U.S. economy

A U.S. recession that risks becoming the worst in 50 years is not the prediction 1,800 advisors wanted to hear from Martin Feldstein. But Feldstein, whose authority on U.S economic matters is matched by only a few, was not there to lift spirits. He was there to share what he observes, and for the short term, it doesn’t look good.

“The situation is bad, getting worse and has the risk of being really bad,” said Feldstein, a professor of economics at Harvard University and the CEO of the National Bureau of Economics. He was speaking to advisors attending the Mackenzie University roadshow in Toronto.

The National Bureau of Economics is the non-profit research organization that always officially declares when a recession occurs. Currently, there hasn’t been enough period of decline to officially do so, but Feldstein said the U.S. is already in the thick of it, and right now it’s only looking to get worse.

Feldstein is optimistic about the long-term prospects of the U.S. economy. He notes the declining dollar will greatly reduce the U.S.’s current account trading deficit with other countries.

But fundamental problems in the U.S. housing market and credit problems in the financial markets will create a prolonged recession that has a real possibility of lasting longer than the one experienced in the early 1980s.

Although not the sole reasons for the decline, the housing and financial markets will take time to work out.

He said that high loan/value ratios on U.S homes are likely to increase as housing prices fall at unprecedented rates. This means a greater proportion of U.S. homeowners will have negative equity in their homes. At the end of 2007, 15% of U.S. homeowners had a mortgage to value ratio on their home greater than 100%, meaning their mortgage were worth more than their homes. Feldstein estimates that this percentage will increase to 20% of homeowners.

Exacerbating the problem is many of the high-ratio mortgages had no recourse loans, so if the consumers default on their payments and vacate their homes, their lender are entitled only to repossess the home, and cannot seek other financial retribution.

Feldstein estimates that buyers will get over the social stigma of having their homes foreclosed and will start walking away, further eroding home prices and shaking confidence among the financial players, particularly those who have a stake in any syndicated investment vehicles with exposure to housing mortgages.

“Institutions are not buying securities and they are not making loans,” he said.

The U.S. Federal Reserve has tried to alleviate this problem by establishing a $400 billion liquidity facility, but Feldstein said this is inadequate to deal with the sheer size of the problem. It is not removing risk off the balance sheets of lenders, but rather just including the Fed in the counterparty risk.

“Relative to the size of the market, $400 billion is very small,” Feldstein said. “The mortgage market is more than $10 trillion.”

Feldstein also warned of the U.S. economy having a new wrench thrown at it, which is a real likelihood of inflation. Traditionally recessions bring down inflation, but demand for commodities by emerging markets, particularly from China and India, will continue to increase even as the U.S. economy subsides. Feldstein noted that much of China and India’s growth is being driven domestically, and is not heavily correlated to the U.S. economy.

Feldstein is worried that the Fed is not paying enough attention to fighting inflation because of its focus on solving the credit problems. He said this recession could be characterized by declining economic growth and rapidly rising prices.

“Inflation is rising — the last 12 months the consumer price index is up 4%. The producing price index is accelerating. The last three months it’s up 6%,” he said. “Recall the 1960s and 1970s. We had an inflation rate in the United States at just about 2% at the start of the 1960s. By the end of the 1970s, that number was over 12%.

One advisor asked Feldstein if he had any predictions about how bad the recession could get and whether clients should be worried. Feldstein said he didn’t want to make any specific predictions.

“The risks I have predicted could lead to a severe recession. I hope they will turn out to be very pessimistic,” he said. “They are significant enough that Washington ought to worry about them, and investors should worry about them. Risks look more serious than they did two months ago. So, go worry.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(04/15/08)

Mark Noble