Our latest quarterly newsletter, Portfolio Insights, has gone the press and can now be viewed on our website.  With limited word count (an obstacle for any writer) I felt I could flush out a few thoughts in this week’s Market Minute.

The big thing I’d like to talk about is the fears of a double-dip in the economy.  Talks of a second recession increased after recent housing and employment data suggested the U.S. economy is more vulnerable.  These fears are obviously compounded by the effects of Europe’s debt crisis and China’s efforts to slow growth.  I believe these concerns are premature for a few reasons.

The first reason is the steep yield curve.  A steep yield curve means that short-term rates are much lower than long-term rates – today the Fed is holding short-term rates at zero.  According to a 2005 study by Arturo Estrella in The International Economy, an inverted yield curve (opposite of what we have today) has preceded every recession since 1967.  According to the study, the lead time between the appearance of a negative month spread and recession can be anywhere from three to 18 months.  The spread last turned negative in July 2006 and recession in the U.S. followed in December 2007.

So until the yield curve becomes inverted, the chances of another recession are very low.  The current the difference between the three-month and ten-year rate is roughly three percent.  An inverted curve would mean that the ten-year Treasury would have to trade similarly to the three-month Treasury, which is currently yielding next to nothing.  I just don’t see people paying the government to hold their cash for ten years right now.

Once the Fed raises short-term rates to above "emergency levels," we will need to re-evaluate the yield curve to look for signs of the spread tightening. 

The second reason is the record amount of cash U.S. companies hold on their balance sheets.  The Federal Reserve reported that companies have a record $1.84 trillion in cash and other liquid assets, or 7% of total corporate assets.  Cash may not be a productive asset, especially when it’s not earning interest, but it does provide a significant buffer to any downside scenario.  The problem is that companies have held off putting cash to work due to economic and policy uncertainties. 

Banks are unsure how much extra capital regulator will require them to hold, power companies are waiting to see if the government caps carbon emissions, and HR departments are still figuring out the impact of the recent healthcare overhaul.  On top of all that, the fate of the Bush tax cuts on personal income, capital gains, and dividends is unknown – they are set to expire at the end of 2010 unless Congress extends them.

Much of this ambiguity could be lifted after Congressional elections in November.  At that point, I expect companies to start deploying cash by hiring workers and increasing investment.  With costs already cut to the bone, companies will have to spend money to increase earnings.  This activity cuts into margins, but will be great for the economy.  I also expect to see cash returned to shareholders through more dividend payments and stock buybacks as the year continues.

My final reason is that the housing market makes up such a small piece of the economy now that it’s less capable of doing damage and can withstand some shocks or fluctuations.  The homeowners that were most likely to default on their mortgage already have and companies in the worst positions (and with the biggest systemic impact) have already failed.  Meanwhile, excess inventory has vastly improved and mortgage rates are at all-time lows, putting affordability (mortgage payments as percentage of household income) near the best it has ever been.  No doubt, the housing data recently has been less than stellar, but that is no reason to call for a double dip or additional quantitative easing.

With regards to quantitative easing, Bloomberg reported two days ago that Federal Reserve Bank President of Richmond Jeffrey Lacker said that any consideration by U.S. central bankers of further monetary easing “is very far away.”  Lacker added, “It would take a very substantial, unanticipated adverse shock” for further steps at stimulus to be appropriate.  Such a shock could be something like a sovereign debt default, which brings me to one last thought.

European banks hold most of the sovereign debt in the Eurozone, thus an actual sovereign default could potentially cause some European bank to go under.  Investors fear that such a failure could lead to a string of negative outcomes, much like we saw in the U.S. after Lehman Brothers failed.  But Europe has an important catalyst is on the horizon. 

Europe will release the results of their stress tests on their largest banks on July 23, and I think we could see confidence restored a bit in the markets and eliminate some of the overhang the situation has created.  When the U.S. performed stress tests on its largest banks, it represented a critical turning point.  Banks that needing to take big write-downs and increase reserves did so.  Now we may see that occur in Europe. 

Peter Lazaroff, Investment Analyst

www.acrinv.com