Policy, Macro

Market Turmoil: Part Deux

September 12th, 2011 | By Nick Sargen


This note updates my initial assessment of the market turmoil that surfaced in early August amid the battle over the federal debt ceiling and the subsequent downgrade of U.S. treasuries by S&P (see note of August 9.) My take then was that the most significant developments were (i) the lowering of U.S. growth prospects by economists to about 2% through 2012, and (ii) the Federal Reserve’s statement that it would keep short term interest rates close to zero through mid-2013.

I deferred rendering a judgment on the fallout of the market turmoil on the economy until there was “hard” data for August. With key reports on jobs and ISM production indices now in, I offer the following assessment

  • The economy is not on the cusp of recession. But it is vulnerable to shocks, growing at only 1%-2% in the current quarter.
  • One risk is the debate over the federal budget could erode confidence further if the political parties cannot agree on a solution.
  • My primary worry is the spreading debt crisis in the euro-zone and strains in European banks, as there is no solution in sight.
  • In this environment, the risk of rising interest rates is low, and we are re-assessing credit risks in the bond market
  • We are neutral on equities, as valuations appear reasonable, but the outlook for corporate profits is diminished

U.S. Economy: Soft, But Not Down

One of the main issues worrying investors is the possibility the recent market turmoil could be a harbinger of a “double dip” recession. Based on the latest readings of the U.S. economy, however, my take is that it is not on the cusp of recession. Indeed, the economy had gained some traction in July, before the political wrangling in the U.S. over the federal debt ceiling and the spreading crisis in the euro-zone undermined consumer and business confidence. One of the fallouts from these developments is that U.S. businesses halted new hiring during August. Nonetheless, two key indicators of the economy – the ISM indices for services and manufacturing – showed those sectors were expanding, albeit at a moderate pace.

The consensus view among economists now is that the overall pace of activity will expand at a 1%-2% rate in the second half of this year. With the economy now at so-called “stall speed,” there is an increased risk of recession down the road. However, several factors that in the past that have been leading indicators of recession -- notably a tightening of U.S. bank credit conditions and rising oil prices – are missing today. Also, there are no significant imbalances in key sectors such as housing and autos: Indeed, activity in these areas remains well below normal levels, and consumers no longer are spending beyond their means. For these reasons, I do not believe the U.S. economy is headed for recession.

The caveat, however, is that there are various risks that could tip the economy into negative territory. One is a major policy mistake; the other is an external shock.

Risk of a Fiscal Policy Mistake

With respect to economic policies, the biggest risk is that the two political parties may not reach an agreement on a second round of deficit reduction that needs to be enacted by December 23. The newly formed Congressional “special committee” has begun deliberations to identify an additional $1.5 trillion in deficit reduction measures over the next 10 years, in addition to the $1 trillion total that was agreed on in early August. If the committee fails to meet its mandate, or if Congress refuses to adopt its proposals, an array of prearranged cuts would kick in amounting to $1.2 trillion.

The latter outcome would pose two threats to the economy. First, it could lead to a further loss of confidence on the part of consumers, businesses and investors. Second, it could also result in “fiscal drag” in which government programs are being cut back at the same time the private sector is curbing spending. Such an outcome could be the final blow that tips the economy into negative territory.

What is so unfortunate is that the looming federal debt problem is completely avoidable: Every bipartisan group that has looked into this issue has reached the same conclusion about how to resolve the problem. Namely, the greatest need is to scale back on surging costs of entitlement programs, especially Medicare and Medicaid, which account for most of the projected spending increases. At the same time, tax loopholes need to be closed to broaden the tax base, which would allow corporate and individual tax rates to be lowered.

Unfortunately, if history is any guide, we cannot assume politicians will make the right decisions. Indeed, the Great Depression in the 1930s was prolonged by policy mistakes around the world, and Japan’s “Lost Decade” was partly attributable to mistakes in fiscal and monetary policies. That said, I still hold out hope that U.S. politicians will realize the gravity of the situation and do what is in the country’s best interest.

The first test will come in the deliberations over the $447 billion package of spending initiatives and tax cuts President Obama proposed to boost the economy. I do not consider the proposal to be path-breaking or controversial: It mainly consists of extensions of unemployment insurance and payroll tax cuts (this time to also include employers), along with increased spending on infrastructure and public schools. The magnitude of the program is not big enough to make a dent in reducing unemployment materially. However, I view it as an insurance policy to preclude fiscal drag in 2012.

The Spreading Crisis in the Euro Zone

My primary concern today is Europe, where conditions continue to deteriorate and policymakers are continually being tested by the markets. Despite all the efforts to bolster Greece, the yield on one year government paper has surged above 80%, and the bond market is now pricing in a default. Italian government bond yields have also edged higher, despite purchases by the European Central Bank (ECB), as investors question the government’s commitment to embark on the austerity program it has announced.

At the same time, investors continue to flock to safe havens such as Germany, where the 10 year government bond yield has fallen below 2% for the first time in history. Also, the Swiss central bank recently announced its intention to limit the appreciation of the franc versus the euro via massive intervention in the currency market.

Even more concerning is the growing strain in the European banks, as reflected in steep declines in their share prices and news reports that some banks may be encountering funding issues. I continue to believe the European authorities will have to take bolder actions to reassure investors that the problems can be contained, and the resources of the EFSF bail-out fund will have to be augmented considerably.

I also recognize how daunting the challenges in the euro-zone are, as negotiations require the involvement of the 17 member countries. With no solution in sight, the situation could deteriorate further before Germany and other creditor countries are compelled to act decisively.

Portfolio Positioning

These developments have caused us to reassess the investment landscape not only for the balance of this year, but also into 2012-2013. With only tepid growth likely in the United States, Euro Zone and Japan and with the Fed on hold through at least mid 2013, the risk of a significant spike in bond yields has lessened. Accordingly, we continue to structure fixed income portfolios close to the duration of their respective benchmarks. Previously, we had been positioning portfolios to take advantage of a steep yield curve, but we have trimmed positions in long-dated treasuries, which have rallied significantly.

The main issue we are debating is how much credit risk is appropriate in a weak economic environment. Earlier in the year, we had cut back on high yield exposure, when spreads were narrow, but we are content to maintain existing positions in high yield and high quality CMBS, as spreads are considerably wider today. We also consider short duration mortgage backed securities to offer favorable yields relative to cash and treasuries.

As regards equities, the U.S. stock market appears fairly valued, and companies have demonstrated an ability to maintain strong earnings growth in a sub-par economic environment. That said, analysts earnings forecasts into 2012 appear too high, and we expect them to be coming down over time. The first test will occur in mid-October, when companies release their third quarter earnings results and provide guidance about the future. In the meantime, we are maintaining a neutral position for stocks versus bonds in balanced portfolios.

This blog contains the current opinions of Fort Washington Investment Advisors, Inc. Such opinions are subject to change without notice. This blog is for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Fort Washington or its affiliates may from time to time provide advice with respect to acquiring, holding or selling a position in the securities mentioned herein. Information and statistics contained herein have been obtained from sources believed to be reliable but are not guaranteed to be accurate or complete.