U.S.: The Credit Squeeze Is Starting To Pinch
In one crucial way, the coming economic slowdown is similar to those of the past: Credit is getting tighter. The big difference is that the Federal Reserve did not trigger the tightening. This time, with a nudge from chillier financial conditions abroad, the financial markets themselves did the dirty deed.
Nevertheless, the impact on the U.S. economy will be the same. Domestic demand in credit-sensitive sectors--capital spending, consumer outlays for big-ticket items, and housing--will take the biggest hit. Also, the $1.5 trillion loss in net wealth since mid-July will be felt to some extent in overall consumer spending and housing. Even Federal Reserve Chairman Alan Greenspan recognized that the sharp runup in stock prices "has been a major factor galvanizing consumer expenditures and holding up housing sales." Now, though, some of that support is gone.
The current credit squeeze and loss of wealth are two reasons some economists are raising the probability of a recession in their 1999 forecasts. Use of the "R" word still seems premature, but clearly, all eyes will be watching the data for signs of just how much the economy is slowing. What should grab the biggest attention? The indicators on future domestic demand. Such diverse data as capital-goods orders, jobless claims, consumer confidence, and mortgage applications will be the numbers to watch.
WHY HAVE FINANCIAL CONDITIONS changed so sharply? After years of soaring stock prices and free-flowing credit, investors suddenly decided that the world was a much riskier place than they had thought (chart). Greenspan himself has acknowledged that the financial-market imbalances arose in large part because investors had begun to underestimate greatly the risk associated with stocks and bonds.
As far back as December, 1996, when Greenspan questioned the stock market's "irrational exuberance," his concern was based on the fact that various measures of risk tolerance, including yield spreads and equity premiums, had fallen to negligible levels. A combination of Asia's crisis, sagging U.S. profits, the Russian debt default, and U.S. political uncertainty is what woke investors up.
What is happening now, Greenspan says, "is a major shift toward risk aversion pretty much throughout the world." At the same time, commercial banks are starting to tighten up what had been fairly lax lending standards, especially for businesses. The result: The cost of capital is rising on two fronts. Borrowing in the credit markets is more expensive, and amid sagging stock prices, equity capital is dearer as well.
The credit squeeze shows up in the yield spreads between corporate debt issues and riskless Treasury bonds. For example, the spread between moderately risky BAA-rated corporates and 30-year Treasuries has soared in recent weeks to levels not seen since the 1990-91 recession. The spread even for top-quality AAA-rated corporates has widened. The AAA yield has declined, but Treasuries have fallen much more.
THE HIGHER COST OF CAPITAL makes capital spending, a key force in this business cycle, the most vulnerable sector in the economy right now. That's especially true since weak profits continue to limit the ability of companies to finance their equipment and construction projects internally.
How companies place new orders will contain the most information on how much damage this unwinding of financial-market excesses is doing. Through August, capital-goods orders have been holding up. But the critical months are those upcoming, as businesses digest the latest round of financial-market tightening.
The other crucial sector is, of course, household spending. As they almost always do, consumers will determine the degree of the economy's slowdown. They have lost some confidence, but as strong September car buying and a rise in retail sales show, they are still shopping (chart). September retail buying rose 0.3%, and third-quarter real consumer spending appears to have grown at a solid 3% pace.
Amid excellent income growth and big wealth gains from the past surge in stock prices and mortgage refinancings, households have been able to handle fairly high debt burdens and an extremely low savings rate. Also, while debt service costs for installment debt as a percentage of income have climbed far above the late- 1980s level, overall debt service is below the 1980s peak, because the carrying cost of mortgage debt has declined sharply in the 1990s.
However, lost wealth already appears to be affecting upper-income consumers. September chain store results showed considerable sales weakness among upscale retailers. Discounters, meanwhile, posted strong gains, reflecting the lower importance of stock market gyrations to most middle-income households, as well as the strongest growth in production workers' real wages since the 1970s. Pay is up 4%, with inflation running less than 2%.
Because paychecks are much more crucial to this segment of householDs, the labor markets will remain central to the consumer outlook. The key indicator to watch is weekly initial claims for unemployment insurance. Despite the September slowing in payroll gains, new claims throughout September remained at the lowest level since 1989. Claims are sensitive to economic turns, and they will provide an early warning if job growth is slowing sharply.
THE FINAL SECTOR that is always vulnerable to a tightening of financial conditions is housing. Supportive financial conditions, including stock market gains and cheap mortgage financing, have upheld gains in homebuilding and sales that have been far and above what demographics projected to be possible. The prime home-buying age group has shrunk sharply in recent years, but homebuilding in the first half rose at the fastest pace in four years.
With mortgage rates still very low, reflecting the drop in Treasury yields, housing should hold up fairly well in coming months. But the summer of 1998 was probably housing's last hurrah. Two key indicators will point the way in coming months: weekly mortgage applications and the monthly survey of homebuilders' assessments of market conditions. In the most recent week, ending Oct. 9, applications to buy a home shot up 12.9%, to a record high (chart). In addition, weekly applications to refinance soared 28.7%, also to a record high.
The ongoing tightening of credit conditions, at least the way in which this one has come about, is highly unusual in economic history. Greenspan said flatly: "I have never seen anything like this." What we can bet on is that the U.S. economy will slow. By how much? For that one, keep one eye on the financial markets, and the other on the data.