September 24, 2007
About a month ago there was a lot of hubbub about the 1-in-3 odds laid by many economic and corporate titans that the U.S. was either currently in a recession or would slip into recession by year end. As an update, I am still not seeing a recession in the cards for 2007. I thought it would be appropriate to revisit this since a fairly common investor question regarding the Federal Reserve’s 50-basis points drop in the federal funds rate has been “what do they know that we don’t know?”
I am not convinced that they Fed knows something dire about the economy that has yet to be revealed to the general populace. Instead my view is less conspiratory – I believe that there is such a thing as a “Bernanke Put” (a brief definition of a put, to help this term make sense – a put is a type of insurance that protects an investor against financial losses). This is not an unfair view since the Fed itself cited “developments in the financial markets” as an influence of their recent policy assessment.
The Bernanke Put follows what has been called the Greenspan Doctrine (which, itself, gave rise to the notion of a Greenspan Put). In a December 2002 speech the then Fed-chairman Greenspan argued that asset bubbles 1) cannot properly be detected and 2) that monetary policy ought not, in any case, be used to offset any bubbles if they did so happen to be recognized. Conversely, Dr. Greenspan argued that 1) the collapse of bubbles can be detected and 2) that monetary policy should be used to offset the fallout.
Similarly, and around the same time, Bernanke had more than effectively endorsed the Greenspan Doctrine when he said, “first, the Fed cannot reliably identify bubbles in asset prices. Second, even if it could identify bubbles, monetary policy is far too blunt a tool for effective use against them.”
Since Mr. Bernanke is now Fed Chairman it would have been reasonable to assume that this doctrine would still guide Fed policy. And with the liquidity injections into the system that have been used to remedy the recent crisis in the subprime mortgage market, that assumption has so far proven itself to be true. To state this more plainly, the Fed has pretty much announced that it will make no effort to deflate bubbles, but it will act aggressively to offset the consequences of the bubbles’ collapse (i.e. to limit the losses, like a put). Or, to quote Greenspan, monetary policy should “mitigate the fallout [of an asset bubble] when it occurs and, hopefully, ease the transition to the next expansion.” As an investor, that’s the sort of doctrine I want my central bank to employ and makes me nod my in agreement when I hear the phrase “don’t fight the Fed.”
So, in addition to all the reasons I cited on August 23rd (see the “CEO’s Recession Prediction” article), we can now include the efforts of the Fed to cushion the negative impact that a “credit crunch” may have otherwise had on the economy.
Don’t get me wrong – I am not trying to be Pollyanna-ish. Certainly I am aware that the growth rate of corporate earnings has slowed; and I am also aware that US GDP growth will slip from last quarter’s 4% rate to something closer to 2% for the next couple quarters. And I am certainly not comforted that, on average, B-rated corporate bonds (the most common junk bond category; bonds with these ratings make up about 40% of the US non-financial corporate bond market) carry an average debt-to-Ebidta ratio (earnings before interest, taxes, depreciation, taxes, and amortization) of 6. That is a historically high level and will make it difficult for creditors to repay their obligations. But all these things fall into the “it could be worse” category.”
It could be much worse. Corporate earnings are growing, not contracting. GDP is positive, not negative. And while the next twelve months will see about $35 billion of defaults that is only a fraction of the full-blown credit crunch we saw in 2001-2002 when there were about $250 billion in defaults.
Additionally, the Fed’s most recent Beige Book report (for data up to August 27th) was generally positive quotations:
- Reports from the Federal Reserve Districts indicate that economic activity has continued to expand.
- Retail sales were generally positive, with increases characterized as modest to moderate.
- Nearly every District reported at least modest increases in employment during the recent survey period.
Of course there is continued and widespread reported weakness in the housing markets. But that is, so far, the only area of uniform economic weakness. And even that could be much worse. The Beige Book reports that “outside of real estate, reports that the turmoil in financial markets had affected economic activity during the survey period were limited.”