Weekly Economic Commentary
Monday, February 13, 2012
The markets continue to be buoyed by positive domestic economic news and thoughts that Europe is no longer on the verge of a disorderly Greek default. Europe still faces serious growth and solvency issues, but the European Central Bank, by generously offering cheap long-term liquidity to the banking sector, has provided a longer horizon for solving these problems.
This positive news has been priced into the markets. Looking ahead, we see scope for still higher equity prices if the news flow remains positive, but we would also expect to see lower Treasury prices as investors begin to price in a stronger (and possibly more inflationary) economic environment regardless of the Fed’s guidance that official rates will remain extraordinarily low through at least 2014.
So, what are the chances that the news flow remains positive? We think, on balance, it probably will, but we are also prepared for some disappointments. We have argued that 2012 will be another year of staggered progress, and we are impressed with gains made so far this year. Economic data should continue to improve, but we think it is unlikely that the data will continue to consistently beat expectations. Moreover, we are feeling a bit cautious in the near term as we head into key votes in the U.S. and abroad.
Our focus for the next two weeks will be on Washington where Republicans and Democrats still cannot agree on how to pay for a full-year extension of the payroll tax cut, extended unemployment benefits and the “doc” fix (which prevents a dramatic reduction in Medicare reimbursement payments to physicians). It is widely assumed that political brinkmanship will result in the passage of a bill in the final hour, but we are starting to wonder if the outcome will fall short of expectations. The extension could be less than a full year and might not include all benefits.
We should learn a fair amount this week because Congress is scheduled to break on Friday for the February recess, and Congressmen would like to avoid having to delay the start of this break. There will be just three legislative days following the break before the end of the month, so it is imperative that real progress is made now. The danger is that we end up witnessing shenanigans similar to what we saw in December when the House passed a bill that could not pass in the Senate and then tried to leave town.
We will also be watching events in Europe. We think investors are becoming somewhat inured to events there, but they should not let their guard down. For example, while investors applauded the Greek parliament for passing harsh new austerity measures last night, it is far from clear that the measures will be implemented. Thus, even though the Greek parliament vote will make it easier for European officials to approve a second bailout package for Greece, the funding could still be cut off in the future if goals are not met. Thus, the Greek situation will remain tenuous even if we get good news in the near term.
Investors have also been understandably excited about the success of the European Central Bank’s long-term refinancing operations, which bolstered European debt and money markets. In December, banks took €489 billion of three-year funding, and investors expect demand to be in the range of €500 billion to €1 trillion at the February 29 operation. Demand will likely be in this range, but we are cautious that even an as-expected result might encourage profit taking following the strong performance of bank and sovereign bonds of late. We also caution that while the ECB has helped solve a serious liquidity problem, banks still need to recapitalize and improve the quality of assets on their balance sheets. Indeed, recent surveys have demonstrated that Europe is suffering from a severe credit crunch.
We continue to believe that problems abroad will most significantly affect the U.S. economy through financial conditions. Financial conditions in the United States. have improved dramatically since late November, and that points to upside risk for economic growth forecasts. If Europe manages to muddle through—and Washington doesn’t blow it—then U.S. growth forecasts will likely be revised higher from the current Bloomberg consensus call for 2.2% GDP growth. Let’s hope that is the case.
This information reflects the viewpoint of Dwight Asset Management Company LLC as of February 13, 2012, and is subject to change. This report is provided for informational purposes only.
