Your Economy (No Politics)

[Bullwinkle]

Bernanke Facing Tough Problems
Comstock Partners, Inc.
Thursday, February 2, 2006


Don’t be lulled into a false sense of security by the near unanimous gushing over Greenspan’s legacy. In our view the Chairman’s legacy is still open to question, and upcoming economic and market developments are likely to result in a much harsher assessment of his lengthy tenure—unless, of course, future historians blame his hapless successor instead. If so, it won’t be the first time this happened. After all, Calvin Coolidge turned the presidency over to Herbert Hoover on March 4, 1929, and went down in history as the president who presided over the 1920s prosperity while Hoover received all the blame for the severe depression and massive bear market that followed. Although Hoover couldn’t possibly have caused all that damage in just a few months, whoever said that history was fair?

Having said that, the difficulty in assessing Greenspan’s reign is entirely understandable since his regime was marked by low inflation, decent economic growth and only two mild recessions. The problem is that this economic record was achieved by the creation of a record stock market bubble that ultimately burst, followed by a huge housing bubble that mitigated the damage, but led to a fragile unbalanced economic recovery fueled by cash raised from soaring home prices. The result is record household debt, a negative consumer savings rate, a huge trade deficit and a dangerous federal budget deficit. All of this is being exacerbated by soaring energy prices.

In trying to determine where the economy and markets are going from here we’ll dispense with the largely fruitless exercise of parsing every word in the FOMC meeting statements. Judging by Fed actions, statements, minutes, testimony and speeches, it seems clear that their main concern is first to restrain the housing boom and, second, to prevent soaring energy prices from creeping into core prices. When they decide that these twin goals have been accomplished they will stop hiking rates, whenever that is and wherever the final rate ends up.

The problem is that Fed interest rate decisions act with a lag that is estimated at anywhere between six months and two years. Therefore it is highly likely that by the time the central bank sees the results of its efforts, the last few rate hikes will still be restraining the economy for some to come. That is why the vast majority of prior tightening periods have led to recessions and bear markets.

In the current cycle the results of monetary tightening can be even more damaging than usual because of the unique role that housing played in the economic expansion. In the absence of normal increases in wage and salary income consumers have used the soaring value of houses to maintain their rate of spending and drastically lower their savings rate. The home values have been turned into cash through home turnover, mortgage refinancing cash-outs and home equity loans. A recent Federal Reserve staff study—significantly co-authored by Greenspan himself—estimated that “discretionary extraction of home equity accounts for about four-fifths of the rise in home equity mortgage debt”. They further estimated that about ¼ to 1/3 of the so-called mortgage equity withdrawals (MEW) directly financed personal consumption expenditures. Other estimates run as high as 50 or 60%.

The Greenspan study went on to say that if mortgage rates rise and loan affordability drops further, MEW would decline and the subsequent fall in consumer goods spending would lead to a drop in consumer goods imports as well as the intermediate goods associated with them. He estimated that MEW was about $600 billion in 2004, an amount equal to 7% of GDP, and that the accumulative MEW accounted for the entire decline in the household savings rate since 1995. The U.S. housing market was therefore the glue that held the fragile global economic balance together. Without continually rising U.S. home prices, consumer spending declines, the savings rate climbs, U.S. imports drop, foreign economies soften, and what was a positive global feedback loop suddenly reverses, and becomes a negative loop instead. In other words, without the U.S. housing market to support it, the fragile balance holding the global economy together unravels with disappointing results for the economy, corporate earnings and the stock market.

Given this potential outcome, it may be that Greenspan’s greatest accomplishment may turn out to be the timing of his exit. Starting yesterday, none of this is any longer his problem and poor Bernanke, who has had a brilliant career until now, will be around to absorb the blame. In the meantime, we believe that the risks to the still overvalued stock market are far higher than the complacent majority is willing to acknowledge.

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