In the most recent Federal Open Committee Meeting, the following was observed by the policymakers:
“Economic growth so far this year has been considerably slower than the committee had expected. Indicators suggest deterioration in overall labor market conditions in recent months, and the unemployment rate has moved up. Household spending has flattened out, investment in non-residential structures is still weak, and the housing sector remains depressed.
As the first statement suggests, the committee had expected relatively better growth than what was observed in the first half of 2011. In line with the weak growth, the FOMC announced keeping interest rates at near zero levels until mid-2013. The key question here is: Are the policymakers again underestimating the severity of the economic downturn for the second half of 2011? Let's investigate if we are headed for a sharper slump in economic activity.
Based on the observations below, my opinion is that the economy might surprise on the downside for the second half of the year. The key factors leading to this conclusion follow.
Consumer confidence at three-decade low
The latest consumer confidence data suggest that confidence among consumers slumped to a three-decade low in August. The Thomson Reuters/University of Michigan preliminary index of consumer sentiment slumped to 54.9 from 63.7 the prior month. Further, the index of consumer expectation for six months from now, which might be a good indicator of consumer spending direction, slumped to 45.7 from 56 in the prior month. Clearly, for an economy primarily driven by consumption, a meaningful drop in consumer confidence is an ominous sign for the foreseeable future.
Nominal personal consumption expenditure declined for the first time in 11 months
As evident from the chart below, the nominal personal consumption expenditure (one-month change) went into negative territory for the first time in 11 months.
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Further, underscoring the fact that consumer confidence has been on a steady decline, the chart below shows the collapse of consumption in the second quarter. Without doubt, the data might be worse in the third and fourth quarter.
High-Yield/AAA corporate spreads widening
In what might be another indicator of the severity of the coming downturn, the spreads between high-yield and AAA corporate bonds have widened from around 250 bps in July 2011 to 419 bps as of August 9.
This also indicates economic uncertainty and expectation of higher rates from risky bonds as the economic scenario worsens (and hence the risk increases).
10- Year Treasury bond yields nearing December 2008 levels
Looking back at the 10-year Treasury yields, the yields reached a low of 2.07% in December 2008. This was period of economic collapse post the Lehmann Brothers crisis. Post that, yields on the 10-year bond have been increasing steadily. However, the yields have again slumped in the last month and are threateningly close to the yields seen in Treasury bonds during the phase of economic collapse.
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Does this mean we are headed for another sharp downturn? In my opinion, markets are telling me this ahead of any data, which surprises many on the downside. It is really important to note here that the yields have slumped even after the recent downgrade by S&P. Surely, the markets feel that, even after the downgrade, bonds are a safer place.
Withdrawals from stock funds biggest since 2008
Over the weekend, Bloomberg reported that investors pulled out most money from global stock funds since 2008 in the last week. Many might argue that it was primarily because of negative sentiments arising from the downgrade. However, in my opinion, market participants are just discounting the slowdown factor from the global markets. Further, if the reaction of market participants is such, one can expect some negative surprise in the last few months of 2011. I have to add here that I expect markets to correct further from current levels. Hence, fresh long exposure to equities might not be a great idea.
The last few months of 2011 might be rough for the economy and the equity markets. Further, this might be a short period in which holding some cash would be beneficial than being invested in equities or commodities. The most important thing would be to watch the reaction of the government and Fed if there is any meaningful slowdown or even recession.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.