“We have nothing to fear but fear by itself”

Some stock markets have suffered their longest and steepest loosing streak since the mid-70^th. The sell-off continued last week after Standard & Poor’s downgraded the rating of US Treasury notes and bonds by one notch to AA+. One factors contributing to the plunge of stock markets is the fear among traders and investors that the US economy might head towards a recession. Thus, it should not come as a surprise that also industrial metals dropped last week. However, is this fear justified or overdone?

As pointed out earlier, the downward revision of US GDP numbers for the last few years including the first quarter of this year came as a negative surprise. However, the market participants focused on the downward revision and ignored that growth picked up in the second quarter. Thus, to fall back into a recession, the US economy would have to shrink in the second half of 2011. We doubt that this is the most likely scenario.

The FOMC reckoned in its statement that GDP growth is lower than the Fed had expected and that it is not only attributable to the rise of food and energy prices. Nevertheless, it has been the rise of these prices, which had been a drag on consumer spending for other goods and services. The rise of crude oil caused by the riots in the MENA region was one factor for the rise of gasoline prices in the US. Another factor was the weather impact on the transportation of gasoline from the refineries to the gas stations. The flood of the Mississippi and its tributaries prevented that sufficient gasoline could be shipped. As a result, gasoline prices soared. The RBOB future at NYMEX reached almost 3.5$/gallon and retail prices came close to the 4$-mark. However, since May, the gasoline price came down again. The RBOB future traded last week shortly below 2.6$/gallon. Thus, the decline of gasoline prices will increase the financial means of private households disposable for spending on other items.

The US economy is not creating enough jobs to reduce unemployment significantly. However, the recent release of the US labor market report also shows that it is dangerous to draw conclusions about a recession from one report. One reason for the expectation of slipping back into recession has been the June non-farm payroll figure, initially reported at 18K. However, this number has been revised up and the preliminary July figure also surprised to the upside. Therefore, the lower number of new jobs created in May and June might be the result of supply disruptions following the earthquake and nuclear catastrophe in Japan in March.

The ISM indices have dropped in July. The manufacturing PMI came in at 50.9 and the service sector PMI at 52.7, which also contributed to the sell off in stock markets. Nevertheless, both indices are still above the 50 mark, which is regarded as the threshold between a positive and negative economic outlook. However, empirical analysis shows that the critical level for entering a recession is below the 50 mark at 46.

Paul Antony Samuelson, a Noble laureate in economics, once said that the US stock market predicted nine out of five recessions. It seems that the current situation is comparable to one of those predictions, which did not end in a recession but was a false alarm by market pundits. Unless a recession is caused by an external shock, as for example after the first oil price shock in the mid-70^th, there is a typical pattern, which leads to a recession. As the economy expands the utilization of the production capacity increases. Less idle capacities imply normally increasing marginal costs of production. These higher marginal costs could be passed easily to the buyers. Prices rise not only for a small number of goods in one sector but over many segments. Not only headline but also core inflation picks up and accelerates. Central banks react by increasing the interest rates. As a result, money market rates rise stronger than long-term government bond yields. The yield curve, often measured as the difference between 10yr T-Notes and 3mth T-Bills, inverts. An inverted yield curve is the best indicator that the economy will head into a recession about 12 to 24 months later.

As the chart above shows, an inverted yield curve also preceded the top of the S&P 500 index in 2000 and 2007. The last few weeks, the US yield curve has flattened significantly due to the flight into the safe haven of US government bonds, despite the last minute compromise to lift the debt ceiling and the downgrade by S&P. However, the Treasury curve is still normally shaped and far from an inversion. The FOMC decided this week that the target Fed Funds rate will be held at the range between 0 and 0.25% until mid-2013. Thus, also the 3mth T-Bill rate will be closely anchored at this rate. It appears rather unlikely that the 10yr T-Note yield will fall below the 3mth T-Bill rate. This was also not the case in Japan despite the traditionally low yield environment. Also the fear that the downgrade by S&P would lead to a significant increase of funding costs for companies seems not justified as the Fed keeps interest rates low for the next two years and the decline of US Treasury yields as the benchmark. Many commentators make the mistake to look just at spreads between the US Treasury yield and yields on corporate bonds. However, what matters for business fixed investments is not the spread but the absolute level of corporate bond yields and funding costs.

Of course, one should not overlook the risk that the panic in stock markets has a negative impact on the economy. The plunge of stock markets and the comments by the famous permanent bears like Dr. Roubini could induce companies to postpone investments and new orders. Thus, the fear of a recession could eventually lead to a recession as a self-fulfilling prophecy.

Based on the past patterns, the steepness of the US Treasury yield curve does not support the view that the US economy would enter a recession. The more likely scenario appears to be that US GDP growth remains below the long-term output potential but positive. Thus, also the drop of prices for industrial metals seems to be overdone. It might offer a good opportunity for commercial users to hedge some of the exposure and for investors to buy again.