The continuing turbulence in share markets reflects concerns about the US/global growth outlook.
Introduction
While a sharp fall Chinese shares two weeks ago may have been the psychological trigger for the current correction in global share markets, the real issue is the outlook for global growth. As is usually the case the US is at the centre of these concerns with problems in the US sub-prime (mainly low doc) mortgage market now taking centre stage. This note takes a look at these issues.
The US economic and investment cycle
The US remains the world’s biggest economy and has the most influential investment markets. If US shares are doing poorly (such as earlier this decade) then it makes it hard for global share markets. If they are doing ok (like over the last few years), then it makes it much easier for global share markets. Similarly, the US remains the primary source of corrections in share markets The latest bout of share market turmoil also has its origins in the US, even though a 9% one day fall in Chinese shares may have provided an initial psychological trigger. (Note that while Chinese shares have recovered two thirds of their fall two weeks go, the correction in global shares is continuing).
The next chart shows the US economic cycle since 1980.
Source: Thomson-Financial, AMP Capital Investors
The broad pattern is one of recession every 8 to 10 years, and a mild or mid cycle slowdown in between. Essentially, during a recession interest rates are lowered to abnormal levels, for example 1% in 2003. This sets the scene for a recovery during which interest rates are returned to more normal levels to avoid growth getting out of hand. Growth then cools, but because inflationary pressures or debt levels have not built to extremes the economic slowdown is mild.
This sets the scene for another 4 years or so of solid economic growth like the “goldilocks” scenario of the second half of the 1990s. The favourable economic backdrop and rising confidence then leads to talk of “new eras” such as that around the IT revolution of the late 1990s which results in excessive risk taking and major imbalances in the form of speculative bubbles and very high debt levels. Eventually inflationary pressures build and interest rates start to head higher which, when combined with the more vulnerable state of the economy, results in a recession. And then the cycle repeats.
Our view is that the US is just going through a growth slowdown with growth likely to average around 2% this year. The Fed has returned interest rates to more normal levels after the post-tech wreck recession lows of four years ago, but inflationary pressures have not been strong enough to justify an aggressive tightening. Similarly, there are none of the other extremes that precede recessions such as talk of new eras, excessive speculation, or major share market overvaluation.
How does the US housing slump fit into this? What about the sub-prime loan crisis?
A concern generating a lot of discussion is the US housing downturn and the resulting fallout amongst mortgage lenders. Basically, the US experienced a boom in housing construction and house prices over the last few years. This ended last year with house sales falling 15 to 25% from peak levels, house prices flattening off and housing starts down around 30%. Our assessment has been (and remains) that the US housing slump is ultimately good for the US economy because it’s contributing to a moderation in growth via both residential construction and consumer spending. It is taking pressure off interest rates and this in turn will be good for the US share market. The UK and Australian experience following the bursting of their (much bigger) housing bubbles several years ago continues to suggest that in the absence of much higher interest rates or unemployment US house prices won’t collapse and the flow-on to the rest of the economy will be mild.
Just as occurred in the UK and Australia, the threat to US consumer spending from a slowing in so-called mortgage equity withdrawal (MEW) – borrowing against the rising value of your house – as house price gains stall is likely to be exaggerated. About of half of MEW is not used to finance spending but is used to pay other debts or to invest. On top of this, other drivers of consumer spending such as employment and wages are likely to remain strong in the face of the strong corporate sector.
The crisis in US sub-prime loans does not change our assessment of a US soft landing – but it does add to the risk. Basically, sub-prime mortgages are mortgages made to borrowers with poor credit credentials. About 45% of the sub-prime market is in low-doc loans.[1] They typically incur interest rates at least 2 or 3% above normal mortgages and most are variable rate. There is another category of mortgages called Alternative-A (Alt-A) which are also low-doc and which charge modestly higher interest rates. As US variable interest rates have returned to more normal levels this has led to increasing defaults and payment arrears (or delinquency rates) – particularly for sub-prime loans and to a lesser degree for Alt-A loans. In the December quarter last year the delinquency rate for sub-prime loans rose to 13.3%, that for prime loans was just 2.6% and that for all mortgages was 5%.
Source: (US) Mortgage Bankers Association, AMP Capital Investors
So far this year around 25 sub-prime mortgage originators have shut down or stopped making loans and the value of sub-prime derivative securities has fallen sharply. On top of this, regulators are tightening regulations and banks are tightening their lending standards. This has all led to concerns of some form of financial contagion/credit crunch through the US financial system and economy. However, while the mortgage crisis is likely to have further to go (as delinquencies and defaults continue to rise and lending conditions tighten, resulting in more weakness in home sales and house prices) and the risk has gone up, a generalised credit crunch dragging the US economy into a recession seems unlikely:
·Sub-prime mortgages only comprise 14% of total mortgages outstanding at most (other estimates are lower at around 8%) with Alt-A accounting for another 10%. If the sub-prime delinquency rate rose to the 2002 peak of 15% that would only affect 2% of US mortgages.
·High mortgage delinquency rates in the past have not necessarily caused a collapse in consumer spending or recession. For example, the 2001 peak did not cause major problems in the US housing market or consumer spending (with the recession at the time being due to the post tech bubble collapse in business investment). Similarly the overall mortgage delinquency rate reached nearly 6% in 1985 and yet the economy had a very soft landing at the time.
·Traditional banks’ exposure to sub-prime loans is low.
·Most US home borrowers are in good shape with strong balance sheets and are seeing solid growth in household income. They have benefited from the recent fall in energy prices. Additionally, 75% of US mortgages are at fixed rates suggesting little impact on most existing (prime) borrowers’ debt servicing costs from the rise in interest rates over the last few years.
·Finally, there is little sign of any contagion. Bank and corporate borrowing spreads remain very low.
More fundamentally it’s worth noting that all of the Fed’s tightening cycles over the last 40 years have ended in some form of financial crisis as shown in the next chart and this is eventually followed by an easing in interest rates. Basically the Fed has continued to tighten until the weakest link in the chain (or economy) snaps.
Source: Thomson-Financial, AMP Capital Investor
Financial crises tell the Fed when it has done enough on interest rates and the sub-prime crisis is indicating just that right now. Fed officials are already starting to take notice of the sub-prime crisis. Even if it doesn’t lead to an interest rate cut it will add to the case for rates to stay on hold. So in this sense, and in the absence of a significant flow-on to other sectors of the economy, the sub-prime mortgage crisis could ultimately prove to be positive for the US equity market. However, there may be a rough ride in the short term for shares as uncertainty about the impact of US mortgage problems on the broader economy continues.
Conclusion
The crisis in US sub-prime mortgages is certainly worth keeping an eye on. At this stage though it is unlikely to threaten the prospects for a relatively mild landing in the US economy and the favourable six to 12 month outlook for equities. But the sub-prime crisis could contribute to rough ride in the short term. We remain of the view that while recent weakness and volatility in share markets may have further to run, it is just another correction in a still rising trend.
Dr Shane Oliver, head of investment strategy and chief economist with AMP Capital Investors.*
[1] Low-doc loans allow borrowers to avoid providing income and asset details in return for a higher mortgage rate. They are sometimes called liar loans in the US.
