-Equity markets have seen a waterfall decline, falling 17% over eleven days. Investors have been broadly de-risking as the sovereign crisis in Europe has moved to core countries (France), coupled with loss of confidence in U.S. policymakers (budget crisis), underscoring the realization that fiscal austerity is a drag on future economic growth.
-Market insecurity about economic stability is naturally high in a world in which (i) fiscal stimulus is exhausted and (ii) monetary policy rates are already at zero. As a consequence, equity markets become the real-time EKG of the economy (the only firewall, essentially) preventing us from slipping into recession.
-As we noted in a previous report (see “US Equity Strategy FLASH: Constructing a Post-Downgrade, Post-Smaller Gov’t Portfolio: It Should Be Cyclical” dated 7/28), history shows that fiscal austerity in the U.S. (measured by reduction in outlays) has not been associated with slower U.S. growth, which we believe reflects that governments are not good allocators of capital and, thus, this reduces the “crowding” out of private capital. That said, we believe the risks of economic slowdown in Europe are substantial, reflecting the contraction of liquidity associated with stress in the interbank and funding markets but expect this to have limited spillover risk to a U.S. recession. Why?
The 10-year vs. 30-year U.S. Treasury curve remains very steep, which has a very good track record of predicting recessions.
-Investors remain overly pessimistic about the probability of a U.S. recession, particularly if they rely on equity markets as the cue. Equity markets have predicted three recessions for each actual recession. That said, the recent downturn in equity markets could also tip us into economic weakness with the transmission mechanism being (i) wealth effect on households from a declining equity market and (ii) business confidence undermined as stock prices fall.
-Ironically, the rally in Treasuries following the sovereign downgrade has pushed Treasury yields down 77bp on average —sustained, this translates into $66 billion of annual reduction in U.S. debt service. Something to consider when we talk about budget deficits.
-U.S. corporate balance sheets are basically the strongest ever—there has never been a recession since 1950 that started with corporate balance sheets this flush (cash as a percentage of assets). Cash as a percentage of assets is 11% (ex-Financials), the highest since 1950, and represents excess cash of $836 billion.
-Structurally, we believe the S&P 500 has made a significant bottom (not necessarily in price index yet) even as recession/bear market fears are out there. For instance, the percentage of stocks with a P/E of less than 10x is currently 29%, a level associated with “end of recession” levels. The percentarge of stocks above their 50-day moving average is 0%, a level only seen in 2008 and not any other time in the past 30 years. Finally, weekly RSI at 30 is basically matching the reading on 3/09 (the daily RSI is BELOW 3/09 level).
-Market insecurity about economic stability is naturally high in a world in which (i) fiscal stimulus is exhausted and (ii) monetary policy rates are already at zero. As a consequence, equity markets become the real-time EKG of the economy (the only firewall, essentially) preventing us from slipping into recession.
-As we noted in a previous report (see “US Equity Strategy FLASH: Constructing a Post-Downgrade, Post-Smaller Gov’t Portfolio: It Should Be Cyclical” dated 7/28), history shows that fiscal austerity in the U.S. (measured by reduction in outlays) has not been associated with slower U.S. growth, which we believe reflects that governments are not good allocators of capital and, thus, this reduces the “crowding” out of private capital. That said, we believe the risks of economic slowdown in Europe are substantial, reflecting the contraction of liquidity associated with stress in the interbank and funding markets but expect this to have limited spillover risk to a U.S. recession. Why?
The 10-year vs. 30-year U.S. Treasury curve remains very steep, which has a very good track record of predicting recessions.
-Investors remain overly pessimistic about the probability of a U.S. recession, particularly if they rely on equity markets as the cue. Equity markets have predicted three recessions for each actual recession. That said, the recent downturn in equity markets could also tip us into economic weakness with the transmission mechanism being (i) wealth effect on households from a declining equity market and (ii) business confidence undermined as stock prices fall.
-Ironically, the rally in Treasuries following the sovereign downgrade has pushed Treasury yields down 77bp on average —sustained, this translates into $66 billion of annual reduction in U.S. debt service. Something to consider when we talk about budget deficits.
-U.S. corporate balance sheets are basically the strongest ever—there has never been a recession since 1950 that started with corporate balance sheets this flush (cash as a percentage of assets). Cash as a percentage of assets is 11% (ex-Financials), the highest since 1950, and represents excess cash of $836 billion.
-Structurally, we believe the S&P 500 has made a significant bottom (not necessarily in price index yet) even as recession/bear market fears are out there. For instance, the percentage of stocks with a P/E of less than 10x is currently 29%, a level associated with “end of recession” levels. The percentarge of stocks above their 50-day moving average is 0%, a level only seen in 2008 and not any other time in the past 30 years. Finally, weekly RSI at 30 is basically matching the reading on 3/09 (the daily RSI is BELOW 3/09 level).
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