False alarms as confidence crises overstated

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By Cees Bruggemans, Chief Economist of FNB.

One only may want to say it cautiously, but have the confidence crises been overdone? Too much false alarm? Markets overreacting in their selloffs (equities) or safety rushes (US Treasuries, Swiss Francs, gold)?

If so, what does a correction look like (equity bouncing, Treasury yields rising, gold pullback)? And what are the policy consequences (less haste)?

Recent weeks have seen massive price shifts in major markets, accompanied by a large increase in the ‘fear’ (volatility) index.

This is often simply a matter of increasing uncertainty, not knowing how to interpret incoming news and data, yet having to decide which way the cat is going to jump.

When doing so blindfolded in an increasingly agitated state, miscalls proliferate, as do their violent corrections.

As Nobel Prize winner Paul Samuelson once sagely remarked, the stock market has predicted nine of the last five US recessions.

Given all the market mayhem, the obvious question to ask is perhaps not whether the market has been ‘right’ to make certain calls but whether there may have been miscalls. If so, how many and how serious? Where does that lead?

Financial markets have been severely critical of Europe’s management of its existentialist crisis.

Until very recently the main selloffs occurred in the peripheral country assets clearly underwater.

The overall European edifice had yet to be seriously challenged, though allowing for defensive policy actions “kicking the debt can down the road”.

Until recently.

In the US, the private credit behavior of recent decades had a public equivalent. Yet when the private credit culture crumbled, the public one opted to take its place with not so much as a murmur from bond vigilantes.

US Treasury bonds kept ranking as one of the safest AAA+ assets in the world, indeed the riskless global anchor for the US could never go bankrupt.

It then took a willful political gambit to shake this belief fundamentally, as the US debt ceiling became a weapon in the hands of politicians determined to face a showdown about the future nature of the Republic.

By threatening to keep the ceiling unchanged, this translated into a threat of defaulting on US debt and/or a massive overnight cutback in US government spending and slide into depression.

A lot of grandstanding did have the effect of rattling household, business and investor confidence.

When a last-minute deal was done, it was overshadowed by a rating agency decision to nonetheless lower the US debt rating from AAA+ to AA+.

US politicians had shown they did not have the integrity to run the fiscal finances as responsibly as possible, calling into question whether needed fiscal adjustments could be negotiated in future.

The reaction to this shock decision was interesting.

For some it meant that AA+ was now the new AAA+, for life had to go on, they weren’t obliged by governance mandates to hold only certain assets and now requiring costly portfolio changes, and the US ability to run its finances was judged by most to be unimpaired (though taking cognizance of the long-term future).

For others the symbolic nature of the US downgrading was a severe shock. It implied a loss of stability and an increase in risk.

When nearly instantaneously equity markets started to heave, the proximity of the severe equity selloffs to the US debt down-rating led to conclusions that the downgrade was to blame (an interpretation rife in South Africa as I personally encountered when interviewed for radio).

But was it? For as equities sold off, in the US and abroad, money surged into US Treasury bonds, lowering yields aggressively, for 10-yr bonds at one stage to 2%.

That made the US Treasury an enhanced safe haven and not a downgraded, more risky, asset class.

It isn’t as if the US rating downgrade won’t have longer term consequences. But markets are saying that whatever happens in the future, for now US finances are unimpaired, no matter the liberties taken by politicians.

So the downgrade wasn’t necessarily a long-term false alarm, even if in the short-term some overstated its relevance completely.

Meanwhile a major second feature entered the jousting lists in early August 2011. The world economy was slowing down, led by the US which had had a very poor first half, some of it explainable due to temporary headwinds, but partly to perhaps deeper long-lasting concerns.

Ere long the accumulating anxieties jumped the fence. The slowdown became hailed as the rising risk of a double-dip recession in the US, pulling down the global growth expectations with it.

Many had been suspicious all along about the long lasting depressant effect of debt burdens, the difficulty to regain vigorous growth, the lack of lasting success following massive policy interventions to get growth going again, the sense of hopeless stagnation.

When the evidence of slowdown gradually became visible and was initially presented as temporary, there was still some buy-in. But increasingly anxiety rose, not least because of the intensifying European debt crisis and the US debt ceiling debate.

Though the debt ceiling was lifted, the debt downgrading along with poor data suddenly made sentiment catch fire, greatly increasing the perception that a double-dip recession was imminent or already underway.

It was this that caused the massive equity selloffs (very much Made in America), at least to European eyes.

Federal Reserve indications that it would ease monetary policy by keeping rates low through mid-2013 and that it would maintain the size of its balance sheet (and perhaps lengthen its term structure) while considering yet more tools (QE3?) favourably impacted but this lasted only for a night, as the next rumour hit.

After the EU peripheral troubles in Greece, Ireland and Portugal, June-July had seen Spain and Italy drawn into the maelstrom, too. Market anxiety now further extended its reach to question the remaining French AAA+ status.

As rumours circled about a possible French downgrade, exposed private banks were sold off heavily. Market panic jumped yet another fence, heavily selling off US equities, especially banks.

It was this that really caused the massive equity selloffs (spillover contagion with an EU origin), at least to American eyes.

But then in quick succession it materialized that French (and Italian and Spanish) government actions were bolstering their fiscal deficit reduction and growth initiatives, the rating agencies weren’t going to downgrade French bonds, and the US economic data turned out to be less dire than imagined.

Indeed, global companies have been remarkably successful in maintaining strong earnings growth despite slow growth, explained as a combination of limiting their labour expansion, benefiting from low finance costs, maintaining strict discipline over non-wage costs and seeking technology-assisted productivity gains.

And not least that slow growth is limited to rich countries, half the worlds’ GDP, while the other EM and commodity half keeps going strongly.

Leading US corporate nowadays get half their profits abroad. European and Japanese multinationals are no different.

With the world not in recession, thank you very much, the global multinationals continue well-anchored with mostly (very) strong balance sheets.

The combination of ongoing, if very slow, rich-country growth, Japan’s post-tsunami revival and sustained EM growth, along with resilient corporate earnings performances, proved to be a durable safety net.

As data and policy support shone through, global equity markets bounced vigorously once again.

It seems there have yet again been more false alarms, as much about French ratings and banks as US double-dip recession potential.

None of this precludes yet more false alarms. In coming weeks, as many people come back from their annual holidays, it remains to be seen how a fresh look at the evidence will be interpreted.

Politically, many European countries face major hurdles in getting parliamentary approval for extended rescue mechanisms already put in place.

China remains a dark horse, with many questions asked about its banking system, property market and inflation.

And the US is far from being out of the woods.

Still, it will be interesting to see how pro-active the Fed will want to become shortly in shoring up the US growth performance. If US growth will in any case revive, though remaining relatively weak for now, it may be accepted that this is a new normal for now – a bitter apple but not something that can be completely sidestepped.

This would still suggest more Fed support, but in a measured way. No need to panic. Leave that to private markets.

Source: Cees Bruggemans, FNB, August 15, 2011.

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