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Money Morning's Three-Minute Review: How the Events of 2007 Will Shape the Economy, and the Markets, in 2008

By , Executive Editor, Money Morning •

William Patalon IIIWilliam Patalon III

By William Patalon III
Executive Editor
Money Morning/The Money Map Report

At the start of 2007, few folks outside of some unsophisticated [in retrospect] mortgage borrowers and the Wall Street investment-banking crowd had ever heard of something called a "subprime mortgage."

We've all heard of them, now.

As the year progressed into summer and then autumn, the term became a daily headline, and spilled over to fuel some of the other top stories of the year: Subprime loans were the catalyst for the global credit crunch, forced the Fed to slash interest rates three times, and led to some of the most significant boardroom ousters [usually spun as "early retirements"]. Subprime loans have also been the culprit behind tens of billions in losses at some of the world's largest financial institutions.

Subprime loans affected stock prices, have been behind the U.S. economic slowdown, and even served as joke fodder, providing some easy punch lines on the nightly talk show circuit [or, at least they did before the writers' strike]. 

While few people noticed when the headlines were dominated early in the year by lesser-known mortgage lenders, the financial world went from a simmer to a full-fledged boil once Wall Street's "big boys" entered the ring.

But even in June, when The Bear Stearns Cos. Inc. (BSC) was forced to bail out two hedge funds that incurred huge mortgage-related losses, most investors thought it was still an isolated problem. Wall Street kept telling us that it was.

Of course, Money Morning subscribers knew better. In July, under the headline "Sen. Dirksen, Allow Me to Introduce You to Standard & Poor's," we told readers that the subprime mess was going to get a whole lot worse.

Soon, it seemed like the race was on to see which institution could top its rivals by posting the biggest write-downs. A "Who's Who" of worldwide financial leaders posted a staggering combined loss of more than $100 billion over the last six months of the year: Countrywide Financial Corp. (CFC), Citigroup Inc. (C), Merrill Lynch & Co. Inc. (MER), Morgan Stanley (MS), Bank of America Corp. (BAC), Wachovia Corp. (WB), Barclays PLC (BCS), HSBC Holdings Inc. (HBC), Freddie Mac (FRE), and others were all contestants in the write-down sweepstakes.

Along the way, Warren Spector [Bear Stearns], E. Stanley "Stan" O'Neal [Merrill Lynch], Charles O. "Chuck" Prince III [Citi], and other executive heavyweights earned themselves a lot of leisure time [while in many cases walking away with tremendous severance benefits].

Then, in one of the bigger stories of the year, state-run "sovereign wealth funds" stepped up and bought big stakes in big-but-ailing financial-services firms, including Citi, UBS AG (UBS), Morgan Stanley, Merrill Lynch and others. Abu Dhabi Investment Authority, Singapore Investment Corp, China Investment Corp, and Temasek Holdings Pte., all made capital infusions to aid in the liquidity needs of the nation's largest financial firms (and inject a global footprint). If history is any guide, Abu Dhabi et. al. are likely grabbing stakes in first-rate companies at bargain-basement prices.

In January 2007, crude oil briefly traded below $50 a barrel.  Suddenly, geopolitical turmoil in Nigeria, Iran and several other hot spots, a free-falling greenback and hedge-fund speculation combined to stoke major supply worries. And the Organization of Petroleum Exporting Countries (OPEC) made no real effort to ease the situation. A new Iran-Venezuela alliance may well make matters worse [Thanks a lot, Hugo Chavez].  The tragic assassination of Pakistan's leader Bhutto pushed oil prices close to $100 a barrel by the end of the year.  And we started the New Year by eclipsing that psychologically important plateau.

During the first quarter of 2007, China's Shanghai Composite plunged 9% in one day and the world indices followed suit. The scare proved itself a non-event and many markets seemed headed for double-digit gains at the year's halfway point.

The Dow Jones Industrial Average surged past 13,000 [and then 14,000], while the broader Standard & Poor's 500 Index also surged into record territory.

Enter the subprime fiasco and weak third quarter earnings.  With daily reports of mortgage write-downs, the Dow suffered its first fourth quarter loss in 10 years and ended 2007 with a paltry 6.4% gain - almost 10% below its 2006 return.

Foreign exchanges did much better - and we mean much better.

Financials dragged down the markets as the sector lost about 20% for the year.  Techs served as one saving grace, and the NASDAQ Composite Index outperformed most of its domestic brethren.

The energy sector also benefited from rising prices.  Small-caps struggled as investors turned to more stable industry leaders.  Emerging markets impressed (again) as Brazil and Indonesia jumped over 40% and Shanghai soared more than 90% [despite the February scare, and even with a late-year retrenchment]. U.S. Treasuries benefited from a flight-to-quality and three rate cuts by the U.S. central bank, although lower-rated corporate bonds and mortgage-related issues suffered through the credit crisis.

As 2007 ended, most folks wished they had never heard of a subprime mortgage.

Chart 1: U.S. Stock Market Performance 2007

Market/Index

1st Qtr
Return

2nd Qtr Return

3rd Qtr Return

4th Qtr Return

2007
Return

Dow Jones Industrial

-0.87%

8.53%

3.63%

-4.54%

6.43%

NASDAQ

0.26%

7.50%

3.77%

-1.82%

9.81%

S&P 500

0.18%

5.81%

1.56%

-3.82%

3.53%

Russell 2000

1.66%

4.12%

-3.39%

-4.89%

-2.75%

Fed Funds

0 bps

0 bps

-50 bps

-50 bps

-100 bps

10 yr Treasury (Yield)

-6 bps

38 bps

-45 bps

-54 bps

-67 bps

Source: Brounes & Associates, Money Morning Research.

Economically Speaking: The Tale of Two Crises

With apologies to Mr. Dickens, 2007 was a tale of two crises - recession or inflation [or both?].

During the past year, the subprime fiasco and rising oil prices headlined the daily business-news reports, created conflicting forces within the U.S. economy.

The subprime lending mess served to stall any potential housing-market rebound and created a full-fledged global credit crisis as some of the world's biggest financial institutions discovered they had a "glass chin." [And in spite of that discovery, they violated a key axiom of boxing and business: "Never lead with your face"].

While housing initially bore the brunt of the escalating crisis all by itself, financial disasters like this are never confined to one sector, or one asset class. Indeed, as we warned readers repeatedly, it was inevitable that the U.S. economy would be affected, and probably in a big way. [Thus, recessionary fears emerged and even such noted "naysayers" as former Fed Chairman Alan Greenspan began assigning percentages to its likelihood].

Making matters worse, oil prices soared throughout the year, something that can't be ignored from either a recessionary or inflationary standpoint. With consumers all facing higher gasoline prices - and higher heating prices this winter - the newfound energy crisis is taking a toll on consumer pocketbooks and investor confidence, all at the same time. Little wonder retailers were singing the post-holiday blues even before "Black Friday" was upon them [On that note, however, what else is new?].

These seemingly "dueling crises" are creating some major challenges for U.S. Federal Reserve Chairman Ben S. Bernanke and his policymaking cohorts at the central bank's Federal Open Market Committee (FOMC).

On one hand, the credit concerns suggested that rate cuts were in order to inject liquidity into the system and to improve the borrowing abilities of businesses and consumers alike.  On the other hand, such an accommodating monetary policy could prove disastrous if inflationary pressures were truly heating up.

In the short term, the credit crisis trumped inflation and the central bank reduced interest rates by half a percentage point in mid-September, and followed that up with quarter-point cuts in both October and December.

The policymakers also moved to inject additional liquidity into the economy by adding new bond auctions late in the year.

Let's consider the current state of the U.S. economy in several different key areas:

  • Inflation: In November, wholesale inflation rose by its largest amount in over three decades, as the effect of rising gas prices finally surged through the U.S. economic system. Likewise, consumers began to feel retail-pricing pressures, largely because such items as clothing, airline tickets and even prescription drugs jumped in price late in the year.
  • Housing: Residential construction plunged to its lowest level in 16 years, and new home sales reached their lowest point in a dozen years as the housing slump turned into a full-fledged downturn last year. The pace of existing home sales is now 20% below the levels of 2006.
  • Manufacturing: While the sector had experienced 10 consecutive months of growth, that streak looked to be nearing an end as 2007 came to a close. The November ISM index barely registered any expansion [and the December index that was released in early January indicated an actual sector contraction].
  • Labor: The one positive in the U.S. economy throughout 2007 had been the U.S. labor market. With unemployment standing at 4.7%, the work force remained intact and employers reported solid job growth month after month. U.S. Gross Domestic Product (GDP) soared 4.9% in the 3rd quarter, before much of the subprime effect began to really weigh down the U.S. economic system. Projections for the 4th quarter are dismal, at best [1.5% growth, or less].

Clearly, many of these problems will carry right over into the New Year. They won't turn around overnight, but here's hoping we see some important improvements as the year unfolds.

From the staff of Money Morning, we all wish you a safe and prosperous [and hopefully crisis-free] 2008.

Guest Writer Ron Brounes contributed to this report.

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About the Author

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Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning at Money Map Press.

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