Recession Still Looks Likely For The US

The US economy grew an annualized 0.6% quarter on quarter in the first quarter of 2008, in line with economists’ consensus estimates. However, we could still see a recession unfolding, with the next two consecutive quarters registering negative GDP growth. First quarter GDP data can be subjected to revisions at a later date, and a downward revision could see the economy contracting in the first quarter instead.

Moreover, the “official” arbiter of whether or not we are in a recession is the National Bureau of Economic Research (NBER), which does not use the GDP numbers. The first quarter GDP growth was better than our expectations which bring us to make some revisions to our forecasts. In this article, we will also touch briefly on the US financial sector.

US Economy Grew 0.6% but Consumption Weakens Substantially

Domestic demand excluding inventories contracted for the first time since 1991. Positive economic growth was supported by the change in inventories and net exports. Consumer spending decelerated significantly, rising by only an annualized 1.0% quarter on quarter, the weakest performance since 2001. This softening was expected, in the context of falling employment, high inflation, restricted credit conditions, falling home prices, and wobbly equity markets.

The strong decline in consumer confidence (with the University of Michigan index hitting a 26-year low of 62.6 in April 2008) points to a further deterioration in the following quarter. The recently published preliminary confidence index for May on 16 May 2008 shows further deterioration.

During times of economic growth, the rising inventories actually signify the optimism of the businesses to build up their inventories in preparation for the increased demand. However, the current rise in inventories could be viewed as a lack of consumption by the consumers, such that inventories remain unsold and piles up. In the next few quarters, if consumption is expected to remain subdued, businesses would probably not be adding on to their inventories and there would be a good chance that the recession would take place even if it does not follow the definition of a technical recession.

While a technical recession would be pushed back for at least a quarter now, investors should be reminded that according to the NBER, “Most of the recessions identified by our procedures do consist of two or more quarters of declining real GDP, but not all of them. Our procedure differs from the two-quarter rule in a number of ways. First, we consider the depth as well as the duration of the decline in economic activity. Recall that our definition includes the phrase, ‘a significant decline in economic activity.' Second, we use a broader array of indicators than just real GDP. One reason for this is that the GDP data are subject to considerable revision. Third, we use monthly indicators to arrive at a monthly chronology.” This means there is still a possibility that a recession defined by the NBER could have started in the first quarter in 2008 .

The government is trying to help by handing out tax rebates to the tune of US$150 billion, with 130 million American households expected to benefit. Although the tax rebate is slated to reach consumers by end-May 2008, consumers might be more inclined to save it or use it to pay off debts rather than to spend it on new purchases of discretionary products. The possibility of consumers saving the money becomes greater when one considers the deteriorating employment market, as businesses lay off workers or delay hiring in view of lower profitability for the year.

The Federal Reserve has cut another 25 basis points off the Federal Reserve Funds target rate on 30 April 2008, bringing the total cuts to 325 basis points since September 2007. The rate cuts have been aggressive and swift, and aimed at averting a possible recession. However, interest rates faced by consumers, mortgage borrowers and businesses remained high as many banks have been reluctant to extend credit unless well compensated.

With inflation risk increasing, more rate cuts are becoming unlikely and if the spreads between Fed funds rate and the rates that consumers and companies can borrow remains wide, interest rates available to consumers and businesses would remain high, dampening consumption and investments.

Table 1: Revised Estimates

Source: Bureau of Economic Analysis and Fundsupermart.com estimates

The first quarter GDP results came in stronger than we expected. We have therefore made some revisions to our estimates. Despite the stronger than expected GDP figures, we are forecasting a recession to take place and the next two quarters would likely show a decline in GDP growth. Data from the housing market continues to show no end to the housing woes.

Unemployment rate stands at 5% for April, compared with 4.6% in 2007. With the financials announcing plans to layoff more people every quarter, chances are unemployment will continue to rise. The corporate profits have also fallen in the first quarter of 2008, companies would be reluctant to hand out strong pay hikes or invest substantially. Low nominal wage growth amidst the backdrop of high inflation means potentially negative real wage growth. Consumers would be reluctant to spend which would lead to a slower economic growth.

First Quarter Earnings Have Fallen 16.7%

There were some hits and misses on earnings forecast when the companies announced their quarterly earnings this quarter. Alcoa kicked off the US earnings reporting season on April 7, saying that first quarter profit more than halved on surging energy costs, lower metals prices and a slumping US dollar. General Electric also sparked a 2% decline in the S&P 500 after the company unexpectedly cut its annual profit forecast and said that quarterly profit fell for the first time in five years on 11 April 2008. Wachovia Corp., the fourth largest US bank, reported an unexpected loss because of sub-prime infected mortgage holdings. The losses and the announced cut in dividends and capital raising plans caused an 8% fall in the share price.

On the other hand, companies like Coca Cola and PepsiCo delivered better-than-expected earnings due to strong earnings from overseas markets. With the weakening of the US dollar, the companies with greater volume of businesses from overseas market would see higher volumes sold as well as higher translated revenue figures.

As of 20 May, 480 companies on the S&P 500 have reported their earnings. The first quarter earnings in 2008 has fallen 16.6% compared with the first quarter earnings registered in 2007. Analysts (Bloomberg compilations as at 20 May 2008) are still forecasting earnings to grow by 8.0% in 2008, despite the lackluster performance in the first quarter of 2008. This implies that earnings are expected to grow 16.8% in the next three quarters. Such optimism might be unfounded. We maintain our stance that consistent with past trends; earnings would decline during a recessionary period. However, we have decided to raise the earnings estimate from the previous estimate of -9% to a revised estimate of -7% for 2008, in view of stronger than expected earnings from companies whose overseas sales have benefited from a weakening US dollar.

Value Starts to Emerge from US Financials

While we are negative on US equity, we have recently taken a more positive view on the US financials sector. Pursuant to the sub-prime crisis and the massive write-offs to date, US financials are trading at a lower price-to-book value. In fact, the US financials are trading at price-to-book levels close to that registered in 1990s, after the Savings and Loans crisis. There may be more write-downs in the pipeline, which will raise the PB ratio in the next few quarters.

However, the financials (included in our analysis) could take another further write-down of close to US$200 billion before reverting to unattractive valuations. The analysis done assumes that the entire US$200 billion of additional write-downs will be borne by these banks in our sample size, which is highly unlikely as any further write-downs will probably be shared by other firms in the industry not included in this sample size, meaning that the effect on the book values in our sample would probably not be so great.

Considering current P/B ratios, we think it is a good opportunity to gain exposure to the financials sector. A more comprehensive two-part report titled Global Financials Back In Contention is available on our website.

Table 1: Earnings growth and Valuation of S&P 500 (as at 20 May 2008)

Source: Bloomberg and Fundsupermart.com compilations

US Equities Remain Unexciting

Year-to-date as at 20 May, US equities have fallen a mere 3.7% (in USD terms), suggesting that the worst of the credit crisis is over, despite the continued write-downs by the banks and significantly weaker economic data in the first quarter of 2008. Due to the appreciation of the SGD, US equities have declined 8.6% (in SGD terms) over the same period. While we have revised of our economic forecast upwards and also improved the earnings growth estimate, we remain cool on the US equity market. The estimated PE ratio is 19.7X and 16.7X for 2008 and 2009 while the earnings growth is -7% and 18% respectively for 2008 and 2009 (figures as at 20 May 2008).

We are maintaining our 'Not Attractive' rating on the US equity market, and we would advise investors to pare down their exposure to US equities to an 'Underweight' position. Within the US equities, we find that investors may like to gain exposure to financials in view of the attractive PB ratios.

Wong Weiyi (Analyst & Financial Adviser Representative) is part of the Research and Editorial team at Fundsupermart.com, a division of iFAST Financial Pte Ltd.

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