Markets have recovered from this week’s reminder that things have changed: risk is being rediscovered and downside is now an option and not something someone remembers from history.
Japanese and Chinese markets are still twitchy; Europe follows their lead and looks across to the Atlantic for the latest news to emerge from the subprime mortgage swamp.
But, as Dr Shane Oliver of the AMP clearly lays out, these concerns are reactions to more deep-seated concerns about global growth.
He says there could even be an upside in the US should the subprime mortgage problem worsen and further undermine the struggling housing industry and parts of the broader economy.
And that could be a cut in interest rates sooner, rather than later, which however would be a signal to the world of a worsening outlook and set off more concerns about growth.
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While a sharp fall Chinese shares two weeks ago may have been the psychological trigger for the current correction in global share markets, the real issue is the outlook for global growth. As is usually the case the US is at the centre of these concerns with problems in the US sub-prime (mainly low doc) mortgage market now taking centre stage. This note takes a look at these issues.
The US remains the world’s biggest economy and has the most influential investment markets.
If US shares are doing poorly (such as earlier this decade) then it makes it hard for global share markets.
If they are doing ok (like over the last few years), then it makes it much easier for global share markets. Similarly, the US remains the primary source of corrections in share markets The latest bout of share market turmoil also has its origins in the US, even though a 9% one day fall in Chinese shares may have provided an initial psychological trigger. (Note that while Chinese shares have recovered two thirds of their fall two weeks go, the correction in global shares is continuing).
The crisis in US sub-prime loans does not change our assessment of a US soft landing – but it does add to the risk.
Basically, sub-prime mortgages are mortgages made to borrowers with poor credit credentials.
About 45% of the sub-prime market is in low-doc loans.1 They typically incur interest rates at least 2 or 3% above normal mortgages and most are variable rate. There is another category of mortgages called Alternative-A (Alt-A) which are also low-doc and which charge modestly higher interest rates.
As US variable interest rates have returned to more normal levels this has led to increasing defaults and payment arrears (or delinquency rates) – particularly for sub-prime loans and to a lesser degree for Alt-A loans.
In the December quarter last year the delinquency rate for sub-prime loans rose to 13.3%, that for prime loans was just 2.6% and that for all mortgages was 5%. So far this year around 25 sub-prime mortgage originators have shut down or stopped making loans and the value of sub-prime derivative securities has fallen sharply.
On top of this, regulators are tightening regulations and banks are tightening their lending standards. This has all led to concerns of some form of financial contagion/credit crunch through the US financial system and economy.
However, while the mortgage crisis is likely to have further to go (as delinquencies and defaults continue to rise and lending conditions tighten, resulting in more weakness in home sales and house prices) and the risk has gone up, a generalised credit crunch dragging the US economy into a recession seems unlikely:
· Sub-prime mortgages only comprise 14% of total mortgages outstanding at most (other estimates are lower at around 8%) with Alt-A accounting for another 10%. If the sub-prime delinquency rate rose to the 2002 peak of 15% that would only affect 2% of US mortgages.
Our view is that the US is just going through a growth slowdown with growth likely to average around 2% this year. The Fed has returned interest rates to more normal levels after the post-tech wreck recession lows of four years ago, but inflationary pressures have not been strong enough to justify an aggressive tightening.
Similarly, there are none of the other extremes that precede recessions such as talk of new eras, excessive speculation, or major share market overvaluation.
How does the US housing slump fit into this? What about the sub-prime loan crisis?
A concern generating a lot of discussion is the US housing downturn and the resulting fallout amongst mortgage lenders.
Basically, the US experienced a boom in housing construction and house prices over the last few years.
This ended last year with house sales falling 15 to 25% from peak levels, house prices flattening off and housing starts down around 30%.
Our assessment has been (and remains) that the US housing slump is ultimately good for the US economy because it’s contributing to a moderation in growth via both residential construction and consumer spending.
It is taking pressure off interest rates and this in turn will be good for the US share market.
The UK and Australian experience following the bursting of their (much bigger) housing bubbles several years ago continues to suggest that in the absence of much higher interest rates or unemployment US house prices won’t collapse and the flow-on to the rest of the economy will be mild.
High mortgage delinquency rates in the past have not necessarily caused a collapse in consumer spending or recession.
For example, the 2001 peak did not cause major problems in the US housing market or consumer spending (with the recession at the time being due to the post tech bubble collapse in business investment).
Similarly the overall mortgage delinquency rate reached nearly 6% in 1985 and yet the economy had a very soft landing at the time.
· Traditional banks’ exposure
