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Economics Weekly - Will the US sub prime mortgage crisis derail global economic growth? Weekly economic data preview - Credit market to continue to overshadow data this week

Economics Weekly


Will the US sub prime mortgage crisis derail global economic growth?


Sub prime crisis result of low interest rates, plentiful liquidity and low appreciation of risk...

The evolution of the current state of affairs in credit markets happened thus: US mortgage loans were packaged and sold on by commercial banks into capital markets. As the US housing market boomed so too did the demand for, and the quantity of, these loans. They were in turn collateralised and loaned on by the capital markets to other niche players and packaged in the newly expanding CDO and CLO markets, which developed quickly due to very low rates of interest, in an environment of plentiful liquidity. And computing power had increased enough to make engineering these new financial instruments viable. The circle was squared by the credit agencies validating these loans by giving high credit ratings to these instruments but some were based on high risk loans in the lower credit quality end of the mortgage market, some of which have now turned bad. As sub prime defaults rose alongside the rise in US interest rates from 1% to 5.25% so concerns spread and risk repricing began in the global financial system, see charts a through to d.


...but sub prime is not the real reason for current turmoil: risk appetites have changed...

But to ascribe all recent financial market turmoil to US sub prime issues and overexposure to the US financial markets is, to say the least, missing the real issues. Not all of the world’s banks and financial sectors have large sub prime losses on their books and are being forced out of a range of global financial markets as a result. What is actually happening is that investors have generally become more risk averse and so are not betting so much on speculative markets or products. This has halted the 'carry trade' as investors worry about margin calls and the need to have liquidity. Indeed, we would argue that financial markets are normalising, so the yen was too weak relative to fundamentals, the AS$ was too strong as was the NZ$ etc. If the credit crisis is leading to more realistic pricing of risk, and bringing these asset classes closer to equilibrium values, then that is actually good news for stability going forward. But this is not to say that large amounts of money are not at stake, with some US $1.5 trillion of subprime loans of which about 10-15% may default and with a recovery rate of 50% therefore implies losses of around $100-150bn may be possible. Estimates also suggest that there could be a further $56-65bn of losses from low grade corporate debt and LBO loans, based on current default rates, making a total of possibly well over $200bn.


...central bank action should not stand in the way of process of risk repricing...

The theory of what central banks should do in situations like these was described a hundred years or so ago by Walter Bagehot, which is to lend money but at penal rates and not to help those in difficulty through their own actions unless the problem affected the whole system. Therefore, central banks are right in injecting funds into the markets to make sure there is liquidity. This should continue so that good creditworthy companies are not impacted, but they should not bail out those who have made wrong bets. To do otherwise would lead to ‘moral hazard’ and investors will likely take even greater risks in the future.


...Global growth and 'economic fundamentals' such as employment and interest rates favourable...

Charts e and f help support the argument that the fundamentals of the global economy are still sound; solid growth, relatively low interest rates and a low longer term cost of borrowing for companies and abundant liquidity, some injected by the central banks. This means there is no underlying problem in the global economy; with falling rather than rising defaults rates, solid profit growth and companies running financial surpluses. In this sense, the current crisis is more clearly a long overdue market repricing of risk. This period of very low risk pricing was down to 5 years of exceptionally low interest rates, owing to low global inflation as a result of increased trade with China and India who effectively exported deflation to the rest of the world. Now that this period of maximum price deflation is over and interest rates are rising, so credit spreads are also widening. This is what should happen and central banks should not stop the process by reproducing an artificially low interest rate environment, especially one that cannot be sustained for very long. Indeed, the risk from cutting rates in the current environment is that it then creates a situation where inflation becomes a problem in 2008 or 2009 and then interest rates have to be raised sharply thus creating the very crisis that official are trying to avoid but at a time of weakening growth.


...but there is a chance that the current contagion could spread further, so central banks should stand ready to cut interest rates though we do not believe they will have to

How could contagion spread? This could happen if the present problem were to lead to banks and capital markets not providing funds for perfectly sound businesses: a credit crunch. That would lead to less investment, lower employment and so to weaker consumer spending growth. If perceptions were that non financial companies were being badly hit then this could lead to an even sharper fall in equity prices and a loss of confidence from highly indebted consumers that might then cut back on spending and so weaken economic growth even more, perhaps creating a vicious downward spiral. As this also implies weaker inflation, then the central bank should cut interest rates. But our view is that we are not yet in that situation. Instead, with inflation now rising in China and India, monetary reflation in the developed countries runs the risk of leading to a bout of future global inflation, which would lead to an even greater economic shock than at present. But if growth does get hit by a credit crunch, then interest rates should, and will no doubt, be cut. Past experience suggests that this stands a very good chance of averting recession in conditions of good economic fundamentals like those that abound currently.


Trevor Williams, Chief Economist


Weekly economic data preview


Credit market to continue to overshadow data this week


• Financial markets this week will remain nervous about global credit market developments and the risk of further flight from riskier assets and trading strategies to 'safer' alternatives is high. Attention has recently shifted to equity markets, reflecting the sharp drop in global stock market indices and based on the view that large declines in this market are more likely to lead to changes in official interest rates. We believe the recent falls still represent a healthy correction rather than a prelude to something worse and so do not warrant an official interest rate response at this time.


• Speculation that central banks could respond to current financial market volatility by cutting or changing the direction of monetary policy has led financial futures to price a 100% chance that the Fed will cut interest rates by October and a reduced probability the ECB will hike rates in September as signalled. We remain of the view that US interest rates will stay at 5.25% this year, unless risks to the real economy from recent market events escalate. The ECB should hike to 4.25% next month.


• Data this week will underline why the ECB should still raise interest rates next month, with the recently introduced 'flash' euro zone manufacturing and services PMIs, on Friday, forecast to show activity remained robust in July. However, the propect of further rises is more uncertain after EU-13 economic growth in Q2 was weaker than expected and inflation remained stubborn below 2%. The German Zew will provide an insight of how investors are feeling; we look for a further fall to 5.0.


UK data last week cast a long shadow over the prospects of another interest rate hike this year. It was actually quite remarkable how market sentiment shifted, particularly after the perceived confidence following the publication of the BoE Inflation Report less than a fortnight ago. We remain of the view that a peak of 5.75% is still possible. Money supply growth could surprise downwards this week, but we look for a modest slowing in both monthly and annual rates in July. The CBI industrial trends survey may show a rebound to -2 in August, reflecting continuing buoyant external demand. There is a small risk that UK Q2 gdp growth could be revised up from 0.9% q/q and 3% y/y, after better than expected outcomes for external trade and retail sales in June.


• It is a relatively quiet week for US data. We forecast durable goods orders rose by 0.8% in July, indicating that business investment is still robust. However, new home sales may have declined again in July, after a sharp 6.6% fall in June, signalling the housing market still remains weak.


• We expect the BoJ to keep interest rates on hold at 0.5% this week, and possibly for the rest of 2007.


Economic data this week will be overshadowed by events in global financial markets, but they should still provide some confidence that the global economy remains in good shape. In the UK, the second release of Q2 gdp should confirm that the economy grew by 0.8% or 3% on an annual basis, above its long-run average for the past six quarters. The first view of the expenditure components is expected to show consumer spending growth of around 0.7% in Q2, up from 0.5% in Q1. However, we forecast slower growth in consumer spending, in the face of higher interest rates and weak household income growth, slowing overall economic growth from the second-half of 2007, such that interest rates may be cut two times to 5.25% by the end of next year. UK money supply data this week will be closely watched for any signs of the difficulties facing institutions from the current credit market uncertainty. The recent strong rise in M4 money supply growth has been largely driven by rising deposits held by non-bank financial companes (OFIs) and it will be interesting to see how they respond. The CBI industrial trends survey (headline orders index) showed a surprisingly sharp fall in June to -6 and is predicted to have rebounded in July to -2, reflecting continuing strong demand.


The first breakdown of German Q2 gdp on Thursday will be important to help gauge whether the current recovery can be sustained. Growth has primarily been underpinned by robust exports and business investment, with consumer spending crucially remaining subdued despite falling unemployment. However, EU-13 manufacturing and services PMI data, on Friday, should show solid expansion continued in July. The German Zew (Tuesday) could showa sharp fall, reflecting falling equities and rising corporate credit costs.


The key data releases in the US are due later in the week. Durable goods orders for July will provide a guide to how business investment is holding up in Q3. It is worth noting that core durable goods orders have declined in the past two months. New homes sales, also on Friday, could elicit strong market reaction, particularly with the UK and euro zone heading into the August holiday weekend.


Jeavon Lolay, Senior Economist


Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500


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