Surprise of 2007

My biggest surprise for 2007 was the equity market downturn that did not happen. The credit crisis in August caused significant upheaval in the sub-prime and CLO markets. Spreads for money markets were greatly affected and still are wide by historical standards. A liquidity crisis required not only intervention with a discount rate cut, Fed funds cuts through the rest of the year, but year-end fund injections. The Fed provided liquidity which may have mitigated some of the loses, but credit has become less available because of tightening standards. Central banks around the world have been forced to increase liquidity in an environment that is closer to seeing increased inflation The housing market is in shambles, rating agency reputations are gone, and financial firms have needed bail-outs from foreign firms. Chief executives had their careers short-circuited, yet the S&P 500 index still showed a positive gain of 3.5% for the year. The highs for the year actually came after the credit crisis began.

So why did we not get our downturn?

The timing may be off. The economy is still adjusting to the real effect of the housing sell-off and the tighter credit conditions in the US economy. The sell-off and slowdown may still come, but it will just take more time. Unfortunately, this is the lament of many forecasters. I am right on the direction, but my timing is off! More specifically, this timing issue is tied to the elusive consumer wealth effect. Do consumers feel poorer because of the declines in housing prices? The timing between financial wealth changes and consumer behavior is one of the most difficult relationships to effectively measure and certainly not something that changes quickly, yet I would have expected a bigger decline in confidence and spending given the size of the credit problem. While the timing issue could off, housing peaked before 2007, so the wealth changes have had some time is sink in for many consumers.

The housing crisis is a regional phenomenon. The housing bubble has been pricked but most of the current correction is focused in a just a few areas which have been overbuilt and saw significant price increases, Southern California, Nevada-Arizona, and Florida. Other areas have actually seen modest appreciation. Most housing prices are still higher than levels of five years ago; consequently, most consumers may be unaffected by the CBO mess. An economic slowdown will occur, but great loses will only be seen by limited groups. This argument focuses on sector dynamics. The stock market will see sector decline but not a large sell-off.

Central banks got it right. Liquidity was provided and a problem was averted. Of course, we will not know if this is a right answer until next year. We also may be affected by the unintended consequence of higher inflation if the liquidity increases were overdone. The credit problem has mainly been in the SIV commercial paper sector which has shrunk.

The power of globalization. The complexity of globalization can be found in the buoyancy of markets to the credit crisis. The sub-prime mess has had a global character with banks hit with loses in Europe and other parts of the world, so to some degree the mess was spread across a wider audience. The banking problems were so large that foreign central banks have had to pour liquidity into the markets to stabilize the rates. The lowering of US rates was a key catalyst for the significant declines in the dollar during the second half of the year, yet globalization has been able to provide support for the US economy and markets. First, the decline in the dollar has led to strong increases in exports which have offset some of the declines in home building on GDP. While the decline in housing has been substantial, the manufacturing sector is still large, so any gains will have a magnified impact on the economy. Second, the strong growth outside of the United States has been a boom for US companies with overseas operations. Profits have been growing outside the US and the translation back into dollar has further increased the earning s of large cap companies. This has offset some of the declines in financials sector of the market. The declining dollar has made some assets in the US look cheap. Foreign firms have stated to make US purchase although some of the capital flow numbers seem to suggest that buyers have been hesitant about purchasing debt instruments.

One of the book that had an impact on me in 2007 was financial history piece, The Panic of 1907: Lessons Learned from the Market’s Perfect Storm by Robert Bruner and Sean Carr. The authors make a strong case for panics started by small changes in expectations and the actions by key players in the market. Individual make history and the actions of the few could carry over to an entire market. Yet, in 2007 there was no widespread panic. We are still sifting through the problem, but the match that was supposed to ignite the market never materialized in the way expected.