January 9, 2008    TIDBITS

Goldman Sachs Says Economy Falling Into a Recession

From Goldman Sachs:  “The recent data suggest that the US economy is falling into recession. We expect economic activity to contract modestly through late 2008, followed by a gradual recovery in the course of 2009. Fed officials are likely to respond by cutting the funds rate target to 2½% by late 2008…The recession is likely to last 2-3 quarters and should be relatively mild by historical standards, with a cumulative decline in real GDP of only about ½% (not annualized). There are three reasons to anticipate a relatively mild downturn. First, we expect Fed officials to set aside their residual inflation concerns and cut the fed funds rate aggressively to 2½% by late 2008, with a 50-basis-point cut at the January 29-30 FOMC meeting. Likewise, 10-year Treasury note yields are likely to decline a bit further to 3½% by late summer. Second, with influential economists on both side of the aisle calling for fiscal stimulus, there is a decent chance that Congress and the Bush administration will agree on a temporary tax cut to take effect later this year, especially if the economic data remain weak. Third, although global growth is slowing somewhat, the weak dollar and the shrinking trade deficit are likely to continue to support activity in export-oriented sectors…In terms of sectors, consumer spending is likely to post a (small) outright decline -- unlike in the 2001 recession -- as the housing downturn spills over via a negative wealth effect and consumers find it harder to obtain credit. The downturn in capital spending should be more moderate than in 2001, largely because the starting point is much less elevated. The decline in economic activity is likely to push up the unemployment rate to about 6¼% by late 2008 and will likely result in a significant setback in corporate profits, by about 7½% on an after-tax basis (GDP definition). With our switch to an outright recession call, we have also deepened our forecast for the cumulative decline in nominal house prices, to a 20%-25% peak-to-trough decline from a 15% drop previously.”

Bloomberg Survey of Economists Predicts U.S. Won’t Go Into Recession

From Bloomberg:  “The U.S. will skirt recession as consumer spending slows without collapsing, a survey of economists showed.  Economic growth will average 1.5 percent in the first six months of 2008, matching the fourth quarter's pace, according to the median estimate of 62 economists surveyed by Bloomberg News from Jan. 3 to Jan. 8. The rate of expansion would be the weakest since the last nine months of 2001…The Federal Reserve will cut interest rates more than previously anticipated, economists said, triggering a reacceleration in growth by the third quarter that will keep the economy from stalling.  Economists put the odds of a recession developing within the next year at 40 percent…Nine of the 47 economists responding to the question put the odds at about even and five said the economy would contract…Growth forecasts were lowered for every quarter of the year, even as the estimate for the last three months of 2007 was boosted. The world's largest economy will expand 2.1 percent in 2008, down from 2.3 percent forecast last month and the weakest since 2002…The Fed will reduce borrowing costs in both the first and second quarters, bringing the benchmark interest rate down to 3.5  percent by mid-year. Last month, economists forecast the Fed would reduce the rate just once more and hold it at 4 percent through 2008.”

St. Louis Fed President Poole’s List of Mortgage Market Mistakes

From MarketWatch:  “Investment professionals' "shortsightedness" led them to make fundamental errors that led to the mortgage crisis and credit meltdown, St. Louis Federal Reserve President William Poole said Wednesday…The bulk of Poole's speech was devoted to the need for better financial education -- not only for borrowers but also for investment professionals.  Poole said five key mistakes were made, and professionals made four of them.  "I can understand the mistakes many financially naïve borrowers made but have a hard time understanding how so many investment professionals could have been so wrong," he said in the prepared text.  "Many observers point to greed, but I prefer a different explanation. Shortsightedness rather than greed explains actions that led to losses of tens of billions of dollars and the failure of many financial firms."  Poole's list of five key mistakes: Borrowers took on mortgages they could not afford.  Mortgage brokers put too many people in unsuitable mortgages. They knew, for instance, that adjustable-rate mortgages probably wouldn't be right for many borrowers if interest rates rose as the market expected.  Investment banks jeopardized their reputations by securitizing mortgages without doing due diligence on the underlying assets, many of which were based on "inadequate or spurious information."  Rating agencies put their stamp of approval on securitized mortgages without considering whether AAA ratings could be maintained if house prices fell. Investors scooped up those securities without doing adequate analysis first. "Investors too readily accepted the AAA ratings at face value," Poole said. "A reach for yield with inadequate attention to risk in another basic lesson that apparently cannot be relearned often enough.  "There are no new lessons here," he said. "The mistakes that brought us to this point have been made before."”

Why High Oil Prices Aren’t Increasing Supply

From Reuters:  “Oil at $100 a barrel should give exporters every incentive to pump more, but their difficulty in doing so shows the world is struggling to sustain production.  A growing number of leading industry figures -- the CEOs of Total…and ConocoPhillips …among them -- now question mainstream forecasts for supply, suggesting the era of "plateau oil" is nearer than many in the business have admitted.  While global oil demand is projected to grow to more than 100 million barrels per day later this century, some argue it may not be possible to boost flows beyond the current rate of some 86 million bpd.  Supply still falls short even after so-called unconventional oils extracted from tar sands and converted from natural gas are taken into account, said Sadad al-Husseini, a former top official at state oil giant Saudi Aramco.  "Today's oil prices are high because there are limited new supplies," Husseini, who ran exploration and production at the Saudi state oil company from 1986-2002, told Reuters. "There's a history now. We're several years into level production."  In 1980, when crude first hit an inflation-adjusted high of $100, the pace of drilling by producing countries and major oil companies became fast and furious, leading to rising output and a price collapse in  1986… Conventional supply from outside OPEC has missed forecasts in recent years and appears for now to have hit an "effective plateau", according to the International Energy Agency (IEA), adviser to industrialized countries.  Non-OPEC countries pump about 60 percent of the world's oil and the 13 members of OPEC make up the balance. OPEC sets output limits for 12 of its 13 members.  Many countries within the Organization of the Petroleum Exporting Countries -- whether for reasons of war or sanctions, lack of investment or falling supply at ageing fields --- are unable to raise output.  "OPEC can do little," Shokri Ghanem, the top oil official for OPEC member Libya, told Reuters. "Most OPEC countries are producing at capacity."  Many analysts expect prices to rise further unless demand crumbles as a result of a recession…”

U.S. Overinvested in Housing

From Robert Samuelson:  “In Sweden, Britain and Italy, new homes average under 1,000 square feet. By 2005, the average newly built U.S. home measured 2,434 square feet…"We're not selling shelter," says the president of Toll Brothers, a builder of upscale homes. "We're selling extreme-ego, look-at-me types of homes." In 2000, Toll Brothers' most popular home was 3,200 square feet; by 2005, it had grown 50 percent, to 4,800 square feet… "Buying a bigger house isn't an investment," warned Wall Street Journal columnist Jonathan Clements. It's "a lifestyle choice -- and it comes with a brutally large price tag." Not only are mortgage payments higher; so are costs for utilities, furniture and repairs.  Worse, government subsidizes these supersize homes along with suburban sprawl and, just incidentally, global warming. In 2008, the tax deduction for mortgage interest payments will cost the federal government $89 billion. The savings go heavily to the upper-middle class and the wealthy -- the least needy people -- and encourage ever-larger homes. Even with energy-saving appliances, those homes are likely to generate more greenhouse gases than their smaller predecessors. As individuals and a society, we've overinvested in housing; we'd be better off if more of our savings went into productive investments elsewhere.”

Roach Recommends Government Not Interfere in Housing Price Correction

From Stephen Roach of Morgan Stanley:  “America’s current account deficit is due more to bubbles in asset prices than to a misaligned dollar. A resolution will require more of a correction in asset prices than a further depreciation of the dollar. At the core of the problem is one of the most insidious characteristics of an asset-dependent economy – a chronic shortfall in domestic saving. With America’s net national saving averaging a mere 1.4 per cent of national income over the past five years, the US has had to import surplus saving from abroad to keep growing. That means it must run massive current account and trade deficits to attract the foreign capital… A sharp decline in asset prices is necessary to rebalance the US economy. It is the only realistic hope to shift the mix of saving away from asset appreciation back to that supported by income generation. That could entail as much as a 20-30 per cent decline in overall US housing prices and a related deflating of the bubble of cheap and easy credit… As home prices move into a protracted period of decline, consumers will finally recognise the perils of bubble-distorted saving strategies. Financially battered households will respond by rebuilding income-based saving balances. That means the consumption share of gross domestic product will fall and the US economy will most likely tumble into recession… Washington policymakers and politicians need to stand back and let this adjustment play out. Yet the US body politic is panicking in response – underwriting massive liquidity injections that produce another asset bubble and proposing fiscal pump-priming that would depress domestic saving even further. Such actions can only compound the

problems that got America into this mess in the first place… It is going to be a very painful process to break the addiction to asset-led behaviour. No one wants recessions,

asset deflation and rising unemployment. But this has always been the potential endgame of a bubble-prone US economy. The longer America puts off this reckoning, the steeper the ultimate price of adjustment. Tough as it is, the only sensible way out is to let markets

lead the way. That is what the long overdue bursting of America’s asset and credit bubbles is all about.”

Countrywide’s Woes Deepen

From Bloomberg:  “[Countrywide’s] Foreclosures doubled to 1.44 percent of unpaid principal in December from 0.7 percent a year earlier at the company's unit that handles billing and processing, Countrywide said in a statement today. Overdue loans increased to 7.2 percent from 4.6 percent.  Countrywide tumbled another 15 percent today after losing more than a quarter of its market value yesterday, when the company denied speculations it will file for bankruptcy… Washington Mutual Inc., the biggest U.S.

savings and loan, and IndyMac Bancorp Inc., the second-biggest independent mortgage company, lost as much as 16 percent… Credit-default swaps on Countrywide moved deeper into distressed levels for a second day. Sellers were demanding 30 percent upfront and 5 percent a year for contracts protecting Countrywide bondholders from default for five years… Countrywide made $6 million in subprime loans in December, down from $3.7 billion a year earlier, reflecting its tighter standards for lending and the inability to sell the loans to investors in the secondary market.  While the change ``has reduced balance sheet risk caused by its non-conforming originations, the dramatic decline in

Countrywide's earnings power this transition has caused has kept CFC's creditors nervous about the company's liquidity,''…”

Relative Asset Class Performance in 2007

From Merrill Lynch:  “Bonds outperformed Stocks in 2007. This is the fifth annual outperformance for Treasury Bonds so far this decade. Treasury Bonds have not led in five or more years of a decade since the 1930s.  Gold outperformed all three major asset classes for the 3rd consecutive year.  This has not happened since the late 1970's.  

Larger stocks took the performance lead in 2007.  The two largest quintiles of the S&P 500 outperfomed the index, whereas the remaining quintiles underperformed.  The performance spread between the largest and smallest quintiles of the S&P 500 was nearly 19 percentage points.  Investors became increasingly risk-averse as the year progressed.  Low beta outperformed high beta by 258 basis points for the full year, overcoming an 800 basis point lag at mid-year.  Only two sectors, Financials and Consumer Discretionary, underperformed the S&P 500 in 2007.  Annual sector outperformance has not been this broad since 1993.  However, only 45% percent of the stocks in the S&P 500 outperformed the index this year, well below the 56% annual average in the prior five years.”

China Adds New Price Freezes to Energy Prices as Inflation Rises

From Bloomberg:  “China will freeze price increases of oil products, natural gas and electricity in the ``near term,'' Premier Wen Jiabao said, as the government tries to curb inflation at an 11-year high.  The government will cap costs of daily goods when necessary.. Inflation in the world's fastest-growing major economy surged to 6.9 percent in November, the fastest since 1996, and was named by policy makers as one of the two major economic risks for 2008, along with overheating. The central bank pledged a ``tight'' monetary policy this year after six interest-rate increases in 2007 failed to rein in price surges.  ``China is facing greater risks of import-induced inflation in 2008 even after factors attributed to last year's price rise, such as pork and grain shortages, dissipate,'' said Zhu Baoliang, chief economist at the State Information Center in Beijing…The Chinese government controls the prices of fuel, public transportation and staple foods that make up most of the basket of goods used to track inflation. Since July, the National Development and Reform Commission, the top planning agency, has asked local governments to refrain from raising prices.  Still, the government unexpectedly increased fuel prices as much as 10 percent in November to help refiners cover costs after crude oil rose to a record. It also raised natural gas prices for industrial users by a third.  ``The government can't put off energy price increases forever,'' said Zhu, whose center is an affiliate of the NDRC. The freezes ``may create more price distortions between domestic and international markets and harm domestic companies' earnings.''”

MISC

From UBS:  “FOMC member Poole today said that it was too early to tell if the housing situation would lead to recession. He said that although economic fundamentals are strong, the Fed is monitoring both inflation and recession risks.”

From BMO:  “The final Redbook report for December showed that sales fell 0.7% from the prior month, and were up just 1.3% y/y …[Consumer] Credit is now up 5.2% y/y, a bit below the 5.8% y/y rise in disposable personal income, but hardly marking a major retrenchment.”

From The Wall Street Journal:  “Since 2005, developers in the U.S. have produced more retail space than office space, rental apartments, warehouse space or any other commercial real estate category.”

From Natixis:  “5y into 5y forward breakeven inflation (from inflation swaps, which abstracts from the financing and seasonal issues embedded in the TIPS BEI curve) fell to the lowest level since 2006 and appears ready to challenge multi-year lows around 2.50%.”

From Merrill Lynch:  “Overall, the S&P homebuilders index took another beating yesterday, falling 6.5% — for this year, the group is already down an eye-popping 18%, on top of a 60% decline in 2007 and 21% drop in 2006.”

From Morgan Stanley:  “Dec 2007 saw the lowest US default rate in 26 years at 0.9%.”

From BMO:  “We now have five trading days behind us, and the Dow is now down 5.1%, the S&P 500 is off 5.3% and the Nasdaq has shed 8% to start the year. Both the Dow and S&P are off to their worst start ever for a year, both probed through to their lowest closes since last spring and both have seen the 50-day moving average drop below the 200-day MA…the 10-year Treasury of 3.78% yesterday was the lowest close in nearly four years (i.e. back when the Fed funds rate was still 1%).” [Note – Bloomberg TV said this was the worst annual start for equities since 1930 this morning.]

From The Washington Post:  “With hurricane fears and the soaring costs of housing and storm insurance, many here have begun to fret that Florida, long a mecca for tourists and snowbirds, has lost its allure.  "The word has gotten out about Florida. It is not the paradise that many people once thought it was,"…According to the Census Bureau, the number of people moving from other states to Florida has declined from 268,000 in 2005 to 35,000 last year -- by far the most precipitous drop since such records started being kept in 1990…And recently released state figures from the moving company United Van Lines suggest that in stark contrast to years past, as many people are moving out of Florida as are moving in. Four years ago, for example, the company's statistics showed about 60 percent of its Florida shipments were inbound and 40 percent outbound; in the past two years, the number of inbound and outbound shipments has been almost evenly split.”

From Business Week:  “KB Home specializes in moderately priced homes, often for first-time home buyers. An increase in KB Home's cancellation rate from 50% to 58% may be a sign these buyers are having a tougher time getting loans, noted UBS analyst David Goldberg.  Deutsche Bank's Hooper says the future direction of home prices may be determined by whether subprime homeowners—those with riskier credit histories and mortgage payments that are resetting to higher levels —can avoid foreclosure. Under a worst-case scenario, 40% of subprime mortgages could foreclose, and house prices could drop 15% to 20% over the next two years. If foreclosures are confined to 20% of subprime borrowers, prices could fall 5% to 10%.  In any case, "home prices could decline for the next couple years or more," putting a drag on consumer spending that "could be with us for some time to come," he wrote.”

From The Street.com:  “Gold gained after heavy buying on the debut of [gold] futures contracts in Shanghai…”

From Goldman:  “Clear signs are emerging of a deterioration in [Japanese] corporate sentiment. A wide-ranging deterioration in sentiment was reflected in the December BOJ Tankan survey. Since the economic recovery began in 2002, business sentiment had been steadily improving in the nonmanufacturing sector on the back of a recovery in domestic demand, but sentiment has now begun deteriorating for the first time in five years. Deterioration is also being seen in many other sentiment indicators apart from the Tankan survey. A particularly notable deterioration is being seen among smaller businesses in the nonmanufacturing sector, where prices of raw materials are increasing as the economy emerges from deflation, which is placing an especially heavy burden on companies with little pricing power. The deterioration in business sentiment reflects weak momentum in corporate earnings.”

From Deutsche Bank:  “…the Euro-zone’s share of world imports (28%) is now twice that of the US (14%), and the US share has fallen 5 % points since 2000 despite strong US consumption growth for much of this period.  Meanwhile, 21% of world imports are now attributed to EM Asia, up from just 9% back in 1980.  These numbers suggest an important “rebalancing” development in final demand growth…Annual US imports stand around $2.2 trillion, 58% of which now come from EM [emerging market] countries… private consumption levels in the BRICs [Brazil, Russia, India and China] have been rising rapidly…at the end of 2006, personal consumption (in USD terms) in the BRICs was almost one-third that of the US…”

From Market News:  “China's passenger vehicle retail sales rose 10.8 pct year-on-year… Ford Motor said its retail sales in China rose 30 pct in 2007 to 216,324 units, led by strong sales of the Ford Focus. German automaker Audi said it sold a record 102,000 cars in China last year.”

From Deutsche Bank:  “The Fed’s announcement of the Term Auction Facility (TAF) program and the passage of year-end has not only narrowed the spread between 1-Mo ABCP and LIBOR by about 95 bp but it has also lowered 1-Mo LIBOR by about 75 bp.  Some of the spread narrowing also reflects the improvement in the quality of ABCP… has reduced the spread of 3-Mo LIBOR relative to expected Fed Funds by about 30 bp…”

End-of-Day Market Update

From UBS:  “Treasuries rallied today on renewed mortgage-related concerns that pummelled the mortgage lender stocks, once again. The 2s30s curve steepened 4bps on the day as of 3pm… Treasury volume was a fairly heavy 144% of the 30-day average… Spreads widened across the board… Agencies…lagged Libor 0.5-1bp, continuing their week-long streak of underperformance. Fannie priced $4B of its new 2-year at L-19, and $4B of a 5-year at L-15.5…Mortgages saw some decent servicer and originator activity, trading in line to Treasuries and 1-2 ticks better to swaps.”

From Bloomberg:  “U.S. stocks gained the most in two weeks after Warren Buffett's Berkshire Hathaway Inc. said it may invest in municipal bond insurers and Hewlett-Packard Co. predicted earnings will withstand an economic slowdown.  Bear Stearns Cos., Merrill Lynch & Co. and Morgan Stanley helped financial shares rebound from a four-year low…The Standard & Poor's 500 Index added 18.94, or 1.4 percent, to 1,409.13, rallying from a 10-month low. The Dow average climbed 146.24, or 1.2 percent, to 12,735.31, erasing an 87-point drop. The Nasdaq Composite Index added 34.04, or 1.4 percent, to 2,474.55.  ``Warren is viewed, rightly or wrongly, as the smartest investor perhaps in the world,'' … ``People took notice of the sector. Financials led the rally.''”

From Deutsche Bank:  “…last hour of trading reverses all of yesterdays post 3:00 rally and then some… as the 'world' seemed to decide that any 'possibility' of an equity investment in the monolines is enough to raise the 'all clear' flag… market tracked a narrow range for most of the day with little activity.”

Three month T-Bill yield rose 2 bp to 3.23%.

Two year T-Note yield rose 5 bp to 2.73%

Ten year T-Note yield rose 4 bp to 3.83%

Dow rose 146 to 12,735

S&P 500 rose 19 to 1409

Dollar index rose .31 to 76.42

Yen at 109.82 per dollar

Euro at 1.466

Gold unchanged at $878

Oil fell $.66 to $95.69

*All prices as of 4:35pm