This higher inflation reading is putting the Federal Reserve in the spotlight, particularly with its Jackson Hole conference coming up soon and its recently sharply lowered assessment of the economy. Based on its recent statements, it does not appear that the Fed is forecasting that the US economy is headed for recession, despite the fact that stocks are forecasting one and that many investors believe a new recession is coming.
Fed options
However, the Fed may also believe that with the difficult situation in Europe, the drop in confidence and the tightening of financial conditions could derail the already-weak levels of economic growth.
At this point, the Fed appears to be weighing its options in terms of whether or not it would choose to engage in some sort of additional easing measures. The central bank likely wants to remain on hold until more information is available, but continued deterioration in financial markets would likely increase the odds that the Fed would ease in some way.
Future moves by the Fed could include an extension of the maturity and duration of the central bank’s balance sheet, although some would argue that the Fed already engaged in de-facto easing by its recent announcement that rates would stay near zero for another two years.
Despite the overall negative tone among investors, not all of the news has been bad in recent weeks. Data regarding July pointed to the beginnings of a stronger economic second half of 2011, including better payroll figures, industrial production, unemployment claims and retail sales. Additionally the Index of Leading Economic Indicators actually rose in July and was ahead of expectations. However, it is important to remember that August is when all of the stresses in the credit markets and equities spiked, so it is very possible that this may negatively impact August’s economic statistics.
Recession question
The question is whether or not the US will experience a new recession. The concerns on the "yes" side involve lingering effects from the rise in oil prices and the Japan supply-chain disruptions that occurred earlier in the year, contagion from European financial stress and dysfunction in Washington that could negatively affect the confidence in financial markets.
In contrast, those opting to answer the question "no" would cite the zero-interest-rate environment, a positive yield curve, a cheap dollar, reasonable support from emerging markets growth and a strong corporate sector. From our vantage point, we continue to lean toward the positive and believe that the US will avoid a recession, but will remain in a very slow-growth environment.
The situation in Europe remains a wild card. Last week’s summit between European leaders indicated that some progress has been made, but many were disappointed that more action wasn’t taken. Our view is that, ultimately, Europe will move further down the path of greater fiscal integration, possibly by adopting some sort of eurobond approach, but the path to get there will be extremely difficult given both the political constraints and the difficulties of harmonizing fiscal policies.
Equity valuations
During times of heightened market volatility, investors tend to focus on technical market levels to look for trading ranges. At present, one of those levels appears to be 1,250 for the S&P 500, which was an important floor for prices before the decline commenced a few weeks ago and now represents an important ceiling. The other level looks to be 1,100, which was the low reached during the height of the panic-selling. For the time being, we expect to see a fair amount of volatility as markets move between those two numbers.
Given the high degree of uncertainty and the extreme volatility in markets, it is not surprising that investors have been choosing to sit on the sidelines amid a ‘buyer’s strike’ until more clarity emerges (which may come in the form of new policy or central bank action).
From a valuation perspective, stocks appear quite attractive both relative to their own history and relative to investment alternatives. To us, this suggests that the long-term outlook for equities remains attractive, but investors will need to remain patient.
