Tuesday, April 22, 2008

The Economic Guessing Game Has Begun

In the past weeks, several clear signs have emerged signaling that investors are shifting their focus away from the credit crisis and toward the real economy and traditional investment analysis. The first and most obvious sign is the earnings reports. The next two are less obvious, but are no less important – the rise in the 10 year US Treasury rate and the increasing number of comments in the media and from economists re the direction of the US economy.

The 40 basis point rise in the 10 year US Treasury rate (from 3.31% on March 17 to 3.71% yesterday*) suggests a degree of relaxation in the flight to quality panic due to the credit crisis. This modest return to normalcy apparently implies that more than a few investors buy the credit crisis end is in sight story.

The other sign that investor focus has shifted is the increasing number of real economy related stories in the media. For example, the April 12th cover story in the Economist magazine, “The Great American Slowdown”, and yesterday’s FT commentary, “Road to ruin? America ponders the depth of its downturn”, explore the depth and duration of the US slowdown/recession. All this brings us to the emerging debate of the shape of US economy slowdown/recession – V, U, L, or W?

The more bullish sentiment is a V shaped decline and subsequent sharp economic recovery. Painful, yet short. The U shape crowd, on the other hand, believes the current difficulties will linger into next year when the end of 2009 comparisons show a sharp enough recovery and return to prosperity.

The L shaped advocates foresee an extended period of economic weakness a la Japan. Then there are the W shape believers, which is the camp I occupy. Things get better for a while (thanks to the stimulus package and the sustained strength of the global growth story – yes, Virginia, decoupling has worked to a meaningful degree) only to be followed by an economic decline into 2009 for a whole host of reasons, including a withdrawal from the US stimulus and a decline in US consumer spending and concurrent rise in US consumer savings (more on this in the near future).

Investment Strategy Implications

The US economy is undergoing a transformation on multiple levels that will produce major disruptions in the financial and valuation models for equities. These more thematic issues – credit crisis and its consequences, for example – will likely alter the economic landscape for years to come thereby producing substantial opportunities and risks. One outcome will almost certainly be a redistribution of economic growth in the US away from a US consumer dominated economy and toward a more export driven model.

That said, it is advisable to cover the traditional bases. Therefore, whatever shape your US economic doughnut might be (despite the fact that the credit crisis is likely to be far from over), the time has arrived for investors to form their view on the future direction of the US economy.

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