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  Posted on: Thursday, September 10, 2009
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Wrong Environment For a Recovery

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In recent comments we have detailed our views on why we believe the economy will remain weak after a temporary uptick due to potential inventory accumulation, the cash for clunkers program and the first-time homebuyers' tax credit. Our reasons include the need for consumer deleveraging of debt, the fragile financial system, tight credit conditions, rising unemployment and the likelihood of a continuing drop in housing prices.  Simply put, we cannot get a sustainable recovery without growth in consumer spending, wages and employment.  This not merely a theoretical belief, but is supported by a number of real-world items related to the consumer, the financial system and housing as outlined below.

1)  Consumer credit outstanding in July dropped by $21.6 billion, the most on record.  It was the sixth consecutive decline, and the year-to-year percentage downturn was the most in 65 years going back to World War ll.  With overall household debt still historically high at a time when home prices are low, credit restrictive and employment and incomes still falling, consumers will continue to cut debt and increase their savings rate for some time to come, putting a severe damper on the outlook for spending.

2)  Manpower's Employment Outlook Survey indicated that hiring plans for the fourth quarter declined to minus 3%, its lowest level in the history of the survey going back to 1962.  The number is derived from the number of firms planning to hire less than those planning more layoffs.  This means that employment is not likely to pick up anytime soon and that the situation may actually get worse.

3)  Commercial real estate loans are the next big trouble spot.  According to the FDIC about one-sixth of all construction loans were in trouble at the end of June.  Construction loans amount to about $500 billion.  Of these, about $290 billion are commercial loans, and according to research firm Foresight Analytics, over 10% are in trouble-either 30 days past due or deemed unable to make further interest payments.  Elizabeth Warren, head of the Congressional Oversight Committee, has stated that this will be a major problem for regional and local banks that are the major lenders to small business.

4)  According to the Wall Street Journal the Federal Housing Administration (FHA) is being hit by mortgage-related losses and may see its reserves dropping below the level required by Congress.  In the absence of readily-available credit from the private sector, particularly for less qualified borrowers, the FHA has stepped into the breach big-time.  The FHA insures private lenders against defaults on mortgages as an inducement to make loans to borrowers who wouldn't otherwise qualify.  Until recently the FHA has been a minor player in the market, but now insures 23% of all mortgages, up from only 2.7% as late as 2006.  At the end of June 7.8% of FHA loans were at least 90 days late or in foreclosure.  This might force the agency to severely cut its lending or become yet another entity seeking a government bailout.  Any substantial cutback would be a major blow to housing.  The FHA insures mortgages with down payments of as low as 3.5%.  Edward Pinto, former chief credit officer of Fannie Mae, says that the portion of mortgage down payments under 10% has not changed in the last two years, and that this is almost entirely due to FHA guarantees.

In our view a sustainable economic recovery under these circumstances is highly unlikely.  The stock market is discounting a far more optimistic picture and will be highly disappointed.  The conventional view is that market movements signal future economic activity, but if that is the case what was it discounting in 2007 and most of 2008?  The S&P 500 is far from cheap at close to 18 times our normalized earnings number, and even that level probably won't be reached in the period ahead.  At this point we believe that the risks are heavily to the downside.                                           

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