A Great Recession, but no Depression: DBRS

Canadians shouldn’t be too quick to think of an early end to the present downturn, says Canadian bond rating agency DBRS. It’s only just begun.

“We don’t want to be alarmist, but we do want to highlight why we think this is a very serious recession,” says DBRS co-president Peter Bethlenfalvy. “We’re a small open economy here in Canada; we’re not immune from not only U.S. economic trends but clearly on a global scale we’re more interconnected than we have ever been.”

Bethlenfalvy made his comments while presenting DBRS’s 2009 credit outlook in Toronto yesterday.

“It’s really hard to find causes for optimism,” he says. Still, as the velocity of job losses rises, he thinks the comparisons to the Great Depression off-base.

“Not even in our worst predictions — we get into some pretty dire predictions — will this be anything like the Depression,” he adds. One reason is that during the Depression, every major country acted alone instead working co-operatively, particularly when it came to protectionism, which compressed global trade by two-thirds.

“Back in the early 1930s, you had about five or six G-1s. You didn’t have a G-7 or G-10,” he explains. “Now we’ve got a G-7 and a G-20. We’re going to have local pressures for trading restrictions, but I think there are so many countervailing forces against that, we’re not going to see anything like that.”

A second difference is the role of the U.S. Federal Reserve Board and the Treasury Department. “The Fed did not view itself as a lender of last resort in the early 1930s and Andrew Mellon, who was the Treasury Secretary, really didn’t view that it was the Treasury’s place to support companies. So he let the market take care of the situation and bank after bank was allowed to fail.”

By contrast, today “the Fed clearly sees itself as a lender of last resort, clearly sees its role to thaw capital markets, and clearly views its role to support any systemically important bank.” That viewpoint is shared by other central banks. But it will not be enough to avert further economic contraction.

As a result, the contraction will be no ordinary recession either, hence his preference for the term “Great Recession.” And he thinks we’re less than halfway through it, despite a year-and-a-half of declines. It could take another year-and-a-half for the economy to stabilize, or more likely three to three-and-a-half years — for a recession cycle of five years.

Leverage is the big reason. Debt in the U.S. — government, corporate and consumer — accounts for 365% of GDP: $52 trillion in debt against $14.2 trillion in GDP. In 1950, the ratio was 120%; in 1980, it was 160%. “This is why we won’t be able to get out of this thing in months; it’s going to take years to get out. This is why it’s the Great Recession.”

Bethlenfalvy doesn’t have a crystal ball to see where leverage will settle. Current non-governmental debt is 310% of GDP. He thinks 150% to 175% for household, financial institutions and corporate debt “is probably a reasonable amount of leverage in the economy. Until that occurs, we’re not going to be able to have a stable economy and a stable financial environment.”

Canada, so far, has fared rather better than other countries, but Bethlenfalvy warns that that’s because Canada usually lags broader trends. With forecasts, now “everyone’s going down and they’re going down fast.” He thinks the economy will contract by 2% to 2.5% in 2009, with growth being flat in 2010. The U.S. will contract by 4% this year, with flat growth next year.

As for the U.S., “it’s not going to take too much for us to get to 11%” unemployment. The figure reported for last month was 8.1%. Canada will lag, he says. “Maybe we’ll outperform on a relative basis, but as sure as I’m standing here, we will start to have [more] significant job losses that we’ve seen” yet.

And there will be further pressure from financial institutions. “Banks are not through the worst of their writedowns and any new capital going in will be used to support those asset writedowns.” Yes, some banks have earnings. But are they enough, Bethlenfalvy wonders. He points to Citibank, which has $2 trillion in assets, but $1.2 trillion in off-balance sheet liabilities. That leaves it in a fragile position.

“You’re a captive of your previous decisions and your legacy assets that are continuing to be marked down. Nobody’s going to buy those assets; there’s a big chunk of those assets that, as we’re delivering, there’s no home for those assets. That will continue. So it doesn’t take much of a markdown to wipe through your earnings.”

By contrast, the big five Canadian banks have roughly the same assets, but much better prospects. But they too will be affected by the downturn in lending as well as a contraction in wealth-management revenues.

More troubling is that so far, three-quarters of writedowns have been made by U.S. banks. Europe, he thinks, faces a “tsunami” of writedowns, given $3.7 trillion in loans to emerging economies. “Those are assets that are going to be written down,” he says, and cites as an example the Polish homeowners with mortgages contracted in euros or Swiss francs and yen. Both their assets and their currency, are being devalued.

In this environment, bonds will be more stressed than they were during the last recession. Bethlenfalvy is predicting a default rate on North American corporate debt of 15%, up from 5% now, though bond markets are pricing in far higher default rates than 15%. During the last recession, the ratio of downgrades to upgrades peaked at 5:1; he expects in this cycle that it will reach 10:1 by the fourth quarter of 2009. In this environment, there will be very few upgrades, and that won’t change after the recession ends. “Ratings will find a new level,” he says. “It’s going to be very hard on the corporate side to get a triple-A rating — very, very hard.”

That said, he also cautions that “it’s not the end of days.” The G-7 statement on supporting systemically important banks, lower interest rates and quantitative easing on the part of central banks, as well as fiscal stimulus, will have an impact. On a more anecdotal level, the Baltic Dry Index, which tracks shipping, indicates very low inventories. Copper prices have reached a floor, which is a leading indicator. Finally, China seems to be trending higher than expected, although he concedes the figures are not reliable.

Yet, despite these promising signs, Bethlenfalvy also warns against seeing “false positives.” Earnings have yet to stabilize in the U.S., and he thinks that an S&P 500 level of 500 is a rational target, given the current earnings outlook and assuming a P/E ratio of 12.5 times forward earnings. One reason is that 37% of S&P earnings comes from overseas. A rising dollar and falling demand means “you can’t count on the rest of the world bailing out the S&P 500.”

(03/12/09)