
will hopefully be catalysts for readers to keep rethinking their (unspoken?)
assumptions that underlie business planning through 2009.
WHAT QUESTIONS DO WE CURRENTLY HAVE ABOUT THE ECONOMY?
Some
common questions:
1.
Will
the U.S.
economy “avoid a recession”? Or, is it already in one?
2.
Are
the government rebate checks starting to turn around the economy like they have
in the past?
3.
Has
the housing slump finally hit a bottom like it did in ‘93?
4.
Is
the oil bubble run up over and gas prices headed down again like in ‘81?
5.
What’s
really going on with financial company stock prices including Fannie and Fred?
6.
Are
the write-offs from bad asset-backed debt instruments just about over? Could my
bank be eventually caught up in a credit crunch? Would they then tighten
lending standards and raise interest rates on us for our next contract?
Some less
likely questions:
1.
How
badly does the US
government air brush the economic data that it reports?
2.
What
are best gauges to look at for forecasting a housing market bottom?
3.
Is
there a commodity bubble that is deflating? Or, is “peak oil” real? Could
industrial metal prices drop more than oil? What are the implications for
chronic, high-priced oil?
4.
Are
there metrics that would suggest that the US consumer-driven economy is ready
to start growing again?
5.
Given
what is going on, what is my firm’s: best, worst and likely economic scenarios
for 2009? How much company debt is too risky for the economy we envision?
Assuming
we don’t have to have instant answers to all tough questions right away, here
are some more thoughts to live with that might help improve our planning.
“GOOD NEWS” FROM THE PAST WEEK:
1.
“Americans
felt better about the economy in August (’08), as a barometer of sentiment
posted the biggest boost in two years amid falling gas prices.” (Conference
Board; 8-26-08)
2.
“The
rate of single-family home price declines slowed from May to June…sales of new
homes rose in July.” (S&P/Case-Shiller Index Report)
3.
“Existing
home sales increased by 3.1% in July. This increase put the annualized pace of
sales up to 5 million units…inventories (however) hit a record high of 11.2
months”(Nat’l. Assoc. of Realtors)
4.
The
GDP grew at 3.3 percent in the April-June quarter, its fastest pace in nearly a
year. (US Commerce Department; 8-28-08)
THE NEWS BENEATH THE HEADLINES:
If we read
a little deeper, however, we find that:
1.
Personal
spending growth slowed to 0.2% in July from 0.6 in June, but adjusted for
4.5% trailing annual inflation – the biggest gain in 17 years – consumer
spending dropped the most in four years.
2.
In
the revised GDP growth figure of 3.3% up from 1.9% (because “exports were
strong”), the Commerce Department used an inflation deflator number of 1.33%. If
they had used the same inflation figure that they did for consumer spending,
the GDP grew at only a decelerating .2%. If the “durable goods” orders were
deflated by the “producer price index”, a 1.3% increase becomes a 9.4%
decrease. Prices were higher, not activity. Government fudging on economic data
has been, unfortunately, documented to be a 20+ year trend that has accelerated
in the past eight years. Where are we going to get reliable data to base
decisions besides just looking at the prices we are paying and the business
activity around us? (Suggestion: try going to google:blogs
and type in any specific economic topic.)
3.
Sales
of new homes rose in July, because vulture investors have started to
aggressively buy foreclosed homes, which are being added to inventory faster
than new ones are selling. The investors’ inventory isn’t really “sold”,
but rather rented and/or temporarily parked until housing turns around, then
the inventory will come back to continue to postpone true, new demand.
4.
Although
the rate of home depreciation had one slower declining month, housing is still
declining and no one foresees a bottom yet, because: jobs are disappearing;
incomes are declining in real terms; mortgage rates are climbing; mortgage
availability is declining; many ARMs remain to be reset; and inventory of all
types of homes is staying above 11 months supply with accelerated additions
from foreclosures and 3-year condo-project additions (now over 17 months supply
and climbing). The Case-Shiller housing index for a twenty-city average has
dropped more than 20% since the peak in June ’06. The Case-Shiller index
futures are currently predicting a bottom in May 2010 down another 15% from the
peak for a total decline of 35%. (Want more “housing bottom” forecasts? Type the
phrase in at google-blogs.)
GLOBAL ECONOMIC TIDES FOR CREDIT AND OIL:
1.
The
US credit bubble (go to google-images and type in “US credit bubble” to click
on some scary charts) went parabolic from ’02-’07 as $3 trillion+ in nothing-down,
dodgy loans for – homes, autos, credit card debt, student loans, leverage
buyouts, etc. – were all securitized into bond-like, credit derivatives which
are now not performing as promised, making their fair market values plummet..
2.
The
financial-system, credit-meltdown crisis that started in the US in July ’07
isn’t over. Like a slow-motion train crash that crumbles one car at a time, we
have seen the sub-prime mortgage problem push into alt-prime and now prime
mortgages. The percentage of non-performing loans is now climbing in all
categories: commercial real estate; home equity lines; credit cards; auto loans
and leases; student loans; leverage buyouts; etc.
3.
So
far, working capital loans for distributors backed by inventory and receivables
that are still within their covenant restrictions seem fine. What if: interest
rates stay high; business profits fade enough to trip covenant standards over
the next 6 to 12 months; and our bank has to reduce lending to meet its own
debt to equity ratio requirements due to lots of carry-trade securities write
offs?
4.
On
another front, “Peak Oil” which has been forecasted for years is here, causing
inflation in every step of business supply chains and transferring wealth from
consumers to oil exporters. To better understand the “future shock” of
chronically higher oil prices from global demand growing right past global
production and ready reserves watch the video at this link: http://www.chrismartenson.com/peak_oil.
WHEN WILL WE KNOW THAT THE ECONOMY IS READY TO GROW AGAIN?
1.
Fannie
and Fred have to be stabilized. They are currently insolvent and if housing
values continue to drop in line with Case-Shiller forecasts, the federal
government will have in excess of a $1 trillion dollar+, bail-out check to
write. More immediately, the twins have to roll over about $270B in debt by
September 30th. Do you think the Feds can find some foreign
government buyers for this debt and stall writing any big, bailout checks until
after the elections?
2.
The
inter-bank lending rates will have to return to normal. They have remained
“elevated” since the credit squeeze began in July ’07, because - due to
write-offs and regulatory capital ratios - banks don’t have money to lend and
don’t know if other bank borrowers are solvent net of toxic securities they may
own. When the squeeze is finally over, the “Libor-OIS spread” should drop back
to normal levels. But, before that happens, US banks have two big hurdles. First,
they must roll over almost $800 billion in debt in the next 16 months that was
originally borrowed two years ago at around 4%, but now must pay 7-12%, if they
can borrow at all. With the prime rate at 5% and many outstanding loan
contracts to customers at 6-8%, they won’t make money on their existing loans. Even
if banks don’t have more derivative bonds to write down (and many do), they
will have to sell assets, raise expensive equity capital, raise loan terms and/or
call any marginal loans to customers that they can. And second, many
banks will have to pay back temporary loans from the Fed’s emergency “auction
facility”.
3.
The
European Central Bank and the Fed will have to figure out how to forgive the
emergency loans that they have given to commercial and investment banks since
August ’07. The trends for these “temporary” schemes are not good. The Fed has
continued to lend more money, for longer periods to more borrowers, who remain
anonymous to the public, in exchange for lousier quality securities for
collateral that has continued to drop in value.
4.
All types of housing for sale – new, resale, condo-supply, foreclosures,
and vulture-investor units – must get below eight months supply.
5.
For
consumers with debt, their debt service to income ratio has to get from its
current, record level of 14.1% back to the 10.5% level that was reached at the
end of the ’82 recession. This will require a reduction in $2 trillion in
consumer debt from its current level, which – not coincidentally – is the high
end of the estimate for total financial system write-offs that needs to be
taken (roughly $500B has been taken so far).
6.
Once
consumer debt has been paid down and/or written off by the lenders, the savings
rate for consumers needs to get back to an historical 8% level. There were
several years during the housing bubble when the savings rate was negative as
people did home equity extraction spending. In a consumer economy in which
boomers haven’t saved for retirement and their asset wealth is eroding, I can’t
imagine people buying stuff until they have free cash flow above a minimum
savings rate.
WHAT SHOULD WE DO NOW?
1.
Continue
studying this not-in-our-lifetime-economy news stream to continuously rethink
our – best, worst, likely – business plan scenarios for which I’d be happy to
help with starting with a simple phone call introduction.
2.
If
we have – on second thought – a bit too much debt, remember that: volume is
vanity; profit is sanity; and positive cash-flow to pay down debt is best of
all. Set a goal to lower debt to a level that is consistent with how much
economic risk we may (re)perceive to be in our economic environment over the next
12 to 18 months. Think also about what our banks may request if and when our
current loan agreement needs to be rolled over.
3.
Rededicate
ourselves to running a better, more strategically focused and profitable
business. If any distributor needs some how-to articles for doing this, please
feel free to click around www.merrifield.com.
©Merrifield
Consulting Group, Inc. Article 1.21, September 1, 2008
bruce@merrifield.com / 919/933-7474
