Midsummer Course Correction-- Investors and businesses in US following already bearish households
Aug. 16, 2011
Kengo Tahara
Economist
In August, a compromise was reached on raising the debt ceiling. Still, S&P (butnot the other two rating agencies) downgraded the AAA rating of US treasury
bonds to AA+.
Stock market is volatile: down 500+ on Aug 4, down 600+ on Aug 8, up 400
points on Aug. 9, down 500 points on Aug 10th. And note, program trading lateon these days intensified the magnitude of the changes.
Money coming out of the stock market went into the bond market, sending theyield on the 10-year Treasury bond down by roughly 80 basis points to 2.15
percent. This created the anomaly of yields falling sharply AFTER thedowngrade of credit rating. Perhaps, 1) worried investors sought safety; 2)more investors feared a double dip recession; 3) money flowed to bonds
temporarily and once the stock market quiets down, that money will come out of
the bond market and go back to the stock market. Actually, all three areplausible.
There are two fundamental problems. First, investors and some businessexecutives have become more concerned about slow or no economic growth,leading to volatile financial markets. Consumers have not necessarily become
more worried because they were ALREADY very worried. So previously more
optimistic investors and business executives have suddenly woken up to what
consumers have been thinking about. The result is sharp declines in stock
values.
The second and more fundamental problem is that worried consumers arepaying down debt, building savings, and very cautious about spending unlessjob and income growth improve (which they are quite sure is not very likely tohappen very soon). Business sees slow sales and therefore, despite large cash
reserves, is holding back on investing and hiring. In turn, consumers think, “See,

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Aug/16/2011

we told you so.” Nothing changes. And there is very little help coming fromfiscal or monetary policy.
Business does not make money on the sales that consumers do not make.
Stock values ultimately reflect future profits. So the stock market woke up inearly August that the period of relatively strong profit growth is over for now.
And portfolio adjustment (over adjustment?) has been swift. Japanese
investors have already seen this show (and don’t like it).
The Conference Board has revised its economic forecast downward: +1.6% in
2011, +1.8% in 2012. The main reason is explained above. In fact, it has not
had to revise its forecast as much as some other forecasts, especially thosefrom financial institutions. Its consumer and business sentiment surveys, aswell as its Leading Economic Index, and Employment Trends Index have been
describing a slow economic environment even as other forecasts wereprojecting as much as 3 percent growth for the second half of 2011. By earlyAugust, especially with the revisions to GDP history, that 3 percent scenario
was no longer plausible.
The 2012 outlook is very weak, for the reasons described. Other forecasts are
now more in line with this story. The question becomes, what could push US
growth to a more robust path. It is clear there are downside risks, even to thisvery weak economic scenario (political gridlock, drought, hurricanes, strikes,etc.). Are there any upside risks? Yes, there are some.
1)Political agreement on fiscal policy. The probability is not very good, but it ispossible2)If bond yields remain very low for some time, mortgage rates could fall lower.
That might spark some home buying and construction and a better housing
market might slowly lead to a relatively more positive overall economicenvironment.
This is not a long list but at least there are a few potential upside risks to anotherwise very weak scenario. There is one more possibility. The Federal
Reserve could entertain a QE 3. This is possible, even though QE 2 proved
largely ineffective. Why? The value of quantitative easing is to flood theeconomic system with liquidity, and that indeed happened. But even with very

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Aug/16/2011

low interest rates, consumers, some businesses, and all state and local
governments are busy reducing debt, not willing to add to debt. Austerity blunts
the effect of quantitative easing (this is also why QE 2 had very little impact on
inflation, despite fears to the contrary).
Slow growth, austerity, and debt problems are plaguing other parts of the global
financial system, and sending stock values lower. Since investors are chasing
the best returns on investment, what happens abroad impacts domestic
markets and vice versa. In other words, the US financial markets might nothave turned so bearish if there were bull markets abroad. The bear markets
abroad have the impact of making the domestic market more bearish (just as
the domestic market makes markets abroad more bearish). So many bears.
Too few bulls. Is this the new normal? Well, at least for August.

Kengo Tahara is an economist in Japan Center for Economic Research(JCER).
He joined JCER in 2008 after receiving a master's degree and completing thecourse requirement for the doctoral program in agricultural economics from theUniversity of Tokyo. For the last three years he specialized in business forecast
for Japan's economy. He has worked as an economic intern at the Conference
Board in U.S. since June 2011.

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