A sticky patch ahead,
or a sea of quicksand
THERE doesn’t seem to be any
doubt that investors are worried about the American economy. The most recent
data, such as the retail sales numbers or the
Consensus forecasts point to a modest slowdown at best, with an annualised growth rate of 2.5% in the first half of the year and 3% (around trend) in the second. But the consensus is notoriously poor at predicting recessions.
What might push the economy into a downturn? The impetus might come from either, or both, of two directions. Most obviously, there is the sub-prime mortgage crisis. This has been generally dismissed as confined to a small area of the mortgage market, the bottom 10%. But these people are the marginal buyers, the ones who were forced to borrow high sums to afford their first house or apartment.
If they lose their access to credit (as rapidly seems to be happening), that must affect the housing market as a whole. Paul McCulley, of Pimco, refers to first-time buyers as the plankton of the housing market, the creatures upon which the rest of the food chain depends.
It is easy to fill in how the
story might unfold from here. Weaker house prices have a wealth effect on
consumer demand, and lower consumer spending hits business activity. How will we
know if this is a realistic possibility? It really needs a couple of months of
clear data, unaffected by the weather; after an unusually warm January, February
A second possibility is a sharp slowdown in corporate profits. Andy Lapthorne, of Dresdner Kleinwort, says that corporate profit warnings have been unusually common in recent weeks; and the annual rate of growth of business sales has slowed to 2%, a low rate by historical standards. Margins could be coming under pressure, especially as labour markets still look tight. Unemployment is just 4.5%. That might prompt companies to shed jobs, a piece of unfortunate timing when the housing market is already weak.
It is hard to say that the market has yet priced in a serious downturn. Yes, the yield curve has been inverted for some time (long bond yields are below short rates). This has historically been a signal of recession. But most commentators are inclined to ascribe low long-dated Treasury bond yields to the Asian savings glut.
After all, if the economy were heading for trouble, corporate bonds would surely be suffering. But, according to Moody’s, the cost of insuring against the default of a typical high-yield bond is currently below a 12-month average. And investors can hardly be blamed for being sanguine: the historic driver of spreads has been the default rate, and Standard & Poor’s says there was just one corporate default in February, keeping the annual default rate at a little over 1%.
If equities have wobbled, the sell-off has been mild, even by the standards of last May. Again, it is difficult for investors to get too bearish, when every day seems to bring a multi-billion-dollar bid for a Boots or an Altadis. In the late 1990s there was supposed to be a "Greenspan put" that insured the markets; is there now a private-equity put?
So it looks as if investors are undecided at the moment—caught between worrying economic data, and the strong technical position (good cashflows) of the market. When investors are undecided, markets tend to move quite erratically. So the best bet for the moment is that volatility will continue.