The following is an excerpt of the most recent research bulletin of the Morgan Stanley Smith Barney Global Investment Committee, which was released yesterday. To read the bulletin in its entirety, click here.
Since we
moved to a more cautious tactical asset allocation on Oct. 6, equity markets have rebounded. Our caution, however, remains intact, based largely on our view that policy missteps in Europe and the US will result in regional recessions and that 2012 earnings growth will be negative—neither of which is fully priced into US or global markets.
EUROPEAN DEBT DRAMA Europe's latest efforts to contain and resolve the sovereign debt crisis have produced sharp swings in risk assets. The plans to recapitalize banks, increase the fire-power of the European Financial Stability Fund and provide aid to Greece led to an unexpected development: Germany said that Greece could exit the euro if it chooses, an option that had previously been taboo. For now, Greece has decided to accept Europe's aid and attendant austerity measures in order to keep the euro as its currency.
Meanwhile, the initial move of new European Central Bank (ECB) President Mario Draghi was to cut interest rates 25 basis points to 1.25%. We expect further rate cuts ahead, with the ECB ultimately taking rates to zero, as the Fed did more than two years ago. Into 2012, we expect the ECB to also begin engaging in Quantitative Ease, which it has heretofore avoided.
However, the ECB can only go so far; unlike the Federal Reserve or the Bank of England, it does not have the authority to act as the lender of last resort and, therefore, is not in a position to supply credit to governments if needed.
Still, the ECB has been making some moves. As Italian bonds have sold off and yields have risen to unsustainable levels, the ECB has been buying those securities in a short-term attempt to stabilize Europe's fixed income markets. Longer term, what is really needed is significant Italian fiscal policy reform. Indeed, the markets initially rallied when Italy settled on a new, technocratic prime minister who is expected to push for reforms—which Silvio Berlusconi, who resigned after losing a vote of confidence, did not deliver.
Meanwhile, the ongoing debt drama in Europe has been unfolding at a time during which the outlook for European growth has hardly been robust. With further fiscal policy tightening in the offing and the ECB easing by “too little, too late,” we suspect that Europe is in the early stages of recession, which would have negative secondary effects for US and global GDP growth.
US RECESSION LIKELY The US economy has been growing at stall speed, and we expect a recession to begin within the next year. We take this view, in part, based on the work of the Economic Cycle Research Institute (ECRI), an independent research institution. The ECRI US Diffusion Index has reached levels that, in the past, have nearly always led to recession. Neither Morgan Stanley nor Citi Investment Research & Analysis is forecasting a US recession next year, though Citi is expecting one in Europe.
That said, Morgan Stanley views the developed-market economies as being “dangerously close” to recession. The Fed hasn't called a recession, but it has lowered its 2012 economic growth forecast to a range of 2.5% to 2.9%, down from the 3.3%-to-3.7% range that was forecast in June.
What's more, the Fed sees the unemployment rate going no lower than the 8.5%-to-8.7% range by the end of 2012. In essence, the Fed is saying that both GDP growth and unemployment will remain at unacceptable levels. By extension, the central bank is also saying there is not much that monetary policy can do about it, and we agree.
While we ultimately believe the Fed will embrace a third round of Quantitative Ease, we doubt that the action will significantly speed up GDP growth. Meanwhile, the St. Louis Financial Stress Index, which is published by the Federal Reserve Bank of St. Louis and measures financial conditions in the economy, has been rising of late (see Chart 1). While the current reading is nowhere near the levels reached during the Great Recession, the fact that conditions are tightening is not a positive sign for the economy.
*The MSSB Global Investment Committee includes: Chief Investment Officer, David M. Darst;Chief Investment Strategist, Kevin Flanagan; Chief Fixed Income Strategist Jonathan Mackay; Senior Fixed Income Strategist, Charles Reinhard; Deputy Chief Investment Officer, Douglas Schindewolf, Director of Asset Allocation.
