Let's Make a (Debt) Deal … and Crush the Market
Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
August 2, 2011
Don't let the headline suggest I'm making light of today's market action. It was an ugly day with the major US equity indices down well over 2% on the day. I don't think it had much to do with the debt deal that passed the House yesterday and the Senate today. For details on that, see our running commentary posted nearby on schwab.com.
Today was about fundamentals, both here and in Europe. We got yet another batch of limp economic news today with weak personal income and spending; while we're still hung over from last week's hit to gross domestic product (GDP) growth for the first half of this year, and all of the recession's era. As a refresher, GDP barely grew at 0.4% in the first quarter and grew a paltry 1.3% in the second quarter.
It didn't help that the S&P 500 crossed below its 200-day moving average, which often begets additional selling by the technically-inclined traders. We should be getting to a point of sufficient oversold and over-bearish technical and sentiment conditions, but not being a technician myself, I won't venture a guess as to when that might occur.
Double-dip?
All of this is only adding to the angst about a potential double-dip recession. Economic luminaries have been weighing in today, and one noted economist—Marty Feldstein from Harvard—puts the likelihood at 50%. Many Wall Street economists are cutting estimates for GDP growth in the latter two quarters of this year. To cut to the chase, I still think we'll squeak by without another recession, but risk is certainly elevated.
It wasn't only stocks that moved dramatically, but bonds, too. The yield on 10-year Treasuries dropped to 2.6%, the lowest since November 2010. It reflects the "stall speed" at which the economy is presently operating, as I noted in my report posted yesterday ("Disappearing Act"). That represents a level of growth low enough that the economy risks losing all remaining momentum and falling into a recession. Of the last 11 recessions, nine were preceded by at least one quarter of GDP growth below 1% in the year before the recession began.
However, low-growth quarters don't always mean pending recession. In the post-World War II (WWII) period, there have been 25 quarters with GDP growth of less than 1% and only 12 of them (as such, less than half) signaled the beginning of or a coming recession.
Maybe not
What do those of us that feel a recession will be avoided hang our hats on? Less than we did before, but we still can point to:
Soaring corporate profits and healthy capital spending (11% of GDP)
A renewed downturn in initial unemployment claims (to a level that suggests 2.5-3.0% GDP growth)
A very steep yield curve (inversions have preceded every post WWII recession)
Pent-up demand, especially within the auto sector
A weaker dollar, which is boosting exports (13% of GDP)
The worst of state/local spending cuts may be behind us
As per the last bullet, Ned Davis Research has a recession probability model that's based on state conditions and it currently has a low 5% probability of a recession. However, the data is only monthly, so the next reading could see an uptick to that likelihood.
Next on the agenda to mull for investors are the decisions by the ratings agencies on the fate of US debt's rating. We discuss the implications of that in our aforementioned daily report on the subject.
QE3 to the rescue?
Also being mulled is the reaction by the Fed to the latest economic sluggishness. Although it's unlikely the Fed is imminently teeing up another round of quantitative easing (QE3), expect the chatter to gather volume as we approach the Fed's annual meeting in Jackson Hole this month. Recall it was at that meeting last year that Ben Bernanke first telegraphed QE2. For what it's worth, PIMCO's Bill Gross believes Bernanke will indeed hint about the possibility of QE3.
We continue to think the bar is high for QE3, but they will certainly be discussing what weapons remain in their arsenal to aim at a struggling economy. After all, as recently as June, the Fed's published its outlook for the economy and forecast 2.7-2.9% growth for this year. That now appears to be a stretch, even with the expected lift toward the latter part of this year.
But there are other things the Fed can do besides QE3. They could lower the rate they pay banks on excess reserves in order to free up more lending liquidity. They could make a stronger pledge to hold their balance sheet at its record high and the fed funds rate at its record low for an even longer "extended period."
Next up … Italy and Spain
As if all the economic angst here wasn't enough, there was yet another eruption of the eurozone debt volcano, with yields on both Italian and Spanish 10-year bonds up to their highest levels since 1997. The debt problems in Europe are becoming a self-fulfilling crisis given the relentless rise in yields that have some concerned less peripheral countries may now be on a path to necessitating bail outs.
Stay tuned for more on all of this from us.
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