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What Will Drive the Economy? Hint: It's Not the Fed

Discussion of the Fed's lending rate should take a back seat to more important economic movers, such as improving homebuying conditions and bank capital levels.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Many investors have their eyes glued on the Federal Reserve's next move. But is that the right place to be looking to figure out what the path of economy is going to be? I'm here today with Bob Johnson. He is our director of economic analysis, and he says that there are some other areas investors should be more focused on.

Bob, thanks for joining me today.

Bob Johnson: Great to be here today.

Glaser: Let's start with one of the first things that you think an investor should be paying attention to but maybe aren't. Deutsche Bank's equity raise almost EUR 8 billion that they are getting in equity. Why do you think that this is so crucial?

Johnson: Well you know, we talked about the Fed a little bit, and the one thing that the U.S. Fed has done so right is they recapitalized U.S. banks back in 2008-09. And that program really stabilized the U.S. economy and really gave the banks a great position from which to lend to grow from. Europe has been a little bit more reluctant to take firm action on that. This capital raise is certainly a step in the right direction.

Deutsche Bank is obviously the poster child of a poorly run, poorly capitalized bank and has been in many cases. If there was a problem, they were there--AIG and Iceland and many other events, the list goes on and on. And certainly they have kind of ignored or papered over the problem, and I think that's held back a lot of reform moves that could be necessary in Europe because of the status of the banks.

And now they're going out and raising additional capital. We can argue about whether it's enough or not. But at least they are taking the step and admitting the past mistakes and getting the bank recapitalized, which I think is huge.

Glaser: Now would you expect other large European banks to follow suit? Is this the start of a trend, or is it really just one bank?

Johnson: Deutsche Bank's case is particularly acute, and I think they are probably trying to avoid some legislative things that are on the drawing board that may hurt them. But indeed, I think it will make it easier for the others to go say, "I've got a few problems, and I need to strengthen my balance sheet, as well."

I'm hoping this is the beginning of more. Obviously equity values have come up in Europe, and this may be the opportunity to do a little work here.

Glaser: The European Central Bank looks poised to potentially act, as well, to try get inflation to potentially jump-start to get growth out of the basement in Europe. Do you think this will be effective? Will this help on the continent, as well?

Johnson: I absolutely think so. They have been pretty clear that they will, and it looks like to me in the next few months ahead they will have to. Inflation has remained incredibly low, and they are trying to raise that up a little bit so we don't get into a deflationary spiral like Japan. They have really said they'll do what it takes to make sure that that doesn't happen. Certainly the GDP growth in the first quarter that we saw out of Europe was subpar, and inflation was incredibly low. I think the odds are that they probably will end up doing a little something to ease in Europe.


Glaser: Looking back at the United States, one of the big question marks has been the health of the housing market and the lending market, in particular. What's happening on that front? Do you see any changes in terms of housing finance infrastructure that could impact that market?

Johnson: I think there is a lot going on, and there is a big long-term picture about what we do with the guarantors Freddie Mac and Fannie Mae that originate so many of the mortgages that are out there. And without them, we probably wouldn't have a mortgage system right now. And certainly there is a long-term reform plan that Congress probably needs to come up with for that.

But I'm kind of more interested now in some of the short-term issues, where they were actually beginning to look like they were going to be a real hindrance to the housing market. And if I look at what's happened, Mel Watt came in to run the Federal Housing Finance Agency, and what he has done is say "Let's not try to do all this big reform right now internally. Let's stop some of the things that were going to be hurtful to the market, and let's get down to business and make sure the housing market keeps going and keeps adding to the economy."

And so he has taken a number of short-term steps that will help, probably the biggest of which was that some of the loan limits on the Freddie and Fannie mortgages were expected to come down this year. That was the recommendation of the prior regime at FHFA. And that's coming in pretty substantially in California, where the prices were high and they were going to bring that way back in. And that was going to hurt that market. Well, he said, "No. Let's take that off the table for now." And so that's certainly going to help the situation there.

The other thing we have talked about is banks have been really stringent on credit. And what's happened there is, part of the fear was that the FHFA would kind of force the mortgages back to the bank that if somebody misses as much as one payment in the first 36 months, the FHFA would say to the bank, "You must have done something wrong. [This loan is now] yours."

Now they are going to allow up to two missed payments before they will put the mortgage back to the local bank, and I think that's probably good news. And that will make the lenders feel a little bit better about lending out again.

Glaser: Speaking of those tight lending standards, I know you track the average credit score of new loans. What's that been looking like recently?

Johnson: That's another piece of good news is. They only release the data quarterly, and the recent data from Fannie Mae, one of the major guarantors, was certainly indicating a continuing improving trend, but not all the way, nor do I necessarily want it go all the way. Before the crisis began, the average credit score on an approved mortgage from Fannie was about 710.

Then once the crisis hit it, it got to 760. So it really made quite a jump and stayed there for 2009, '10, '11, and '12, and then it backed off just a little bit in 2013. The average for 2013 was 753. And now we got the data for the first quarter, and the number for the first quarter is 741. We are back off from the 760 top. We are not down to the 710; in fact we are not even halfway there. But we are seeing some loosening.

Why is that important? Well I think the credit standards have been so tight that they have really held the market back, and that's part of the reason the housing market, I think, has slowed up here besides that little bit of a jump in price and the slightly higher mortgage rates. So I think that has really held things back.

You could take a look at the auto industry where credit has been free-flowing, and that industry is now back to where they are producing and selling as many cars as they did at the last peak. And the housing market's only selling at half of the last peak and two thirds of its normal levels.

You can kind of see that because of the tight credit, housing is growing slower. But now we have taken some steps to make that a little bit better. And that's really good news, and that's I think the news that people have missed. I think watching what the Fed's doing is probably the wrong thing to do.

Glaser: So taken together, why are these more important than looking at the Fed? The tapering program and when rates are going to rise, why does that not have as big of an impact?

Johnson: I think in a lot of business projects, a lot of homeowner decisions, whether the interest rate is on short-term rates of zero, 0.25%, or 0.50%, or whether the longer-term rate is 2.5% or 3.0%, to an executive or to a homeowner that's not a big meaningful difference in prices. And yes, rates may move a little bit higher, but I really don't think that's the driver.

I think people's confidence in business, where their incomes and employment are, are much bigger drivers. And now also I've been harping forever on housing and lending standards. And I think that those things are really what's going to drive the economy, not what the Fed does in the next six months.

Glaser: Bob, as always, thanks for your commentary.

Johnson: Thank you.

Glaser: For Morningstar, I'm Jeremy Glaser.

Robert Johnson, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.