Seldom is there such a huge disconnect between expectations and reality. The stock market is already starting to pay for a new earnings cycle and the bond market is already charging for Fed interest rate hikes. Yet, in reality, the stock market faces at least another quarter of double-digit earnings declines and the next move from the Fed will likely be a rate cut, not a hike.
Both markets are obviously counting on a bold new recovery. Looking past the recession seems legitimate now, given the noticeable slackening in the recent pace of manufacturing and job declines stateside. But the bold recovery looks more like fiction than fact. Don't be surprised if consumer spending, at least on big-ticket items like autos, is weaker during the recovery than during the recession. And Washington's big stimulus package, worth about two-thirds of most people's forecast of U.S. gross domestic product growth this year, is languishing in a quagmire of partisanship from which it may never emerge.
Investors shouldn't expect anything better, and quite possibly something weaker, than the "jobless" recovery that followed on the heels of the 1990-91 recession. While expectations are always of bold V-shaped recoveries, history shows that there are, more often then not, gently sloping U's, or in Canada's case, a long flat line. Yet at the same time that shouldn't scare people away from the stock market. It didn't take any big surge in economic activity to catapult the Standard & Poor's 500 index 30 per cent from its recession lows. And it's a good thing earnings didn't matter because there weren't any.
The same holds true for Canada, where there was an even larger disconnect between stock market performance and the economy. The Toronto Stock Exchange's performance wasn't that far behind that of the New York market even though the Canadian recovery lagged miles behind the U.S. economic rebound. Today, as back then, all that the equity market needed was a whiff that the worst was behind it, and investors were more than prepared to throw caution to the winds.
Judging by interest rate expectations, fixed-income investors have also bought into the bold recovery forecast that is driving stock markets higher. Fortunately for them, the outlook for interest rates is not nearly as bleak as the slope of the yield curve suggests. With a spread of more than 300 basis points between the 10-year note and the federal funds rate, the slope of the U.S. Treasury curve is steeper than a black diamond run at Fernie.
There may be only one more easing left from the Fed, but the fact of the matter is that the fed funds rate isn't going up anytime soon. Yet if you look at the futures curve, the market is already pricing in no less than 200 basis points of tightening from the Fed over the next two years. That kind of boomerang in rates hasn't happened after a recession since the double-dip in the early 1980s when inflation clung stubbornly to double-digit rates.
Investors should at least be able to earn the coupon (the annual interest payment) in the U.S. Treasuries and do even better in the Canada bond market. With the cycle running a good quarter behind in Canada than stateside, the Bank of Canada has a lot more work to do than the Fed. Instead of the 25-basis-point cut in interest rates that the market is currently discounting, the central bank has more like another 75 basis points of easing to go. While those cuts will undoubtedly be both dollar-weakening and curve-steepening, they've got to be worth at least a couple of points to holders of 10-year Canada bonds.
For my money, the stock market is the place to be this year. There are probably brilliant sectoral calls to be made, but unfortunately I can't think of any. So I'm just hitching my wagon to the index. I've put half my portfolio in the Barclay's S&P/TSE 60 iUnits (XIU-TSE), which are already up 6 per cent since I started buying in November.
All that matters for now is that the stock market sees signs that the recession in the U.S. economy is ending. Down the road, the market will come to to realize that what it has been so generously paying for is a growthless recovery. But, by that time, valuations should be up another 10 to 15 per cent.
Jeffrey Rubin is chief economist and managing director of CIBC World Markets.
© The Globe and Mail
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