The crowd expects an economic slowdown. Even former Fed chairman Alan Greenspan has hopped on the bandwagon, warning yesterday that the risk of recession is “clearly rising.”
And so it is by a number of statistical measures. But even if we all think we know what’s coming, there’s still plenty of risk to waylay strategic-oriented investment portfolios. This, in short, is no time for complacency or immoderate confidence.
The primary challenge for the next several months is less about a slowing economy. Rather, the potential for surprises–positive or negative–are considerable, which could bring dramatic spikes in volatility. Ultimately, higher vol presents opportunity, as well as risks, although the price of entry will be making decisions that are in conflict with the crowd.
Our thinking about the possibilities arising from a new round of drama in the capital markets was inspired at yesterday’s press briefing at the New York office of Barclays Capital, where your editor heard presentations from several analysts on a broad array of economic and investment topics. On the matter of the U.S. market, the Barclays team, led by Larry Kantor, head of economics and market strategy, was in agreement: economic growth in America is turning sluggish. Barclays predicts that growth will slow to 1% in this year’s Q4 and 2008’s Q1. If so, that would be a sharp slowdown from Q3’s 4.9% rise.
The challenge is deciding how much variation is possible (or not) in this outlook. Yes, the economy’s rate of growth is surely decelerating as we write. But as yesterday’s strong retail sales report for November reminds, there’s still a fair amount of strength percolating from the all-important consumer sector. The 1.2% rise in retail sales last month was double the consensus forecast, suggesting to some that the slowdown could end up being mild.
“We should still see reasonable sales growth and no recession,” Allan Meltzer, professor of political economy at Carnegie Mellon University, told Bloomberg News. “It’s quite reasonable to expect high energy prices will slow business investment and, eventually, consumer spending, but people are working, the unemployment rate is low and Christmas is Christmas.”
Also giving optimists hope is the export machine, which is providing a timely offset to the weakness elsewhere that’s weighing on GDP. Consider this year’s Q3, when exports surged at a real annualized 18.9% rate–the highest since Q4 2003. The weak dollar, which makes U.S. exports less expensive in foreign-currency terms, is obviously at work here. Until and if the buck mounts a considerable rebound, the export boom is likely to continue. Yes, a number of forex strategists think the dollar may now tread water for a time as the market digests the currency’s sharp decline this year. But we’ve yet to hear of any one predicting a new bull market for the buck any time soon.
The combination of exports and consumer spending, in short, look set to provide some degree of offset to the weakness in other areas, including the ongoing housing-related ills. Lending confidence that consumer spending may hold up for the next few months is the buoyant labor market. Although job creation is slowing, it’s yet to deteriorate in any meaningful way. The unemployment rate remains a low 4.7%. To be sure, that could change quickly in this environment. But if Joe Sixpack can keep his job, he’ll keep spending–perhaps at a lesser pace–and continue to pay the mortgage, even if his house is worth less. It may be a close call on this one, but the game isn’t over yet.
Another positive, according to Barclays, is the outlook for foreign economies. Although the forecast is for slower growth for overseas, the downshift will be milder compared with the U.S., providing support for American exports, or so we’re told.
The complication in all this is that the Fed has been cutting rates in a pre-emptive effort to head off recession. The risk is that the economy turns out to be stronger than expected, thereby exacerbating inflation. Pricing pressures are already bubbling, and so another uptick or two may roil investor sentiment. Yesterday’s update on producer prices showed wholesale inflation at the highest rate in 34 years, although after carving out food and energy costs the pace was only the highest since February. The trend was confirmed with this morning’s report on consumer prices, which increased by 4.3% for the year through last month–the highest in more than a year.
If the economy still holds the power to surprise on the upside, inflation will continue to be a risk factor for the markets. The Fed, as a result, may be inclined to reverse its liquidity injections at some point in Q1 2008 once it’s clear that the immediate risk of recession has passed. That opens the possibility for a sharp selloff in equities. Bonds, too, may be subject to revised thinking on the inflationary risks. Indeed, the 10-year Treasury yield was 4.17% at yesterday’s close–below the current annual rise in CPI inflation.
At the same, it’s not obvious that the economy can avoid the ongoing troubles related to housing. The Barclays team yesterday advised that there are still more mortgage-related ills to come in 2008. What’s more, higher inflation tends to trim consumer spending in real terms, research from Barclays shows. If pricing pressures move up much more from here, Joe’s anticipated lesser spending habits may be amplified as a negative through the economy in inflation-adjusted terms.
Unfortunately, it’s impossible to know if the negatives or the positives will prevail in next year’s Q1. Surprises of one sort or another, as a result, seem likely, and so the markets may be roughed up from time to time. Strategic-minded investors with an appetite for contrarianism should be prepared to exploit any surge in volatility for rebalancing portfolios. For what it’s worth, this writer thinks the opportunities on that front will be considerable in the weeks and months ahead.