SERIOUS MONEY:US investors would be deluded to think anything other than a fragile, lame recovery is in the offing, writes CHARLIE FELL

IT IS said that stock markets climb a “wall of worry” and that has certainly proved true in recent weeks as prices have rebounded strongly from the lows registered almost two months ago despite the continued onslaught of grim economic data that places the current downturn among the most destructive of the past century.

The rebound in US market indices is greater in duration and magnitude than each of the previous five aborted rallies of the past 15 months and, should it be remembered in hindsight as just another seductive bear market rally, the 34 per cent jump in prices will rank second only to the “false dawn” that took place between late 1929 and spring 1930.

Investment professionals who remained fully invested as the crisis enveloped Wall Street but turned cautious as the carnage reached Main Street are feeling the heat and the panic is palpable. But is now really the time to chase prices higher?

The surprising magnitude of the recent advance cannot and should not be dismissed out of hand, as stock prices are an important indicator of economic activity.

Market indices typically hit a trough two quarters before the economy hits a trough, and the magnitude of the rebound from the early-March low, which has seen prices move comfortably above both their 50- and 100-day moving averages, suggests that the economy will register positive growth in the fourth quarter of this year and perhaps as early as the third.

The signal emanating from the US stock market is corroborated by movements in Treasury prices, where the recent rise in 10-year yields and the accompanying increase in growth and inflation expectations are consistent with an imminent turnaround in the economy’s fortunes.

However, investors would be deluded to think that anything other than a fragile and lame recovery is in the offing.

The sharp economic recession has seen the output gap reach a negative 6 per cent by the end of the first quarter and the slack is set to expand to a 70-year record of more than 8 per cent by the end of the year.

The US economy has shed more than five million jobs over the past 15 months, with two million jobs lost in the past three months alone.

The year-on-year percentage decline in household employment is the largest since the current data series began in 1949 and, not surprisingly, the unemployment rate has jumped to the highest level in more than a quarter of a century.

Meanwhile, a broader measure of unemployment that includes the underemployed has almost doubled from a cycle low of 7.9 per cent to 15.6 per cent in March.

The economic slack is evident not only in the labour market but in the non-financial corporate sector.

Industrial production has dropped almost 14 per cent from its expansion peak and has exhibited zero growth over a 10-year span for the first time since the late 1930s.

Capacity utilisation for all industries and manufacturing declined in March to their lowest levels since the data series began four decades ago and both are roughly 15 percentage points below their long-term average.

The economy is drowning in excess capacity and surplus labour, which will depress business investment and household spending for an extended period.

Oversupply combined with soft demand has placed downward pressure on product prices and unit volume such that the corporate sector is experiencing declining sales and is as a result in the throes of the deepest earnings downturn in decades.

The pressure on non-financial corporate cash flows and profits has contributed to significant balance-sheet deterioration with debt to net worth jumping from 44 per cent three years ago to 68 per cent last December.

The hostile environment has seen default rates on corporate debt increase sharply and, disturbingly, the recovery rates on recent settlements have been far below the 40 per cent assumed on senior unsecured debt.

The record year-on-year percentage decline in employment has placed downward pressure on household income and made it difficult to repair stretched balance sheets.

Wages and salaries shrank at a 4 per cent annual rate in the first quarter as a result of soaring job losses and contributed to an almost 40 per cent surge in the number of bankruptcy filings year-on-year to an average of almost 6,000 a day during March.

The American Bankers’ Association reported that the delinquency rate on consumer loans during the fourth quarter last year increased to the highest level since it began gathering data more than three decades ago and the rate is certain to increase further in the months ahead as the unemployment rate approaches 10 per cent.

Financial market indicators suggest that economic growth could turn positive by autumn, but an examination of the fundamentals indicate that the seeds of a self-sustaining recovery are not in place.

The need for the corporate and household sectors to deleverage, combined with falling incomes, means that any turn in the economy’s fortunes is sure to be fragile.

The large and expanding negative output gap indicates that the risk of deflation remains high and, consequently, it is hard to get excited about stock markets at current levels. Investors should be patient.

charliefell@sequoia.ie