And This Time, Impact Is Global
By E.S. Browning And Joanna Slater, WSJ | 23 January 2008
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Working Out Distortions
Bears see a much longer working-out of the distortions that developed this decade as the U.S., along with many other nations, went through a burst of housing exuberance. Home prices surged far beyond historic levels relative to income. Stocks in home builders, mortgage companies and financial institutions cashing in on the boom as all benefited.
Confident U.S. consumers fed— and were fed by— a broader boom abroad, particularly in developing markets such as China and India. Exports from Asian countries excluding Japan grew to 55% of their total economic output in 2005 from 45% in 2001, according to the Asian Development Bank. The lion's share of those exports— about 60%— end up in the U.S., Europe and Japan.
"We are all still tied together one way or another, either psychologically or through trade," said Hans Utsch, who manages the $10.5 billion Federated Kaufmann Fund, which focuses on U.S. midcap stocks but also has 15% of its portfolio in Indian shares. "Only if you're living in a dream world do you say, 'I'm immune.'"
The current market looks a lot like the beginning of past bear markets, said Paul Desmond, president of market-research firm Lowry's Reports in North Palm Beach, Fla. First, the most troubled stocks decline— home builders and financial stocks in the current case— and then others gradually get hit, including small stocks, retailers and technology stocks. Finally, even stocks of strong companies are affected.
Japanese companies, for example, are historically cheap relative to profits, which are rising for a sixth consecutive year. Yet Toyota Motor Co., the world's most profitable car maker, plunged 7.2% yesterday.
"There's a crisis of confidence at the moment," said Khiem Do, portfolio manager at Baring Asset Management, which manages about $13 billion in Asia. "In fact, good stocks with strong fundamentals are getting routed because people want to lock in profits."
As a bear market develops, Mr. Desmond says, trading volume and price movement get heavier and heavier for stocks that are declining, and lighter and lighter on the buying side, as more investors look for a way out. When the selling reaches a climax, the bear market is nearing an end, but Mr. Desmond says he doesn't see any sign of a climax yet. "We feel we have been in a bear market since July. Everything that we have seen since then has just been a progression, almost like a disease that you are monitoring and the disease is spreading," he says. "We are still a long way from a major bottom."
He is watching for a sign of panic selling, but says it hasn't gotten to that point yet. "Everything we are seeing looks like a typical bear market," he says. Yesterday, even commodities including oil and copper declined, amid concerns about slower world growth. Investors put money into refuges including gold and Treasury bonds, pushing their prices higher.
World-Wide Market Plunge
The Fed's move yesterday was hastened by the world-wide market plunge on Monday, when U.S. markets were closed. While some investors thought the Fed's move looked panicky, others liked it because rate cuts reinforce the Fed's willingness to support the economy despite inflation risks. One silver lining to the links among world markets: If the Fed rate cuts do blunt the credit crisis and support growth, that should benefit markets world-wide. The U.S. is still by far the biggest, strongest economy in the world. If Americans begin spending and borrowing again, then economies and markets around the world will benefit.
Investors around the world had their eyes on the Fed yesterday. After the Fed news hit, "everyone was trying to buy and our order screens were full. Then within minutes, that euphoria evaporated," said Martin Slaney, head of derivatives at GFT Global Markets in London. European markets continued to gyrate, although they recovered from the day's lows and many finished with gains for the day.
The Dow Jones Industrial Average was down 464.48 points, or 3.84%, shortly after the opening bell. It finished down 128.11 points, or 1.06%, at 11971.19, the first finish below 12000 in more than a year. Total trading in New York Stock Exchange-listed stocks hit 6.42 billion shares, the second-heaviest day ever, after last Aug. 16.
Some more-optimistic investors were beginning to buy already, and others were looking for buying opportunities. Uri Landesman, a senior portfolio manager at ING Investment Management in New York, said he slept fitfully Monday night, with some of his international stocks showing double-digit declines. Yesterday, he went through all of his holdings and came up with seven potential stocks to sell and to buy, but decided to do nothing— for now. "Anything I want to sell is already oversold," he says. As for buying, he's waiting to see if markets steady.
Investment strategist Thomas McManus of Banc of America Securities, who last year had urged clients to pull back from stocks, recommended that they buy beaten-down shares, boosting their stock holdings by 5%. U.S. banking stocks, which have been among the hardest-hit in the selloff, staged a recovery yesterday, in part on hopes the rate cut will improve their profit margins.
Fed Rate Cut Halts Market Free Fall,
But Recession Fears Are Mounting as
Foreign Shares' Tumble Prompts Bernanke Call—
Biggest Trim In 20 Years
By Greg Ip, WSJ | 23 January 2008
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The Federal Reserve chairman, who normally tries to avoid reacting directly to financial markets, saw global markets in free fall, and yesterday abruptly orchestrated the single deepest cut in the Fed's main interest-rate target in more than two decades. The move shored up confidence, at least for the moment. U.S. and many global markets quickly rebounded from huge losses in response to the three-quarter percentage-point cut in the target for the federal-funds rate, to 3.5%.
But in a sign that risks to the U.S. and global economy remain strong, the Fed hinted another rate cut next week is likely. The central bank's moves may be too late to stop the U.S. from entering recession, as many economists now forecast, but it may make one milder and shorter. By acting so explicitly in response to market developments— just a week before a scheduled meeting to decide on rates— the Fed is running a risk. Investors may view the steps as panicky, undermining the goal of the rate cuts. And investors may come to judge the Fed's success narrowly, by how the stock market, rather than the economy as a whole, performs.
Still, Fed officials agreed on the emergency move during a videoconference call convened hastily Monday evening by Mr. Bernanke. It came after Mr. Bernanke spent Monday in the office, despite the national holiday, watching the fallout as Asian and European markets plummeted and consulting with aides. Futures markets Monday were predicting a 4% plunge Tuesday in U.S. stocks.
His main concern: Investor fears of an economic catastrophe could become self-fulfilling. Another big drop in U.S. stocks, on top of a 15% decline since last October, would represent a hit to household wealth on top of eroding home values. Falling asset prices could force banks to take more write-downs, further eroding capital and constricting credit. Mr. Bernanke believed the Fed should try to short-circuit the negative psychology, and that it stood a better chance by acting right away instead of waiting a week. It was the first time the Fed has cut rates between meetings since the aftermath of the terrorist attacks of Sept. 11, 2001.The Dow Jones Industrial Average, down as much as 464 points early in the morning, later recovered to close down 128.11 points, or 1%. European markets, which were falling steeply for a second straight day, reversed course and closed higher on the Fed's action. "Appreciable downside risks to growth remain," the Fed said in a statement, vowing to "act in a timely manner as needed to address those risks." Futures markets see a high likelihood of another half-point cut, to 3%, at the meeting scheduled for next Tuesday and Wednesday , and see the Fed bringing its target as low as 2% by year end.
"The sense was that we were facing a meltdown," said former Fed governor Laurence Meyer, now at forecasting firm Macroeconomic Advisers LLC. "That was the reason for trying to get out in front rather than trying to sit out on the sidelines." The move would be "pointless" if it merely shifted a scheduled rate cut ahead by a week, he added. The aim, he predicted, is to get the rate lower by month's end than it otherwise would have been. He predicted another half-point cut next week.
Mr. Bernanke's rate cut is a telling sign of the urgency with which policy makers are responding to the risk of recession. The Bush administration is pushing for a fiscal stimulus package of $145 billion composed primarily of temporary tax breaks. Treasury Secretary Henry Paulson told the U.S. Chamber of Commerce in response to a question yesterday that the Fed's rate cut is "constructive...That should be a confidence builder." After President Bush met congressional leaders at the White House amid growing anxiety about the economy, there was speculation that a fiscal stimulus bill might exceed $145 billion, or that it might be accompanied by measures that would take effect automatically later in the year if the economy weakens.
The odds of recession are rising, and some economists believe the U.S. already has entered one, or is about to do so. "The best forecast now, based on guesstimates of first-quarter data, is that we're not in a recession right now," said Robert Gordon, a Northwestern University economist who sits on the academic National Bureau of Economic Research committee that officially dates recessions. But he says odds favor a recession starting late this quarter or next quarter. Merrill Lynch yesterday predicted that the economy will contract in each of the first three quarters of the year. Today's economy shows some signs that are common to most recessions: Stock prices are falling; long-term interest rates are dropping below the level of short-term rates; housing construction is declining; and the unemployment rate is up sharply.
But some usual indicators aren't flashing recession. Employers haven't trimmed employee work weeks, as they commonly do when demand trails off; initial claims for unemployment insurance have been dropping recently, and inventories aren't unusually high, which makes it less urgent for manufacturers to scale back production. "There is no clear evidence" a recession has begun, said Victor Zarnowitz, a scholar at the Conference Board who is also a member of the NBER committee, "but it bears watching very, very closely."
Consumers are feeling the pinch of weaker job growth and higher energy prices. Darion Hammie of Inglewood, Calif., who makes about $50,000 as logistics coordinator for a freight-forwarding company, has been cutting back on everything from Christmas toys to organic groceries. Her wages are rising, but rent on her two-bedroom house has risen $200 to $1,400 a month from last year. Filling her Ford Explorer costs $80, up from $40 or $50 a few years ago. So she has largely abandoned Whole Foods for less-expensive supermarkets, and enrolled her children in the lunch program at school. "I have to make choices that I never thought I would have to make," she says.
Businesses are also cutting back in response to tighter lending conditions and weaker demand. Dan Imbrogno, president of Ohio Screw Products Inc., a manufacturer in Elyria, Ohio, started noticing a slowdown in inquiries a few months ago in September, which accelerated in the past month. His company, which makes hydraulic fittings as well as screws and bolts, took delivery of a computerized metal-cutting machine last fall that cost more than $100,000 and was planning to get a second machine early this year. He has now canceled the order.
The Fed move marks a radical shift for Mr. Bernanke. Since August, the Fed has cut its target for the federal-funds rate— at which banks lend to each other overnight— three times by a full percentage point. But at no time was it willing to say it was more worried about the weakening economy than inflation, a reflection of the stubbornness of price pressures emanating in particular from energy costs.
But by earlier this month, weakening employment, retail sales and manufacturing activity convinced Mr. Bernanke that risks to the economy were paramount. In a Jan. 10 speech he promised "substantive" action, widely read as a promise to cut rates further. Many in the markets expected a cut shortly at that time. Some Fed officials saw merit in the idea. Mr. Bernanke thought it better to act at next week's scheduled meeting. But market events forced his hand. Last week, bond insurers faced the threat of rating downgrades that would force banks to take on billions of dollars of added default risk, and then came the global stock-market plunge on Monday.
The Fed itself and markets were closed for the Martin Luther King Jr. holiday, but Mr. Bernanke— who comes into the office seven days a week— was at his desk. After consulting with Federal Reserve Bank of New York President Timothy Geithner and Vice Chairman Donald Kohn, he convened a videoconference call of the Federal Open Market Committee. Since economic fundamentals justified a significant rate cut, the main issue was convincing the committee that it should be done now. All but one of the participants, William Poole, president of the Federal Reserve Bank of St. Louis, voted for the move. He didn't believe conditions justified moving before the meeting, the Fed said. Another member, Fed governor Frederic Mishkin, was on a skiing trip and unable to get to a secure Fed facility in time for the session.
The timing may resurrect accusations that the Fed is too quick to bail out investors at the expense of low inflation and prudent behavior. And by setting aside the longstanding preference of moving only at meetings, the FOMC risks looking desperate. Vincent Reinhart, a former top staffer at the Fed who is now a scholar at the American Enterprise Institute, said the Fed may have put itself in "harm's way" by basing its action so explicitly on market developments.
"If markets go down after you've acted, do you jeopardize some of your credibility? I think they did," Mr. Reinhart says. If market panic resumes, "You are then faced with the question, what is plan B?" But former Fed governor Lyle Gramley, who now follows the Fed for Stanford Washington Group, says the risk of not acting was larger. "You have a credibility problem whenever things don't go right," he said. "You have a much larger credibility problem twiddling your thumbs, doing nothing, when the economy is going down the tubes."
Before announcing the rate cut Tuesday, the Fed notified its counterparts in Japan, Britain, Canada and the European Central Bank. By the end of the day, only the Bank of Canada had followed suit, lowering its short-term rate a quarter of a percentage point at a scheduled meeting, as expected. But the governor of the Bank of England suggested rate cuts in the U.K. are likely, and markets anticipate the European Central Bank— despite its tough rhetoric about inflation worries— will follow later this year.
The Fed said it acted because of a "weakening of the economic outlook and increasing downside risks to growth. Broader financial market conditions have continued to deteriorate and credit has tightened further for some businesses and households. Moreover, incoming information indicates a deepening of the housing contraction as well as some softening in labor markets." It also said it expects "inflation to moderate in coming quarters" though it will "monitor inflation developments carefully."
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Stanford economist Robert Hall, chairman of the seven-member NBER committee that dates recession, said colleagues on the usually dormant panel have begun to discuss the numbers by email. "The crystallizing event was the weak employment numbers at the beginning of the month," Mr. Hall said. It would not announce a starting date for any recession until well after one has started, he said. Typically, lower interest rates begin to help revive a sagging economy by spurring purchases and construction of homes. But the deflating real-estate boom has left an unprecedented share of homes standing unsold and vacant, says Columbia Business School economist Christopher Mayer, suggesting the moves may have less effect than usual. "No matter how much the Fed cuts interest rates we are not going to see an appreciable pickup in home construction for a couple of years," he says.
Lou Barnes, president of Boulder West Inc., a Lafayette, Colo., mortgage bank, said the cuts will help only those home buyers who qualify for prime mortgages of $417,000 or less. Banks that used to originate mortgages for less-than-perfect credits or for amounts above $417,000 are reluctant to do so because they can't sell them to investors and have little room left on their own balance sheets for them. (Mortgage giants Fannie Mae and Freddie Mac can't buy mortgages above $417,000.)
Still, lower short-term rates will produce benefits that grow with time. Because banks usually borrow for shorter terms than they lend, the reduction in short-term rates will make lending more profitable and thus appealing. Major banks yesterday lowered their prime lending rates to 6.5% from 7.25%, which will deliver savings to anyone with a prime-linked loan, such as on a home-equity line of credit. Stanford's Mr. Hall said while fiscal stimulus plans will take too long to influence the economy significantly, by contrast, "the Fed can turn on a dime as it did this morning. Claims that it's lost its grip on the economy are misplaced."
The current month is proving to be a critical test of Mr. Bernanke's leadership. He became chairman in February 2006, intending to be more collegial than his predecessor, Alan Greenspan. He made sure fellow FOMC members had their say before he settled on the course for interest rates, tried to stay out of the limelight and to avoid explicit clues on interest rates. While that style worked in his first year on the job, it has been criticized since the crisis erupted in August for encouraging Fed officials to air multiple, often disparate, views when the markets most want clarity. Officials have since been advised to hedge their remarks more carefully, people close to the Fed say.
Mr. Bernanke also tried to focus the market's attention more on explicit forecasts than verbal clues. In October, the Fed released the first of expanded quarterly economic projections which helped quantify the inflation rate the Fed is aiming for. But like most of the Fed's projections lately, that forecast was made obsolete within days by the intensifying credit crunch and housing slump. Wall Street has been quick to vilify Mr. Bernanke for being slow and indecisive. "A number of our clients believe Bernanke has lost it and they are uncertain as to what the Fed is up to," ISI Group, a New York brokerage firm, wrote in a morning report. Greg Peters, head of credit strategy at Morgan Stanley, said, "I think the Fed definitely has lost a decent amount of credibility...they have been behind the curve and reacted to the market and that doesn't engender a lot of confidence."
But Mr. Bernanke's defenders note he has plenty of company: Most Wall Street economists have also had to mark down growth expectations and mark up expected Fed easing as the outlook has deteriorated since August. Investors also wrongly thought the worst had passed in October when they pushed stocks to their last, all-time high. Moreover, even as Mr. Bernanke battles the risk of recession, inflation has not faded from view. "You have the underlying inflation rate moving in the wrong direction," noted Al Broaddus, former president of the Richmond Fed. If the Fed is going to be flexible in the face of risks to growth, "it needs to move back in the other direction as soon as the balance is shifting back towards inflation risk. And it's not easy to do that."
Tuesday's move came closer to the day of a scheduled meeting than any between-meetings move since the Fed began announcing rate changes in 1994. The Fed last cut the target for the federal-funds rate in one move by as much as three-quarters of a point back in 1982, when it was lowered a full point. Prior to 1994, however, the Fed publicized only the less-important discount rate, charged on the Fed's direct loans to banks. It cut that rate a full percentage point in 1991.
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