This past summer U.S. financial markets suffered double-digit declines due, in part, to continued weak economic growth and concerns that the country might slip back into a recession. A spate of positive news in October led to a market rally and largely quelled those concerns, but a number of major obstacles—both in the U.S. and across the globe—remain. Thomas Dillman, President of Mutual of America Capital Management Corporation, reviews the major issues hampering long-term sustainable global economic growth.
Over the past year and a half, we have been chronicling the evolution of the key risks to global growth. The major factors affecting the markets during this period include:
the extreme sluggishness of the U.S. economic recovery;
the potential for a serious growth slowdown in China as the result of policy initiatives to contain inflation and a property bubble;
the ineffectual efforts of the U.S. Congress to come up with a credible debt reduction plan leading to a humiliating downgrade of U.S. Treasury securities; and
a sovereign debt crisis in Europe that at the very least portends an increasing likelihood of Eurozone recession and at worst represents a threat to the European Union and its currency, the euro.
Indeed, global markets have been hostage to these major macroeconomic and political themes. The volatility of both stock and bond prices, especially in recent months, has equaled if not surpassed that experienced during the worst of the 2008 financial crisis. Correlations among individual stocks have risen to records, indicating that investors are not differentiating between companies based on their fundamentals, but are trading almost exclusively in response to the daily macro headlines.
Sovereign Debt Issues Continue to Affect U.S. Stock Market
Through early July of this year, the S&P 500® oscillated between year-to-date gains of 0% to 8%, peaking on May 2 and almost hitting that mark again at the start of July. However, from early July through the beginning of October, the market declined precipitously, falling 18% through October 3. The decline was initially prompted by disappointment in the European Union's (EU) announcement of its plan for a second bailout of Greece. This plan was widely viewed among investors as inadequate to address the magnitude of the issues confronting Europe, especially the concern that Greece's problems would spread to other highly indebted EU members, including Spain, Portugal, Italy and even France.
At the same time, the U.S. Congress was embroiled in an acrimonious partisan debate about how much and in what manner to reduce rising U.S. deficits in order to arrest the growth in overall U.S. sovereign debt. The plan that finally emerged targeted far less deficit reduction than expected and was viewed as disappointing. The markets also viewed skeptically the creation of a "super committee" to come up with additional savings that would be voted upon by Congress by the end of the year. These factors prompted Standard & Poor's to take the unprecedented action of downgrading U.S. Treasury securities from their hallowed risk-free status of AAA to AA+.
Flagging Global Economic Growth Prompts Fed Action
During the waning months of summer, U.S., European and Chinese economic statistics kept coming in on the dreary and disappointing side, resulting in an increased probability of global recession. Compounding this risk was the potential for a Greek default to set off another global financial crisis that would make a serious recession unavoidable and, worst of all, unpredictable in its trajectory or outcome.
It was in this context of flagging growth and increased uncertainty that the Federal Reserve decided to institute a new program of stimulus at its late September meeting. In what has been coined "Operation Twist," the Fed announced that it would sell $400 billion of Treasury securities with zero- to 3-year maturities held in its portfolio and invest the proceeds in Treasuries with 6- to 30-year maturities. Some analysts concluded that the impact of Operation Twist would prove greater than its predecessor, QE2. The goal of both was similar: to reduce long-term interest rates and provide incentives for investors to take on more risk, in particular with equities and residential real estate. In addition to extending the maturity of Treasury purchases, the Fed also announced that it would resume its suspended practice of reinvesting the proceeds from maturing agency and Mortgage-Backed Securities (MBS) back into the MBS market rather than buying more Treasuries.
While longer-term Treasury rates and MBS spreads did decline initially, strengthening economic data began to offset the decline somewhat. The net result for mortgage rates was that they remained essentially flat at their historical lows of approximately 4% for 30-year fixed rate loans. Despite such low mortgage rates, however, banks remained extremely reluctant to lend because of heightened credit standards and the large number of homes stuck in the foreclosure pipeline awaiting resolution.
Positive Economic News Emerges Entering 4th Quarter
After the difficult period of July to September, the flow of information began to take on a slightly more positive tone in October and markets reacted positively. U.S. economic data began to show improvement and beat expectations in many cases, including vehicle sales, chain-store sales, manufacturing and nonmanufacturing Purchasing Managers Indices (PMI), retail sales, unemployment claims, state income tax receipts, money supply growth and bank loans. Except for housing, this trend continued through the month, culminating in the announcement that the 3rd quarter 2011 Gross Domestic Product (GDP) came in at a 2.5% annualized rate, in line with recently upwardly revised expectations but well ahead of estimates earlier in the summer.
Importantly, key drivers of the strength were personal consumption and corporate investment. The data were still weak, suggesting only tepid growth, but economists started to reduce their odds of an imminent recession and began to take a more sanguine view toward future growth prospects. Because of the improved data, the S&P 500 rallied 14% from its October 3 low through the first week of November, bringing it to breakeven for the year-to-date period. Corporate bond spreads, both investment grade and high yield, also improved during the month.
Meanwhile, the 3rd quarter 2011 U.S. corporate earnings reporting season began, continuing the trends during the previous two-and-a-half years of positive year-over-year growth in both revenues and earnings; positive surprises in the 60% to 70% range for both top- and bottom-line measures; year-over-year growth exceeding consensus expectations; and, as a result of the latter, rising estimates for the final 3rd quarter 2011 earnings number.
At the same time, Chinese inflation began to peak and there were hints that policymakers there were preparing to loosen policy, although not with regard to real estate. The prospect that policy tightening was on the verge of ending, if not reversing, was received by markets with some relief, especially in the context of the improving situation in the U.S.
The most important development during October was the emergence of a third plan to deal with the Greek debt issue. The proposal included provisions to shore up the capital of systemically important European banks exposed to sovereign debt write-downs, agreement with private creditors to accept a "voluntary" 50% reduction on the carrying value of their Greek debt, and an arrangement to leverage the €440 billion euro European Financial Stabilization Facility (EFSF) by up to four to five times. While this plan was really only an outline, and not a binding agreement among the various parties, the market response globally was generally positive.
Europe Grappling for Solutions to Sovereign Debt
Despite these apparently more positive developments, viewed from a broader perspective, they really do not represent any convincing substantive change to the risk profile facing the global economy. Perhaps they offer a glimmer of hope that we can avoid a meltdown similar to 2008, but there is much work to be done to address and resolve the many longer-term and deep-seated structural economic and political problems in the U.S. and Europe. In the meantime, economic growth remains very anemic and extremely vulnerable to shocks of any type.
The recently announced plan to address the Greek sovereign debt issue provides a specific example. The new plan was almost immediately undermined by the Greek prime minister's announcement to hold a referendum for Greeks to accept or reject it. The EU vehemently rejected the idea of a referendum. Since then, the prime minister resigned and an interim "unity" government was formed to approve the plan and the required austerity measures to have it implemented. Such an unexpected development testifies to how tenuous the process of controlling the situation is. Despite significant progress toward recognizing the need to ultimately change the organization of the EU to provide for a more centralized fiscal authority, Europe is a very long way from actually implementing anything of the sort.
In the meantime, markets have moved on to attack the next soft underbelly of the sovereign debt crisis, Italy. Italian bond yields have jumped well over the 6% threshold that most analysts deem tenable for refinancing. European Central Bank purchases of Italian debt, such as those employed to shore up Ireland, Portugal and Spain are beyond the scope of political possibility, except in limited, and thus insufficient, amounts. The total amount of Italian debt outstanding far exceeds any of the other troubled European nations. Attempts to pressure the Italian prime minister, Silvio Berlusconi, into implementing the draconian austerity measures necessary to even begin to address Italy's debt problem had been unsuccessful until Berlusconi agreed to resign on the condition that the Italian austerity measures be enacted, which they were. Such turmoil makes it clear that the troubles of Europe are far from solved despite the hopeful sign that one obstacle after another is being removed.
U.S. Federal Deficit Weighs Heavy on Domestic Front
Here in the United States, the so-called super committee has failed to deliver a deficit reduction plan by the deadline. While the committee's deliberations were kept secret, most commentators expected any proposal to fall short of anything credible because the bipartisanship of the summer's debate persists, with Democrats insisting that increased taxes must be part of the plan, and Republicans seeking all reductions through budget cuts. Failure of the committee now sets in motion an automatic $1.2 trillion sequestration of funds from the Federal budget, scheduled to take effect January 1, 2013. President Obama has threatened to veto any Congressional attempt to avoid sequestration, thus pressuring Congress to come up with a viable deficit reduction proposal before the end of next year. The evidence would suggest that the current partisan stalemate will preclude that possibility. Thus, the U. S. budget deficit issue will continue to roil markets and will inevitably be a key issue in the upcoming election.
On the corporate profit front, the growth rate of year-over-year quarterly earnings has been declining, although it remains in double digits for the 3rd quarter of 2011. In addition, the percentage of total positive surprises has also been declining over the past couple of quarters. This is somewhat expected after 10 quarters of exceptional performance. More worrisome in the 3rd quarter of 2011 reporting season is that the estimates of future quarters, and for the current and following fiscal year, have begun to fall. These downward estimate revisions seem to be the result of cautious corporate guidance accompanying the current positive results.
Global Economic Growth Likely to Continue on Weak Path
In summary, the risks facing the global economy and financial system persist, and will continue to do so until policymakers come up with viable and enduring solutions. As we've noted before, this will take time, and the process will be fraught with the potential for accidents or mistakes. Under such conditions, global economic growth is very likely to remain extremely weak, making recession a periodic threat. As a result, we expect stock, bond, commodity and foreign exchange markets to remain highly volatile for an extended period of time until risk has been reduced, imbalances have been addressed and greater clarity regarding the future has been established.
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 statements.
Mutual of America Capital Management Corporation is an indirect, wholly owned subsidiary of Mutual of America Life Insurance Company. Mutual of America Life Insurance Company is a registered Broker/Dealer.
Standard & Poor's®, S&P® and S&P 500® are trademarks of Standard & Poor's Financial Services LLC, a subsidiary of The McGraw-Hill Companies, Inc.