U.S. Economy: The Good and The Bad

Investors over the past few weeks have been beset by a strong dose of volatility in both news reports and stock markets. Economists disagree on where the U.S. economy will go from this point forward and their forecasts seem to get increasingly divergent by the day. A recent Bloomberg article, “It’s the Dog Days of Summer, Shall We Take a Double Dip?: The Ticker,” discusses varying views on the likelihood of a double dip recession. The article enlightens both the optimistic and pessimistic sides of the issue. Their conclusion indicates that although the U.S. and global economies are clearly moderating, the consensus scenario is that recession will be avoided.

The Bad:

Polls conducted recently by the Wall Street Journal and USA Today reveal that the consensus on the likelihood of the U.S. entering another recession has risen to 30%, twice as high as a few months ago. Economists generally accept that U.S. growth will be slower and unemployment will remain inflated for a longer period of time than previously thought. On August 22, Citigroup, Goldman Sachs, and JPMorgan Chase cut their 2011 and 2012 GDP projections. Finally, the need to reduce government spending will handcuff legislators from adopting stimulus measures and the Fed has few tools left to jump-start growth.

The Good:

The consensus on the likelihood of entering another recession is still below 50%. Bob Doll, the chief equity analyst at BlackRock, states: “Stocks have fallen 15% or more in the past few weeks, but since the Great Depression there have been 30 market declines of 15% -- but only two of those predicted a recession.” Even with their reduced U.S growth outlook, Citigroup will projects a 20% stock increase over the next 12 months. The jobs picture is discouraging, but is still strong enough to avoid recession. To be sure, the 12-month data regarding new jobless claims has improved and bank lending conditions have eased. Credit flows, an indicator of reinvested savings, continue to be adequate. Corporations are generating strong profits and carry record cash holdings. Recessions are usually associated with having a negative bond yield curve (whose short-term rates rise above long-term rates), and right now the U.S. has the opposite. Schwab economists sum up these positives with the observation that the U.S. will avoid recession “due to continued positive leading economic indicators, an improving jobs picture, solid corporate balance sheets and a still-steep yield curve.”

The slowing U.S. economy is expected to have only a limited impact on global growth. For example, Morgan Stanley recently cut global estimated GDP growth in 2011 to 3.9 percent from 4.2. The dramatic fall of world stock markets in the past few weeks, which we consider excessive, discounts a much greater than 0.3 percent drop in global growth. For a more in-depth view of Marietta’s opinions on this issue, please refer to earlier posted blogs “Clouds Gathering on the U.S. and International Economic Horizon” and “Financial Market Turmoil.”

Standard & Poor’s Downgrades U.S. Debt

Wild swings in the U.S. stock market escalated to unprecedented levels last week as the Dow Jones Industrial Average gyrated over 400 points on 4 consecutive trading sessions. Market observers agree that the principal catalyst of this turmoil was the decision by S&P to lower the U.S. Government’s credit rating from AAA to AA+. The downgrade and the market’s reaction raise important questions:

• Was the downgrade warranted?

• Will it have a lasting impact on the U.S. and global financial markets and economies?

The downgrade was promptly supported by some conservative economists even as it was condemned by the White House and prominent financial leaders including Warren Buffett. Stirring the controversy was that neither of the other two rating firms, Moody’s and Fitch, reduced their top ratings. Moody’s sharpened its disagreement with its larger competitor on August 8 by emphasizing on its website its reasons for not reducing its rating (moodys.com).

We accept S&P’s own definition of the proper function of credit ratings; they “express the agency’s opinion about the ability and willingness of an issuer, such as a corporation or state or city government, to meet its financial obligations in full and on time” (standardandpoors.com). By this standard, the downgrade is dubious. The U.S. Treasury has affirmed clearly that its highest priority is to stand behind U.S Government debt and, with the raising of the debt ceiling by Congress and the President on August 1, there is no legitimate doubt as to its ability and determination to honor this pledge.

To justify its downgrade, S&P executives asserted that they were influenced by the messy, acrimonious struggle between Republicans, Democrats, and the Administration to reach a compromise. Here S&P is introducing criteria for a downgrade that is outside their own definition of the purpose of credit ratings. Congressional and S.E.C. investigations into S&P’s action have been launched, and in particular they will focus on whether S&P was motivated by a desire to influence politics. It is noteworthy that S&P is already under investigation by aggravated Euro Area governments for using sovereign debt downgrades to improperly impact political processes.

The initial fear of economists, policy makers and investors was that the downgrade would damage the U.S. economy by driving stock prices lower and bond yields higher. This has not happened. Key governments, including China, promptly declared last weekend that the downgrade would not impact their purchase of U.S. Treasurys. When markets opened after the weekend, investors increased their appetite for Treasury securities and drove yields to lows not seen since the crisis days of late 2008. For the week, the yield of benchmark 10-year Treasurys fell from 2.56% to 2.24%, while 2-year Treasurys dropped from 0.29% to 0.18%. Obviously, investors ignored S&P’s warning and, to the contrary, established unmistakably that in their view U.S. government securities remain the safest investment in the world. Last week’s trading also indicates that bond investors are shifting from credit agencies like S&P to credit default swaps (insurance premiums paid in the open marketplace by bond investors in order to protect against default) to determine the relative credit risk of sovereign debt. The role of rating agencies in sovereign debt markets is fading.

Will the downgrade of U.S. debt by S&P continue to roil global stock markets? We do not think so. Following three consecutive up days for U.S. stocks, it appears that the initial dramatic impact of the downgrade is already diminishing. If the bond market continues to ignore the downgrade, the stock market will likely follow. The real threat to the U.S. and global equity markets is an inability of U.S. policy makers to take decisive action on the issues of deficit reduction and job creation.

We think that S&P has acted unnecessarily and, given the fragility of the stock market and economy, irresponsibly. Fortunately, we do not think the downgrade will have a lasting impact.

Financial Market Turmoil

Recent weak economic reports coupled with the inability of European and U.S. policymakers to deal effectively with sovereign debt problems and adopt growth initiatives has eroded investor, consumer, and business confidence and rattled financial markets. We acknowledge that the global economic “soft patch” will likely be more severe and prolonged than we, and most economists, projected a month ago. Nevertheless, we do not think the U.S. and leading international economies will relapse into recession. The most probable scenario is a muted and delayed recovery that extends the expansion into 2013.

Predictions of gloom and doom, fanned for their sensationalist impact by some of the media, often ignore or underestimate the elements of strength and resilience:

• Surging demand in the fast growing emerging economies will continue to buttress growth.

• Lower commodity prices, especially oil and gasoline, have been a direct consequence of the soft patch and will boost consumer spending and corporate profit margins in the developed countries. In the emerging economies, lower commodity prices will reduce fears of inflation and asset bubbles, enable central banks to curtail restrictive policies, and improve confidence in their future growth.

• Lower interest rates in the U.S., another consequence of the soft patch, will reduce mortgage rates and other consumer borrowing rates, and will alleviate the financial debt problems of states and municipalities.

• Policy makers in Europe and the U.S. have been condemned by the media as “dysfunctional” and rebuked by financial markets. With the added pressure of voter discontent, the policy makers will feel a growing pressure to act responsibly and decisively. We think they will.

• If there are signs of a U.S. economic uptick, huge corporate cash reserves (estimated at $960 billion) will permit companies to hire workers, expand production, update technology and increase R&D budgets.

We are confident that global stock markets a year from now will be higher, and possibly significantly higher. In the near term, however, markets will likely continue to be volatile and highly sensitive to any new geopolitical and/or economic shock. In these circumstances, conservative investors should be more cautious until there is convincing evidence of economic recovery and markets settle down. More aggressive investors should look for bargains among industry-leading companies with strong balance sheets, experienced managements, positive earnings momentum, and attractive valuations.

The negative case for the global stock market has been highly publicized. On the other side of the ledger, the positive case includes:

• Corporate profits continue to grow and exceed estimates. Bloomberg reported on August 5 that over 75% of S&P 500 corporations have outpaced earnings estimates for the second quarter. Wall Street research analysts are predicting an 18% jump in profits in 2011 with an additional increase of 14% in 2012.

• Market valuations are very attractive. The U.S. market has already priced in a severe recession. The S&P trailing P/E ratio of 13.2x is 20% below the average since 1954 (Bloomberg). If the estimates for 2012 are even close to correct, the market looks even less expensive.

• The massive corporate cash reserves will fuel increased dividends, stock buybacks, and merger and acquisition activity.

Our major concern for developed country economies and markets is the expanding mood of crisis fatigue and despair among consumers and investors. Psychology is becoming increasingly important. Policy makers motivated by partisan political advantage and adamantly refusing to compromise have contributed significantly to this pessimism. Synchronized global policy maker cooperation and dynamic action was decisive in arresting recession impulses in 2008-09, and we expect that policy makers in Europe and the U.S. will once again recognize the need for leadership to restore economic growth and elevate investor confidence.