One of my fondest childhood memories was playing Little League baseball in St. Joseph, Michigan, with my best friend Marty. He played catcher and I played pitcher for the Twins. Our coach, who happened to be Marty’s dad, tortured us with running every afternoon in ninety-degree heat, which we never enjoyed. But we both loved batting and pitching practice. On game day, we would practice our hand signals during class, and fortunately our teacher was a baseball fan. “Go Twins!” he would say when the afternoon school bell rang as Marty and I sprinted out of the classroom towards the baseball field for opening day.

“Play ball!” the umpire shouted. I was on the pitcher’s mound for our first game against the Dodgers and Marty called for a low fastball away from the leadoff batter. “Ball one”…“Ball two”…“Ball three”…“Take your base.” Not once, but twice – I had walked the first two batters. Sure enough Marty’s dad called time out and approached the mound to try to calm me down. With the third batter in a 2-1 count, Marty called for a curve ball. As I threw the ball, I sensed the batter would be swinging, and sure enough, he did. With the runners on first and second base taking off, the batter swung and hit a line-drive directly back at me which I managed to catch and, thanks to Marty screaming “second base”, threw to our shortstop, who stepped on second base then swiftly threw to our first baseman to end the inning. “Triple Play!” Marty yelled. Our team did something incredible! While we ended up beating the Dodgers that day and later winning the league title, it was our team’s only “Triple Play” on opening day that I will always remember.

It turns out that baseball’s “Triple Play” has analogies in the investment world that are equally rare and powerful, and today’s credit markets seem poised to experience exactly what the Dodgers felt on that spring day. Three conditions – (1) declining home prices, (2) weakening corporate profit growth which may lead to downward pressure on stocks, and (3) rising unemployment – are now in play which, when combined, will likely create significant challenges for the U.S. economy and headwinds for investors. Just as a “Triple Play” ends the inning in baseball, it is likely the economy could experience an end to the current business cycle and a recession in the absence of aggressive and immediate monetary and fiscal policy initiatives.

Let’s examine each “Triple Play” factor individually to better understand all three of today’s credit market “outs” before suggesting how investors may want to navigate this environment, given this year’s unique combination of challenges.

Declining Home Prices

We have written extensively about our negative views on the U.S. housing market over the past several years.¹ Housing prices peaked over a year ago, yet typical housing cycles last three to four years, suggesting that prices will likely not bottom until 2009 or 2010. Though housing price declines started last year, the downside risks to prices have only intensified amid high and rising inventories, a pick-up in delinquencies, continued adjustable-rate mortgage resets, tightening credit standards and reduced credit availability. As a result, housing prices nationwide will likely decline up to 15% peak-to-trough. In Florida and California, where inventories are alarmingly high and speculators, creative financing, and subprime mortgages long ruled the market, price declines of 30% peak-to-trough are possible.

Why do we remain bearish on housing? First, inventories remain elevated due to significant imbalances between supply and demand in both the new and existing housing market. On the supply side, inventories are greater than nine months’ supply for new homes and over ten months’ supply for existing homes (Chart 1). Despite significant price concessions and discounts for new homes, the inventory of 505,000 units² remains elevated. Meanwhile, an existing home inventory of 4,273,000 units is up +12% year-over-year.³ Combined, the overhang of unsold homes is near its highest level in decades. At the same time, nationwide home prices have started to decline, loans have become more difficult to obtain, and cancellation rates are rising. New buyers are also becoming less willing to purchase a house because prices are declining. Consumers are now recognizing housing prices can fall, and investing in a home isn’t always a one-way, profitable trade. Yes, you can lose money in housing!

The second reason we are bearish is that delinquencies for both prime and subprime mortgages are on the rise (Chart 2). Mortgage lenders extended marginal loans (prime, alt-A and subprime) in good times when borrowers needed only minimal down payments. The use of adjustable-rate mortgages (ARMs) in a low interest rate environment allowed borrowers to afford larger homes, while past double-digit price gains attracted many investors seeking quick profits. In higher price areas of the country, the use of ARMs resulted in increased speculative activity and further price run-ups. Many of these homes were not even occupied, evidenced by the material rise in homeowner vacancy rates over the past few years (Chart 3). Housing prices will likely come under further pressure as speculators abandon homes with negative equity, causing more delinquencies and rising foreclosures. Because foreclosed homes are typically auctioned off at 20% to 40% discounts, the outlook for housing prices is quite negative.

The third bearish factor for housing is that mortgage resets will remain elevated throughout 2008 and into next year (Chart 4). An analysis by Credit Sights estimates two million ARMs will reset in the next two years, which could lead to over 1 million borrowers losing their homes.⁴ This additional inventory of homes will be coming back into the market at the time when housing is already oversupplied. While the current Bush/Treasury proposal attempts to provide some relief on ARM resets, its scope is limited to subprime resets and does nothing to address prime resets. It also targets borrowers who financed with 97% loan-to-value ratios (LTVs) or higher, and only during a specific time period. While a few hundred thousand people may stay in their homes for a little longer under this plan, the government’s approach may ultimately have the unintended consequence of lifting mortgage rates, because bond investors will demand extra compensation to take on heightened regulatory risk.

Finally, asset quality deterioration and increasing regulatory scrutiny is making lenders less willing to extend credit. On the lender side, financial firms and banks have so far only written down approximately $56 billion of loans. According to a recent research report by Citigroup, another $125-185 billion in losses and write-downs remain to be implemented.⁵ The days of low documentation, phony appraisals and no down payment loans are gone. With lenders increasing scrutiny of borrowers and requiring larger down payments, the pool of potential homebuyers will continue to shrink.

What are the implications of declining housing prices for the broader economy? Consumer confidence and spending will come under increasing pressure. Up until last year, annual housing price gains were exceeding the financing cost, or mortgage rate, from 2001 through 2006. In mid-2005, for example, housing prices nationwide were up at a rate of +13.5% year-over-year, and at the same time, mortgage rates were 5.5%.⁶ This positive spread of +8% generated rising return expectations, and confidence that real estate was a great investment. It also helped propel home prices to unaffordable levels for many potential buyers. Nevertheless, the five-year journey up to 2006 helped create an enormously positive wealth effect, helping to elevate consumer spending to 72% of gross domestic product (GDP). With the relationship between housing prices and mortgage rates now sharply negative, consumer spending is likely to weaken considerably (Chart 5). The first “out” in the economic “Triple Play” is declining home prices and the negative spillover effect on consumer spending.

Weak Corporate Profits and Lower Stock Prices

Companies make money when consumers spend. Unfortunately for Corporate America, consumer spending is likely to slow materially this year as consumers are negatively impacted by pressure on housing prices. Consumer debt levels are high, and personal savings rates are low (Chart 6). High energy and commodity prices are further squeezing consumers’ purchasing power. At the same time, credit availability to consumers is receding across all asset classes, including mortgages, credit cards, and auto loans. This is particularly troublesome because tighter credit will negatively impact corporate profits. The link between mortgage debt and profit growth has been strong over the past 20+ years (Chart 7). Housing price gains enabled easy credit availability, which in turn provided collateral for debt growth which stimulated consumer spending.

The corporate bond market has begun to price in an increasing risk of default and economic recession. Credit spreads for investment grade companies have widened across the overall market, and particularly in the financial sector. Credit investors have begun to price in a significant increase in bank write-downs and a decline in corporate profitability. Ironically, it appears the equity market, up until the past month or so, had ignored these signals from the credit market (Chart 8).

In our U.S. Credit Perspectives from November 2007 titled Driver or 2-Iron?, we highlighted this divergence between credit and equities, suggested future pressure on corporate profitability and stocks, and mentioned the credit markets were likely to be the leading indicator in this economic cycle.⁷ Investment-grade credit spreads are now approaching recessionary levels, indicating significant headwinds for economic growth. Over the past six months, credit spreads in cyclical sectors have widened more than the overall market, as investors have become more concerned about the health of the consumer.  A pullback in consumer spending, combined with poor corporate profitability, will be negative for business investment. In addition, if economic growth deteriorates, or if we enter a recession, stock prices are likely to come under significant pressure (Chart 9). Historically, the average peak-to-trough nominal decline in the S&P 500 over the past ten recessions since 1948 has averaged 22.6%.⁸ Assuming the average decline for this cycle, the S&P 500 could fall another 15% if the U.S. enters a recession.

Although credit markets are foreshadowing these heightened risks, equity analyst forecasts of double-digit earnings growth for this year suggest a more positive outlook.⁹ As a result, stock prices could come under significant pressure over the course of this year should corporate profit growth fall short of consensus expectations. In addition, government revenues are now coming under pressure, according to comments by Peter Orszaq, the head of the Congressional Budget Office, who notes, “the slowing is most marked in corporate tax receipts.”¹⁰ Together, the negative wealth effect from falling stocks and home prices would be a double whammy for consumer spending and the economy this year. This risk of weak corporate profit growth, and its potential for negative impact on the stock market, is therefore our important second “out.”

Rising Unemployment

Historically, profit growth tends to lead employment trends by roughly six months (Chart 10). S&P 500 operating earnings turned negative on a year-over-year basis last quarter. Going forward, future profitability is likely to take a further hit given significant write-downs. This is particularly the case in the financial sector, where banks are facing further asset quality deterioration. Weak earnings and sub-par economic growth should lead to softer job creation and rising unemployment this year.
 

As a result of rising unemployment, the worst news for the housing market may be yet to come. Today’s high level of housing inventories has occurred in an economic environment that has yet to experience significant and prolonged deterioration in the labor market. Job growth throughout last year held up relatively well, and the unemployment rate only last month jumped to 5%. Should the U.S. economy head into recession, the unemployment rate could climb another percentage point or more, resulting in a further hit to housing prices and consumer confidence, and hitting consumer spending from all angles.

Unemployment also has a significant slowing effect on income growth. This trend will happen at a time when consumers are becoming increasingly dependent on their jobs to offset negative trends in net worth, debt and savings. Consumers spend freely when their income and net worth are rising, and when they can readily borrow and tap into savings. But with slower income growth, a lack of wealth effect, and more cautious lending, consumers may have no choice but to moderate spending and cut back on debt levels. Given these trends, consumers need to rely on their jobs to maintain spending. For these reasons, rising unemployment is the final “out” of our “Triple Play.”

Policy Response to the “Triple Play”

As a result of the “Triple Play,” monetary policy will likely transition throughout this year from modest rate cuts over the past few months to more aggressive initiatives, including the return of 50 basis point cuts, starting as early as January 31, 2008. Chairman Bernanke signaled such a move at a January 10 speech, when he said the Fed “stands ready to take substantive additional actions as needed to support growth and to provide adequate insurance against downside risks.”¹¹ We continue to believe the Fed will have to lower the Fed Funds rate to 3% nominal or lower, and 1% real, in order to restore economic growth. Through aggressive rate cuts, the Fed can contribute to a more positively sloped yield curve which may, over time, help financial sector profitability, foster risk taking and encourage renewed lending back into the economy.

Fiscal policy initiatives could also be forthcoming. President Bush, in his upcoming State of the Union address on January 28, 2008, will likely propose fiscal relief in the form of tax cuts for low- and middle-income workers and investment incentives for businesses. The markets will likely begin to price in increasing odds of a fiscal stimulus bill; however the magnitude and timing of these initiatives remain unclear. The Federal budget remains in deficit and future individual and corporate tax revenue growth is set to decline as the economy slows. Republicans and Democrats appear sharply divided on how specifically to allocate tax stimulus. As a result, our best guess is that fiscal policy, while increasingly likely, may be delayed and too weak to offset sufficiently the headwinds of today’s “Triple Play” of declining housing prices, weak corporate profit growth and rising unemployment.

Credit Strategy and Relative Value

In terms of credit strategy, PIMCO continues to maintain a high-quality bias in portfolios, emphasizing investment grade versus high yield based on both relative valuations (Chart 11) and our cautious economic outlook. We emphasized “defense” throughout 2007, having under-weighted credit overall, moved cyclical sectors (home builders, building materials, paper and consumer cyclicals) to large under-weights, and emphasized credits tied to healthy global growth (energy, metals and mining and emerging markets) and non-cyclical, defense sectors (utilities, healthcare, pipelines, telecom and cable). Over six months ago, we increased under-weights in the retail, REIT and cyclical sectors, anticipating future weakness in housing and a sharp slowdown in consumer spending.

Recently, we have added selective credits, mainly in the banking sector, through the new issue market where relative valuations have become attractive. While PIMCO’s top-down and bottom-up investment thesis in credit was beneficial in 2007, we believe the combination of the “Triple Play” themes described above will allow for further upside in our defensive credit positioning. This in turn may create significant potential opportunities for our clients.

The back-to-back nature of today’s credit market “outs” has increased the chance of recession. While monetary and fiscal policy is likely to come to the rescue, asset prices are now falling at a time when the availability of credit is falling. At the same time, employment growth is softening. Under these circumstances, consumers and businesses will both de-leverage in an attempt to repair balance sheets and raise liquidity. On the corporate side, recent equity infusions from both private equity and sovereign wealth funds into selective U.S. banks and brokers indicate this transition has begun. We expect to see rising share issuance, dividend cuts and asset sales over the next several quarters. Our transition from “defensive” to “offensive” may therefore occur over a more extended period as we wait for opportunities to develop in both the banking and financial sectors as well as in other areas. Given the uncertainty of both U.S. monetary and fiscal policy initiatives as well as in the global macroeconomic outlook, we are maintaining our defensive bias in credit.

The “Triple Play”

Watching baseball today brings back many great memories of my childhood and our Little League team’s “Triple Play” that opening day. In watching the credit markets now, I can’t help but wonder if many years from now I will reflect back on today’s credit market “outs” with a similar scene in which our team was able to navigate through an incredibly rare period. The “Triple Play” is very uncommon, however as was the case for our baseball team, our talented portfolio management, credit and quantitative team looks forward to the challenge of managing risk and identifying opportunities during these interesting times. While Marty and I are no longer practicing for “opening day”, PIMCO’s team of portfolio managers and credit analysts can’t wait to “play ball” this year, in the hopes of continuing to generate strong performance in the credit markets for our clients.

Mark Kiesel

January 11, 2008

¹ Please see For Sale, June 2006, U.S. Credit Perspectives, and Still Renting, May 2007, U.S. Credit Perspectives.