Global markets have had a nice bounce in recent weeks as the worst case Armageddon-type of scenarios now seems off the table. The actions of the Fed in opening up the discount window to investment banks now make it highly unlikely that another Bear Stearns type of collapse is possible. A combination of extreme negative sentiment, strong regulatory response to shore up the financial system, and by and large decent earnings(ex financials) have combined to give us a nice bounce in global equities. The inevitable question is: What does one do now? Should one remain invested and bullish, or do we run the risk of another leg down?
As attention moves away from the financial crisis and its impact on the solvency of the US financial system, (though there seems to be fresh trouble brewing in the UK), investors will once again have to refocus on the US economic outlook. How deep and long can the coming recession be? How much will corporate earnings growth decline?
There is to my mind a general sense of complacency among both investors and the sellside on the US economic outlook. Everyone accepts that the first half of the year will be weak, but the consensus seems to be that the upcoming $170 billion fiscal stimulus will stabilise economic conditions towards the second half of 2008 and we will be back to near trend growth in 2009. One can understand this type of forecast, given the pace and extent of the typical recession of the 1990s-2000. If we are in a typical recession, then the market decline of about 15 per cent from the top is about normal and the markets will bottom about 4-5 months before the end of the contraction, ie in May-June.
However, there exists the strong possibility that this recession will be far worse than the norm of the last two decades and the pain will be concentrated in the area of the consumer.
As the folks in Merrill point out, this cycle bears closer similarity to the recession of the mid-1970s as opposed to what happened in 1990 or 2001 (the last two recessions which are used as a guide post by most). Similar to the 1973-75 cycle we have today a sustained rise in food and energy prices as well as a severe squeeze on consumer balance sheets from simultaneous declines in both the housing and financial markets. In the 1973 recession, retailers ultimately fell by 50 per cent, regional banks also halved and the S&P 500 fell by 40 per cent. If this is the true template of what we are going to go through then all talk of the market having bottomed out is premature.
We are going into this recession with household debt at an all-time high, both when measured to income (140 per cent) and assets (20 per cent). It is amazing that the US debt/income ratio has risen as much in the last six years as it did in the previous 39 years. Never before have interest rates been so low yet the debt service burden on households this high, going to show just how levered the US consumer is from a historical perspective. The trends in employment are also worrying, with private payrolls down by 141,000 in the last three months and most forward-looking employment data like hours worked or temporary agency employment numbers indicating that things will get far worse before they get better. Given the employment outlook as well as the pressures on real wages, it is no surprise that consumer confidence has collapsed and is at its lowest level since the 1981-82 recession. We could see a multi-year retrenchment in the 30 per cent of total consumer spend that is discretionary, as families rebuild savings and normalise debt service ratios.
On house prices, we are in a secular bust with prices falling in every single region of the US and the inventory of unsold homes at an all-time high. Many market observers expect house prices to fall by another 15-20 per cent before we hit the bottom. One can only shudder at the default rates and write-downs in such a scenario. Even if house prices were to decline by another "shockingly" high 20 per cent, we would have only retraced about a quarter of the price rise between 2000 and 2006.
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We should be prepared for a very serious consumer recession in the US in 2008-09, all the signs point to it and we have not seen anything like this for the past 30 years (well beyond the memory of most active investors). Yet the consensus still sees double-digit earnings growth in the US in 2008-09 (ex-financials). What chance that these earnings growth rates will actually transpire? My best guess is that we will actually see zero earnings growth in the US this year, with exporters and global MNCs preventing a negative print.
If we get another leg down in the US as investors get disappointed with earnings and fully grasp how bad things could get for consumption, that cannot be positive for the emerging market (EM) asset class, as risk aversion will rear its ugly head once again. We could have a two-stage correction in the US, similar to 2001, wherein we had a correction first in tech, and then a broad market decline driven by an economic recession. The first stage of pain and decline today is largely in the financials and we could now broaden out.
The EM markets also have their issues with inflation, and we have a cycle wherein all the major EM central banks are actually hiking rates and tightening monetary policy at a time of slowing global growth, not a recipe for strong outperformance.
It looks like we have passed the worst of the financial crisis, and markets are naturally celebrating, but it may be a little premature to assume that we have seen the lows for global markets in this cycle. We have a potentially brutal consumer retrenchment ahead of us in the US, the likes of which most investors of today have never experienced. Markets may still have pain ahead of them and it would be unwise to use up all your financial reserves.