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Markets Holding Up Despite Volatility

Ken Taubes
calender-icon Posted on August 16, 2012

Despite a steady stream of negative headlines and high volatility, markets are holding up pretty well. The broadest measure of the stock market, the S&P 500 Index, is up nearly 13% year-to-date through today, August 13, 2012. The NASDAQ is up almost 17%. High yield bonds are up almost 9.7% while investment grade corporate bonds have gained over 7%. Even Europe has managed 7.5%, as measured by the FTSE Eurofirst 300 Index in dollar terms.

Especially interesting are corporate bonds. They’re basically at their lows for the year in terms of both yields and spreads. In fact, after starting the year at around 725 basis points over Treasuries, high yield bond spreads are about 600 basis points over Treasuries today. Investment grade spreads started the year at about 257 basis points over Treasuries, and now are around 190. Investment grade bond yields are around 3%, High Yield bonds around 7%.

Are We Heading into Recession? Not so Fast.

If we’re heading into a recession or economic slowdown why would credit spreads narrow? Well, from my point of view, it’s one of two things (maybe a little of both). First, I’ve never seen high yield and credit spreads tighten aggressively like we’ve seen ahead of a recession. Usually that’s not what happens. The bond and credit markets are good at sensing when there’s the potential for a serious credit event or deterioration in credit. We don’t usually see this sort of spread tightening. Therefore, one conclusion may be that the market isn’t really going to see the type of recession that a lot of analysts and television commentators are crying out.

Second, it could be that central bank policies, which include interest rate easings by the Fed, the Bank of England, the European Central Bank, and some of the Asian central banks, are beginning to create an environment where investors are desperate for greater yield and are ignoring the fundamentals in order to get some sort of income. I’m not 100% sure how much each is a factor, but I suspect a little bit of both.

Where’s The Economy Going?

Economically, our mantra all year has been that we’re in a slow-growth environment. That hasn’t changed. Companies have continued to be able to generate good earnings, despite a weaker revenue and growth environment, by holding down costs. As always, however, it’s a double-edged sword of stingy hiring and weaker investing. Nevertheless companies for the most part are holding up their margins.

One of the most interesting topics today is what the Fed and the ECB are going to do. Starting with our own Fed, I believe if the data doesn’t pick up as they expect, then they’ll ease. However, I also think it means that if the data does pick up, they will not ease. I don’t think it’s an automatic given. Moreover, I don’t know what they’re going to do about a potential QE3 action given recent economic data. The employment market isn’t as bad as the worst scenarios. It doesn’t look like it’s gotten any better, but it doesn’t look like it’s gotten any worse.

Consumers spending on bigger ticket items such as automobiles and housing continue to hold up or improve. Auto sales continue to be running around $14 million per annum in the U.S. and they haven’t really deteriorated from that level over the last three or four months.  Housing, despite up and down data, continues to get better. Generally, if people are really pinched or are expecting something bad to happen, they don’t go out and buy cars and houses. I think we’re in a weak growth environment where most of the weakness we are seeing is related to manufacturing.

For me, the bottom line is people will continue to hold back on investing, buying goods and equipment, because of uncertainty on our tax laws and the regulatory environment, until after the election.   I think if we had some agreement on taxes, the markets and the economy would be doing much better. That’s not very likely. Nonetheless, I think companies and investors whether confronting higher taxes, lower taxes, good regulation or bad, just want to see some conclusions at this point so that they can make investment plans.


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