After broad rallies from mid-March through May, the markets have cooled down and, generally, stabilized. So what lies ahead for the U.S. financial markets and economy? Thomas Dillman, Executive Vice President of Mutual of America Capital Management Corporation, takes a close look at the current status of the economy, the continuing impact of Federal Reserve programs, news from within the corporate sector, and the prospects for a lasting recovery.
As we have documented in our periodic Economic and Market Perspective reports, the global economy fell off a cliff last fall. In the U.S., the Gross Domestic Product contracted by an annual rate of over 5% in both the 4th quarter of 2008 and 1st quarter of 2009. Results in other developed economies were similar, while growth rates diminished dramatically in higher-growth developing nations. A review of almost any data series anywhere in the world from October last year through at least February of this year confirms the free fall that occurred with respect to trade flows, industrial production, consumer spending, capital spending, lending, and of course, corporate profits.
Economy Flattens Out
Inevitably, such a precipitous contraction was destined to slow down. It is that notion, subsequently supported by a host of "green shoots," the metaphor for "less bad" or even positive economic data, to which global equity and bond markets have been responding so positively since early March. The S&P 500 Index advanced nearly 36% from early March through the end of the 2nd quarter, while the Russell 2000 Growth and Value Indexes are up 45%–50%. Most other equity markets around the world, especially among developing and emerging economies, are up 50% or more.
We've documented the fact that this powerful global equity rally from March through May was consistently driven by the smallest, cheapest and lowest quality stocks; in other words, by the riskiest assets available. The dramatic 1,000-point-plus contraction in high yield spreads over that time period represented a similar willingness by bond investors to buy the riskiest assets. It is important to note that during this time, economic and financial system fundamentals remained extremely weak. In addition, the powerful rally in stocks was based to a large extent on hope that recession was likely to give way to recovery sometime within a reasonable time frame, probably before year-end.
As yet, however, the data have not turned definitively positive. Serious long-term structural problems with the domestic economy remain, including continued rising foreclosures of home mortgages, increases in unemployment, a rising consumer savings rate reflecting a cutback in consumption, cutbacks in inventories and capital spending budgets by most corporations, and soft export markets.
In the meantime, the financial crisis, which provided the accelerant to a global economy already headed into recessionary meltdown in early fall 2008 as the result of the housing crisis, has been met with an aggressive set of monetary and fiscal initiatives globally. These seem to have stabilized the situation for the time being, much as they have contributed to the flattening out of the economic contraction.
What Happens Next?
We are now at one of those points in an economic cycle where the outlook becomes a lot more difficult to discern. Key questions facing investors include: Are there more unforeseen events that might precipitate panic in financial markets and/or another free fall in the economy? And, if we have reached a bottom in economic contraction, what is the likely trajectory of growth going forward?
The candidate scenarios include: the classic "V" (a precipitous decline followed by a dramatic snap-back); the vintage "U" (decline, plateau at low levels of activity, then recovery) or its stretched variant (plateau phase for an extended period of time); the rare "W" (so-called "double-dip," or "head-fake"); or the dreaded, but never yet seen, "L" (perpetual economic stagnation).
We are waiting to see if all of the liquidity and stimulus measures put in place, both domestically and globally, will have their desired effect. As noted, they do seem to have stabilized the situation for the time being, as things do not appear to be deteriorating. And, in fact, there have been some signs of improvement.
Stimulus Plan Still in Early Stages
It is worth noting that of the $780 billion U.S. stimulus plan, only $150 billion has been authorized, and only $40 billion has actually be allocated, so the bulk of the stimulus is still ahead of us. On the other hand, some of the programs initiated to address problems in the financial system have been less than successful, and their continuation is in question. Three examples include: TALF (an attempt to restart the securitization market for credit cards, auto loans, etc.); the Private-Public Partnerships designed to rid toxic assets from bank balance sheets; and the Obama administration's plan for the renegotiation of 4 to 5 million mortgages.
Similarly, the Fed's aggressive program to purchase government bonds and asset-backed securities has been met not with lower, but higher mortgage rates, a result contrary to its stated purpose. Also, notwithstanding all the liquidity programs designed to buttress bank lending, banks are not lending. Even though the large banks have passed their "stress tests," while most have raised capital and half have repaid TARP, the bad assets at the root of the crisis remain on the banks' balance sheets. Moreover, their negative consequences are only being held in abeyance by a suspension of mark-to-market accounting. Furthermore, the positive yield curve created by exceptionally low Fed Funds rates and relatively high long-term rates will take much longer to help banks build capital without a resurgence in lending, which as noted, has not occurred.
Eye on Corporate Earnings
The near-term movers of the markets are likely to be 2nd quarter earnings, scheduled to begin to be released early in July, and then the normal spate of economic data as they are disclosed during the 3rd quarter. Corporate 2nd quarter earnings are likely to be similar to those of the 1st quarter, with some marginally positive surprises, but with continued caution on the part of companies regarding the outlook. The degree of caution versus optimism in comments by companies will be somewhat influenced by the economic data as they are released. The most likely consensus assessment will be that the economy has "stabilized," meaning that it is no longer contracting, but with relatively limited conviction in any one trajectory scenario for the future, leading to sideways and somewhat volatile markets.
Longer-term issues will serve as a backdrop for second-guessing the stimulus and recovery efforts. For one, President Obama's recent Financial System Regulatory proposal will, as it wends its way through the congressional committee and corporate/trade group lobbying circus, make it difficult for investors to assess the profit prospects of financial services companies, except to suggest that growth will be constrained by additional regulation. Markets in general do not react well to uncertainty, so handicapping the likely outcome of the debate on the ultimate regulatory framework for the U.S. financial system will probably provide a headwind to sustained stock advances.
Additionally, the President's top two legislative objectives, Healthcare Reform and Environmental Reform ("Cap and Trade"), prompt larger questions, such as: How much more spending, and how much more debt, can the federal government pile on in addition to the stimulus efforts? And, what's the exit strategy before we precipitate a crisis for our sovereign debt rating and the value of the U.S. dollar in the global financial system?
A Long and Winding Road Ahead
In terms of economic prospects, we are of the opinion that a "V" shaped recovery is unlikely, but that we will begin to see a gradual improvement during the latter half of this year, and probably more of the same in 2010.
Growth will likely be labored, uneven and slow, with occasional signs of strength, but lingering constraints to the types of powerful advances we had witnessed over the prior 30 years. That means corporate earnings growth will probably return to its longer-term trend of about 5–7%. Price-earnings multiples will likely remain in the 12–15 times range – typical of periods of sustained but slower growth – rather than the 15–20 times range witnessed in the late 1990's and the middle of this decade.
In such environments, security selection tends to be the key driver of excess investment returns for equity markets. Security selection will also play an important part in bond portfolios, because in weak economic environments cash generation needed to operate and refund debt, and thus remain solvent, is essential.
Should inflation become a problem in the future, as it could given the recent flood of liquidity and the massive buildup of national debt, multiples could fall to the 8–12 range, although that is not our expectation. The current excess productive capacity in the global economy, coupled with what will likely prove to be at least a partially effective "exit strategy" from the stimulus regime of the past year (based on the admitted hope that the Fed has, or will create, the tools necessary to do so), should hopefully make inflation a manageable problem. But markets will surely go through episodes of fear that the domestic economy will experience both inflation and anemic growth, or "stagflation," which generally results in subpar or negative returns.
To complete the metaphor that opened this essay, after having fallen off a cliff, we're injured and limping along and a long way from being out of the woods. And when we do get to the clearing, the scenery may not be particularly attractive, and the going will likely remain tough for some time.
The
views expressed in this article are subject to change at
any time based on market and other conditions and should
not be construed as a recommendation. This article contains
forward-looking statements, which speak only as of the date
they were made and involve risks and uncertainties that could
cause actual results to differ materially from those expressed
herein. Readers are cautioned not to rely on our forward-looking
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