In my opinion the equity market sell-off over the last week—and rise of Treasury debt prices–is a reaction to three negative events: the debt-ceiling agreement reached by Congress on August 1, the failure of the U.S. economy to leave behind the economic “soft patch,” and the debt crisis in Europe. These three factors have done two things. First, they have elevated uncertainty. Second, they have darkened the economic and market outlook. And none of these things are ever well received in the stock market. In this note I take on each of these events, one at a time, and try to explain how they have affected the stock market, and what they imply for the future.
It’s not S&P
The S&P downgrade per se did not have, in our opinion, any meaningful impact on asset prices. U.S. treasuries were as creditworthy last week as they are today. Not only that, but the S&P decision did not unveil any news that the markets did not already know. S&P relies on public, freely available data, all of which was known by the markets.
S&P’s decision is newsworthy only in that it is the opinion of an official sanctioner of credit quality. It has a direct impact in that some investors, notably some insurance companies, are required to hold AAA-rated securities, and those investors are forced to sell treasuries. But they are a small minority, especially because the two other leading rating agencies have kept the AAA. Money market funds, for instance, are allowed to hold AA-rated debt.
If you are not convinced, look at the yields. Treasuries --the very instruments which were just downgraded — are up, with the 10-year bond yielding 2.31% as of today’s closing [August 8], 72 basis points lower than two weeks ago.
The debt ceiling agreement, on the other hand, was bad news in the short term. The agreement is supposed to reduce the deficit by $2.5tn over the next ten years. A fiscal contraction of that amount spread over such a long period of time, should not by itself have moved the market in a normal economic environment. The problem, of course, is that we do not live in a normal economic environment. Since the end of the recession in 2009, the economy has posted unusually weak rates of growth. In fact, we are barely growing at all. In that environment, a fiscal contraction of modest size can easily result in recession.
It’s the economy, stupid
Adding to the bad news is that we are not leaving the “soft patch” behind. Many economists, including myself, believed that the slowdown that started in March was the product of the supply-chain disruptions triggered by the disasters in Japan and the lagged effect of oil prices. “As soon as we get through this,” the consensus was, “the economy will start doing better.” Up until June, I would say, the consensus was that the U.S. economy would resuscitate in the second half of 2011. So far we have been proven wrong. I would not say that the economy is definitely tanking, but it is definitely not bouncing back either. The downward revision of past GDP numbers, added to the mediocre PMI and jobs numbers reported last week, in a climate of unusual uncertainty about the economic outlook, have prompted people to revise up their subjective estimates of another recession. And recessions are very bad for equity prices.
Finally, having put behind its own debt crisis, the U.S. markets have started to pay due attention to the debt crisis in the eurozone. The suspicion that Italy –the third largest issuer of debt in the world— and Spain might default, brings the world to uncharted territory. If we learned one thing from our own financial crisis in 2008 is that market exposure is like an iceberg: much more is hidden below the surface than above. Indirect exposure through bank liabilities and derivatives markets transmits local financial shocks far away, and makes the entire banking system surprisingly fragile.
And, above all regarding the situation in Europe, there is uncertainty. What are the implications of an Italian default? We don’t know. How will the eurozone respond to a debt crisis, in a context of independent fiscal policies of its member countries? We don’t know (although we do know that fiscal stimulus is not an option, as it was in the United States in 2008). Has the European Central Bank the same power (and bravado) to conduct unconventional monetary policy as the Federal Reserve once had? We don’t know. But the uncertainty is killing the market.
What do we know?
What do we know, then? Not much with certainty. But I can offer you my reasonable conjectures. First of all, the equity markets probably overreacted. U.S. stocks are not worth 20% less than they were at the market highs around 1,370, last May. A recession is not a certain event just yet. A partial counter-reaction of the stock market is likely in the short term, even if we do not return to pre-crisis levels. Second, a default by Spain or Italy is likely, but not immediately. Those two countries face almost insurmountable debt dynamics that, realistically, can be solved only by either partial default or by leaving the currency union. There is strong resistance from European leaders to either defaults or union dismemberment, which will result in a protracted drama. Eventually, I would say, there is no escape. Third, the Federal Reserve is now more likely to announce another round of asset purchases (a.k.a. QE3) than it was a month ago. If the economic outlook continues to deteriorate, I predict that QE3 will be announced by the FOMC meeting on September 20, if not earlier.