Firms Face Tough Times at Home and Abroad
May 1st, 2008For some time I’ve suggested (see most recently NY Times on Retail Bankruptcies) that the credit crisis – in addition its impact on the U.S. economy – would likewise negatively impact the world economy. In last week’s post I wrote:
Moving forward, the real action will be in how these effects reverberate throughout our economy, and then spillover to the broader world economy. Outside of housing and financial firms (the epicenter of this crisis), the next obvious lurch downward, which we’ve already begun to see, is in durables (autos, appliances, etc.); retail; and travel. In essence the recession is now beginning to impact those businesses closest to the struggling consumer. From there, just follow the supply chain upstream to the manufacturers of intermediate goods and providers of intermediate services. And as it so happens, many of those providers of intermediate goods and services are foreign.
And this is how a U.S. recession effectively turns into a worldwide recession.
Recently, the stock market has rallied (up about 7% in April alone) leading some to conclude that the worst of the crisis is behind us, and that the chances for a broader worldwide slowdown are slim.
I am skeptical.
In my view, market participants are erroneously pricing in a short and shallow recession (based on a handful of better than expected Q1 earnings reports) when, in fact, there is mounting, consistent, and convincing evidence to the contrary. Market participants therefore would be better off (and probably more accurate) pricing in a longer and deeper recession.
As with any economic slowdown, it takes time for the effects the fully play out. However, given the spate of recent bad news and my best estimates for the likely trajectory, I am concerned about the current health of the overall corporate sector (outside a few pockets of strength).
For example, CFO magazine reports Credit Cost Hikes Know No Boundaries:
A majority of companies in Asia, Europe, and the United States are paying higher prices for bank credit lines and long-term debt issues, and are being forced to accept tighter terms and covenant restrictions on loans…
…60 percent to 65 percent of the companies said pricing for revolving credit facilities has increased since the collapse of the U.S. subprime-mortgage market last summer, and 65 percent to 70 percent said costs have risen on bank term loans as well.
More than 50 percent of companies said they are paying higher rates on commercial-paper programs. In addition, 70 percent said the cost of issuing long-term debt has increased, including more than a quarter that reported the cost has risen “significantly.”
The survey also found that about 60 percent of companies said it has become more expensive to issue asset-backed securities, and about 70 percent said costs associated with structured finance transactions have increased since the start of the global credit crisis. For example, U.S. companies estimated that commitment fees on revolving credit lines have increased 15 to 20 basis points since the start of the crisis, and spreads have widened 55 to 60 basis points. Term loan commitment fees appear to have increased roughly 25 basis points on average, while spreads have widened by more than 100 basis points.
Meanwhile, many companies are trying to avoid borrowing under any circumstances. (emphasis added)
In addition to that article, Financial Week reports (see Manufacturing Execs Downright Gloomy):
U.S. manufacturers are much more pessimistic about the U.S. economy and the direction of their businesses than they were three months ago, according to a quarterly survey of senior industrial executives released Tuesday.
Only 12% of manufacturing executives said they are optimistic about the U.S. economy over the next 12 months…
Executives have lowered their estimates for sales and industry growth this calendar year, and more of them said gross margins are falling, while almost two-thirds said their costs are rising. (emphasis added)
“The question becomes: How long is the downturn and how far will it reach across the seas?” Mr. Misthal said. “To the extent that it starts to hit their international markets, then they can be in for a difficult time.” (emphasis added)
This is the key – how weakness in the U.S. economy translates into weakness in foreign economies. Recently, there has been some indication that the effects are starting to spillover, at least to Europe (see European Confidence Declines to Lowest Since 2005).
Confidence among European executives and consumers declined to the lowest in more than two years in April, suggesting the euro’s gains and record oil and food prices are hurting economic growth.
German and French business confidence slumped in April as higher costs squeezed margins, while Spanish workday-adjusted retail sales fell 5.5 percent on the year in March.
“We are living through uncertain times, which makes obviously the exercise of predicting how the economy is going to evolve in the present year and even more in the next year more difficult,” Amelia Torres, spokeswoman for European Union Economic and Monetary Affairs Commissioner Joaquin Almunia, said today in Brussels. (emphasis added)
To me, things seem to be worsening both at home and abroad. And in my opinion, the current U.S. recession (which is practically a certainty at this point) seems likely to result, at the very least, in a significant worldwide economic slowdown, and potentially, an outright worldwide recession.
While it is clear that some European countries are now struggling (e.g., Spain and the U.K.), we should keep an eye out for weakness to spillover to the other EU economies, Japan, China, and India too. Should that happen, we should be especially concerned about the effects on U.S. corporate earnings moving into Q2, Q3, and Q4; as the cheap dollar and foreign sales that have been propping up the earnings of U.S. multinationals would almost certainly disappear.
The markets seem to be unduly discounting such a scenario.
