Last Wednesday, the US Federal Reserve cut the Federal funds rate by 50 basis points, down to 3%. It had lowered the rate from 4.25% to 3.5% only the week before. The stock market rallied on the news but gave up all the gains to close lower on the day. Equity markets appeared to be telling the Fed that rate cuts were part of the problem and not the solution. I nodded in agreement. Evidently, I had nodded too much, too soon.
On Friday, before the January US employment report was released, came the announcement of a bid by Microsoft for Yahoo. Equity markets were excited. European stocks flew high and American stock index futures pointed to a very strong opening. Accumulated evidence that most mergers and acquisitions end up destroying the value for shareholders is an inconvenient detail to be ignored safely.
The American employment numbers that were subsequently released tell an interesting story. Before the numbers came out, there was speculation that it would be much better than expected. Goldman Sachs economists had revised their estimate from 25,000 new jobs created to 125,000 new jobs created. In the end, employment in the US non-farm economy contracted by 17,000 in January. Not one of the 80 economists who were surveyed for this data had predicted the contraction. On Thursday, weekly data on unemployment insurance claims revealed an unmistakably rising trend. Jobs are harder to come by.
This was followed by the release of the survey of purchase managers in the manufacturing industry. The headline number indicated improving confidence among them. Details revealed the fault-lines. New orders by purchasing managers were gathering dust in warehouses even as their customers were reducing their stockpiles. Employment in the manufacturing industry shows no sign of turning around. American manufacturing might soon become an oxymoron.
Further, evidence that the famed consensus (yes, similar to the one that did not predict the employment contraction in January) is yet to come to terms with an economic slowdown is available in the estimate for American corporate earnings for 2008. Standard and Poor’s research predicts higher earnings for S&P 500 companies. In recent years, much of the earnings growth came from the financial industry with its unsustainable practices. With manufacturing contracting and with financial firms getting a reality check, earnings by American corporations ought to be a lot lower this year.
MBIA, one of the bond insurance companies in the centre of the storm, fielded its CEO to defend his company. Instead, he criticized those who had sold his company’s stock and caused its stock price to dive off a cliff. Without offering any substantiation, the CEO said the company would keep its vaunted AAA credit rating. In response, Standard and Poor’s announced it was placing MBIA on a credit rating downgrade watch.
In a display of demagoguery that a Dravidian politician from Tamil Nadu would have died for, former treasury secretary and Harvard president Lawrence Summers said Main Street (households) should not have to pay for the sins of Wall Street. Ricardo Hausmann, a Harvard professor, had to remind him that problems would not have arisen had ordinary Americans not borrowed well beyond their means to buy homes that they did not need. However, the White House and Congress are responding with a fiscal relief package that would give each American household $1,000 (Rs39,400) in cash by April.
It turns out that Main Street and Wall Street in America are Siamese twins. Undaunted by such trivial details as jobs and incomes, American households continue to extract equity from their homes. Mortgage equity withdrawal is estimated at $145 billion in the fourth quarter of 2007, not much lower than it has been in recent times. To borrow to maintain and defend the American way of life is a national duty.
If Wall Street sold Main Street dreams, loans and homes that it should not have bought, it is paying back in kind. Households are voluntarily defaulting on their mortgage loans so that they can buy cheaper homes some months later. Even those households that are current on their credit cards and other payments display no sense of shame in abandoning their homes and mortgages.
Investors decided that all this meant that American stocks deserved a higher valuation and stocks closed the week higher. Could it be that someone is propping up stocks deliberately, in a puerile (and eventually futile) show of strength? Silly, it does not happen in America.
(V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore.These are his personal views and do not represent those of his employer. Your comments are welcome at email@example.com)