Abnormal Times- Abnormal Reaction

Concern has, for good reason, been focused on the state of the US economy.  Recent US data have certainly contained more bad news than good on unemployment, employment, retail sales and housing. But employment data is imprecise, and open to revision.    The consensus view on retail sales has also frequently been proved wrong in the past. 

This is not to say that the US economy is in no worse shape than in December: it clearly is.  But we must not get carried away and shift the odds of recession to ‘well over 50%’ just because of a few, poor quality, ‘bad’ data.   We note that the consensus forecast for US growth in 2008 has in fact shifted down only very slightly: those (few) forecasters who have dramatically moved down their forecasts have however garnered perhaps excessive attention in the press.

The risk for policymakers is that they become seen as ineffectual.   The Fed had itself already inferred that its past programme of interest rate cuts has not been up to the task.  Even before today’s rate cut, there had been strong suggestions that the Fed would soon shift to a more dramatic pace of monetary easing: bigger rate cuts sharply reduce the time it takes to get to a specific target level.   And, although fiscal policy is a blunt tool, it is one that can be helpful when a lot of wood has to be chopped – as is the case now.  President Bush’s fiscal stimulus, announced last Friday, made sense, is sizable (as a percentage of GDP) and is likely to be deliverable.  So, even if (realistically) it has come too late to make a lot of difference to the first half of this year, it will, nevertheless, make a big difference to the shape of any recovery, and limit the duration of any economic slowdown.   So the right policy tools are being used, even if they are imprecise in operation.

The markets remain sceptical.   They (until today, at least) have been putting a low weight on the efficacy of monetary policy; possibly almost no weight on fiscal policy.  Over time, we judge that they will adopt a more balanced tone. But we remain worried that the overly-negative reaction of markets will become more and more self-fulfilling, “polluting” economic fundamentals.   Usually, there are two sides to a market, with the forces of fear and greed playing out.  But occasionally a situation develops where no-one is willing or brave enough to adopt one of these two frames – a market ‘funk’, which now seems prevalent.

What does this ‘funk’ mean for investors?   The worry is that markets take on a life of their own, with fear pushing them down even in the face of mildly good macro-economic news.     In this world, the non-linearity of the real world may turn out to be a real issue: hence the 75bp cut by the Fed should, for example, have made a much greater impression than two equivalent smaller cuts.  Clearly, a policy response of ‘steady as she goes’ (25bp per meeting) risked disaster.  

We continue to believe that policymakers will respond in determined and appropriate fashion, and that the markets will eventually gain courage. So we stick with our ‘long-term’ call – based on our assessment of what the world with look like in, say, a year’s time.    But we are much less sure about how long this ‘funk’ will continue, and whether equity markets will plumb new lows before they find a floor and start generating decent returns again.    We suggest sticking close to home on asset allocation in the short term, even though we retain conviction in our long-term (and long- held) view that equities will outperform bonds.  For most investors, this doesn’t feel like a good time to be brave.