Monday, 15 August 2011

Markets decline, recession coming?

Last week turned out to be another turbulent one for markets.

Stock markets fell for a third consecutive week last week after Standard & Poor's cut the credit rating for the United States to AA+ from AAA the previous Friday. The Standard & Poor's 500 Index fell 1.7 percent to 1,178.81, the STOXX Europe 600 Index slipped 0.6 percent to 237.49 and the MSCI Asia Pacific Index fell 3.3 percent to 121.92.

Policy makers took action last week after the prior week's market declines. In Europe, the European Central Bank bought Italian and Spanish government bonds, helping to push 10-year yields down by more than 100 basis points to about 5 percent. In the US, the Federal Reserve's statement following its monetary policy meeting last week said that the exceptionally low level of the federal funds rate is likely to be maintained at least through mid-2013.

Investors' reactions to the policy actions were mixed. Stocks fell again on Monday even after the ECB started buying Italian and Spanish bonds. Investors reacted better to the Fed move, pushing stocks up on Tuesday following its monetary policy meeting. Although those gains were given back on Wednesday, the rebound resumed on Thursday and Friday, enabling stock markets to end the week on a positive note.

The generally positive market reaction to the Fed's latest move is reminiscent of its earlier moves in 2009 and 2010 when it launched securities purchase programmes that have since been called quantitative easing 1 and 2 respectively. In both cases, markets also reacted favourably to the liquidity injections.

In fact, Edward Harrison at Credit Writedowns goes so far as to call the latest policy action QE3. In “The Fed has already begun its third easing campaign”, he writes:

This is what we just got last week, permanent zero. I believe this is the first salvo in a renewed easing campaign by the Fed. I had been saying full-blown QE3 wouldn’t begin until 2012. In fact, the permanence of the zero to which the Fed has committed is much longer than I had anticipated. I would go so far as to call this full-blown rate easing, one of the three easing policies I identified earlier as QE3 contenders. That’s why you got three dissents at the last FOMC meeting, which you will almost never see at the Fed.

At least one economic report last week provided supporting evidence that low rates will be needed in the US for quite some time longer. On Friday, the Thomson Reuters/University of Michigan preliminary index of consumer sentiment for August was reported to have plunged to 54.9 from 63.7 in July. The August reading was the lowest since May 1980.

Ryan Wang of HSBC wrote in a research note that the August consumer sentiment reading was almost 16 points below the average over the prior 12 months. He said that such declines are a “strong -- although not foolproof -- signal for a downturn in the U.S. economy”.

Somewhat more sanguine is the CalculatedRisk blog, which thinks that the decline in the index “was related to the heavy coverage of the debt ceiling debate, and not due to the usual suspects: gasoline prices or a weakening labor market”. As such, “sentiment should bounce back fairly quickly”, albeit only to an already-low level.

Retail sales data in the US also do not indicate a declining trend in consumer spending. A report also released on Friday showed that retail sales rose 0.5 percent in July, accelerating from a 0.3 percent rise in June.

Most economists also think that the economy will continue to grow. A survey of economists earlier this month by USA Today showed that economists put the chance of a US recession at 30 percent.

Having said that, economists are notoriously unreliable in calling recessions. For example, the last recession started in December 2007 but was not recognised by most economists until well into the second half of the following year. The stock market, which had peaked in October 2007, turned out to be a better predictor.

With that in mind, the fact that, at the end of last week, the S&P 500 closed 13.6 percent below its peak in April is not a good sign for the economy.

However, the full set of historical data show that the stock market itself is also not a reliable predictor of recessions. The stock market, for example, famously crashed in 1987 but no recession followed soon after.

One analyst who did foresee the last recession was John Hussman of Hussman Funds (see “Expecting a Recession”). And unfortunately, he is seeing recession once again. Hussman wrote today:

The composite of recession warning evidence we observe here (year-over-year GDP growth of just 1.6%, S&P 500 below its level of 6 months earlier, widening credit spreads versus 6 months earlier, yield curve spread at 2.2%, Purchasing Managers Index at 50.9, year-over-year nonfarm payroll growth below 1%) falls into a Recession Warning Composite that has been observed in every recession since 1950, and has never been observed except during or immediately preceding a recession.

Hussman's view notwithstanding, the question of whether a US recession is imminent will not be settled soon. The uncertainty over the direction of the economy means that, despite the positive end to last week, the wild ride for markets is likely to continue.

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