One of our firm’s recession models, based on the Philadelphia Federal Reserve’s State Leading Indices, is now putting a near-zero percent probability on a U.S. recession in the next six to 18 months given the January 2012 readings. This is a sharp turnaround from the recession warning triggered in August 2011:
Exhibit 1 – Symmetry Capital Recession Model
While that probability is sure to fluctuate in the months ahead, there are some interesting facets to the underlying data, and some caveats for the longer term outlook.
- The current outlook for all 50 states is positive, an event that has only occurred in 11% of the monthly observations since January 1982.
- At 2.29, the median state outlook is in the top quintile of monthly observations since 1982.
- The median is higher than its last peak in the second half of 2003 and its prior high of late 1999 (Exhibit 2).
- Historically, U.S. GDP has almost always been positive when the median outlook is at current levels.
Exhibit 2 – Median State Leading Index and U.S. GDP
This report continues a string of economic surprises that have unfolded since late 2011:
- In late summer 2011, the U.S. Congress abandoned (however temporarily) its hellbent intent to welch on existing financial commitments, and U.S. budget deficits have remained high.
- In the fourth quarter of 2011, The European Central Bank (ECB) forcefully (but quietly, given the Continent’s morbid fears of waking the ghosts of Weimar) committed to ring fencing the government debt of Italy and Spain for at least the next three years through its Long-Term Refinancing Operations (LTRO).
- Japan’s economy and Asia-based supply chain linkages have recovered following the natural and nuclear disasters in Japan.
All in all, the immediate economic outlook looks fairly upbeat. There are some caveats though:
- The post-2008 recovery (as well as the strongest GDP readings during President George W. Bush’s administration) have been accompanied by significant federal deficits. A resurgence of irrational deficit/debt phobias and policy prescriptions poses a significant risk to markets. Given that 2012 is an election year, perhaps Congress will take a more constructive (or at least less dramatic) approach to fiscal affairs than it did in 2011.
- It’s speculative at this point, but given recent income improvements, the current tax season may take a bite out of those currently large net budget deficits, leading to an economic soft patch at around the same time that equity markets typically start their ‘summer break.’
- As economist Diane Macunovich has demonstrated, demographic shifts in the U.S. do not augur well for domestic GDP in the rest of this decade (see Exhibit 3). The proportion of young adults of household-formation age is set to begin dropping sharply. Thanks to the large current crop of ‘boomerangers,’ there may be significant pent-up demand for household formation that would be unleashed if employment and incomes continue to improve. But such a possibility remains highly dependent on a continuation of easy fiscal policy in our view, and is unlikely to completely offset the negative effects of a sharp contraction in this age group.
- A widely under-appreciated risk (hat tip to Warren Mosler) is the threat of more private-sector haircuts for holders of troubled European government debt. However one might feel about the fairness of such an approach, it would impose a severe shock on the asset side of banks’ balance sheets, leading to a replay—and perhaps an intensification—of the global market turbulence and stress caused by Greece’s debt travails. If unmanaged, it has the potential to threaten the global payments system as badly as the collapse of Lehman Brothers and near-collapse of AIG did in 2008. That would completely undo the benefits realized thus far from the ECB’s LTRO, which already suffers from the extreme policy conservatism of the European Union.
- It’s also important to realize that Europe is still wearing the fiscal straitjacket rather tightly, which limits the ultimate effectiveness of the ECB. As long as this continues, it will pose a risk to the EU economy. It’s important to note that the UK government is making similar mistakes, with similar effects.
- China’s economic growth rate will continue to slow. The extent to which this impacts global financial markets and the world economy remains to be seen.
- And of course, there are always the ‘unknown unknowns.’ Japan in 2011 and the attacks of September 11, 2001 are good examples.
Source: Diane Macunovich
Our Current Asset Class Views
In terms of investment assets, we think it’s worth weighing in on the recent back up in U.S. Treasury yields, given the loud told-ya-so’s from the Death-of-the-U.S.-dollar-and-American-way-of-life Cassandra Chorus. While we have defended long-term Treasury yields in the past, they are much less attractive (at least at this point in time, but if policymakers lead us the way of Japan, that would change) at sub-2% on the 10-year and circa 3% on the 30-year. Furthermore, the recent string of upside economic surprises strongly argues for higher yields. However, this is not the beginning of some fancifully imagined “end,” and we would be likely to add significantly to long bonds once again for the appropriate clients if 30-year yields were to re-approach the 4% level or higher.
In the current environment, non-sovereign corporate credit looks interesting to us, although spreads have come in dramatically since the second half of 2011, and a strengthening dollar could present a meaningful risk to riskier credits (high-yield to some extent, but externally denominated emerging-market debt especially). And as attractive as the world of preferred stocks has been since the last forceful hiccup in Europe, the risk of more private sector haircuts could cause renewed turmoil in that asset class due to intensifying concerns over banks’ balance sheets (financial companies are a significant proportion of preferred issuers). Such an event might present an opportunity judging by policymakers’ and regulators’ behaviors since 2008, but for current preferred holdings, attention to risk seems warranted.
Among equities, we continue to believe that Japan presents a rare opportunity. Although its overall population growth is nothing to write home about, its internal age structure should be in the years ahead (Exhibit 4). And after twenty bitterly disappointing years for Japanese equity investors, its stock markets are ridiculously cheap. One must always be attentive to exchange rate risks and the risks associated with exposure to a single country—the 2011 disasters are instructive in this regard—but the current risk-reward calculus makes Japan a no-brainer in our view.
Source: Diane Macunovich
This leads us to one prediction that I have total confidence in—if Japan’s economy improves as expected over the coming decade, the Japanese Government Bond zombie-vigilantes will shout victory from the rooftops as domestic interest rates rise in Japan. However, if they do so while ignoring an improving economy and equity markets and the fact that their predictions of inflationary collapse aren’t materializing, then they’re being completely disingenuous. Take their words with a grain-of-salt chaser, or better yet, ignore them.