In a tumultuous year for global equity markets, a flicker of optimism has emerged, igniting hope among both analysts and traders. While previous rallies this year proved to be fleeting, the prevailing sentiment is one of renewed possibility. The driving force behind today’s surge in international markets appears to be the anticipation of further stimulus measures. President-elect Obama made waves on the talk show circuit this past weekend, pledging an unwavering commitment to support, bail out, and revitalize the economy upon taking office. Similar promises from governments globally are fostering confidence that additional stimulus initiatives are forthcoming.
While it remains to be seen if this optimism can sustain a prolonged market rally, the combination of appealing equity valuations, depressed prices, low interest rates, and government spending commitments are drawing attention. Though timing remains unpredictable, the stock markets are currently accounting for significant pain, as the table below illustrates.
The major concern is the trajectory of the global economy in 2009. Are equities sufficiently priced in light of what lies ahead? Perhaps, but clarity will only unfold gradually. The future remains hazy, and perhaps even more so than usual, as the U.S. recession is still grasping its early stages.
Our ongoing concern that economic hardships would intensify before any recovery truly begins has been validated by today’s November employment report. According to the U.S. Labor Department, nonfarm payrolls plummeted by 533,000 last month—the sharpest decline since 1974 and the sixth-worst figure recorded since 1939.
The labor market, quite frankly, is hemorrhaging, and it’s unclear when this will stop. The negative momentum is palpable. The Federal Reserve must act swiftly, potentially lowering the Target Fed Funds Rate to just 50 basis points, if not further to 25 basis points, while amplifying unconventional monetary practices like quantitative easing. With interest rates so close to zero, these alternative methods of injecting liquidity become crucial. However, their effectiveness remains uncertain, yet hesitation is unwarranted at this juncture.
The primary battleground against deflation and recession is now in Congress, focusing on fiscal stimulus. Unfortunately, a political dilemma complicates matters. The economy can’t afford to wait until President-elect Obama takes office late next month. Allowing the economic situation to continue unchecked over the next seven weeks could exacerbate the already troubling circumstances. It is essential for the Bush administration to collaborate with the Obama transition team and work together with the outgoing Congress.
While it might be early to anticipate a sustained stock market rally, it’s never too soon to examine potential future trends.
We’ve compiled various insights that shed light on cyclical patterns, including the critical question: When will the bear market come to an end? As of November 20, the current downturn is the most significant in the post-World War II era concerning the S&P 500.
Prior to the recent November rally, the year-to-date loss for the S&P 500 had at one point surpassed even the staggering 43.3% drop observed in 1931, as noted by Morningstar’s Ibbotson division. Whether we will see further record lows by the end of this year remains uncertain. As of last night, the S&P 500 had decreased by less than 40% on a total return basis—a painful statistic, yet somewhat better than the November 20 closure’s 47.7% year-to-date loss.
A single blip does not define a trend.
The uptick in our comprehensive measure of October’s data seems promising, yet it’s likely just an anomaly—a momentary respite within the broader bearish trajectory.
We are referring to our proprietary CS Economic Index, an equal-weighted metric that encompasses 17 leading, coincident, and lagging indicators tracking the overall economic trend in the U.S. Nearly half of this index’s composition comes from leading indicators. Our chart below shows that the October index registered a modest rise—the first after four consecutive monthly declines. As monthly economic data has a time lag, October’s figures were only recently completed as of last Friday.
Unfortunately, this isn’t indicative of a recovery. Much of the October blip can be attributed to reduced interest rates, which positively impact our index. Ordinarily, lower rates provide a bullish boost to economic activity both in the present and future. However, the current situation is anything but ordinary. The effectiveness of lower interest rates now seems diminished in the real world, despite their appealing statistical appearance.
Just a few months ago, contemplating this scenario seemed unimaginable. A year prior, it was utterly out of the question. However, the unbelievable occurred yesterday when the 10-year Treasury yield plunged to unprecedented lows.
Closing at 2.69% on Tuesday, this marks a record low. The unmistakable implication is that the market anticipates deflation or something eerily close to it. In their rush to secure a safe investment, investors have driven government bond prices skyward, resulting in yields reaching astonishing lows.
This outlook predominantly stems from the frail state of the economy. “The broader context for these exceptionally low Treasury rates is the most sluggish economy we’ve seen in at least a generation,” Jay Mueller, senior portfolio manager at Wells Capital Management, informed BusinessWeek. “We are confronted with a profound recession, and the Treasury market is reflecting that view.”
The prescribed response to deflation entails making money cheap, and the Federal Reserve is exerting every effort to achieve that. Currently, the effective fed funds rate stands at approximately 0.5%. However, this raises the challenges associated with the so-called zero bound.
According to the National Bureau of Economic Research, the recession officially commenced this past January. With that clarification, we can turn our attention to a pressing issue: When will it conclude?
Various indicators may provide insight into the timing of the business cycle. Predicting the turning point has always been challenging and is even more so given today’s complexities. The severity of the economic and financial crises complicates matters. During this perfect storm, discerning the signs becomes an arduous task. Moreover, the Federal Reserve’s anticipatory monetary policies further muddle the landscape. Traditionally, the Fed raises rates to temper economic growth; now, however, they’ve been reducing rates in anticipation of a recession. Given that Bernanke and his team are running out of room for rate cuts, we face a dilemma if the downturn lasts longer than typical.
Meanwhile, conventional data sources that typically gauge the business cycle are offering an array of mixed signals. As Bob Diele from NoSpinForecast.com recently advised, various economic and financial indicators suggest different forecasts regarding the timing of the economic contraction. Has it just commenced? Is it nearing its conclusion? Or does it lie somewhere in between? Each of these scenarios carries weight based on the data points highlighted.
For instance, the chart below from NoSpinForecast.com illustrates that, disregarding the NBER’s announcement, a simple review of GDP suggests that economic activity peaked earlier this year, potentially after the 2.8% annualized growth in Q2 2008. Observers might reasonably view Q3’s -0.5% GDP decline as a potential starting point for the recession, especially since most economists predict an even steeper Q4 downturn, and 2009 appears bleak as well.
Source: NoSpinForecast.com
Year-over-year comparisons of nonfarm payrolls also hint at a similar forecast. Historically, these comparisons tend to steeply decline ahead of economic troughs. Clearly, the labor market has been weak this year, suggesting that the peak may have recently passed. Diele points out that year-over-year variances in nonfarm payrolls often align with periods of economic distress.
The stock market, on the other hand, may indicate that we are deeper into the cycle and closer to economic recovery than either GDP or payrolls suggest. Historically, equity markets tend to decline ahead of economic troughs. Given the significant losses experienced in the market this year—including notable negative signals from rolling 12-month changes—one might infer that Wall Street anticipates an economic bottoming process.
Finally, consider the yield curve’s behavior, which may indicate that the economic trough is well behind us and that recovery is underway. The curve has inverted periodically over several years, leading to the belief that an imminent rebound is on the horizon. However, we must remain cautious about oversimplified interpretations of these signals.
This array of metrics is usually synchronized in identifying the business cycle’s position. Yet this time, the divergence in signals is more pronounced. Maybe this reflects the unpredictability of a year when traditional indicators have faltered. The challenge remains in discerning which metrics may be providing misleading signals. Our intuition suggests skepticism regarding the financial spread, hinting that the contraction may have further to run.
The thorough losses experienced in October began to ease in November. Although the month remained challenging for various asset classes, bonds played a pivotal role in halting the extensive downturn.
Except for high-yield debt, bonds generally rebounded in November, providing relief from the significant declines seen earlier. The U.S. bond market led this recovery, with the Lehman U.S. Aggregate Bond Index surging by an impressive 3.3% last month, as illustrated in the table below. Foreign government bonds in developed markets followed closely behind, rising by 3.2%. Notably, even the struggling emerging market debt managed a 1.7% gain in November. TIPS and cash also recorded positive performances.
However, other asset classes suffered ongoing declines, with REITs being particularly affected—plummeting nearly 25% in November, adding to their substantial losses of over 32% in October. Since the summer, REITs have experienced a nearly 50% decline.
While the extent of these losses is noteworthy, they align with a broader trend. As the chart above indicates, double-digit losses have become increasingly typical. It’s unclear whether the correction has truly reached its conclusion. The market is likely to continue reassessing the potential for future economic and financial issues until investors find clarity about what lies ahead. Currently, confidence remains elusive, leaving sellers in control.
Nonetheless, we should appreciate small victories. The fact that November offered some respite from total losses—even if temporary—hints that the worst of the carnage may be behind us. Valuations appear somewhat favorable, prompting long-term investors to consider future opportunities rather than dwell on past losses.
That said, considerable volatility is likely to persist, accompanied by significant declines across asset classes. With shattered confidence and a population still evaluating the recession’s severity, it is a modest achievement that some of the red ink was cleared from the records last month. Some may view this as progress.
The financial markets have been struggling for over a year, but the economic troubles are just beginning, as evidenced by today’s slew of sobering news.
The most alarming indicator is the reported drop in personal consumption expenditures (PCE), which fell by 1% last month—marking the most significant monthly decline since September 2001. Unlike the aftermath of the 9/11 attacks, which had a temporary and mostly unrelated impact on an otherwise recovering economy, the current situation reflects a persistent downturn. When terror struck in 2001, there was an emerging economic wind at our backs; today, we face a strong headwind, and it’s likely to grow stronger in the coming months.
The significant pullback in spending cannot be attributed to income, which actually increased by 0.3% last month, up from a mere 0.1% gain in September. The data suggests that consumers are now prioritizing saving over spending. In some respects, this shift is encouraging, as the savings rate has been on a downward trend for years due to elevated consumption. However, this reversal of trends is detrimental in the short term, as the economy relies heavily on consumer spending—about 70% of total activity. Thus, this sharp decline in spending foreshadows a significantly weaker Q4 GDP than the earlier reported Q3 decline of -0.5%.
Have we seen a familiar story unfold? It certainly sounds like a déjà vu.
Once again, the government has stepped in to rescue a financial institution, and initially, the market reacts positively. Yet, as reality sets in, the cycle begins anew. Perhaps a true sign of a recovery will emerge when the government orchestrates a bailout and the market declines on the news.
However, we are not there yet. The latest round of intervention revolves around the once-mighty Citigroup. For now, the stock market—including Citigroup’s shares—has responded positively, at least in the early part of the day.
Citigroup, a giant within the financial sector, represents the epitome of the “too big to fail” concept. If any institution necessitates a rescue at any cost, Citigroup fits the bill.
With total assets exceeding $2 trillion in September, this figure accounts for approximately 14% of the annualized U.S. GDP for the third quarter.
This year will undoubtedly be remembered for numerous reasons, most of them negative, harsh, and rather bleak. Nevertheless, 2008 will also be noted for offering remarkable opportunities to strategic investors. Conversely, it may also be remembered for the scarcity of investors willing or able to take advantage of these opportunities.
That’s the nature of the financial landscape. When anticipated returns are low, investors flood the market; conversely, when risk premiums rise, market participation dwindles—especially when fears of economic depression abound.
Consider the chart below, illustrating the astonishing risk repricing currently happening within the market. The spread on junk bonds compared to Treasuries has reached extremes not witnessed since the inception of high-yield bonds as an asset class in the 1980s. Presently, this asset class offers yields nearly 1,700 basis points above the 10-year Treasury yield. The market is reticent to accept such offers, contributing to the high spread. For context, in June 2007, this spread had compressed to below 260 basis points, a level investors were enthusiastic to accept.
There are myriad reasons for shunning such attractive yields, just as there were numerous justifications for accepting narrow spreads in June 2007. It is essential to remember that appealing yields often accompany economic downturns and increased default rates in the junk bond sphere. They don’t earn the label “junk” for no reason.
