Equity markets are taking a reality check after a month-long bullish run that lasted into the first days of this month, defying the ever gloomier mood of economists. In all likelihood, it will prove to have been a bear market rally driven by a closing of short positions. I think it will take several more months before a more durable improvement in investor confidence can emerge.
Investor confidence will face some formidable headwinds in the coming months: even the more optimistic forecasts envision a significant rise in corporate defaults and unemployment rates. Consumers will get a measure of relief from decelerating inflation, but this will not be able to offset the greater sense of job insecurity and financial uncertainty. Against this background, it will be hard to see the more mixed tone of the macro data as anything more than a statistical correction after the precipitous drop of the last two quarters—the assumption, in other words, will be that the economy is hitting the bottom with a “thud” rather than a “boing”. Believing in the effectiveness of policy measures will still seem more like an act of faith than a rational expectation.
In my view, however, the recent equity market rally sends a very important signal, one which should not be dismissed out of hand: it is telling us that the growth outlook is much more uncertain, and that while a miserable economic performance in the next 6-9 months is baked in the cake, beyond that point the risks are much more balanced. When I say that risks down the line are more balanced, I recognize that 2010 might be uglier than we predict if ongoing efforts to restore transparency and confidence in the financial sector should fail—but also that if these efforts are at least partially successful, market confidence might return quite quickly and leverage the major monetary and fiscal stimulus already in the pipeline.
Economists have failed to anticipate the speed and brutality of the current recession, and have remained behind the curve for most of the last two quarters, scrambling to revise forecasts every month. The disruptive impact of Lehman’s collapse and the unprecedented nature of this financial crisis are important mitigating factors, but the collective forecasting failure remains.
It is quite possible therefore that once the economy turns around, economists might once again be left behind the curve, underestimating both the timing and perhaps the strength of the recovery. As a profession, we have been shell-shocked by the vertical collapse in each and every activity indicator over the last six months, and having succumbed to the overwhelming destructive force of the crisis it becomes almost impossible to forecasts any kind of convincing recovery.
I am very well aware that speaking of a faster or more buoyant recovery seems ludicrous at this stage, and our house forecasts and analyses are far from expressing any degree of irrational exuberance (please see in particular our latest Euro Compass published earlier today). But if we phrase the question as “could economists possibly be wrong again?”…perhaps it does not sound as ludicrous anymore.
Bottomline: watch for a resurgence of risk-aversion in the short-term, as flagged by the latest recovery of the JPY against EUR. Brace yourself for the onslaught of ugly data especially in terms of corporate defaults and unemployment. But keep an open mind on the possibility that a recovery might indeed materialize by year-end, starting probably in the US and Asia and eventually pulling Europe along.
