Sunny with a Chance for Storms
When forecasting the weather, meteorologists focus on many points of data which help them build a model to predict the chance of rain on a given day. Imagine how difficult this job would be if the forecaster could not depend upon past information about how all of the variables interact with each other. Currently, the economy is looking at storm clouds and investors and economists alike are trying to determine what the forecast will call for.
The current economic environment includes a large number of unknown events that have not occurred previously. Just like the weather forecast, the financial markets forecast the future based upon the past interaction of a wide array of data. In the investment world, these interactions are much more dynamic than they are for the weather. Changes in the political climate, consumer moods, and world events can cause even the most tested economic theories to respond differently than expected.
The current economic climate has a much higher level of uncertainty than normal. It is this uncertainty that has resulted in increased volatility in the financial markets in recent weeks. When looking at the current global economic environment it is important to look at the headwinds that are causing increased levels of uncertainty:
- European Debt Crisis – Greece, Italy, Spain, and Portugal are all struggling with a high level of government debt. While the global economy is in a much stronger position today than the fall of 2008, it is difficult to sort through whether or not a default or restructuring of debt will occur and any potential impact.
- The US budget debate – The downgrade of US debt sent a signal to US policymakers that the long term path of US government spending is not sustainable. This problem can be addressed in many ways; however, both Republicans and Democrats have shown that finding a compromise agreeable to both parties will be difficult. This impacts the corporate world because without a sense of potential future tax liabilities, health care costs, and other expenses, businesses are less likely to hire new workers. The debate in August showed that the American consumer is tired of the fight, and the world economy is watching.
- The US economy – The impact of the great recession is still lingering and the domestic economy is not responding in the same manner as it has following past recessions. Unemployment remains elevated and the housing market and other consumer driven sectors remain depressed. Consumer confidence has slipped in recent months in response to events like the debt ceiling debate.
- Lack of monetary policy options – The Federal Reserve Board has lowered interest rates dramatically, trying to entice consumers to return to the housing market and businesses to invest in new projects. However, these lower rates have failed to create the normal response from both groups. Not only has demand for loans been less than expected, lending standards have remained tight at many banks, making it more difficult for the smaller number of individuals wanting to borrow to get a loan. Attempts at new policy are not as predictable as the policy options that have been used in the past and the past options have not created the expected responses.
These issues paint a broad economic picture that points toward slowing economic growth. It is important to note, however, that these items are not signaling negative growth. Today, the Federal Open Market Committee released a statement regarding their most recent meeting, which wrapped up this morning. That committee noted that “recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated.” They went on to say, “The Committee continues to expect some pickup in the pace of recovery over coming quarters but anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets.” This quote underscores the above points that the US economy is recovering but is fragile and a shock like a full blown economic crisis breaking out in Europe could put us back into a recession. As we continue to consider the impacts of a wide range of potential outcomes, we believe it is important to hold course with the changes we’ve made recently to our asset allocation models. Throughout the fall we will communicate updates to the asset allocations models as we continue to analyze and monitor economic data.
If you have questions about this article, please contact our office.
-Investment Policy Committee