A potentially deadly "cocktail" for a recession

The recent focus has once again shifted onto the sub-prime mortgage loan crisis in the USA, with the markets there suffering their worst one-week drop since August 2007. I had watched with alarm as a seemingly deadly mix of sub-prime woes, a falling US dollar and high oil prices combined to create one of the most potentially devastating mix of problems for the US economy moving forward. Let’s take a look in turn at each of these events and their probably impact on the economy in the months to come.

Sub-Prime Mortgage Loan Crisis – Unless one has been living under a rock for the last 6 months, the sub-prime mortgage problem should now be a familiar mention among investors and pundits. The result of over-leveraging for people in the USA with poor credit histories, and being overly lax on credit policies, this problem has ballooned into a major crisis of confidence in renowned banks all over the world. Packaged debt instruments called “collateralized debt obligations (CDO)” are losing their value almost on a daily basis and forcing financial institutions such as Citigroup, Morgan Stanley, Merril Lynch and UBS to make massive write-downs. The indirect effect this has had on the credit markets is that it is now not easy to get a home loan anymore, as credit policies have been tightened in the USD as a result of the sub-prime fallout. On a macro scale, the property market there is taking a hit as foreclosures hit a record high on falling home prices. On a more micro-level, consumers have been hit hard with “negative equity”, which is what happens when the value of what you own (in loans) is higher than the value of the underlying asset (i.e. the property they hold in this case). The crisis will have two effects which I can forsee in the coming months: There will be a major slump in the property market as foreclosures get under way, and more and more people will restrict spending (lowered consumption) as their mortgage loans eat up more and more of their savings. This is the perfect recipe for an economic slowdown, which has been predicted by the Federal Reserve’s Mr. Ben Bernanke.

Weakening US Dollar – The US dollar has weakened considerably in the past few months, dropping from 1:1.55 SGD to the current 1:1.439 SGD (as at the time of writing). This is most probably a result of the huge US budget deficit and is further exacerbated by the Federal Reserve’s interest rate cuts to 4.5% (25 basis-points on October 30, 2007). The US dollar is now at a ten-year low against the Singapore dollar and at an all-time low against the Euro, which has led some pundits to remark that perhaps the US dollar will soon cease to become an international currency for exchange ! The positive part is that this makes US exports cheaper to other countries but I feel that the weakening dollar may signal more economic problems within the USA which have yet to surface.

High Oil Prices – Oil prices have been on a rally of late, touching US$98.62 per barrel (an all-time high) for light sweet crude just a few days back but now settling around US$95 per barrel. The reasons for this are manifold: supply concerns, unrest in the Middle East (again !) as well as the falling US dollar are all contributing to the steady rise in oil price. This, in turn, will have an effect on the costs and subsequently profits for many companies which use petroleum or petroleum-based products as their raw material for manufacturing. The effects are probably not apparent now but investors should take note of oil price’s impact on the costs for the companies they own, as many companies’ gross margins (e.g. in the furniture industry) may be squeezed by this development. For the man on the street, higher oil prices also mean that pump prices at petrol stations have hit a high and this makes it more expensive to top up fuel for vehicles now.

The above is just a very brief discussion on the three factors which I think possess the deadly “cocktail” to propel the US economy into a recession, unless strong and immediate measures are undertaken by the relevant authorities to address the situation. How this will pan out for the outlook for Singapore companies is uncertain, but the effects of the sub-prime crisis have already taken a toll on the three local banks which have been forced to make provisions for their CDO-related assets. I will be closely watching the effects of these 3 events and will give readers an update again in the coming months, as well as my personal views and analysis.

Note: I added a link under "Research Links" on the right-hand sidebar for the Public Insight program, which I recently discovered to be airing reviews on Singapore-listed companies. They are into their third season episode 1 right now and all previous episodes (including one on Ezra Holdings Limited) can be viewed from the links within the website.