Serious Money: The turmoil that gripped financial markets in recent months is deemed to be at an end and the probability of recession has been downgraded as the US Federal Reserve, under the leadership of Ben Bernanke, circled the wagons and delivered a more-than-expected half-percentage point reduction in short-term interest rates, writes Charlie Fell
This is the view emanating from the elite on Wall Street, but investors should note the experience of Gen George Armstrong Custer, who famously declared that "there are not enough Indians in the world to defeat the seventh cavalry". His confidence proved ill-founded at the Battle of the Little Bighorn in 1876.
Astute investors will recognise that there are sufficient headwinds to render Bernanke's actions impotent and to bring the current economic expansion, as well as the upswing in stock prices, to an end.
The Fed's recent actions are welcome but unlikely to alleviate the numerous problems facing American households.
The largest threat to the economic upturn is undoubtedly the housing recession, which continues to worsen.
The impending loss of wealth through falling house prices, which could amount to as much as $4 trillion (€2.83 trillion), not to mention the estimates that more than two million households will have to return to the ghettoes, will surely force the US's indebted consumer to deleverage (reduce their debts).
Lower short-term interest rates will not prevent a further deterioration in the housing market. The available stock of unsold homes is at least three months in excess of estimates of market equilibrium and, despite cutbacks in residential construction, incremental supply continues to exceed demand.
Inventory will continue to build, as the subprime crisis has closed the market to all but prime borrowers.
Additionally, mortgage rates have not come down in the wake of the Fed's interest rate cut, while the reckless lending of 2005 and 2006 will see roughly $500 billion worth of mortgages repriced upwards during the first six months of 2008 - more than all of this year - and payments due will increase by as much as 25 per cent.
Defaults will continue to edge higher, as too will the supply of unsold homes, and house prices will drop by as much as 50 per cent in some areas, according to Prof Robert Shiller of Yale University.
Recession in the US housing market, which the bull-market cheerleaders confidently declared to be close to an end just months ago, will continue through 2008 and perhaps even longer until the supply and demand balance is restored.
The "have now, pay later" consumer has already lost access to releasing equity from their homes as a convenient way to support spending - the annualised rate of equity release has dropped by roughly $700 billion from its peak. Far more seriously, though, the consumer is now faced with falling home prices.
A cumulative decline of 15 to 20 per cent is possible, which will reduce household wealth by $4 trillion. This is important given that certain academic research* shows that the wealth effect emanating from housing is twice as large as that attributable to stock prices.
The mess apparent in the US housing market should prove enough to dampen the spirits of the beleaguered consumer, but the headwinds have grown greater. Oil prices are at record levels, while food costs are commanding a greater share of personal income. And, while the cost of credit has stabilised, availability is by appointment only.
More importantly, the labour market has softened. Looking forward, it's hard to see why the corporate sector would engage in a hiring binge. Indeed, weaker consumption will not only negatively affect the labour market, but the inevitable inventory build will hurt capital spending.
The firepower available to the American consumer has been seriously reduced by recent events in the world's capital markets and, though the bull market cheerleaders on Wall Street believe that the economic expansion is back on track, their views will prove comical as the economy is gripped by recession.
An economic downturn is already being signalled by the Conference Board's index of leading economic indicators, which is registering a year-on-year decline in the quarterly average.
Such a contraction has preceded every recession since 1960 and emitted just one false signal in 1967 when US president Lyndon Johnson's "Great Society" programme and the military build-up in Vietnam prevented a fully-fledged downturn.
It is clear that, at present, there are enough Indians to defeat the seventh cavalry. Caveat emptor.
charliefell@sequoia1.ie
* Comparing Wealth Effects: The Stock Market versus The Housing Market, Cowles Foundation Discussion Paper No 1335, by Karl E Case, Wellesley College; John M Quigley, University of California, Berkeley; and Robert J Shiller, Yale University
