Tuesday, 9 August 2011

2008 or 2010 Revisited?

Since the stock markets hit their most recent high point in late April of this year, we have been living through a market correction that has been most notably highlighted by the sharp drop in value over the past two weeks. As usual, the media has been quick to jump on investor worry with lurid and large headlines.
Depending on your media poison of choice, recent events have been heralded as the Collapse of 2008 version 2.0.

Although these headlines are great for selling newspapers or drawing viewers, they unfortunately don’t represent the real economic story that is unfolding under the headlines. As occasionally happens, what we are seeing in the market is the temporary triumph of Worry over Wisdom.

There seem to be three themes at the heart of current market concerns. The first involves the European debt crisis, and is centered on the worry that debt issues in smaller economies such as Greece, Ireland and Portugal will spill over into the much larger countries of Spain and Italy. If this happens, so the story goes, the European Union would not long survive, and the economic dislocation would resonate around the world.

The second issue is the long simmering crisis over the level of U.S. debt, and the seeming inability of a divided congress to come to grips with the hard choices that must be made to bring the spiraling government deficit under control.  The compromise that was reached at the 11th hour was, in the view of these critics, only a band-aide solution, and the Standard and Poor’s decision on Friday to lower the quality ranking on U.S. Government debt from Triple A to Double A (Plus), was the first step in the looming failure of the U.S. government.

The third worry, stemming from the effects of the first two, is that the world economy, buffeted by the failures of Europe and the U.S., will slide back into recession. Bleakness, darkness and despair will triumph, and the end of the world will be nigh. Perhaps I exaggerate a touch, but you couldn’t tell by reading SOME of the news articles out there.

So that is the worry, and the reason that markets have reacted so negatively over the past week in particular. Now let’s look at the reality.

With respect to Europe, the threat of contagion between countries has been significantly overblown. According to Eric Lascelles – Chief Economist at RBC Global Asset Management - most professional investment managers have long acknowledged that Greece is likely to default on its debt, and Ireland and Portugal are at significant risk as well, although recent bailout plans have gone a long way towards changing this outcome. In terms of Spain and Italy the good news is that economic fundamentals are really not that bad. Italy has a large government debt, but only a small annual deficit, strong banks, most of its debt doesn’t mature for a long time, and it is held domestically (and therefore not open to international manipulation). Spain’s deficit is large, but their national debt is smaller than the European average. Both countries have started austerity programs. Very recently, the European Central Bank has begun to battle speculators by purchasing government bonds in the secondary market.

The recent response to S&P’s downgrade of U.S. Government Bonds is puzzling.
As I write this, equity markets have fallen significantly over the past two days. However, at the same time the yield on U.S. Treasury bills have also declined as investors who sold their stocks rushed to the perceived safe haven of U.S. government bonds. Am I the only one who finds this strange? U.S. stock prices fall because Standard and Poor says that U.S. Government bonds are less trustworthy than they were a while ago, and yet these investors flock to buy these bonds! This seems like a very curious repudiation of Standard and Poor’s outlook, and perhaps more than anything reflects the irrational nature of the current market response to events.

In reality, a minor downgrade by one of three credit agencies from the highest credit ranking to the second highest credit ranking is ultimately relatively minor. In fact, the other two credit agencies have re-affirmed their highest ranking for U.S. government bonds, at least for now. As we have seen, the bond market has seemingly repudiated the S&P downgrade by voting with their feet and rushing to government bonds yet again, even though they receive an effective yield of 0%.

In real economic news, on the other hand, seemingly lost in the noise over the credit downgrade, last Friday saw the release of strong employment numbers in both Canada and the U.S. Most importantly, ALL of the growth in employment came from the private sector as governments in both countries reduced their payroll. In the auto sector, General Motors announced that their world wide profit over the past year doubled, to over 2 billion $US. For their part, Ford of Canada announced that their June results were the strongest in 10 years, while Chrysler Canada announced that their June results were the best in their history! Year to date, corporate quarterly results have exceeded expectations 88% of the time. Clearly there is a disconnect between the headlines and recent economic reality.
So going forward, where does this leave the world economy? Is this a repeat of the market collapse of 2008, or is this just a correction along the lines of the 2010 debt worry that occupied the market during the spring and early summer of that year?

Discounting the media noise, fairly clearly this is not 2008, and the world is not on the brink of another global recession. In contrast to 2008, the credit system is very liquid. Credit markets are not showing signs of stress. Corporate balance sheets are flush with cash, banks have restored their capital and reserves, and there are no credit indicators showing signs of stress. In fact, investment grade and high-yield bond spreads are all better than at the start of 2011. The negatives of 2010 are no longer a drag, and the U.S. housing, financial and consumer sectors are, if not fully restored, much improved from their prior levels.
For their part, corporate inventories are relatively low and materials costs have recently declined, with oil currently being $30 lower than its high.

 During the first half of the year, global economic growth clearly has been muted. The real and perceived economic impacts of the Japanese tsunami and the Arab Spring both had negative implications for economic activity. The result was a series of economic reports that cast doubt on the health of the economic recovery, and the debt crises in Europe and the U.S. have only increased the level of worry and fear of a return to recession.

Again, the real situation is not nearly so dire.  It is important to remember that historically, economic recoveries following financial crises tend to be muted. The current situation falls right into the ‘normal’ category for such a recovery. In fact, the Royal Bank of Canada notes that it follows 51 leading indicators of economic activity, and that most point to slow – but real – growth going forward.

The reality is that, as often happens, equity markets have been over sold out of fear. There is always a tug of war between emotion and reason (economic reality), and every so often anxiety wins, and market values plunge.  The current situation is one such event, creating a crisis of emotion and fear, but also an opportunity. We have had, and will continue to have, aftershocks from the 2008 financial crisis, but at times like this amid the fear and worry we can also see buying opportunities for those who refuse to be drawn in by short term emotion. For those currently invested, sit tight and try to ignore the noise and emotion. It was good advice in 2008, it was good advice in 2010, and it will serve you well today.