Risk Appetite
A
sustained U.S. economic expansion can best be achieved without
market disturbances and interferences.
May and June's decline in the value of riskier asset
classes corresponded with increased risk aversion as higher
market volatility and uncertainty unsettled investors.
The fact that events surrounding sovereign debt problems
in Europe were the catalyst for May's U.S. market disturbances
is of little concern. Late
June's U.S. equity market decline had much to do with a broad
reassessment of U.S. economic conditions
- concerns over a weakening U.S. economy have risen over
the past several weeks amid disappointment surrounding recent
U.S. data on home sales, manufacturing, employment conditions
and consumer confidence.
May and June's market turmoil
noticeably rattled investors and forecasters. Some modest
reductions in future U.S. economic growth estimates have
recently occurred and further modest downgrades are likely
(latest real U.S. GDP consensus estimates from Bloomberg - July
9 - are arguably too optimistic).
All said, it would likely take continued market turmoil
and negative returns in risk assets to meaningfully derail the
modest economic recovery at hand as a protracted period of falling
stocks would indeed become a headwind for the economy.
July 15, 2010:
Given the fragile nature
of current economic conditions, reestablishing stability in the
financial markets is necessary to sustain many of the favorable
economic trends that have emerged over the past year. May
and June's decline in the major stock indices, decline in
Treasury yields and overall widening in credit spreads were
indications of increased risk aversion.
Although May's decline in
some commodity prices did not continue through June as crude oil
prices rose - reflecting some risk taking - U.S. inflation
expectations declined further last month limiting the overall
market impact of June's climb in energy commodities.
Unfortunately, June's 20 bps flattening in the U.S. Treasury
yield curve was consistent with a mild downgrading of U.S.
growth expectations (10-yr Treasury minus 2-yr @ 233 bps
end-of-June vs 252 bps end-of-May).
Between the first quarter of
2009 and April 2010, the broad equity markets experienced very
limited sustained downward momentum, which helped contribute to
recent U.S. economic improvement. In S&P 500
terms, overall declines were seen in just 4 months since Feb
2009; Oct '09 (down 2%), Jan '10 (down 3.7%), May '10 (down
8.2%) and June '10 (down 5.4%). Furthermore, all but one
of these monthly declines corresponded with some degree of
public sector interference - Oct's decline was arguably
influenced by rate hikes in Australia, Jan's decline was likely
impacted by China's determination to lift reserve requirements
in response to double digit growth while May's market tumble was
associated with Europe's sovereign debt crisis.
Unfortunately June's decline, which is also the most recent, was
more likely due to investor concerns over corporate earnings,
economic growth (given recent data disappointments) and general
uncertainty. This combination of factors is not likely to
pass soon.
Ahead - July's overall
performance in stocks, as well as in the broader categories of
risk assets, will be meaningful for the near-term economic and
interest rate outlook.
- In the event the major
U.S. equity market indices can rebound favorably in
July, it might help isolate May and June's negative price
action as more of an overdue (downward) correction.
Furthermore, in the event the U.S. Treasury yield curve
holds steady or were to steepen somewhat in July, it could
help confirm such resiliency. As of this writing, the
S&P 500 is up over 5% in July while the 10-yr minus 2-yr
Treasury curve spread has steepened a mild 5 bps to 238 bps.
Overall, U.S. Treasury yield movement so far in July has
been minimal although the 2-year U.S. Treasury yield did
fall mildly to a record low of 0.577% earlier today
following some weaker-than-expected regional manufacturing
reports from the Fed.
- In the event U.S. equity
prices have another unfavorable outcome in July, it
would likely indicate deeper concerns over fiscal
conditions, economic growth potential and overall risk
taking tendencies. A July decline in the S&P 500
index, following May and June's large drop, would result in
the first 3-month consecutive decline in the index since
Sept - Dec 2008 - when markets were in crisis.
Incidentally, the S&P 500 has not seen a consecutive
4-month decline since Dec 2007 - Mar 2008.
Furthermore, a July decline in the broad equity indices
would likely sustain the downward Treasury yield pressures
that began in mid-April.
Uncertainty:
With details of pending financial reform still on the horizon,
the magnitude of tax reform largely up in the air, unsettled
matters in Europe's sovereign debt crisis, an increasing volume
of disappointing economic data releases, limited capacity for
further U.S. monetary and fiscal stimulus combined with the
approaching U.S. mid-term elections, there remains considerable
uncertainty. Favorable equity market performance amid such
uncertainties would be encouraging and pose a risk for some
upward interest rate pressures.
Robert Podorefsky, Interest Rate Strategist (617) 973 - 4091
