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Resilient Markets Mask Greater Concerns in Real Economy

December 5, 2012

Equity markets have settled into an eerie calm in recent weeks; with volatility — as reflected by the CBOE Volatility Index, or VIX — near a three-year low, one might assume all’s right with the world. But it isn’t, as can be seen clearly in the real economy. 
-Douglas Cote, chief market strategist, ING

Resilient Markets Mask Greater Concerns in Real Economy

  • Equity markets have settled into an eerie calm in recent weeks; with volatility — as reflected by the CBOE Volatility Index, or VIX — near a three-year low, one might assume all’s right with the world. But it isn’t, as can be seen clearly in the real economy. The tug of war between the markets and the economy is confounding, and in the end only one of them can be right.

 

  • The sound and the fury surrounding the fiscal cliff hardly matter, as the spending cuts and tax increases that were agreed to as part of last year’s debt-ceiling debacle will become the law of the land on January 1 unless a compromise can be reached. Normally, markets like certainty; however, they are unlikely to react positively to what may prove to be the country’s first “scheduled recession”.

 

  • Meanwhile, we appear to be entering a corporate profits recession. Negative year-over-year earnings growth in the third quarter is quite likely the canary in the coal mine, signaling that both the U.S. and global economies have serious growth problems. But Armageddon it is not. For example, even though year-over-year earnings growth for the third quarter was negative, it was still the third-best quarter in history. And there are some positive indicators — including broadening manufacturing, consumer strength bolstered by a resurgent housing industry, and tectonic shifts such as global trade and an energy revolution — that are catalysts for growth.

 

  • Notwithstanding the severe challenges ahead, we expect a Christmas rally based on more central bank action and cosmetic changes to the fiscal cliff. In particular, the Federal Reserve is likely to announce that Operation Twist — the $45 billion per month of long-term Treasury purchases/short-term Treasury sales that are scheduled to expire on December 31 — will simply be added to QE3. Meanwhile, the markets will applaud any attempts to “kick the can” down the road, no matter how short-sighted.

 

 

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