What if US falls into a recession?

Preferred themes in times of global uncertainty.

While the idea of a recession is technically defined as a decline in a country’s gross domestic product (GDP) for two or more consecutive quarters in a year, the American National Bureau of Economic Research sees it simply as “a significant decline in economic activity across the country”.

With the US possibly flirting with a recession, what should Singapore investors do?
What are some stocks worth looking into?
Recession or not?
Recessions are generally thought to be recognizable only after they occur,which is why there is much ongoing debate about the present state of the US economy.
During March before the current sub-prime housing crisis had fully manifested itself, former Federal Reserve Chairman Alan Greenspan had mentioned that there is a one-third probability of a US recession in 2007, a distinct contrast to the outlook stated by the Fed officials back then.

However, according to the co-founder of the Quantum Fund Jim Rogers during October, he believes that the US has already entered into a recession.
A poll carried out by CNN during the same month also revealed that 46% of the American citizens hold that belief. While some may maintain that the US economy is not yet into a recession, many would argue that it is unquestionably on the brink of one. Listed below are the factors that have brought about this present economic uncertainty and may further serve as the tipping point.

Sub-prime housing concerns.
US sub-prime housing issues should be well-imbued into the minds of anyone who reads the morning papers by now. Its impact was not confined solely to the housing-related industries – numerous banks and hedge funds have registered astronomical losses as well due to defaults in mortgage payments and asset devaluation while in several cases, have even led to bankruptcy for some. Currently, those which have filed for Chapter 11 include sub-prime lenders New Century Financial and Ameriquest, mortgage lender American Home Mortgage, on-line bank NetBank and cash-management firm Sentinel Management Group.
As of Nov-07, it was also estimated that a total of US$30bn in sub-prime related losses had been recognized by banks, while an additional US$8-US$11bn is still pending from Citibank.

Actions undertaken by the Fed to mitigate this crisis has been the lowering of interest rates by 75 basis points so far, although it has also injected US$41bn into the money supply for banks to borrow at a lower rate. The size of this injection by the Fed has been the single largest amount prior to 19 Sep 2001 when US$50.35bn was poured in to response to the fallout from the Sep 11 terrorist attacks. Meanwhile, in October, a group of US banks (Citigroup, JPMorgan and Bank of America) backed by the US government introduced a “super fund” of US$100bn in hopes of restoring liquidity to the market through the purchase of mortgage backed securities whose mark-to-market value had nosedived in this sub-prime crisis.
Despite all the remedies that have been engaged thus far, however, the sub-prime housing issue looks set to worsen. It has been surmised that 16% of the estimated US$1.3 trillion(around US$200bn) in sub-prime mortgages were in default as of Oct 2007. Taking into account that higher refinancing rates are in store for US$500bn worth of sub-prime mortgages for the next 12 months, this would undoubtedly place additional pressure on the homeowners while the original US$200bn figure is set to balloon even further. Banks, funds and mortgage lenders holding on to their mortgage backed securities would undeniably receive another hit.

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with their losses escalating.
Soaring crude oil prices. While the recent pullback in crude oil to US$90 from US$99 comes as a relief, higher prices are seemingly here to stay. Refinery constraints, geopolitical concerns, hurricanes and excessive speculation all look to contribute even further to oil’s rampant rise from its 2007 low of US$50.48. The International Energy Agency has also cautioned during October that the rapidly growing appetite for fossil fuels in China and India is likely to keep oil prices high for the foreseeable future and would threaten global economic growth. It noted that these two countries had accounted for more than two-thirds of global oil demand for the last 18 months and that demand for oil in China would eventually equal the entire supply from Saudi Arabia.

Appreciating fuel prices that consumers and businesses have absorbed earlier in the year could now be tipping the US economy into recession, according to the chief economist at Global Insight who was formerly a Federal Reserve economist. Fed Chairman Ben Bernanke seems to agree, as he told Congress during November that high oil prices places further restraint on growth while accelerating inflation. Coupled with concerns over the housing market, crude at US$120 could very well serve as the coup de grace for the US economy.
Declining US economic growth. According to the US Bureau of Economic Analysis (BEA), GDP had expanded at an annual rate of 4.9%in 3Q07 which was its fastest pace in four years.
This positive showing was attributed to higher contribution from exports and an increase in inventory investment. The devil is in the details, however, as growth was not balanced with nearly half of which came from the aforesaid two factors. The housing component recorded a seventh straight quarter of contraction and shaved off a full percentage point from the growth rate. Corporate profits also fell by US$19.3bn or 1.2% after a US$94.7bn increase in the second quarter.

Ever since hitting its peak at 3.6% in 2004, economic growth in the US has been on a downtrend. After the figures for 3Q07 were released, forecasts for full year growth in 2007 now range from 2.1% to 2.7% with the private sector (the Blue Chip Economic Indicators survey)being the most pessimistic. Government officials from the White House saw a better picture and pegged growth in 2007 and 2008 to be 2.7%. The FOMC, however, thought otherwise and expected a range of 1.8% – 2.5% GDP growth for next year. All three bodies concurred that economic expansion is set to fall even further.

Figure 1: US GDP growth and estimates
US GDP growth FOMC White House Blue Chip Economic Indicators
survey
2008 (F) 1.8% – 2.5% 2.70% 2.40%
2007 (F) 2.4% – 2.5% 2.70% 2.10%
3Q07 (A) 4.90%
2Q07 (A) 3.80%
1Q07 (A) 0.60%
2006 (A) 2.90%
2005 (A) 3.10%
2004 (A) 3.60%
Source: Reuters

A weakening US dollar. After rising approximately 500 bps from 119.00 to 124.00 in the first half of the year, the USD/JPY currency pair whose movement is highly correlated to the DJIA, has now fallen to around 110.00 as investors unwind from their carry trade positions.

The drop in the US dollar is also evident in the USD/CAD currency pair, where it nosedived from 1.1800 during the start of the year to hit parity on Sep-07. Commodity crosses told a similar story as the Aussie dollar rose 8 cents against the US dollar to 0.87 while the New Zealand kiwi jumped roughly 6 cents so far for the year. The rival currency of the US dollar, the Euro, also hit its alltime
high of 1.4960 during Nov-07.

As if to further exacerbate the situation, the Gulf Cooperation Council (consisting of Saudi Arabia, Bahrain, Kuwait, the United Arab Emirates, Qatar and Oman) are to meet for the Doha

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Summit in December to discuss breaking their respective currencies from the US dollar peg.

Meanwhile, Chinese officials have also expressed their intent to diversify the nation’s US$1.43 trillion reserves in response to the falling buck. Comments from Greenspan that the Euro will eventually be the world’s reserve currency also did not instill much confidence to the US dollar.
Consumer spending in the US accounts for around 70% of its economy. As such, if the purchasing power of the US consumer were to decline dramatically, this would inevitably raise concerns over the sustainability of the whole economy. The inclination by the Federal Reserve to cut interest rates for the foreseeable future that would further weaken the US dollar does not help.


WHAT TO DO
Given the uncertainty surrounding the US economy, what are investors to do?

The overallmarket may weaken, but we see strength in particular sectors. Companies riding on the domestic reflation story – banks, property and construction companies - should benefit. Banks have been hit particularly hard in recent months as a result of the US subprime crisis, but have stabilized in the last couple of weeks. Of the Big Three, UOB should be the biggest beneficiary of mortgage financing of residential projects due for completion in the next 2 years. Margins are also expected to head north as the macro climate improves.

Notwithstanding the high oil prices, transport companies also offer a good shelter for investors should the weather turn nasty in the US. We like SMRT for its organic growth and cost efficiencies. Ridership on its trains is expected to grow a healthy 6% in 2008 on the back of Singapore’s strong economy, which has bolstered employment and discretionary travel (eg
shopping on weekends). While 6% growth may not seem to be impressive, it actually is so due to cost efficiencies. For example, in its 2QFY08 results, revenue inched up 5%, but net profit actually jumped 25%.

StarHub, Singapore’s second largest telco, is another play into the domestic growth story. It has its tentacles in telco (mobile and fixed), Internet and cable services and is growing nicely through its “hubbing” strategy. With mobile number portability (MNP) coming on in the second quarter of 2008, StarHub is in a good position to improve its market share. At 5.2%, it has the best yield among the telcos.

Media giant SPH has a few positive drivers in 2008 – robust publishing business, higher retail property income and earnings coming through from its Sky@Eleven project, which was sold out shortly after its launch earlier this year. One of the biggest draws of SPH is its attractive prospective yield of over 7%, one of the best among the blue chips.

Offshore and Marine is another sector that is worth looking into. Order books running into billions of dollars are locked-in and run till 2011. The forex debacle at SembCorp Marine and Labroy Marine threw up some doubts on the industry’s internal controls and practices, but these cases seem to be the exception rather than the norm. We believe second-tier players like ASL Marine and Sinwa have the potential to outperform its industry peers in 2008.

ASL Marine is a fully integrated marine company with a strong focus in shipbuilding, shiprepair, shipchartering, and other marine related services, catering to customers mainly from Asia Pacific, South Asia, the Middle East, and Europe. The strong demand for offshore oil and gas exploration activities is driving up orders for new support vessels. As a result, it is sitting on record ship building orders of over S$600m. It is also riding on the back of booming infrastructure development in the Middle East.

Sinwa, a regional marine supply and logistics company, services the oil and gas industry and sea-going vessels in Singapore, United Arab Emirates (UAE), China and Australia. The ship chandler is expected to benefit from the buoyant shipping industry, especially from its 7 ports in China. Its fledgling Australia operations, which support the offshore marine activities, turned around in second quarter of 2007 and is expected to be profitable for the full year.