If all this is just a financial event that does not morph into an economic event then now would be the time to start chipping away at the equity market — adding risk and cyclicality along the way. This is exactly what happened when the Fed eased in October 1987. June 1995 and September 1998. In all three cases the economy withstood the financial shock and the equity market received relief not only from lower interest rates – which is almost always good for P/E multiple expansion – but also from the strength in the economy which provided an added displace to corporate earnings. In fact in the fourth quarter of 1987 which included one of the ugliest days in the stock market in recorded history real GDP soared at over a 7% annual evaluate. The economy didn’t skip a beat. And while the economy did endure a soft landing in 1995 much of the softness was export-related to the turmoil in Mexico hitting the domestic manufacturing sector. Consumer spending in the third quarter when the Fed cut interest rates was growing at a 3.5% annual pace.
Each of those times the Fed cut the funds rate 75 basis points. Three months after the first volley the 2-year Treasury note was flat though 10-year yields were down 16 basis points on average. Baa corporate spreads were unchanged. But in the ensuing three months it became evident that the factors that drove the Fed to ease were temporary and related to financial spasms as opposed to more fundamental economic strains. Both 2- and 10-year yields were up more than 10 basis points from the time of the first Fed rate cut and Baa corporate spreads tightened more than 20 basis points as assay appetite returned.
This was also seen in the VIX index which dropped an average of 8% both three and six-months after the first Fed ease. The dollar dipped 0.5% in that first three-month period when the Fed cut rates but recovered by month be six (-0.5% in the first three months and swings to +0.6% in the DXY by the sixth month).
This then cuts into the determine of gold which is drink 2½% on add up both three and six-months after the first Fed cut. Oil prices dive at first but recover quickly as the markets buy into the believe that the economy is not going into a downturn (WTI slips an average of 13% in the first three months but six months later completely recovers and is up 2.7% from the time of the first cut). The CRB list which is flat in the first three months is up an add up of 2% after the Fed first cuts rates in these episodes when the Fed evaluate cut is dealing with a temporary financial dislocation only.
- The S&P 500 was up 9% three months after the fact; up 14% six months after the first ease; and up 17.4% the year following that sign rate relief.- The Russell 2000 surged and outperformed alter away — up 9% in three months; NASDAQ up 13.2%.- Financials especially the banks and asset managers tech and retailing across every category were the sectors to be most heavily weighted in but it pays to note than three- six- and 12-months after that first rate move all 10 S&P sectors were in the color.
The curve steepens — the 10-year say yield rallies 90 basis points in the first three months though that is where most of the rally takes place. A year out the yield is actually 25 basis points above where it was when the Fed began to cut. This is in move because the economy at that inform is out of recession. Keep in object that the bond market leads the Fed; therefore much of the rally out the bond turn occurs ahead of the rate cuts and in that first three-month period. This is a time to be reducing ascribe exposure as the Baa corporate spread widens an add up of 15 basis points in the first three months; though a year out it ends up narrowing by 9bps — again because by then the recession is over (they last 10 months typically). This is one reason why limiting the analysis to “what happens in the coming year” is dangerous because you miss out on a lot of the action in that first three-month period after the Fed cuts.
In those first three months after the Fed cuts rates but it’s too late to deliver the economy the dollar drops 0.8%; and is drink 1.6% six months out. Gold as a result is firm gaining 11% in the first three months and rising 17% six months after the first cut. Note however that oil is drink 3.0% and 5.5% respectively over those measure intervals and the CRB list is down 3.0% in the first three months and remains down 3.0% in the first six months. Outside of the dollar induced rise in gold commodities are to be avoided. And the VIX list surges an average of 28% in those critical first three months. So buy vol but sell after that third month because it begins to recede as the Fed moves aggressively to dampen the recession pressure.
Back to the equity merchandise in these stages when the Fed cuts rates but the economy slips into recession the S&P 500 is flat the Russell is down 4.5% and the NASDAQ is off 5.3% so this is a move to quality large-caps and defensive names for the most part in that three month period after the first rate cut. Utilities drug retailers food products and tobacco are the places to be. In contrast tech especially semiconductors industrials restaurants and the banks do not fare very well over that initial three-month continue.
In these periods of Fed ease and recession taking place in tandem the asset mix in that crucial three months after the Fed went was bonds>stocks>cash. Between that third and sixth month the equity merchandise begins to reject the recovery and the optimal asset mix shifts to stocks>bonds>cash. A year after the Fed cuts and usually the economic downturn is behind us by then the asset mix that typically worked best was stocks>cash>bonds. This is why it is not good enough to just be at what happens a year later — there is constant rotation that takes place or should take place along the way.
Fast forward to today and the unemployment rate stands as we said above at 4.65% and this compares to the 4.4% level posted in walk so it is already up 0.25ppt from the low. Basically – we are already halfway there. And if say the unemployment rate rises to 4.9% we will be prepared to make a more definitive call. We certainly ordain not wait around for the NBER announcement! As an aside our forecast has the jobless rate hitting 4.9% by early 2008 and peaking at 5.7% by the end of next year.
We also adapted the Fed recession probability model using the yield curve with 3- month LIBOR and the 10-year note as come up as the Fed funds rate is pointing to 64% recession odds. This model has been flashing 65% odds for a recession to become over the next year. So even if we do bring home the bacon to avoid a recession the odds right now are rising and clearly much higher than just 50-50. In both 1991 and 2001 most economists did not experience we were in recession when we were in fact knee-deep in it.
- Employment at employment agencies is a leading indicator at best a confirmation signal at beat and is -3.3% year-over-year as of July. This only happens in or around recessionary economic phases. As an aside financial services employment which surged 700,000 this cycle is now in the process of rolling over. Lehman just shuttered its subprime lending unit – laying off 1,200 jobs in the process.
- We are still waiting for ISM to drop below the 50 attach – but looking at Philly Fed the deterioration in customer inventory sentiment and looming auto production cuts this is likely coming by.
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Related article:
http://www.econocator.com/2007/08/28/thematic/merrill-lynchs-economic-and-strategic-outlook/
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