Ten problems for 2005
January 11, 2005
Lawrence Schnurmacher is executive director/investments, private client division, for a national brokerage firm.
1. The rubber will finally hit the road for the automobile manufacturers as well as automobile retailers and auto part suppliers. During a historically difficult economic growth environment, automobile manufacturers have "magically" induced the American public to "buy" their new vehicles at a pace which just a few years ago was thought to be impossible. The problem with the sales activity is that many, if not most, of the sales were encouraged and facilitated through financing that left much of the risk on the seller's balance sheet. The manufacturers basically allowed consumers to get their cars for "little or no money down," in some cases with no payments for 3-6 months, while accepting favorable financing terms (for the buyers) and extracting no collateral to do so. In addition, the manufacturers continued to produce vehicles at a pace that created a glut of new cars that last longer and have better warranties than previous production ramps ups. This has created a situation where we now have the "youngest" and potentially longest "life span" vehicles on the road than ever before. Used car values have dropped substantially, and in the next few years many consumers will own their vehicles "free and clear" and will have little or no incentive to buy a new car.
The real "bogey man" for the automobile manufacturers may come in the form of credit defaults. During this period of peak sales, those sales have become harder and harder to come by, and the sellers have become more and more lenient with credit approvals. Those two factors were a terrible combination for Sears a few years ago, and I foresee a similar problem for the lending arms of the major automobile manufacturers. Finally, as sales slow, the earnings from the financing divisions will drop. While the sales trends have been artificially propped up by incentives and creative financing deals, the bulk of the auto manufacturers' earnings over the past three years have come from the financing of the vehicles. Some 50-75% of profits came from the financing divisions of Ford and General Motors. Slower sales will necessitate difficult production cuts that could last for 12-24 months. The combination of production cuts, lower earnings from the financing arms, and higher credit defaults could produce a very difficult economic reality for the automobile industry.
2) Higher Interest rates will matter and will have a negative impact on many consumer areas, but most significantly on the over-heated HOUSING market. The marginal buyer who was given the gift of low interest rates, an easy lending environment, and lax appraisal process for the last three years will now encounter the reality that a home purchase is "the biggest and most important purchase of your life." Carry costs will become unmanageable, ARM's will adjust higher and raise mortgage payments, and any economic difficulty or career disruption will result in a problem. For new buyers, the mortgage application/approval process, along with the valuation/appraisal process, will become more stringent and less forgiving. The refinance activity that helped to support homeowners with carry costs, upkeep, and home improvements will slow with higher rates and more stable or falling home values. Homeowners will struggle to deal with higher rates on adjustable rate mortgages (ARMs) and will find it difficult to extract any new cash from their homes. Low interest rates that fueled strong sales of new and existing homes will be a distant memory, and further increases in home sales and prices will become harder and harder to achieve.
Homebuilders that have continued to forecast unabated sales growth, and have built inventory of spec homes and acquired land for future building, will find a more difficult pricing environment and a less than able consumer. And remember the one about "three hikes and a stumble" and "don't fight the FED"? Well, how about "five hikes and a wipeout" and "don't forget that stocks usually go down when rates go up"!
3) Refinance activity will slow dramatically. This will happen due to higher interest rates and a slowdown in the appreciation of real estate values. Other factors will converge to reverse a huge increase in lending activity which occurred, in part, due to lower rates and large increases in values of real estate. The combination of those two factors, along with higher demand, creative financing, easy credit process, and lax appraisal processes, allowed for a huge "extraction" of capital from hard assets which was subsequently "spent" by consumers to maintain their living standards. These trends are likely to reverse, and credits will be strained. Lenders including banks, credit card companies, mortgage lenders, automobile lenders, store branded credit card lenders, furniture lenders, will experience a decline in credit worthiness of borrowers/buyers that will lead to a rise in credit defaults and lower sales volumes due to fewer qualified borrowers/buyers.
Prime and sub-prime lenders will be hit with a "double whammy" in the form of lower sales/transactions/servicing fees and higher default rates which will lead to large write-offs. A third impact will be higher expenses as they will have too many employees and overhead to handle the lower levels of business volume. Clearly the sub-prime lenders would suffer severely from a slowdown in mortgage lending activity and an increase in default rates on loans to the somewhat less than credit worthy borrowers. Others to experience this "pain" could include companies that have benefited greatly from the mortgage refinance boom of the last few years.
4) The US consumer will finally run out of money &/or credit causing retail sales to slow significantly. Consumer retail darlings will suffer sales declines and will be forced to close rather than open new store locations. Clothing, furniture, auto, electronic, jewelry, and home improvement companies will all experience this slowdown. If the retailer relies on easy credit and/or a frivolous consumer, it will face challenges in 2005.
5) GOLD and other metals such as silver, platinum, copper, aluminum, etc. will reach new highs as the US dollar continues to erode and demand from Chinacontinues. Implications are hard to predict, yet it seems pretty clear that foreigners may limit or stop investing in US dollar priced assets, and may limit or stop lending money to the US Government, thus hurting spending and causing rates to rise. Metals price increases will hurt manufacturing and cause renewed interest in storing capital in "hard assets" such as Gold and Silver. Any type of serious geopolitical "upset", i.e. major terrorist attack, would also cause a surge in the price of Gold.
6) Fannie Mae will falter and create a significant credit crisis for the mortgage market. The SEC, Justice Department, NYSE, and governmental scrutiny will all prove to be "too little too late" for equity shareholders and for some bond holders, as shortfalls in capital and internal controls will be uncovered, revealed, and will pose a meaningful systematic risk for the overall market. My guess is that the newly placed CEO and management of the company will blame the highly computerized qualification process, new computerized credit scoring systems and approval processes, and lack of internal controls at lower levels for the foul ups. The Federal government will in some way "come to the rescue" of this "too big to fail" entity, for the greater good, but the shareholders equity will be greatly diminished in the process.
7) Energy prices will resume the uptrend and will reach new highs at the levels that many analysts and economists say will create an OIL CRISIS. I think there is a 50/50 chance of a supply disruption caused by terrorism, natural disaster, or OPEC "problems," which would not only cause prices to rise dramatically, but would cause other problems for the economy as well. Many industries that rely on energy to make their products will suffer margin compression as costs rise and competition will pressure selling prices.
8) The iPod will prove to be the latest example of a great idea/gadget that "flashes" in the pan. Even as the "gift of the year" this past holiday season, I believe that competition and new product offerings will prove too much for the iPod to handle. Sales of the popular and colorful MP3 player will flag and will not create new interest in the Apple computer hardware or Macintosh operating system. Recent history is full of what I call "cool but worthless" products. The most recent example is the Palm Pilot, which continues to be a great product and very useful, yet once it was mass produced by every electronic manufacturer and the prices fell while inventories increased, the future profitability disappeared. Another "cool but useless" gadget is the picture phone, which is fun and cool for the first month the consumer has it, but thereafter is just a novelty that is rarely used by the cell phone customer, and such phones will ultimately not earn phone manufacturers higher margins.
The iPod is the latest example of a glorified gadget. It is no more than a "fancy" MP3 player that does way too much, holds way too much, and costs way too much. Many formidable competitors have entered the fray to sell MP3 gadgets to the insatiable American consumer, and the result will likely be a similar demise in prices and profitability as the Palm Pilot and picture phone suffered, as well as a decline in iPod demand.
9) The War in Iraq, being sold to the American public as an important front on the War on Terror will spin totally out of control. The Coalition forces will endure more casualties and deaths than in the previous years, and I predict that they will be hit with a "catastrophic" attack resulting in the loss of hundreds of troops. An attack similar to the Beirut Barracks Bombing that was the beginning of the US exit from Lebanon. If this does happen, the American public will revolt against the war in Iraq, and the President and his administration will be forced to withdraw troops and turn over Iraq to Iraqi control. I think that there is a 50/50 chance of a terror attack in the US which would result in a renewed sense of fear in the general public and a lack of confidence in the governments efforts to protect the US from terror, despite all the money spent and the efforts put forth to do so.
10) The above confluence of events will result in a very bad trading environment for US equities and will create an environment where investors will continuously be disappointed with geopolitical events. Bad news will dominate the headlines and news crawls. Business and economic news will suffer. Business leaders will retrench again and will resist hiring new workers and will cut back on capital spending until a more stable world is evidence. This will result in lower equity prices and I think the major indexes will give back all of the gains of the last 2 years.
I continue to believe that we are in a long-term period of economic decline. I see the last few years, since 2000, and the next few years, till say 2008-2010, as the 2nd Great Depression for the majority of the US population, especially the rapidly growing middle and lower class. As with most things, financial well-being and economic prosperity are "relative" and relative to past economic periods, the current state of our economy and the future economic outlook is at best "relatively" dismal. Unfortunately the baby boomers are unprepared for this economic reality, and the government is totally unprepared to take care of them . As the "greatest generation" lives longer than any of its ancestors, the economic reality of huge healthcare costs, lack of employment opportunity, lack of savings, and high costs of living will create a very difficult period of time for this huge swath of the population during their "golden years."
AI
