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Financial Insights on Retailing.

The Signs of a RecessionAfter a year of housing market declines and six months of financial market turmoil, the U.S. economy starts off the new year in a recession. I am somewhat loath to use the word recession because it conjures up all kinds of very negative images from the 2001-2002 experience; and I think this downturn will be very different both from an economy-wide perspective and the perspective of the firm.

What makes the difference are the differences in the two business cycles. The 2001-2002 downturn was technology-related. It started with the bursting of the financial bubble in tech stocks. What followed closely after was a round of tech-related bankruptcy that was almost entirely income-statement-related. The entire downturn was made worse by the shifting of technology investment due to Y2K.

This downturn will be consumer-focused and is being driven by a bursting of a financial bubble in mortgage debt. The loss of financing, in turn, is leading to a decline in home prices and the loss of mortgage refinancing money. What will follow will be significant financial service business distress and bankruptcy that is almost entirely on the balance sheet.

The signs of a recession first show up in financial markets, and they are all around us. First and foremost, we have seen large and dramatic increases in risk spreads, the difference between the interest rate on risk-free assets like Treasury bills (T-Bills) and the rate on asset-backed commercial paper (CP). The spread between CP and T-Bill rates should be around 15-30 basis points. Recently, it has been as high as 225 basis points.

Secondly, with higher risk premiums, there has been a corresponding sharp fall in credit creation. Business credit in the three months ending in December fell at its fastest pace since 1973. The contraction in credit creation and the continued tightening of credit is a second leading indicator of a coming recession. Credit creation is what ultimately drives growth; without it, growth has to be financed by internal means or it does not happen.

All of which leads us to the third leading indicator, a decline in corporate profitability.

Profits are what drive the economy. When profits rise, businesses hire more workers, take more risks and make more investments. When profits decline, businesses respond by cutting costs, reducing head count, raising cash and limiting investment, all of which has a negative impact on the economy. U.S. Treasury receipts from profits have declined in five of the past six months. For the last three months through October, receipts from profits fell 30 percent from a year ago.

What will make this recession so difficult from a consumer business perspective is the coming drop in home prices. The decline in home prices is just getting started. Given the build-up in unsold inventories of homes, with the rise in mortgage foreclosures adding to that total, home prices are likely to fall 10-20 percent over the next couple of years. Falling home prices will reduce household net worth by $2-4 trillion, eliminating home equity withdrawal as a source of future consumer spending.

Home Prices% Change, Year-to-YearSource: U.S. Bureau of Census, Case-Shiller

Not all is lost. What will keep this recession relatively mild will be solid growth overseas, giving a boost to U.S. exports. U.S. export growth has risen 15 percent from a year ago. With the dollar's slide on foreign exchange markets, U.S. exports will continue to take market share. Also adding to the mild nature of any recession is the lean nature of inventories. Traditionally, recessions have been deepened by the swing in inventories. Years of investment in supply chain technologies have removed this threat to the economy.

What will determine the longevity of the recession will be the public policy response to it. In the early 1990s, both the U.S. and Japan faced a similar bank balance sheet kind of recession. The U.S. responded vigorously to the problems in the S&L industry, forcing banks to merge or close, selling off assets, rationalizing the industry as quickly as possible. It was not a pretty process and cost the U.S. Treasury some $350 billion. Japan took a different course. It allowed the ailing banks to remain in business and sought to spend its way out of the recession with giant public works projects and dramatic cuts in interest rates. Japan suffered a decade of sluggish growth and deflation; the U.S. got a decade of solid growth and low inflation.

So far, the public policy response in the U.S. has not been encouraging. The Fed has lost a lot of credibility in caving so quickly to the equity markets. In doing so, it has replaced the Greenspan Put with a Bernanke Put. The U.S. Treasury has been even more disappointing. The attempt to create a Super fund to buy up some of the banking system debt has gone nowhere and, by Secretary Paulson's own admission, is only designed to give the banks some time in marking their value-depressed assets to market. The more recent mortgage solution which was given the Orwellian title of the 'Hope Now Alliance' has no chance of giving much hope to anyone. The only impact that any of this will have is to delay the day of accounting.

What to Do?Retailers and other consumer businesses need to plan for the worst while hoping for the best. Cash will remain king. Banks will be no help in raising future capital. Consumers will become even more price-driven as once-abundant home refinance money dries up. Keeping inventories lean, expansion plans modest and labor costs in check will provide a solid financial base from which all consumer businesses will be able to weather the coming storm.

Comments? csteidtmann@deloitte.com
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Author:Research, Chief Retail Analyst Dr. Carl Steidtmann Deloitte
Publication:Gourmet Retailer
Date:Feb 1, 2008
Words:963
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