Think again if you think that, by knocking 50 ‘bips’ off the Funds rate, the Fed is taking risks with economy. The move is defensible! Fundamentally, the case has been building for easing decisively (see our recent note, Judgement Day Ahead – 50 bps off the Funds rate! 12th September 2007). For a start, the housing market is proving to be weaker than expected.
Importantly, the labour market is now weakening and this spells even more bad news for the housing market. Where there’s no job, there’s no income to buy a home and support a mortgage. Also further weakness in the housing market will make home owners less able to extract mortgage equity and that alone will depress the growth of consumer spending. But there’s more!
A weakening labour market increases default risk. It slows personal income growth which, in turn, slows the growth of consumer spending and makes it harder for consumers to service debt, not just on mortgages but on all forms of consumer debt (e.g., auto loans and so on). That’s aside from the squeeze on consumer spending and the likely pressure on any and all debt servicing arising from any re-setting of mortgage interest rates.
And all that’s before any consideration of what a credit crunch might do to the economy. Given that inflation is low and already moderating, the contractionary forces of a credit crunch could easily take the disinflationary impulse of a recession down a road to where no one wants it to go, i.e., deflation. A recession usually sows the seeds of its own recovery but, with deflation, that’s not necessarily so, as we know from Japan’s lost decade and a half. No one wants to go there, and, if anyone should know that better than most, the Fed Chairman should, with all the research he has done on the subject.
So what to expect now?
More of an upward sloping yield curve in the US Treasury market? Granted, it takes time before policy easing stimulates economic activity, but the Fed’s action could now powerfully and positively influence sentiment and that would be no bad thing. For companies about to shed jobs, i.e., where the decision hangs in the balance, the Fed’s action might dissuade them from doing so knowing that relief is on the way.
As noted in Judgement Day Ahead – 50 bps off the Funds rate! 12th September 2007, a meaningful cut in the Funds rate should help calm concerns about default risk in the credit markets and this should help ease the pressure on the interbank market, thereby making a credit crunch a much less likely prospect.
Does this mean happy days are here again? The outlook is likely to prove challenging. Less angst about default risk could prevent a further widening of credit spreads, and they might even narrow, but that’s providing the estimates for corporate earnings aren’t revised downwards by much.
A downgrading of earnings across the board is likely by virtue of the slowdown expected in the major economies, and the US in particular. Valuations, therefore, may not be quite what they seem. However, as suggested in our previous note, we’re still talking about a prospective p/e ratio of 15 for the S&P 500 and 12 for the FTSE 100 with only half the earnings growth the consensus expects over the next 12 months. Not bad! Not cheap but not dear.
China and India may be the new economic frontier but global financial leadership still lies with the Fed and Wall Street. The Fed has made a bold policy move, which should now help restore confidence in financial markets worldwide. It should take out some of the volatility in the equity markets and steady them.
The August lows in equity markets are unlikely to be tested. With less angst about default risk, the Financials, the Bank and Real Estate sectors in particular, should make a start at recovering some of the ground they have lost. Also, it may well be that with less angst about default risk, the more adventurous areas of the market, like the mid caps, might also make something of a come back. Importantly, though, our long standing year-end targets for the S&P 500 and the FTSE 100 of 1525 and 6550 respectively stand a good chance of being met - if not exceeded!