Macro

2011 Q1 Market Commentary: Déjà Vu All Over Again?

April 13th, 2011 | By Nick Sargen

At the start of this year, investors were notably upbeat about the prospects for the U.S. and global economy owing to resurgent economic growth and accommodative fiscal and monetary policies. The positive sentiment continued into February, when the U.S. stock market at one point stood nearly 30% above its end-August levels.

More recently, market volatility has increased in response to a series of unforeseen developments. They include widespread turmoil in the Middle East/North Africa, a horrific natural disaster in Japan, and renewed concerns about European sovereign debt. Accordingly, we are analyzing how these developments have altered the economic outlook and investment landscape.

We detect several changes. First, worries about inflation have increased in the wake of surging prices for food and energy. Forecasts for headline CPI inflation in 2011, for example, now range between 2%-3% compared with less than 2% at the beginning of the year. However, projections for the core rate – which exclude food and energy components – have changed very little and remain slightly above 1%.

Second, forecasters are scaling back projections for economic growth in the United States, mainly in response to the $15-$20 per barrel rise in oil prices in the past two months. The consensus is now closer to 3.0% compared with 3.5% previously. Similarly, those forecasters who were calling for growth to reach 4% or more have lowered their projections by about half of a percent or so.

Third, the policy response around the world is becoming more diverse. The Federal Reserve and Bank of Japan are likely to keep short-term interest rates near zero this year. However, the European Central Bank recently began to raise rates, and an increasing number of emerging economies are tightening monetary policies as well.

Taken collectively, these developments have increased uncertainty and caused us to reassess both risk and reward. Over the past two years, the winning strategy has been to take risk in credit markets and in equities on grounds that the global economy would improve. The principal exception occurred last spring and summer, when the U.S. stock market sold off by more than 15% while treasuries rallied, amid fears of a “double dip” and deflation. The question we ask, therefore, is “Could this happen again?”

Our assessment is that several factors lessen the risk of recession and deflation. First, while economic growth of 3% or so is not robust considering the severity of the recession, the composition of growth has improved recently. Specifically, it reflects a broad-based improvement in final demand, rather than a temporary increase in inventories. Furthermore, the pickup in demand is coming from the private sector in the form of increased consumer spending and business investment, rather than from increased government spending. On the financial side, businesses have ready access to capital markets, and banks have begun to expand consumer and industrial loans.

The main factor that would cement the case for a sustained expansion would be evidence of strong jobs growth. On this score, we are encouraged by the steady downward trend in jobless claims in the past six months, the recent improvement in nonfarm payrolls and the drop in the unemployment rate to 8.8%. That said, we also acknowledge that the rate of underemployment (which includes part-time workers who are seeking full-time jobs) is considerably higher at about 16%.

The biggest risk to the outlook would be a spike in oil prices linked to potential supply disruptions in the Middle East and North Africa. As noted earlier, the recent increase of $15-$20 per barrel to $100-$110 for West Texas Intermediate (WTI) is estimated to have lowered global economic growth by roughly half of a percentage point. While a rise of this magnitude does not pose a serious threat to the global economy, we would be concerned if oil prices were to reach the previous peak of $140-$150 per barrel: Such an increase would represent a significant tax on consumers and could undermine confidence. The impact on the global economy would also depend on whether policymakers responded by raising interest rates to counter the inflationary impact of higher oil prices, or by becoming more accommodative to offset the deflationary impact.

By comparison, we see other global developments as having more limited impact. The horrific earthquake, tsunami and nuclear disaster in Japan is a human tragedy that is hard to fathom. However, the history of natural disasters is that the period of devastation is followed by one of reconstruction and renewal. And we believe this will be true in the current crisis.

With respect to Europe, the sovereign debt crises in Greece, Ireland and Portugal are back in the news again, and their default probabilities have spiked. A key difference from a year ago, however, is that these countries now have access to financing through the European Financial Stability Facility (EFSF). Also, the good news is that Spain has managed to distance itself from the problem countries. This is very important, as Spain is a pivotal country that could determine whether the crisis is contained or morphs into a bigger issue.

In light of these developments, we have not made significant changes to our investment strategy. We continue to believe stocks will outperform bonds this year, but we also recognize that the period of steady gains is over. While the stock market has doubled in value over the past two years, we do not think it is extreme, considering that corporate profits have surged to record levels and top-line revenue growth is improving.

Looking ahead, one of the main issues investors will have to grapple with is how the Federal Reserve will handle the completion of its quantitative easing (QE) program. At this juncture, we do not expect the Fed to announce a new program. However, we are unsure whether it will maintain its balance sheet of securities around the current level of $2.6 trillion or allow it to shrink gradually. We will be monitoring this situation closely, as it could have important implications for treasury yields and risk assets. In the meantime, we are not deviating significantly from our benchmarks with respect to duration.