After a false sense of calm at the beginning of last week, market volatility returned with a vengeance on Thursday, as the S&P tumbled 4.5%. Recession fears and worries about Europe were to blame.
Consensus forecasts still predict that the U.S. will experience a period of very slow growth - or even a mild contraction - but avoid dipping into a full blown recession. Should that be the case, equities are likely to be oversold at this point. However, given the global risks to growth and financial stability, it is hard to recommend share purchases at this time.
The chance of another recession appears to be increasing. Estimates of a double dip, which hovered around 20% a month ago, have increased to between 30%-35%. A recession could make it harder for small businesses to regain their footing and for companies in general to hire workers. A recession could also extend the slump in the housing sector and retard the process of deleveraging.
From an equity standpoint, a 2-3% decline in GDP growth could result in another slump in stock prices. Although equities are currently attractive at 11 times forward earnings (or 12 to 13 if we assume no earnings growth for the next year), valuations are not the best tool in timing an entry point. Other factors, such as negative sentiment and inadequate political policies, can keep markets depressed.
A recession was not the only concern for investors this past week. Euro zone banks sparked a bit of a panic when, on Thursday, word leaked out that one unidentified European bank had borrowed $500 million from an emergency fund at the European Central Bank. That set the Federal Reserve, regulators and investors worrying that perhaps one or more European banks might be having a hard time raising money to run their day to day operations.
While U.S. banks own little of the troubled euro zone sovereign debt and have only modest estimated exposure to credit default swaps on that same debt, commercial banks, money market funds and central banks do make short term loans to European banks on a regular basis. In addition, foreign banks utilize money inside the US to fund their operations here. One fear is that if European banks become cash-strapped because credit dries up, U.S. banks and institutions could be hurt. That is because once banks sense a freeze on cash flow, they could begin to hoard what they have and exacerbate the problem of availability of money.
Also last week: Finland demanded cash collateral from Greece before it would lend money to the struggling country, eroding confidence in the European Central bank and the EFSF, the European bailout fund. And German Chancellor Angela Merkel and French President Nicolas Sarkozy's much trumpeted meeting fell flat, as no serious policy proposals (such as the issuance of Eurobonds) were put forward.
Taken together, the European issues of bank funding, debt support and political paralysis are keeping markets on edge. Add in global recessionary concerns and the outlook for stocks in the near term is very uncertain.
What could bring us out of the current slump? Perhaps a major policy move in Europe or the US, although that is unlikely in the coming months. The U.S. is reluctant to initiate another stimulus or monetary easing program. And European leaders remain stubborn and somewhat isolationist - willing to wait until financial stability deteriorates further before acting convincingly. The European Central Bank, an alternative source of support, is also reluctant to take a major step. It is dependent on European political leadership and is willing to go only so far at this point.
That leaves the turnaround of economic fundamentals as the best means for re-establishing positive market sentiment. In the coming weeks, the Institute for Supply Management's Report on Business (next release date: September 1, 2011) and the Non-farm Payroll Employment Report (out on Friday, September 2, 2011) will be critical indicators to watch. They will help define our economic tipping point, and whether we are heading below it or above it.