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Confidence Counts: Risks of a Renewed Recession are Heightened as Continued Erosion of Confidence could Push Perception into Reality

Global markets continue to trade in a highly volatile fashion. Confidence is very tenuous and it isn't taking much for investors to react in a big way both on the buy and sell side. Much of the recent focus has been on the European debt crisis. The globalization of the financial system means that it can be difficult to determine the extent to which the tentacles of any banking problems in other countries may filter through to the US system. This uncertainty contributes to the instability and volatility we’ve seen in the equity markets over the past couple of months.

US recession on the cards?

Clearly the risks of a renewed recession in the United States have risen as evidenced by both the stock and bond market action. According to ISI Group, historically when the S&P 500 was down 17% over 11 days, only twice did a recession not follow—1987 and 2002. Meanwhile, Treasury yields continue to trade near record lows with the 10-year yield dipping below 2%. We never ignore what the markets are saying, but we also need to look at the entire picture that is developing. First, the stock market is a forward-looking mechanism, so by the time we know for certain what growth rates look like for the third and fourth quarters, the market will be looking into 2012; so waiting for clarity is often not the best strategy before executing a long-term plan.

Taking a look at the broader economic picture yields what we believe is a less convincing likelihood of recession than the market appears to be pricing in. Again according to ISI's research, previous market routs as we've seen recently saw initial jobless claims spike by around 50,000 following big drops like we've seen recently. There has yet to be a spike in claims as they remain near the 400,000 level, down from 420,000 or so earlier this summer. Although at anemic levels, the US economy is still adding jobs.

Additionally, despite a shaky market, a high unemployment rate, a contentious political environment, and a very negative news cycle in July, retail sales for the month jumped 0.5%; while excluding autos and gas they rose 0.3% and June was revised higher. According to Ned Davis Research, when consumer confidence was below 66 historically (it’s now at 59.5) the average stock market gain in the year following for the Dow Jones Industrial Average was 14.4%; far better than the performance seen during times of higher confidence.

Declining confidence and continued erosion in the markets can have a self-fulfilling aspect to them however, which is one reason why the possibility of a recession has grown, in our opinion. The Philly Fed Index falling to -30.7 may be an example of this as the decline in the market may have influenced responses, which in turn led to a huge surprise on the downside, which led to more market losses—a self-fulfilling prophecy. However, actual data doesn't exactly match the survey. We’ve seen indications of more confidence recently, such as the jobs data mentioned above, as well as a recent Federal Reserve survey showing that demand for loans by businesses is increasing, while credit standards have loosened.

Eurozone recession increasingly likely

Across the pond, the crisis of confidence in Europe could have a more lasting negative impact on economic growth than a decline in confidence and economic slowdown in the United States. Reasons include a weak starting point for growth in the eurozone, debt markets demanding steep near-term fiscal spending cuts to reduce deficits, and banks increasingly under the threat of a cash crunch.

Amid the negatives, there have been some positive eurozone developments, such as the late-July second Greek bailout, although that is now in question; and expansion of capabilities of the European Financial Stability Facility (EFSF), and purchases of Spanish and Italian debt by the European Central Bank (ECB).

European policymakers seem to be in denial about the role of confidence in financial systems, and in response, a contagious illness has begun to feed through—uncertainty temporarily subsides, only to pop back up again. We believe several measures are needed for the eurozone debt crisis to stabilize:

  • European banks need more capital.
  • The EFSF needs to be made significantly larger.
  • Greece needs a more substantial debt restructuring.
  • Government revenue prospects need improvement through growth measures such as labor reform and a move away from dependence on the public sector for jobs.
  • Tax collection needs to be reformed.
  • Closer fiscal coordination is necessary, possibly through the issuance of a common Eurobond.

Some of the measures to stabilize the crisis could happen quickly, while others may be tougher sells; in particular the ability to achieve closer fiscal coordination. This is the underlying flaw of the euro exposed during this crisis: a currency and monetary union without fiscal union may be unsustainable.

Important Disclosure
This material is issued by Charles Schwab, Hong Kong, Ltd. The information provided here is for general informational purposes only and has not been reviewed by the Securities and Futures Commission in Hong Kong.

Content provided by Charles Schwab, Hong Kong
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