Goldman Sachs is arguably the most prominent and perhaps the most notorious of the financial services behemoths. Their analysis, written over the weekend, is notably sanguine. They express surprising disdain for the S&P downgrade (joining a long list of similarly engaged detractors) and relative optimism about the longer term economic prospects.
A couple of noteworthy points: Goldman's research demonstrates that warning signs of financial decline began in 1990, approximately the point at which extreme financial deregulation began in the US and at which point financial services began its historically unusual command of the US GDP. Second, the Goldman report points out that recovery from severe financial shocks always take longer than from 'normal' recessions. The implication is not necessarily comforting; the world may be in for another five years or so of subpar growth. However, given the excesses - to which Goldman contributed - the results thus far are consistent with rational economic expectations. Now if the politicians would only pay attention. JL
Goldman Sachs'Investment Strategy Group August 7 market commentary:
Over the last several months, as the US debt ceiling negotiations dragged on and the sovereign debt crisis in Europe deteriorated, it seemed that a day did not go by without an article or market commentator asking if another “Lehman Moment” was imminent. Today, the question is whether the “Lehman Moment” has arrived. After all, the S&P 500 has fallen 11.3% since July 22nd, we experienced a one-day drop of 4.8% last Thursday, incremental yields on Spanish and Italian sovereign bonds are at all time highs, first quarter US GDP was revised down from 1.9% to 0.4%, while the second quarter was a weaker-than-expected 1.3%, and Standard & Poor’s just downgraded US sovereign credit on Friday evening.
In Europe, policy makers continue to equivocate about the optimal approach to the Euro zone sovereign debt crisis, consistent with their handling of this crisis since Greece's budget woes surfaced in the fall of 2009. In the US, the path to the debt ceiling agreement and the absence of clear spending cuts has undermined confidence in the long-term effectiveness of US policy makers. In China, the high-speed railway accident has brought to fore many questions about the sustainability and quality of Chinese growth. And yes, the odds of a recession in the US and Europe have clearly increased as global growth projections are revised downward.
However, that is not to say that we are close to a repeat of the 2008/09 economic and financial crisis: in the US, the economic backdrop, the earnings environment, private sector leverage, and market valuations do not point in that direction Let’s examine why a double dip recession and a commensurate market drop is not our central case. We will begin with a review of the latest economic data, followed by a review of the risks emanating from Europe. We will then review the most likely implications of the S&P downgrade on the economy and the financial markets. We will follow with our view of earnings through 2011 with some commentary on the most likely path through 2012, including why current market levels provide some upside in the long-run. Of course, in an environment where perception can drive reality, downside momentum could continue in the short-run. Lastly, we will conclude with our investment recommendations.
The Odds of A Double-Dip Recession
Since the end of the financial crisis, investors have been plagued by the fear of a double dip recession fostering a second leg down in the equity markets, along the lines of what was witnessed in the Great Depression. In that episode, a 9% per year real GDP recovery was followed by another recession in 1937-8 which caused the market to forfeit almost three quarters of the 324% equity market gains it enjoyed from the trough. The fear is particularly acute given the fact that there are not many tools left in the toolbox and whatever tools do remain may not be effective: short terms rates are at zero, the Federal Reserve’s balance sheet has already grown to $2.9 trillion as a result of two rounds of quantitative easing, the budget deficit.is at a 9.1% of GDP and additional fiscal stimulus seems unlikely unless the economy weakens significantly.
So what are the odds of a double-dip recession? First, we should state that a recession is not our central case. There are several key factors that account for our view:
1. As shown in Exhibit 1, financial conditions, which tend to lead economic growth, are very easy. In the absence of a shock and no clearly overvalued economic or equity market sector, it is harder to justify a recession in the face of such easy financial conditions.
2. A broad range of leading economic indicators continue to suggest positive GDP growth of about 2% in the second half of 2011, as shown in Exhibit 2. While these indicators do a reasonable job of indicating the trajectory of growth, none has consistently predicted recessions. The most reliable among them is the Conference Board Leading Economic Indicator, which is currently suggesting 3.8% growth. While some have highlighted the recent peaks in the ISM indexes as a harbinger of recession, we note that the ISM manufacturing index, which goes back to 1948, has typically peaked 40-45% of the way through an economic expansion. On this basis, we are around the midpoint of this modest expansion and would not expect a recession until closer to 2013.
3. Some key cyclical sectors of the economy,such as autos and residential fixed investment, are already quite depressed, making them less likely to weigh on growth. Similarly, business investment, whether in relation to either earnings or GDP, has lagged this cycle, (see Exhibit 3) suggesting it’s unlikely to grind to a halt as it did in 2008/09.
4. The negative effects of some temporary shocks, such as the Japan earthquake and rising energy prices, have abated and Japan’s recovery has alleviated some supply chain constraints. For example, the recent increase in vehicle sales to an annualized rate of 12.2 million units was a positive surprise and partly attributable to the easing of auto-related supply chain constraints.
5. Initial Jobless Claims have improved over the last several weeks with the four-week moving average of claims dropping from 428,000 to 408,000. Moreover, Friday’s non-farm payroll increase of 117,000, coupled with a gain in average hourly earnings, is not consistent with an economy in recession.
6. The Goldman Sachs Global Investment Research economics team’s recession indicator, based on the change in the unemployment rate, is flashing orange but not yet red. Their “three-tenths” rule of thumb” notes that in the post-World War II period, whenever the 3-month average of the unrounded unemployment rate has increased by more than 35 basis points from a trough, the economy has either entered a recession already or will do so within six months. The current 3-month average has increased by 23 basis points—far enough from the 35 basis point recession threshold for now.
Since the economic slowdown in the US has raised the concerns of a double dip, we should also put this sub-par growth since the third quarter of 2009 in the context of past financial crises in developed markets. Professors Carmen Reinhart and Kenneth Rogoff, (Authors of This Time is Different: Eight Centuries of Financial Folly), in their updated research1 show that after major global financial crises, GDP growth is substantially lower in the decade following crises relative to the decade prior to the crisIn advanced economies, per capita GDP is 1% lower in post-WWII financial crises. Our own analysis of the data indicates that the first five years post the crisis are subpar but the subsequent five years are even higher than the growth rates prior to the crises. Using this historical template of financial crises, we should expect slower growth rates for the next several years and with them, episodic concerns over renewed recessions. Our base case is for GDP growth of about 2% over the next 18 months.
One of the key drivers of slower growth in the periods after financial crises is the deleveraging that is required to unwind the excesses of the prior cycle. Reinhart and Rogoff estimate that this deleveraging takes about seven years, on average. As shown in Exhibit 4A and 4B, US household increased their savings rate in earnest in the second quarter of 2009 and lowered household debt to GDP to 89%, a level not seen since Q2 2005. But deleveraging has further to go, which will remain a headwind for consumption growth rates for the foreseeable future.
While a recession in the US is not our central case, we do think the risks to the downside have increased significantly. Our colleagues in Global Investment Research estimate a one-third probability of a recession. The Wall Street Journal reported that former Federal Reserve Vice Chairman Donald Kohn, who was a guest speaker at a recent Investment Strategy Group client call, puts the odds at 20%, while Vincent Reinhart, (Resident Scholar at AEI and former director of the Federal Reserve Board’s Division of Monetary Affairs) estimates the odds at 40%.2 For our part, we agree with our colleagues in Global Investment Research that the odds of a recession are 30% - 35%, particularly given that the low trajectory of US growth makes the economy more vulnerable to any external shocks. These shocks include ones we cannot anticipate (like the Japan earthquake or the Middle Eastern turmoil earlier this year) and those that are ongoing, such as a worsening of the European sovereign debt crisis (to which we assign a high likelihood) and a negative reaction by the markets to the S&P downgrade (to which we assign a lesser likelihood).
European Sovereign Debt Crisis: Worse Before it Gets Better?
As shown below, the incremental yields of sovereign debt from Greece, Ireland, Italy, Portugal and Spain (GIIPS) have increased over the last two week and Spain and Italy’s spreads are at their highest level since the inception of the European Monetary Union. This is particularly significant in light of the July 21 Euro-zone Summit in Brussels where policy makers agreed to a number of measures to contain the crisis. Market participants have questioned the strength of these measures:
Will Greece still need to restructure since the voluntary private sector involvement was not sufficient to reduce Greece’s debt burden in a meaningful way?
When will individual parliaments approve the funding required to get the European Financial Stability Fund (EFSF) to the 440 billion euro target?
Will Spain and Italy achieve their stated budget cuts?
Will Germany continue to resist the ECB’s purchases of sovereign bonds of Greece, Portugal and Ireland (as reported by the Wall Street Journal, the Bundesbank “opposed the resumption of bond purchases” by the ECB3)?
Will Portugal implement the structural reforms required by the IMF/EU programs?
Will there be sufficient support if countries like Italy, Spain and even France face further market pressures?
…the list goes on.
One of the key concerns is that European policy makers will continue with their incremental and reactive approach. When forced by market participants through wider spreads, and funding pressures on the financial sector, policy makers have responded with additional yet incremental measures. Yet it seems market participants are increasingly losing patience with these stopgap measures. As the last 18 months have shown, incremental measures have been repeatedly challenged by the market, leading to wider spreads and contagion to larger Eurozone countries with larger levels of total debt.
Clearly, the fact that Spain and Italy have been drawn into the crisis is worrisome given their size. Spain and Italy account for 2.2% and 3.3% of world GDP and have $872 billion and $2,446 billion of gross government debt, respectively. That compares to Greece, Ireland and Portugal with 1.2% of world GDP and $774 billion of debt combined. In an attempt to calm the markets and solicit the purchase of Italian bonds by the ECB, Italy has announced additional fiscal austerity measures. In Spain, upcoming elections in November are expected to further strengthen the government’s hand in implementing the necessary austerity measures. But it does not seem that market participants have the patience to see if fiscal austerity will reduce the debt burden of these larger countries.
Late this weekend, the ECB announced that it will implement its Securities Market Program in “dysfunctional” market segments, which presumably means that it will purchase Italian and Spanish bonds. The statement released on Sunday by the Governing Council seems to indicate that they will intervene in the secondary markets until the EFSF is fully activated. Thus far, the ECB has been very reluctant to purchase government bonds in the secondary market in any meaningful size. However our colleagues in Goldman Sachs Global Investment Research believe that while the statement may lack the clarity some might have hoped for, they “interpret the fact that the ECB highlights the role governments have to play as implicit acknowledgment that it is now also willing to play its part in stabilizing the financial system.”4
In the meantime, what remains to be seen is the extent to which tax payers in the stronger European countries like Germany, the Netherlands, and Finland will provide the required funding for the EFSF—both the committed levels as well as any incremental funding. Another critical issue is Germany’s support of the ECB buying the sovereign debt of a broader group of countries. German policy makers know that a weaker euro-zone is not good for Germany. As mentioned in the past, German banks’ exposure to the debt of the GIIPS is over 15% of German GDP. In addition, 70% of German exports go to other European countries and exports account for 31% of German GDP. An additional concern is that the economic backdrop in Europe is less favorable today than a year ago. While Eurozone Purchasing Manager Indexes are still pointing to positive economic growth, they nonetheless confirm a clear loss of economic momentum. Our central case is for growth of about 1.0% - 1.5% for the next 18 months.
Given the pattern to date, it seems that progress in resolving the sovereign debt crisis will continue in fits and starts: markets will force the policy makers’ hands, new measures will be announced and markets will then improve until the cycle starts all over again. This dynamic is likely to be reinforced by the difficulties of bringing policy makers from different countries into agreement, especially in the absence of fiscal union and greater enforcement mechanisms.
Can the S&P Credit Downgrade Derail the US Economy?
As much as Standard and Poor’s had telegraphed their intention to downgrade US’s sovereign credit rating from AAA baring a $4 trillion fiscal consolidation plan, their announcement of a downgrade on Friday evening was still a surprise. After all, the Budget Control Act of 2011 was passed before the August 2 “deadline”, and while not $4 trillion package, the $2.1 – 2.4 trillion budget cut target seemed to be a step in the right direction and certainly ahead of expectations even last year. It is even more surprising that they proceeded after the Treasury, according to multiple sources,5 pointed out a $2 trillion “error” in S&P’s analysis.
At the heart of the discrepancy was S&P’s assumption about the trajectory of discretionary spending. For context, the Congressional Budget Office uses a series of baselines to project the fiscal profile of the US. According to Politico,6 Standard and Poor’s initially used a baseline (referred to as the Alternative Baseline) where discretionary spending grows by 5% over the next 10 years instead of the more updated March 2011 baseline where spending grows at just 2%—hence the $2 trillion difference. Importantly, Politico reports that the Treasury has pointed out that under the latter baseline, net Federal debt-to GDP stabilizes at 79% by 2021, rather than continuing to rise—another point of disagreement between the rating agency and the Treasury.
S&P stated that one of the key motivations for the downgrade is their view that “the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges”. The response to this political assessment as a cause for the downgrade has been decidedly negative since many have contended that the debt ceiling negotiations were “messy” but “working exactly the way our Founders intended it to.”7
We highlight the “$2 trillion error” and S&P’s assessment of the US political process because it may well temper how the markets react to the downgrade. That said, we have no direct US experience against which to assess what a downgrade might imply, since the US has had the highest rating from both S&P and Moody’s since they initiated coverage in 1941 and 1917, respectively. As such, the impact on Treasury yield levels, either from a credit perspective or from the impact of forced selling pressures from the typical holders of Treasury securities is hard to dimension.
Even so, our best guess is that the real long-term impact (as opposed to the immediate market reaction on Monday) will be limited for the following reasons:
1. Two other rating agencies, Moody’s and Fitch, affirmed their ratings. Notably, most investment guidelines specify that more than one rating agency must downgrade to trigger automatic selling.
2. S&P affirmed its short-term debt rating of A1+ (the highest rating), so money markets funds are not impacted.
3. Banking regulators, including the Federal Reserve, and the Federal Deposit Insurance Corp have stated that the rating action by S&P will not affect the capital positions of the nation’s banks. In addition, under Basel I and II, OECD government debt, or debt rated AA and above, gets a zero risk weighting.
4. The rating change will not force a large swath of investment managers to liquidate positions given that their investment guidelines specify allocations to US Treasuries and government agencies, but do not include a ratings designation.
5. For insurance companies, the top tier “NAIC1” capital category does not distinguish among securities rated AAA through A. Moreover, Treasuries, GSE debt, and GNMAs are exempt from capital charges (GSE MBS are not exempt, but are automatically assigned an NAIC1 rating).
6. Sovereign wealth funds and central banks are unlikely sellers of US Treasuries given the size, liquidity and credit quality of alternatives are lacking. Among other AAA sovereign issuers, the next three after the US are the UK, France, and Germany; combined, these countries have 80% less debt than the US, and neither the UK nor France are exempt from their own set of fiscal concerns with debt to GDP in the UK at 83% and France at 88%. Among AA issuers where the debt markets are large such as Japan, its debt to GDP stands at 220% of GDP, making credit quality the greater concern.
7. Households and the Federal Reserve (as large holders of US Treasuries) are unlikely to be impacted by the downgrade. At the end of the day, US Treasuries remain very high quality and pose little if any credit risk.
Will Robust Corporate Earnings Limit the Downside to US Equities?
So where does all this leave us with equities? The current backdrop is one of stark contrast: weaker global economic growth, continued fits and starts in addressing the European sovereign crisis, an S&P downgrade of mixed impact, and continued deleveraging in the household and government sector in the US stands side-by-side with robust earnings growth, pristine corporate balance sheets, and fair valuations. With Q2 earnings season close to an end, we estimate that 2011 operating earnings will be higher than our initial estimates of $88-93 per share and close to $95. Against this year’s better earnings performance, as well as the long term trend in earnings, we still think our below consensus yearend target of 1300-1375 is reasonable, although risks are tilted to the downside. Furthermore, as we look to 2012, we think mid-single digit earnings growth is still the most likely outcome. Should earnings continue on a positive, albeit modest growth trajectory, we think equities can have mid-teen returns from current levels. So on a purely fundamental basis, if a recession is averted which is our central case, equities can provide some attractive upside from current levels.
The question on our clients mind, however, is probably not the upside but the downside risks from here. Can equities go below 1000 for a cumulative downdraft of 25% from the S&P 500’s July 22 peak, resulting in an even greater downdraft than we witnessed last year? It is certainly possible as fear and negative sentiments dominate the markets. Moreover, equity downdrafts can certainly create their own negative feedback loop in the economy, as reduced net worth and consumer confidence slow spending, thereby affecting the long-term fundamentals.
Of course, positive fundamentals can also have their own momentum. And on this point, company fundamentals remain robust at present, with S&P sales growing almost 4% since last quarter and 13% over the last year, significantly better than US GDP growth. In turn, this sales growth has translated to around 18% earnings growth in Q2. We also take some comfort from the fact that while only about 20% of S&P 500 firms have provided earnings guidance for the upcoming quarter (lower than the past) more than half have provided some form of guidance (next quarter, this year, or next year guidance) over the last month. Notably, of those firms that either raised or lowered guidance, about 72% issued positive guidance. We conclude that while near term volatility and political uncertainty might affect the next quarter, companies are more positive about their long-term business outlook. So while the short-term trading backdrop is highly uncertain, the longer-term investing backdrop remains supportive.
Investment Implications
So what should our clients do against a backdrop of slowing US growth and now a US rating downgrade? As we have written for the last several months, we think clients should brace themselves for more turbulence. With the right strategic asset allocation tailored for each client, a well-diversified portfolio has enough fixed income securities and hedge funds to withstand the current volatility. For example, while equities dropped 12.5% from their recent highs, a diversified portfolio would probably have declined 4-5%, which seems tolerable for a client with moderate risk appetite. Since a recession is not our base case, we would not recommending underweighting equities at current levels. However, because the risk of adverse outcomes remains elevated, we have recommended clients hedge tail risks, where equities could drop well below 15%, with out of the money puts. Again, while a recession is not our central case, we believe some cheap protection against that scenario is appropriate.
For clients who are more worried about the downside risks (and, therefore, unwilling to withstand this level of volatility and willing to forgo the upside risks as well), they should reduce their allocation to equities by either raising fixed income or cash, or using structured notes with some principal protection for equity exposure, or increasing hedge fund allocations at the expense of long only equity allocations.
Now a word of caution for clients who are thinking about fleeing US equities to purchase more key emerging market stocks. Since its post-crisis high on May 2nd, US equities are down 12.5%. Since their respective post-crisis highs, Brazil is down 25%, India down 20%, China down 17% and Russia down 15%. Notably, we do not think emerging market equities will outperform in the case of a US recession. Many of the emerging markets are more export-driven than meets the eye. China’s economy is more driven by exports today at 30% of GDP than in 2000 based on the latest available IMF data; furthermore, if one takes into account investment in the export sector, that number increases to 45%. A 1% slowdown in US consumption alone could shave about 1% off China’s expected GDP. A slowdown in Europe, which has been a growing export destination for China, would also hamper growth. Similarly, a decline in commodity prices due to a global slowdown will affect countries such as Russia, Brazil, Chile, and Malaysia. As such, we continue to believe that growth in the emerging markets is highly synchronized with the major economies. Therefore, emerging market equities are unlikely to offer protection in the case of a US recession and large US equity market downdraft, in our view. Instead, we think high quality government bonds, including US Treasuries, are a better safe haven. Indeed, just witness the recent performance of US Treasuries, which are up 13.3% since May 2nd, when the S&P 500 peaked.
To conclude, while there are unquestionably many downside risks, there are still upside risks as well. A recession is not our base case, but the market is increasingly pricing one, which will lead to equity upside if it fails to materialize. Moreover, some of the concerns mentioned above are largely political problems, creating somewhat binary outcomes. As such, if sufficient political will materializes, risk assets could react very positively. While positioning one’s portfolio in this type of environment is admittedly challenging, we believe a moderate model portfolio is designed to enable a moderate risk investor to withstand the current volatility.
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