Talking Point: US economic recovery: a period of paralysis?

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• the slowdown in US economic growth points toward a growing risk of a double-dip recession
in 2011
• the risk of deflation
• the Federal Reserve’s downgrade of its outlook for the economy and the policy change it announced to partially address such risks.
In a statement, the Federal Reserve (Fed) recognised the risks facing the economy and admitted
that “the pace of economic recovery is likely to be more modest in the near term than had been
anticipated.” The statement went on to say that the Fed would maintain monetary policy at its current level. “To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at the current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.”
This move was broadly expected by the market and, in short, means that the Fed will reinvest the proceeds of its last round of quantitative easing (which ended on 31 March 2010) into treasury bonds. This slight change in policy was met with a mixture of responses: some quarters argued the Fed should not make any change, while a vocal minority felt the Fed should have embarked on another round of quantitative easing to grow its balance sheet beyond the current $2.3 trillion.
Shortly after this announcement, the New York Fed clarified that its reinvestment of cash into socalled “longer-term” treasuries would be focused on the 2-year to 10-year part of the treasury curve.
Treasuries promptly rallied, and stocks and credit also initially rallied on the news. Within 12 hours, however, risk assets began to fall in price as investors fretted about the economic outlook and the ability of the government to have any lasting impact.

View from the investment desk
It had been our view, for some time, that the Fed would start reinvesting the cash from mortgage
paydowns back into the treasury market; we also expected this policy change to be announced in last Tuesday’s statement – which it was. The action helps support treasuries at very low yields and this could benefit US consumers who have mortgages and consumer loans that are set based on 10-year treasury yields.
Although we believe the move is positive, it is important for investors to bear the following in mind:
• money supply does not increase with this action. The Fed is merely avoiding a passive tightening policy by electing to reinvest cash into treasury securities
• the move does not address the issues plaguing the US economy, such as the lack of loan growth from banks and the lack of credit demand from the private sector
• the Fed is attempting to ease the pain of a long deleveraging process, and this announcement is just one more signal that the Fed is cognisant of the tepid recovery and will try everything in its policy toolkit to avoid a “Japan-like” deflationary spiral.
With Q2 corporate earnings season now coming to an end (of which results have been good, but earnings will not be a key market driver in coming weeks) and macro concerns reappearing as investors grapple with the disconcerting slowdown in the recovery, credit spreads could drift wider in the coming weeks. Supply has been extremely heavy in both investment-grade and high-yield bonds over the past two weeks, so many investors may be approaching the satiation point with at least one more week of strong supply before the market is expected to quiet down for late summer holidays.

Looking ahead
Overall, economic growth in the second half of 2010 could be difficult as the impact of fiscal stimulus begins to subside materially. The absolute level of GDP in Q2 (now likely in the 1.1%-1.5% saar1 growth range), and the lack of momentum heading in H2, has the potential to paralyse the recovery.
Asset prices are being distorted by both fiscal and monetary policy. This is preventing capacity from being removed from the system, which further extends the deleveraging process. We are also aware that risks to economic forecasts have risen sharply to the downside. The global growth story has served as a buoy for the US recovery and corporate profitability, but sustainability of worldwide growth has been the focus of increasing skepticism. Against this backdrop, exogenous shocks will have greater influence and impact than would otherwise be expected.
Over the course of H2, volatility will remain exceptionally high. While this volatility can cause risk assets to sell off during periodic waves of risk aversion, over a 12-month horizon, corporate bonds, high yield, and investments in the securitized sectors are likely to generate better returns than treasuries (and this has indeed been the case so far in 2010, with CMBS, EM sovereigns, high-yield and investment-grade corporates outperforming treasuries). With the economic outlook likely to remain uncertain, as active investment managers, we aim to remain nimble by booking profits after risk assets have rallied strongly, by employing tactical strategies to protect portfolios during bouts of volatility, and by resetting core positions when asset prices sell-off.

Author: Alan Brown, Group Chief Investment Officer – Schroders

Source: ETFWorld – Schroders