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Volatility Returns with A Vengeance


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As usual, there has been a litany of rationalizations attempting to explain what has been going on. Yet many of these explanations are just plain off base. Consider a few:

The S&P Downgrade

On Friday, after the markets closed on a high note, Standard & Poor’s decided to downgrade U.S. treasury debt. Monday morning opened with an enormous drop in the markets—caused surely in part by S&P’s move.

Was the downgrade unprecedented? Absolutely. Logical? Absolutely not. A bond rating is an estimate of the chance that the borrower will not pay back their debt fully and on time. To justify a downgrade, one has to show why the probability of default has increased. Has the chance of a US default increased in recent months?

As for the amount of debt itself, despite the budget battles and ongoing gap between revenues and expenditures, overall net U.S. debt is still quite low for developed nations—somewhere on the order of 68% of current GDP once the holdings by the Social Security Administration are factored out. Given low interest rates, the current cost of servicing the nation’s existing debt is less than 10% of all expenditures. There is clearly no threat of a default in the near term, even if the de bt ceiling had not been raised.

As for the pace of accumulation, it is impressive. At the current rate the net increase is roughly 8% to 9% of GDP. But if the economy grows at 2% in real terms and has 2% inflation, this only means that the debt accumulation as a percent of GDP will grow at 4% to 5% of GDP per year. And remember that the deficit is already shrinking due to the scheduled end of certain stimulus programs. Additionally, the Bush era tax cuts are due to expire at the end of 2012, bringing in additional revenue despite Republican opposition to tax increases (NOTE: if the Republicans take over the Senate and White House, these tax cuts would almost certainly be extended. Of course, one might presume that spending would also be cut although the record of George W. Bush would suggest otherwise. This might be reason for a downgrade, but it seems early for the S&P to call it). As such we are many years away from debt levels hitting the 90% or higher level that many bond analysts see as entering the danger zone.

Another long terms issue is the underfunding of the major social insurance programs, particularly Social Security and Medicare/Medicaid. Are they underfunded? Absolutely. But as bad as these problems are, keep in mind that this only becomes a worry if one presumes that at some point in the future the U.S. government will forego payments on existing debt in order to fund current expenditures in these programs. But such a choice won’t be made for 10 or 15 years. Its hard to see anything that has occurred in recent months would have a reasonable impact on the assessment of such choices in the future.

While the math didn’t seem to work in their favor, S&P discussed the political climate as an important component in their decision, more than the actual debt level. But—without a current crisis, it’s hard to cite current politics. After all, political winds change rapidly. The Tea Party may not even exist after a couple more elections—petering out like so many other political fads of the past.

Still, this is all moot. What the stock market would truly worry about is the impact of the downgrade on interest rates via the bond market. Had they risen, this could have put pressure on an already weakened U.S. economy.

Ten-year treasury rates have fallen, not risen, since S&P’s announcement. And frankly there is no bigger vote of ‘no confidence’ out there. S&P is unlikely to stick its neck out further after this debacle and downgrade US debt any further. The only decision left for them is how to withdraw this ridiculous change without making themselves look even more foolish.

A Double Dip Recession

Another big worry is that the U.S. economy is falling into another recession—something that is sure to spook the markets given how corporate profits shrink sharply during such periods. This is perhaps more believable, given the clear slowdown in economic growth during the first half of 2011. The slowdown was becoming apparent in the second quarter of this year as oil prices and a lack of available Japanese autos put a major crimp on consumer spending. But when U.S. GDP data was released at the end of the July, the bigger surprise was the downward revision in first quarter growth to almost zero. Add to this two weak employment reports and some bad reports on manufacturing, and its understandable why the markets would be worried.

Yet even here there is room for skepticism. The slow growth in the first quarter was largely due to an unusual pullback in spending on national defense and non-residential structures—spending that bounced back in the second quarter. July’s employment report was more positive, and since then initial claims for unemployment insurance have actually fallen. The primary driver of weak consumer spending in the second quarter has also been removed: Oil prices have fallen sharply—particularly since the stock market began to fall so rapidly. And Japanese cars are again starting to move into the market. Even the housing market—the source of bad news earlier in the year—is starting to show mild signs of life. Prices have risen a bit, as have permits for new residential construction.

In any case, for another recession to occur, there must be a driver. In 2008 it was the collapse in consumer spending – after years of overspending fueled by inflated home values – combined with the post-Lehman credit crisis. In 2001 it was the collapse in business spending after the end of the tech bubble. To call a recession now, one has to find a similar driver.

Looking high and low at the major parts of the U.S. economy, I cannot find such a driver. We have downgraded our growth forecasts for the rest of the year by a modest amount—but we have a long way to go before we end up in another recession.

Troubles in Europe

Lastly there are the sovereign debt issues in Europe. It started with Greece and Ireland and has spread to Spain, Portugal, and most recently Italy. Banks in Europe are heavily exposed to sovereign debt, and one or two major defaults could potentially collapse the European banking system—a problem sure to spill over to this side of the pond.

But even here we cannot find good cause for a pullback in the market right now. While the problems in many European nations are profound, only Greece and Ireland have truly been pushed to the brink of default. In Greece’s case, it is due to years of bad government. They hid the rapid pace of debt accumulation through various nefarious accounting manipulations. The economy is stagnant and uncompetitive, driven there by massive government interference as well as one of the worst corruption problems in Europe. And there is their fundamental inability to raise revenues in a nation famed for its tax avoidance. As for Ireland, none of these factors are in place. There it is only because the government agreed to use public funds to prevent the collapse of the large Irish banks. That had become so heavily involved in the property bubbles in the US and UK.

As for Spain, Portugal, and Italy there are serious problems—but none of these nations is anywhere close to the brink of default. Spain and Portugal have relatively low levels of debt relative to their GDP. Italy has a huge amount of debt, but its economy is stronger than it looks on the surface—and it has a history of being able to handle such crises at the last moment.

As profound as these nations’ problems are, there is nothing immediate about them. Instead they have to play out over the next couple years. Could it get serious? Yes. Will it collapse the European banking system? No. If what happened to the U.S. banking system during our massive credit crisis is any guide, the powers that be in Europe will rush to the rescue. The banks will be protected and nursed back to health. There will be some pain—but being prepared is half the game. The reason Lehman had such a powerful impact on the financial markets was mainly because it was unexpected.

A Price Level Too Far

So why are the markets falling, if most of these rationales are empty? One way to view the situation is to consider the reactions to a speech given by Federal Reserve Chairman Ben Bernanke at an International Monetary Conference in Atlanta in June of this year. The disparate headlines in the Los Angeles Times and Wall Street Journal the following day were telling. The Times headline read “Bernanke predicts stronger recovery in second half of year” while the Journal stated bluntly “Fed sees recovering lagging.”

Recent GDP numbers show just how far behind the U.S. economy remains. As of the second quarter of this year economic output has not yet exceeded the pre-recession peak. Labor markets are healing slowly and many fundamental problems remain. Despite this, the recovery in the financial markets has been nothing short of astonishing. Spreads on risky debt have fallen to pre-recession levels. In spite of weak growth, P/E ratios again have become high from an historical standpoint. It is clear that Wall Street was expecting a more robust recovery than was delivered.

What the last few months have showed us is that the U.S. economy still has much healing to do before it can catch up. And even then it is clear that our nation will feel some permanent effects from the great recession. The markets have finally realized that they were ahead of the game. This is hardly new—the markets had reached a peak of near insanity at the peak of the tech boom in the late 1990’s. Financial markets got out of hand over the course of the last decade. And they completely missed the start of the recession, only falling when Lehman Brothers imploded.

Twice bitten, third time shy? Although the markets weren’t as out of whack this time as during the last two episodes, traders likely did not want to be caught off guard again. The numbers made it clear that expectations were too high and the sell off that had to occur to correct the markets was going to lead to this spasm of volatility.

Predicting the stock market is always a fool’s game. But every once in a while even a forecaster has to play the fool. My best bet is that the next few weeks will see more indications that the United States is pulling out of its first half funk. With this news, the markets will settle and start to rise again gradually. Let’s hope that the irrational exuberance that drove the last two bubbles does not return again

CATEGORY: General Economy



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