Double-dip recession? NO, says Fidelity
Double-dip recession? Not so fast
Fidelity Viewpoints — 06/16/10
Editors' note: The editors of Fidelity Interactive Content Services (FICS) selected this article for its clear insight into the current state of the economy, and what this means for investors.
With the financial crisis in Europe continuing to make headlines, talk about a double-dip recession is on the rise. But Lisa Emsbo-Mattingly, Fidelity's director of economic analysis, says, "Not so fast." While she sees a slowdown in Europe, she thinks the risk is still low that it will hop the Atlantic. As the U.S. economy moves from recovery to expansion, growth may moderate, but that shouldn't be mistaken for a recession. This climate, she argues, could favor companies that can demonstrate sustainable growth and earnings—as well the stock pickers who can identify them.
Q: The financial crisis in Europe is getting a lot of attention, but will it snowball globally, as we saw in 2008?
Emsbo-Mattingly: One of the things that happened in 2008 was that the interbank lending market shut down. It wasn't distressed—it literally shut down. Lines of credit were withdrawn and the European economy froze up. What you're seeing now is continued distress in that financial system, but it's not anywhere as bad as it was in 2008. Recently, I met with our fixed income group, which is on the front lines of the market, and they said, yes, the market is volatile, and yes, it's messy. But it's certainly not anywhere near what we were seeing in 2008.
Q: So you don't see this crisis escalating and sending the U.S. into a double-dip recession?
Emsbo-Mattingly: I just don't see the evidence for that argument. Look at the recent data. The ISM Manufacturing Survey (measuring manufacturing activity) is high and in clear expansion territory.1 Consumer sentiment, which is still low, also is rising. And even though the May employment report was weaker than expected, it still showed job growth.
We haven't seen classic signs of recession, such as an unexpected decline in demand and a rise in inventories. Raw industrial prices, oil prices, and commodity prices in general—yes, they're down, but they are not plunging as they have in prior recessions. I'm looking at these glasses in front of me and I think they look half-full, not half-empty.
Q: But is growth, or the pace of the upturn in the U.S. economy, moderating?
Emsbo-Mattingly: You typically get the strongest spurt off the bottom of recession. And we saw that with the index of leading indicators. It was up strongly in March, 11.5% year-over-year. In April the pace of ascent moderated and it was up 10.2%. When the indicator bottomed last spring, it signaled that the economy was moving from recession to recovery. Now it appears it is signaling, through this moderating growth rate, that the economy is moving from recovery to expansion. But here's my point: Since 1958, we've never had a double dip when the leading indicators have been up this much on a year-over-year basis. I'm not saying a double-dip recession is an unreasonable concern, but I think the indicators I look at are still pointing to expansion.
Q: So Europe won't alter that picture?
Emsbo-Mattingly: Remember the Southeast Asian crisis back in 1997? At that time, I was worried because Southeast Asia accounted for a not-insignificant portion of global GDP and it was falling into a deep recession. Well, here's what happened: As Asia slumped, oil prices fell; our cost of capital also declined sharply because international investors flocked to risk-free U.S. Treasuries. So the Southeast Asia crisis basically became a stimulus to the U.S. economy. The same thing may happen this time around—already interest rates are heading down as overseas money flocks into Treasuries for a safe haven. [Past performance is no guarantee of future results.]
Q: So is it a good time to refinance your mortgage?
Emsbo-Mattingly: Mortgage rates are at very low levels. Assuming you can get a better rate, refinancing is definitely worth considering.
Q: As the economy shifts from a rebound to expansion, what does that mean for earnings and the stock market?
Emsbo-Mattingly: The explosive part of the business cycle is behind us. Now we have expansion. There's nothing wrong with expansion, but in this climate you have to actually earn your money. Now a company is going to have to show investors that it has sustainable revenues and margins—not just one-time gains from cost cutting. And I think that's really the story of the market, going forward.
Q: It sounds like this climate benefits classic stock pickers?
Emsbo-Mattingly: It definitely benefits stock pickers, at least the good ones. Over the past 12 months, it was a bit hard to be a stock picker because we were getting a lot of what they call junk rallies, where the worst companies did best. That's now over, in my opinion. In the next 12 months, as the economy shifts into expansion mode, I believe there will be a lot of emphasis on evaluating whether a company is able to generate a high level of growth and sustainability in earnings.
Q: Let's turn to the fixed-income side. What are these continued low yields telling us about the economy?
Emsbo-Mattingly: The 10-year bond is around 3.2%, so I think the bond market is forecasting very low growth and very low inflation. But the interesting thing is that this is way out of whack with what I think the stock market is telling us. Right now the market represented by the S&P 500® Index (.SPX
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) is selling at an earnings multiple of 12.5—assuming we reach $85 in earnings this year—which implies an earnings yield of a little under 8%.
Q: Can you explain that?
Emsbo-Mattingly: If you invest in 10-year Treasuries, they are yielding 3.2% currently. This is a fixed rate, so there is very little upside for this asset; that would require rates to go down even further. If you invest the same amount of money in the S&P 500, the earnings from these companies amount to nearly 8%. That makes for a simplistic risk premium of 4.8%. In post-World War II history, we've rarely seen so large an equity premium, and certainly not since the early 1980s.
So my question is, which would I rather bet on? Right now, I'd rather bet on the stock market. The earnings yield will moderate only if earnings turn sharply lower or the stock market rises, and I don't think earnings will tank at this point.
There's another possible explanation for this discrepancy. The low multiple in the stock market may be due to the perceived volatility in the economy, earnings, or inflation. That may be what's causing this huge spread between the risk-free rate (Treasuries) and the earnings yield in the stock market.
Q: And if volatility declines—if the crisis passes—the risk premium and earnings yield may move down?
Emsbo-Mattingly: Right, and if that happens, I think the market may rally.
Q: In the current climate, which asset classes look the most attractive to you?
Emsbo-Mattingly: Long-term government debt has had a very good run, but that looks the riskiest to me right now. I would consider high-yield corporate debt. Those bonds are "pricing in" a high level of default, but if you look at the leading indicators of default in that market, they are all turning positive, indicating default rates are coming down.
Q: What about interest rates? Are these low rates here to stay, or will the Fed begin to tighten soon?
Emsbo-Mattingly: It's very similar to 1998 and 2003, when the Fed was getting its ducks in a row to start changing monetary policy. The Fed has been positioning to tighten, but the Euro Zone crisis put that on hold. You don't need to raise rates to combat inflation if others are doing the heavy lifting for you. With the Eurozone crisis, the higher dollar has sent U.S. import prices down. A downturn in Eurozone growth will also reduce demand for raw materials, acting as another brake on inflation. So that gives the Fed more latitude to hold steady.
Q: So what's your bottom line for the economy?
Emsbo-Mattingly: I think we are likely to see some moderation of growth rates as the slowing of some of the European Union economies impacts part of the U.S. and global economies. But this is simply a slowing of growth from the rates typically seen in a recovery, to a rate typically seen in a mid-cycle expansion. The rally in Treasury and mortgage markets, the weakening of energy prices, and the slowing of the Fed rate hike cycle could actually extend the expansion for longer than I would have originally expected.
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