NORTH AMERICAN & INTERNATIONAL ECONOMIC HIGHLIGHTS
1. This is not 2008 all over again. In fact, it’s 2008 in reverse. Back then a financial crisis and a market
meltdown led to the recession. Today, it’s the fear of a recession that is behind the sell-off in the market.
Today’s situation is more normal since the market has the capacity to price-in a slowing global economy. Back then we were in a free-fall since the market had no tools to price-in the magnitude of the financial meltdown.
2. The downgrade of US debt by S&P was not the reason for the panic in the market. And the proof is that the bond market rallied following the announcement. While until recently the market was operating under the assumption that somehow the US Administration will find a way to continue to keep the economy afloat, the debt ceiling saga and the S&P downgrade led to the realization that fiscal support is no longer an option. This realization is probably the most important factor behind the reduced expectations regarding the future growth trajectory of the US economy and the fact that the problem in Europe is receiving even more attention.
3. The second bailout package will remove the near-term risk of a Greek default, but will not solve the problem. The package calls for roughly €70 billion reduction in debt—well short of the €200 billion that is needed to bring the country to a more normal fiscal situation. This means that while Greece was able to buy some time, the eventual outcome must be additional haircuts with further losses to Greek bond holders and their counterparts.
4. The focus is now on Italy. The issue with Italy is not its budget deficit which is only 4.6% of GDP (vs. 10% in Greece, 32% in Ireland and 7% in France) but the size of its debt. With markets looking more favourably at debt haircuts to alleviate fiscal burdens, and given the sheer size of Italy’s outstanding debt, even the pricing in of a small default probability has sent the value of Italian bonds plunging. This is a real risk given the country’s sizeable refinancing needs in the coming quarters.
5. Furthermore, with government spending accounting for 20% of euro area GDP, the upcoming fiscal austerity will work to limit growth in the region in the coming years. So when it comes to the euro zone, the only reasonable thing to expect is that it won’t take long for the market to realize that further explicit debt haircuts are the only escape hatch—suggesting downside for the euro and turbulence in investor confidence still ahead.
6. With the US economy rising by close to 1% (annual rate) in the first half of the year, the focus is on Obama’s ability to gain enough support to extend the payroll tax cut (despite the fact that it is not part of debt ceiling agreement). Such an extension along with lower gasoline prices suggests that the US economy will be able to show a roughly 2% growth in the coming 12 months. However, without the
extension, the US economy will probably be rising by 1.0%-1.5% in the coming year with a real possibility of negative quarter at one point. So regardless how you look at it, GDP growth in the US will be very modest in the coming year.
7. As for Canada, the recent volatility in the market and the disappointing numbers from the US suggest that the Bank of Canada will again postpone its next tightening move. At this point it is reasonable to assume that rates will remain stable until 2012.
8. So what to do it this situation? The most important question to ask is not how slow the global economy will grow, but what the market is already pricing in. If you look at the bond market, it is clear that the market is extremely depressed with the 10-year US rate close to 2%—resulting in a very flat yield curve. This is a market that is basically discounting a recession. In this sense, if you count on the extension of the payroll tax cut and the positive impact of lower energy prices, the likelihood is that the bond market is somewhat mispriced and rates will rise moderately in the coming 6-12 months.
9. For the Canadian market, which enjoys a much higher level of consumer confidence than south of the border, the extended period of low interest rates along with lower gasoline prices, suggests that consumer spending (and potentially borrowing) might be somewhat stronger than currently expected. It
also means that any decline in the five-year rate due to the recent rally in the bond market should be seen as an opportunity to lock.
10. As for the stock market. Is it a buying opportunity? For the coming months the best approach is to invest defensively. The market will be waiting for better news from Europe and some signals that the US economy is avoiding a recession. During this period, gold, along with high quality dividend-paying stocks will outperform. As well, American and Canadian manufacturing companies that are directly or indirectly linked to consumer demand in emerging markets will continue to outperform.
11. For an investment horizon of say a year and over, the market appears to be over-sold, and represents a buying opportunity, mainly in the commodity space as well as in financials.
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