Bund Tbond and the bernakka's und trikeko's injection VM199
- Creatore Discussione gipa69
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.... ma fleurs non c'è ?
gipa69
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Is it a good time to start adding to one’s equity portfolio? David Rosenberg at Merrill Lynch looks to previous episodes of emergency Fed easing for insight, and says it depends on whether the Fed is already too far behind the curve and the economy is headed for recession, or whether the crisis remains relatively isolated to the financial markets:
If all this is just a financial event that does not morph into an economic event, then now would be the time to start chipping away at the equity market — adding risk and cyclicality along the way. This is exactly what happened when the Fed eased in October 1987, June 1995 and September 1998. In all three cases, the economy withstood the financial shock and the equity market received relief not only from lower interest rates – which is almost always good for P/E multiple expansion – but also from the strength in the economy, which provided an added lift to corporate earnings. In fact, in the fourth quarter of 1987, which included one of the ugliest days in the stock market in recorded history, real GDP soared at over a 7% annual rate. The economy didn’t skip a beat. And, while the economy did endure a soft landing in 1995, much of the softness was export-related to the turmoil in Mexico hitting the domestic manufacturing sector. Consumer spending in the third quarter when the Fed cut interest rates was growing at a 3.5% annual pace.
Fast forward to the third quarter of 1998, and even though the stock market corrected and the corporate bond market froze due to the spreading impact of the Asian turmoil, Russia’s default and the LTCM fiasco, real GDP growth was an amazing 4.7% annual rate.
Looking at what happened to the financial markets during these episodes, Rosenberg reports:
Each of those times, the Fed cut the funds rate 75 basis points. Three months after the first volley, the 2-year Treasury note was flat, though 10-year yields were down 16 basis points on average. Baa corporate spreads were unchanged. But in the ensuing three months, it became evident that the factors that drove the Fed to ease were temporary and related to financial spasms as opposed to more fundamental economic strains. Both 2- and 10-year yields were up more than 10 basis points from the time of the first Fed rate cut and Baa corporate spreads tightened more than 20 basis points as risk appetite returned.
This was also seen in the VIX index, which dropped an average of 8% both three and six-months after the first Fed ease. The dollar dipped 0.5% in that first three-month period when the Fed cut rates, but recovered by month number six (-0.5% in the first three months and swings to +0.6% in the DXY by the sixth month).
This then cuts into the price of gold, which is down 2½% on average both three and six-months after the first Fed cut. Oil prices dive at first, but recover quickly as the markets buy into the view that the economy is not going into a downturn (WTI slips an average of 13% in the first three months, but six months later completely recovers and is up 2.7% from the time of the first cut). The CRB index, which is flat in the first three months, is up an average of 2% after the Fed first cuts rates in these episodes when the Fed rate cut is dealing with a temporary financial dislocation only.
And what of the stock market?
Fed rate cuts that end up saving the economy from slipping into recession in the past was fertile ground for the bulls. While there was turmoil ahead of the Fed ease, what happens after the rate cut is this:
- The S&P 500 was up 9% three months after the fact; up 14% six months after the first ease; and up 17.4% the year following that initial rate relief.
- The Russell 2000 surged and outperformed right away — up 9% in three months; NASDAQ up 13.2%.
- Financials, especially the banks and asset managers, tech, and retailing across every category were the sectors to be most heavily weighted in, but it pays to note than three-, six- and 12-months after that first rate move, all 10 S&P sectors were in the green.
In terms of asset mix, in these phases of Fed ease but no recession, it is a case of stocks>bonds>cash by a huge margin right through both the first three- and six-month periods after the first rate move. A year later, stocks retain leadership, but cash begins to outperform bonds as the Fed rate cuts sow the seeds for a higher inflationary phase as the lags from the easings kick into their highest gear.
However, this is only half the picture. We also have to ask what happens when the Fed steps in too late to save the day and economic growth turns negative. Episodes of Fed easing coupled with negative economic growth can be found in the early 80s, 90s and 2001:
In these phases, the Fed cuts the funds rate, and cuts it hard. On average, it is down 215 basis points in just the first three months. A year later, the funds rate is still 100 basis points lower than it was at the start of the cycle.
The curve steepens — the 10-year note yield rallies 90 basis points in the first three months, though that is where most of the rally takes place. A year out, the yield is actually 25 basis points above where it was when the Fed began to cut. This is in part because the economy, at that point, is out of recession. Keep in mind that the bond market leads the Fed; therefore, much of the rally out the bond curve occurs ahead of the rate cuts and in that first three-month period. This is a time to be reducing credit exposure as the Baa corporate spread widens an average of 15 basis points in the first three months; though a year out, it ends up narrowing by 9bps — again, because by then, the recession is over (they last 10 months typically). This is one reason why limiting the analysis to “what happens in the coming year” is dangerous because you miss out on a lot of the action in that first three-month period after the Fed cuts.
In those first three months after the Fed cuts rates, but it’s too late to save the economy, the dollar drops 0.8%; and is down 1.6% six months out. Gold as a result is firm, gaining 11% in the first three months and rising 17% six months after the first cut. Note, however, that oil is down 3.0% and 5.5% respectively over those time intervals and the CRB index is down 3.0% in the first three months and remains down 3.0% in the first six months. Outside of the dollar induced rise in gold, commodities are to be avoided. And, the VIX index surges an average of 28% in those critical first three months. So, buy vol but sell after that third month because it begins to recede as the Fed moves aggressively to dampen the recession pressure.
Back to the equity market in these stages when the Fed cuts rates, but the economy slips into recession, the S&P 500 is flat, the Russell is down 4.5% and the NASDAQ is off 5.3%, so this is a move to quality, large-caps and defensive names for the most part in that three month period after the first rate cut. Utilities, drug retailers, food products, and tobacco are the places to be. In contrast, tech, especially semiconductors, industrials, restaurants, and the banks do not fare very well over that initial three-month span.
In these periods of Fed ease and recession taking place in tandem, the asset mix in that crucial three months after the Fed went was bonds>stocks>cash. Between that third and sixth month, the equity market begins to discount the recovery and the optimal asset mix shifts to stocks>bonds>cash. A year after the Fed cuts, and usually the economic downturn is behind us by then, the asset mix that typically worked best was stocks>cash>bonds. This is why it is not good enough to just look at what happens a year later — there is constant rotation that takes place, or should take place, along the way.
Turning to the question of whether we are headed for a recession, Rosenberg first says the Wall Street rule of thumb of two successive quarters of negative GDP growth is not correct and turns to the NBER’s definition that ‘A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.’ The problem here is that the NBER normally calls a recession some two years after it has begun. Rosenberg also points out that while the consensus call is for soft growth ahead, ‘the consensus has never before called for a recession, even on the eve of the recession’:
The outlook, says Rosenberg, is not so positive:
The one reliable statistic of whether the economy has entered into a recession is that lagging indicator otherwise known as the unemployment rate. There has never been a time when it has risen 0.5 percentage point from the cycle low – this is true whether or not the starting point was 2% or 8% – and the economy failed to land into a recession.
Fast forward to today and the unemployment rate stands, as we said above, at 4.65% and this compares to the 4.4% level posted in March, so it is already up 0.25ppt from the low. Basically – we are already halfway there. And if, say, the unemployment rate rises to 4.9%, we will be prepared to make a more definitive call. We certainly will not wait around for the NBER announcement! As an aside, our forecast has the jobless rate hitting 4.9% by early 2008 and peaking at 5.7% by the end of next year.
We also adapted the Fed recession probability model using the yield curve with 3- month LIBOR, and the 10-year note as well as the Fed funds rate is pointing to 64% recession odds. This model has been flashing 65% odds for a recession to occur over the next year. So, even if we do manage to avoid a recession, the odds right now are rising and clearly much higher than just 50-50. In both 1991 and 2001, most economists did not know we were in recession when we were in fact knee-deep in it.
A host of additional factors are provided to support the case:
- Unemployment rate up 0.25ppt already to 4.65% and history shows that 0.5% or higher means recession has arrived. It’s the change that matters, not the level.
- Housing starts down 35% year-over-year this cycle – these foreshadowed recession in seven of eight cycles (exception was mid-1960s due to rampant fiscal expansion under LBJ).
- Auto sales have fallen in five of the past six months and are down 10% year over-year – every recession followed such a decline.
- Conference Board’s coincident-to-lagging indicator at 96.7 is at a level that in the past presaged recession – every time. See chart below.
- The University of Michigan consumer sentiment reading at 83.3 in August was lower than it was in March 2001 (91.5) and July 1990 (88.6) when the last two recessions began.
- Employment at employment agencies is a leading indicator at best, a confirmation signal at worst, and is -3.3% year-over-year as of July. This only happens in or around recessionary economic phases. As an aside, financial services employment, which surged 700,000 this cycle, is now in the process of rolling over. Lehman just shuttered its subprime lending unit – laying off 1,200 jobs in the process.
- We are still waiting for ISM to drop below the 50 mark – but looking at Philly Fed, the deterioration in customer inventory sentiment, and looming auto production cuts, this is likely coming by 4Q. After all, GM just announced that it has well in excess of 110 day’s supply of inventory on many of its key models and is going to adjust this by cutting overtime shifts at six of its North American plants.
- The Fed funds/10-year yield curve has a superb track record in calling for recessions, and yet is always discredited for some reason. In the context of a Fed tightening cycle, inversions in the Fed funds/10-year note yield curve have had an 85%-plus success rate in predicting recessions and the lag is typically 14 months; range of eight to 20 months. Recall that the curve inverted in July 2006, so the clock is ticking.
Quite the bearish case.
