Economists are famed for being unable to spot a turning point until they are at least half way through the turn and markets are known to have predicted nine of the past six recessions.
But eventually they tend to agree.
Right now, there is a gulf opening up between what economists, including those at central banks and most leading market commentators are saying, and what is happening in the markets.
As we noted last week, economists tend to stress the underlying health of the global expansion; the strength of corporate balance sheets; and the need for some re-pricing of risk.
Ultimately, most agree that this crisis will blow over, having inflicted only limited damage on the global economy.
Meanwhile, equity markets are reliving some of their worst days since the immediate aftermath of Sept. 11, 2001.
We can illustrate this dichotomy perfectly using two models for predicting U.S. recessions that we have developed.
The first model is based on a methodology developed and used by the Federal Reserve. The key variable in this model is the slope of the yield curve, specifically the spread of the three-month rate over 10-year Treasurys.
The greater the spread, the higher the perceived risk of a serious economic dislocation from the market's perspective. It is thus a proxy for the risk that the market is attaching to such an event.
Our other measure is based on macroeconomic data including the Fed Funds Rate, CPI inflation and the manufacturing ISM production question.
Recessions become more likely with a higher Fed Funds rate, higher inflation, and a lower reading on the ISM.
Happily, the two measures broadly agree, especially when there is actually a recession - both have a predictive power of around 50%.
Interestingly, though perhaps not entirely surprisingly, the market flagged a warning before the macro data ahead of both the 1990 and 2001 recessions. But it also sent a false signal in 1998, while both got it wrong in 1995. Of course, in both 1995 and 1998, the Fed did eventually step in by cutting rates by at least 75 basis points.
Both measures have picked up recently. But they are sending very different signals.
The market-based probability has risen from 31% in June to 43% now; while the macro-based probability has risen from around 1% in June to just over 6% now.
To put the numbers in perspective, there is usually about a 10% chance of a recession over the next 12 months.
The bottom line is that in the run up to actual recessions, both measures move up over 50%.
So, which measure is likely to be right?
The current situation is probably best described as a liquidity crunch. In short, private or commercial banks have lost confidence in each other's creditworthiness. That is, not yet a full blown credit crunch.
As long as central banks make it clear that they are willing to lend as much cash as required, a willingness that the central banks have been at pains to emphasize, then the crisis should eventually blow over.
But what if this turns out to be more than just a liquidity crisis?
It's been another difficult week in the markets, to paraphrase former U.K. Chancellor Norman Lamont.
It is beginning to look like equity investors do now see a real potential for the credit crunch that seemed to have been avoided earlier in the year, that is, tighter lending standards and a commensurate decline in real economic growth.
There is a growing sense that even if it does blow over, the financial sector will experience lower earnings growth as a direct result of a cessation of the LBO, IPO and M&A activity that has been so important for the sector's revenues over the past few years.
This is particularly true in the U.S. equity market where financial stocks make up almost 20% of the S&P 500's market value.
In fact, if you stripped out financials from the S&P 500 index it would be over 10% lower today.
Financial sector earnings growth has outstripped earnings growth in the rest of the index, by around 120% since the start of 2006. Investment bank fees can be as high as 5% of these billion dollar restructuring deals. But with falling revenues it won't be long before these banks start to ask themselves if their deal teams need to be so large, which would clearly have implications for
financial sector employment levels.
And of course the other providers of professional, financial sector services such as law and accounting firms, will also experience lower revenues.
Other asset prices, like housing, may also feel the sharp end of lower bonuses, especially in the U.K.
For now, the fact that the macro-data-based recession measure is still relatively low should provide some comfort, and is probably the better gauge of how the Bernanke Fed is currently viewing things.
But even without the dreaded credit crunch there could still be a direct, and long-lasting, negative impact on equity market valuations going forward, as the great credit boom fades.
But eventually they tend to agree.
Right now, there is a gulf opening up between what economists, including those at central banks and most leading market commentators are saying, and what is happening in the markets.
As we noted last week, economists tend to stress the underlying health of the global expansion; the strength of corporate balance sheets; and the need for some re-pricing of risk.
Ultimately, most agree that this crisis will blow over, having inflicted only limited damage on the global economy.
Meanwhile, equity markets are reliving some of their worst days since the immediate aftermath of Sept. 11, 2001.
We can illustrate this dichotomy perfectly using two models for predicting U.S. recessions that we have developed.
The first model is based on a methodology developed and used by the Federal Reserve. The key variable in this model is the slope of the yield curve, specifically the spread of the three-month rate over 10-year Treasurys.
The greater the spread, the higher the perceived risk of a serious economic dislocation from the market's perspective. It is thus a proxy for the risk that the market is attaching to such an event.
Our other measure is based on macroeconomic data including the Fed Funds Rate, CPI inflation and the manufacturing ISM production question.
Recessions become more likely with a higher Fed Funds rate, higher inflation, and a lower reading on the ISM.
Happily, the two measures broadly agree, especially when there is actually a recession - both have a predictive power of around 50%.
Interestingly, though perhaps not entirely surprisingly, the market flagged a warning before the macro data ahead of both the 1990 and 2001 recessions. But it also sent a false signal in 1998, while both got it wrong in 1995. Of course, in both 1995 and 1998, the Fed did eventually step in by cutting rates by at least 75 basis points.
Both measures have picked up recently. But they are sending very different signals.
The market-based probability has risen from 31% in June to 43% now; while the macro-based probability has risen from around 1% in June to just over 6% now.
To put the numbers in perspective, there is usually about a 10% chance of a recession over the next 12 months.
The bottom line is that in the run up to actual recessions, both measures move up over 50%.
So, which measure is likely to be right?
The current situation is probably best described as a liquidity crunch. In short, private or commercial banks have lost confidence in each other's creditworthiness. That is, not yet a full blown credit crunch.
As long as central banks make it clear that they are willing to lend as much cash as required, a willingness that the central banks have been at pains to emphasize, then the crisis should eventually blow over.
But what if this turns out to be more than just a liquidity crisis?
It's been another difficult week in the markets, to paraphrase former U.K. Chancellor Norman Lamont.
It is beginning to look like equity investors do now see a real potential for the credit crunch that seemed to have been avoided earlier in the year, that is, tighter lending standards and a commensurate decline in real economic growth.
There is a growing sense that even if it does blow over, the financial sector will experience lower earnings growth as a direct result of a cessation of the LBO, IPO and M&A activity that has been so important for the sector's revenues over the past few years.
This is particularly true in the U.S. equity market where financial stocks make up almost 20% of the S&P 500's market value.
In fact, if you stripped out financials from the S&P 500 index it would be over 10% lower today.
Financial sector earnings growth has outstripped earnings growth in the rest of the index, by around 120% since the start of 2006. Investment bank fees can be as high as 5% of these billion dollar restructuring deals. But with falling revenues it won't be long before these banks start to ask themselves if their deal teams need to be so large, which would clearly have implications for
financial sector employment levels.
And of course the other providers of professional, financial sector services such as law and accounting firms, will also experience lower revenues.
Other asset prices, like housing, may also feel the sharp end of lower bonuses, especially in the U.K.
For now, the fact that the macro-data-based recession measure is still relatively low should provide some comfort, and is probably the better gauge of how the Bernanke Fed is currently viewing things.
But even without the dreaded credit crunch there could still be a direct, and long-lasting, negative impact on equity market valuations going forward, as the great credit boom fades.
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