By Rom Badilla, CFA, Bondsquawk
The economic data this summer has looked eerily similar to last summer’s. The ISM Manufacturing Index stood on the precipice of contractionary signals for the U.S. economy in mid-2011 while recent data releases are nearly the same. Furthermore, real GDP Growth for the second quarter for both 2011 and 2012 hovered below the so-called “stall speed” of 1.5 to 2.0% while the Unemployment Rate ticked up during the summer months of the past two years.
Despite the mirror image of the two summers from an economic standpoint, market sentiment has been very different as evident by the subsequent performance of the stock market according to Goldman Sachs’ economist, Andrew Tilton:
Despite the parallels with summer 2011, the market reaction has been quite different. Then, many forecasters (including us) worried openly about the possibility of recession, with a few even making recession their base case scenario. The S&P 500 index tumbled more than 15% and did not return to its springtime highs before early 2012. This year, recession talk has been scarce, the market drop less severe, and the recovery quicker — with the S&P 500 just off its highs for the year (and since the financial crisis).
So what is different this year that is propelling stocks to near-term highs? Goldman Sachs’ research team points out the following factors that are markedly different this time around:
1. Housing activity has picked up considerably. The housing sector is an important “leading sector” with a profound impact on the overall economy, as the financial crisis made plain. Housing starts are up nearly 25% year-over-year; in summer 2011 they were still in the doldrums and some forecasters worried about a major “double-dip” in housing prices.
2. Oil prices look less threatening. Although oil prices have gyrated considerably this year, on net the price of Brent crude is little changed from the beginning of the year (or a year ago). Contrast this with the winter of 2010-2011, when crude surged roughly 50%, from $80 to $120 a barrel.
3. The equity market paints a more optimistic picture. As already noted, the S&P 500 is close to its high for the year, whereas last year the market never recovered its springtime highs. Also, importantly, interest rates are considerably lower. More broadly, financial conditions look fairly supportive for growth–our GS Financial Conditions Index is roughly at springtime levels, near its easiest point for the year; in 2011, it tightened by more than 50bp in the late summer.
A few other factors beyond those included in the model may also have played a role:
4. Lower expectations. Investors had higher hopes for the economy in spring 2011. Our US-MAP score of economic data “surprises” implied about twice as much disappointment in spring 2011 as spring 2012. The scale of the disappointment may have caused investor sentiment to overshoot to the negative side, even though the data were not recessionary in an absolute sense.
5. The “won’t get fooled again” phenomenon. On a similar note, given that last year’s focus on recession turned out to be unwarranted, investors may be less nervous about another weak patch in the data. Evidence that seasonal adjustment distortions may play some lingering role in summertime weakness, particularly for the unemployment rate, may also make forecasters and investors wary of excessive pessimism.
6. No debt limit debacle–yet. The brinksmanship over the debt ceiling in mid-summer 2011 created great uncertainty, and severely damaged business and consumer confidence. While a repeat is certainly possible, investors and managers can at least hope that last year’s searing experience and the end of election season will pave the way for a smoother process this time.
While the research team is able to isolate the reasons for the divergence, they do admit that this model is limited since it does not include market expectations on both European Central Bank and U.S. Federal Reserve policies.
Specifically, concerns regarding the European Debt Crisis have subsided in recent weeks due to the fact that the ECB will institute some major form of bond purchases to rein in escalating borrowing costs for the Peripheries. Also, there are some rumblings that the Federal Reserve will expand their balance sheet and incorporate Quantitative Easing in the coming months in order to prop up asset prices and the overall economy.
As Tilton pointed out, failure for the Central Banks to deliver could disappoint the markets which would lead to another decline in risk assets which in turn would raise the alarm of another recession.
Furthermore, the model does not include the effects of the Fiscal Cliff that continues to loom over the economy at year-end. In the event that a modest correction in equities occurs and a milder form of fiscal retrenchment is implemented that jeopardizes GDP growth, the probability of a recession spikes to 50% by Goldman Sachs’ estimation. Obviously, if the full form of the Fiscal Cliff were to take place, then that probability rises even higher according to their research.