SEPARATING the signal from the noise in last week’s market gyrations tested the senses.
The recent US downgrade played out as expected with the attendant stock market volatility.
Add in disconcerting data on productivity and employment costs and the rise in credit default swaps for France and Germany and the global sell-off we are in the midst of makes sense.
I suspect that investors are suffering headline fatigue and are voting with their feet. Our baseline view of the world remains that we will not slip into another recession.
The economy continues to grow, albeit painfully slowly. However, with the release of revised first quarter data on GDP and productivity, along with recent soundings on the manufacturing and service sectors, the risk of another slide into recession is rising.
Watching for this development, our focus remains on employment and consumer behaviour. With roughly 70% of the economy being consumption related, it is the consumer who holds centre stage in this drama. Judging from the increase in July retail sales, the consumer continues to do his part supporting the economy.
The real locus of the current sell-off is Europe. The cost of insuring against German and French sovereign default has increased. The market is clearly worried about France.
Add in the sovereign cost of insurance and increasing risk aversion of European banks to lend to each other and the convulsive reaction to the market becomes clear.
Something is rotten in the heart of the euro area. These stresses will push European policymakers to lean even harder into supporting periphery economies while also buttressing their own fiscal positions.
The news flow from Europe will likely be the driving force for markets going forward.
The fear trade is in vogue. The Swiss franc, gold, yen and US treasuries have benefited from the global dyspepsia. Gold is up more since July 1, the price chart for the “barbarous relic” has gone parabolic in a full-throated repudiation of fiat currencies.
Investors are grappling with two primary questions: will the US slip into another recession and will the euro survive?
While the risks have risen as economic activity has slowed, the fact remains that jobs are still being created, corporate profits remain robust and resilient, and the consumer is still spending. On the survival of the euro, there has been too much political and financial capital expended to let it die.
Currency unification is an enormous and complicated enterprise. Decades in the planning, leaders have shown one consistency: the willingness to do whatever it takes to support one another in the name of economic union.
Undoubtedly, this will lead inexorably to further economic integration and the likely creation of a eurozone ministry of finance – the European counterpart to the US Treasury department. Some have posited the notion that this will create the united states of Europe.
Playing out what would likely happen under different economic scenarios is instructive. Looking at recessions since 1945, the average length of a contraction is 11 months and the decline in economic activity is 1.5%. The stock market, on average, declines 5.5%. Earnings, on average, decline 15.7%. Even if S&P 500 earnings decline 15.7% from the current 2011 consensus estimate of $99.35, the market would still be trading at a Price/Earnings multiple of 14, below its 10-year average. At current levels, Mr Market has more than discounted a recessionary outcome.
What if the pessimists are wrong? With the market trading at under 12 times this year’s earnings, a re-rating of US equities is clearly in order. If the level of corporate profits remains as resilient in the second half of the year as they were in the first, then the S&P should see a 20% or more gain from current levels. If, as expected, the economy does not slip into recession, the market is cheap by several multiple points.
Even with 1.5-2% GDP growth, while not recessionary, such weak growth certainly feels like the economy is in a funk.
:: Andrew Miller is regional office head of Barclays Wealth in Newcastle
