I just wanted to get some thoughts down, partially to clarify my own thinking. Feel free to disagree and point out any mistakes.
Causes for Recent Moves
There appears to be several possibilities. The non-exhaustive, non-mutually exclusive list includes:
1) The risk of the downgrade causing margin calls and the unwinding of significant amounts of mark-to-market leverage in our economy
2) the risk of a double dip recession in the US, along with the recognition that fiscal support will be unavailable, and monetary support very weak
3) The risk that the lack of any bids in Italian and Spanish debt will blow up the EU, or at the very least create a sharp recession there.
The risk of (1) fortunately has a very short half-life. Given that there haven’t been any reports of leveraged entities going under yet, this risk appears likely to partially dissipate over the short term, and may well explain the bounce today. Indeed, one reason banks were the hardest hit yesterday was because they are some of the most levered entities in our economy. Also supporting this view is the fact that Libor-OIS has remained stable. Unfortunately, this risk will continue to hang over bank shares until the US gets back onto a sustainable fiscal trajectory.
The risk of (2) appears more likely, although the consequences are much less severe. The ISM print was pretty bad, and corporate spending is one of the key remaining pillars of US growth. However, the risk of a very bad recession in the absence of a full blown financial meltdown appears low. The typical contributory factors to a recession – overbuilding, overinvestment – are not present outside of the real estate sector, simply because we’ve only had 2 years to rebuild, which was also off of a very low level. However, compounding this risk is the fact that there is very little room left for fiscal or monetary stimulus, as well as the fact that the federal budget trajectory will be contractionary for the foreseeable future. These factors all suggest a decent probability of at least 1 quarter of marginally negative GDP growth. I note here that the risk of a Japan type deflationary spiral in the early 90’s is unlikely to replay here, mainly because liquid financial assets are not excessively overpriced, while mark to market leverage has fallen.
The risk of (3) is probably the most uncertain. There are several open questions, including the impact of the wide spreads on Spanish and Italian growth, the impact of the spreads on EU bank lending behavior, and whether the ECB or the EU are willing to increase support for the market. As the perceived risk of each item is negative for growth, risk premiums will remain high. Unfortunately, this is a reflexive process that will clearly get worse over time unless a solution is found. Fortunately, the immediate economic impact on the US will remain small unless things get out of control. This is probably something the stock market will remember over the intermediate term.
The Next Step
The market is now in the process of adjusting to the above risks, which will take time. How the non-financial economy reacts to recent headlines and market moves is also crucial. The amount of leverage in the economy increases the prospect of a reflexive process, whereby expectations alter fundamentals. In particular, growth expectations has been revised down sharply over the past couple weeks, which explains part but not all of recent moves.
QE3 is clearly on the table now, although it is likely to be only marginally effective as stimulus, given that treasury yields are already at or below levels from last October. The key obstacle is the rebound in inflation, but this appears to be clearing away given that Core PCE appears to have peaked.QE3 may also be initiated if we get a negative GDP print. Eitherway, it appears likely and the bond market is pricing it as such. However, although treasuries could conceivably rally further, 2% coupons in the face of even 3% nominal growth is too rich. A possible outcome is a continued rally through the QE3 announcement, followed by a sell off. It is conceivable that the rally extends to 1.5% if recession fears take hold.
If earnings can remain stable, as I think they can, the S&P is very cheap. On both a trailing and forward basis, the S&P P/E is at levels from 4Q08 and 1Q09. This suggests decent upside for equities, even if we do get a quarter or two of negative GDP growth. Earnings expectations could certainly fall further, but the scope for a sharp drop is not there, for the same reasons that we are not likely to get a deep recession. In the meantime, it will take time for equities to price in the various risks and find a clearing level. Based on these arguments, we are likely not too far away from there. A likely QE3 down the road could act as a catalyst for higher prices.
The bearish trend for the dollar is unlikely to be reversed. Almost every conceivable scenario involves some sort of dollar debasement. A catastrophic drop is not likely simply because there are no good alternatives to the USD. This will probably continue until the US deleveraging process concludes.
The Long View
There are twokeypoints. First, trend real US Growth is probably ~1% until the overhang of excess housing stock dissipates over the next 5 years or so. The unskilled labor pool in the US is effectively idle until new houses start getting built again, as manufacturing jobs are unlikely to return. State and Municipal budgets, which have been contracting over the past several years, are also highly correlated to this vector. The 1% figure also makes sense given recent data, asthe 3% growth we saw in 2010 coincided with a sizable fiscal stimulus. Second, the level of leverage in the global economy increases the importance of expectations as they relate to fundamentals. This is the reflexive process described by Soros. Simply put, leverage increases the power of feedback loops.The deterioration in the condition of the EU periphery and the correlation of financial asset performance to the announcement of QE are both examples of that.
There are multiple takeaways, but I will only note two here. First, economists continue to talk about ‘stall speed’ for the US economy, which is a level relative to where they see trend growth. Many economists, including those at the Fed, continue to see trend growth at 3% or higher. As a result, 1% prints, even though it is trend growth, will elicit additional policy actions. In other words, the Fed is going to continue easing over the next few years, at least until they revise down their estimate for trend growth. The effect on yields, stocks, and the dollar from this is straightforward. Second, unless the EU and/or ECB officials deal decisively with the structural issues, the issues with the periphery will continue to worsen. Italy and Spain cannot pay 4% on their debt when growing at 3% or less nominally. The longer it takes to resolve this issue, the higher the average coupon will be. The effects are likely to have the largest impact on EUR rates and the EU equity risk premium.