Markets have become risk averse. This is illustrated by the (trailing) equity earnings yield less the yield on 10-year Treasuries – the current spread is around 485bp (1.6 standard deviations above its mean, Figure 1).

Markets are concerned that the processes of deleveraging and deficit reduction will entail renewed recession (at best), and deflationary depression (at worst). While history will be the ultimate judge of the Bernanke Fed, we venture that the central bank is unlikely to preside over deflation. Both the Fed as an institution, and the Fed chairman himself, have studied closely the phenomenon of debt deflation – particularly as it has applied to Japan since the 1990s and to the US in the 1930s.

Although the true ability of central banks to avert fluctuations in the real economy is not yet well understood, it is clear that central banks can avoid deflation (if they try hard enough). A significant amount of de-leveraging has been under way in the household sectors of the US, UK and Spain (Figure 2).

However, in recent quarters this de-leveraging has been accompanied by a slower pace of rise in the household saving ratio (as in the US) or even decrease (in Europe). This is because the saving ratio is influenced much more by net wealth than by gross liabilities, as well as by perceptions of the economic environment and the level of interest rates. Overall, although there is a risk that household saving ratios may rise again if substantial negative wealth effects re-emerge. However, in our baseline scenario we see household saving ratios as being, from here, either relatively stable (for the US) or set to decrease gradually (in the UK and euro area – indeed, in Germany this process may have started in Q2).

Concern about de-leveraging also arises from fear that a tougher regulatory environment will spark a renewed credit crunch. However, this should be less of a concern in the US, given corporates’ greater recourse to market financing (or to the government now as a source of mortgage supply). There has been a significant improvement in CP issuance by US non-financial corporates this year, taking their outstanding CP to $105bn in July (from a low of $68bn in February). Also, US mortgage applications have been rising sharply as refinancings surge in response to record-low mortgage rates (although, as noted in the US Outlook, many borrowers are unable to access lower mortgage rates). Meanwhile, the US commercial banking system has already moved to a highly cautious balance sheet stance (Figure 3).

Its holdings of Treasuries and agencies in July were 12.9% of total assets, up from a low of 8.9% in May 2008, while its holdings of cash (including excess reserves it holds in the FRS) were 10.4%, up from just 2.6% in March 2008. Stacking up these alongside its holdings of other securities gives a ratio of securities/cash holdings of 30.1%, the highest since early 1973, while the proportion of loans and leases on its balance sheet is at a historical low of 57.3%. For the US banking sector, as elsewhere in the private sector, there has already been substantial balance sheet adjustment.

While some recent US data have been distinctly weak, notably existing home sales and durable goods orders, in our view, the downward revision to US Q2 GDP puts an unduly pessimistic perspective on recent US economic developments. By contrast, US industrial production (IP) grew by 6.6% annualised in Q2, after 7.0% in Q1. The gap between the growth rate in US IP and GDP in Q2 was unusually wide, while IP has also made a strong start into Q3 (Figure 4). This also suggests that some of the pessimism may be overdone.

Clearly, the US does face a substantial fiscal challenge, with the general government deficit at 11.0% of GDP in Q2 (after 10.7% in Q1). If there is no extension of the fiscal stimulus measures due to expire this year, the US might experience a fiscal headwind of 1% of GDP next year. Nonetheless, in our view the ultra-low position of the US interest rate curve is anticipating future potential turbulence from fiscal drag. As discussed in the US Outlook, the Fed could engage in a renewed bout of asset purchases if it becomes more concerned about weaker growth and/or further declines in inflation expectations. The Fed’s stance seems likely also to result in easier conditions in both Japan (where we expect an extension of the maturity and volume of BoJ fixed-term lending, and quite possibly FX intervention) and in the euro area (where the ECB seems likely next Thursday to pledge a continuation of full allotment in its main and longer term refinancings until at least early 2011).

Fiscal challenges are clearly an important influence also on European markets. Renewed concerns about the ability of governments in Greece, Ireland and Portugal to stabilise their debt/GDP ratios have led to a substantial widening in spreads, with Irish spreads (reflecting concerns about yet larger financial sector losses) at their widest since early 1988. The nerve of governments and markets is likely to be tested, particularly given the likely emergence of greater political resistance to fiscal consolidation and economic reform, including in France and Spain. That said, the European Financial Stabilisation Mechanism is likely to be operational next month, providing some potential support to stressed euro area bonds.



source: BarCap