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NEW YORK (
) -- Lower mortgage/interest rates a la Operation Twist are no longer the answer. The ball is in the politicians' court.
"Economic growth so far this year has been considerably slower than the committee expected. Indicators suggest a deterioration in overall labor market conditions in recent months, and the unemployment rate has moved up. Household spending has flattened out... " -- FOMC
Let's review my thoughts regarding Operation Twist, the U.S. stock market's reaction yesterday and the German and Chinese economic news released last night (that seem to be the proximate cause for the schmeissing in S&P futures over night).
As I expressed in my FOMC Post Mortem, I still don't know why there will be any real benefit to the economy from this strategy, as the shape of the curve and the level of interest rates are not currently growth constraints.
The ball is in the politicians court now.
The Bernank does not control fiscal policy and the economic ball is no longer in his court. It is in the hands of our political "leaders."
Upon reflection, I see the FOMC release as a negative to risk assets because it emphasized (for those who live in another bullish economic galaxy, and there remain some) that the current domestic economic challenges (significant downside risk in FedSpeak) will likely continue to be in place absent a pro-growth strategy.There were other factors that led to a post-FOMC decision selloff yesterday and overnight:
- Reports that French bank BNP might be seeking capital.
- The European banks continue to be reluctant to recapitalize (which they must).
- A divided Europe continues to be unwilling to address its fiscal issues.
- We still have no sense regarding counter party risk when Greek defaults.
- The tape was already exhibiting deflationary signals going into FOMC announcement -- industrials, transports, etc. breaking down -- so maybe the "downside risk" Fed statement was a tipping point where investors simply gave up.
- By making the "downside risk" statement, investors might have come to the conclusion that the Fed has a better sense of how bad upcoming economic numbers will be and that poor August sentiment will translate into weak hard economic data in early winter. (One can even argue that the "significant downside risk" pronouncement might have frightened the markets more than Operation Twist helped in reducing interest rates.)
- Growing recognition that the Fed will not likely entertain QE3 in the face of much opposition within the Fed and in the Republican Party.
- Growing recognition that the domestic economy (combined with the eurozone uncertainty and structural challenges) is now on its own.
Overnight there were signs that the adverse turn in sentiment in the late summer (caused by the U.S. debt downgrade and growing sovereign debt contagion) are beginning to impact hard economic data as both the Chinese PMI and the German economic data show. In response, Asian and European stock markets have tanked and commodities (copper and gold are down big), across the board, continue to weaken.
This data, coupled with the economic risks to the downside offered in the FOMC comments, raise the legitimate issue of a synchronized worldwide economic slowdown and that consensus corporate profit forecasts for 2012 are too high (a view I have long held).
As I wrote in
The Hard Truth About Easy Money
, we have a balance-sheet recession and market participants are now finally coming to the conclusion that the cost of borrowing may not be the right remedy in resuscitating growth. Pro-growth fiscal policy is the answer. Without it, at best, we muddle along. At worst, we double dip.
Let's now briefly return to a discussion of home refinancing and mortgage activity, which helps to explain an important reason why I believe that lower interest rates may no longer hold the economic answer.
Based on Wednesday, the Federal Reserve and its chairman appear to still be in favor of more cowbell. They see lower interest and mortgage rates as fuel for the consumer, as lower-rate refinancings, in theory, aid consumer's cash flows and expenditures. But refinancings have not improved in response to easing rates. In fact, the opposite has occurred.
The logic behind more Fed easing has grown less compelling. That's a blow to the easy money crowd and explains the broken connection between lower interest rates and an improving housing market. Perhaps it also helps to explain the market's recent pasting, as well as help to explain the recent dissents among voting Fed members.
The residential real estate industry is suffering from a structural imbalance between supply and demand. An unprecedented 35% drop in home prices, due in large measure to the egregious use of debt, has resulted in 22% of all U.S. homes with mortgages under water and another 5% at "near negative" equity.As to refinancing trends, the relationship to lower rates and a rise in refinancings has been broken for some time for numerous reasons. The Fed has been remiss in understanding structural issues (vs. cyclical) like this, though they are slowly warming up to the reality.
1. The mortgage-origination business has changed in the last six months. Most mortgage brokers now get paid a salary plus small commission. The people I know that remain in the business are making one quarter, at best, of what they used to make in the last cycle. They no longer want to bother with smaller and more complicated loans, which tend to be the mainstay of the mortgage business.
2. The transformation from low- or no-documented mortgages (like a pendulum) has moved back to the old days, when credit scores, incomes and net worth are actually documented. Many are no longer qualifying for mortgages (as their loans to values are too high and incomes/credit scores too low).
3. As credit gets tighter, the appraisal process is getting much longer. It's more conservative and much more stringent since lenders do not want to make any errors, be sued or face additional rep and warranty issues.
4. The pool of available refinancing applicants are diminished importantly by the number of homes that are still underwater and the weight of a heavy supply of shadow inventory of unsold homes (which keeps home prices down).
5. The weak jobs market is still keeping homeowners on the sidelines (especially after a 30%-plus drop in prices over the last five years).
6. The tenuous real-estate market is forcing many homeowners that are considering refinancing to raise their equity investments before banks agree to lower mortgage rate terms.
Given that shaky situation, the banking industry is not keen to expand its mortgage lending activity, even if Treasury rates move ever lower and real-estate lending provides a better net interest margin. The housing situation remains weak and it will take years to clear despite affordability at multi-decade highs. Lower mortgage (interest) rates a la Operation Twist are no longer the answer.
The ball is now in Washington's court. While I remain suspicious of a meaningful break in gridlock, the current crisis could potentially serve to reduce the divisiveness and polarization even before the November 2012 elections.
But should a divided government not change, we are in for an extended period of uneven and lumpy domestic growth and that's hard for investment managers (with limited upside and corporate managers with limited pricing power to navigate.)Nevertheless, all is not lost and getting more bearish with lower share prices could be wrong footed.
With sentiment and expectations low and finally adjusting to reality, inflation contained, a friendly Federal Reserve and balance-sheet-healthy corporations (operating at a high level of profits), I still expect that we have seen the lows on the S&P for the year.
At the opening, the S&P cash will stand at around 1130. By my calculation, this level incorporates a 2012 S&P earnings of about $78-$80/share (consensus is well over $100/share) and a near-50% chance of recession.
Despite the recent news, I remain in the muddle through camp and view a recession with only 30% probability. While 2012 corporate profit projections remain too ambitious, $78-$80/share is too pessimistic.
My 12-month target for the S&P Index remains at about 1205 (5-6% upside) as expressed in The Kass Model Portfolio.
Despite the aforementioned economic challenges, the recent drop in stocks has improved the market's risk/reward and, as we move ever closer to the early August levels (providing 9-10% percent upside) I would start to raise my long exposure.We are not too far away!
Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.