Week In Review: Help Is On the Way
By Erik Aarts, Fixed Income Product Manager, PIMCO
09.22.01
The pain created by the loss of family, friends and heroes in the aftermath of September 11th’s tragic events puts the decline of the economy and drop in the financial markets into perspective. It’s bad, but it could be worse. And, as the Federal Government and Federal Reserve move rapidly to provide help, America will recover and rebuild. After all, we are the land of the free and the home of the brave.
While the economic conditions here at home have deteriorated more rapidly since the attack, it was clear that the economy was already headed in this direction. In fact, one could argue that the economy was already in a recession prior to recent events. Certainly, many indicators would back this assertion. Industrial production, which is often used to measure the business cycle, plunged in August, its 11th consecutive decline. Aggregate hours worked are down from January. Indices measuring activity in manufacturing and services sectors suggest declining business across the economy. Layoffs had already surged.
Now these trends are being exacerbated in the aftermath of the tragedy. Layoffs are accelerating, led by the airlines. Hotels, travel-related industries and others are sure to follow. The unemployment rate may well be headed to 7% as a result. This should have a ripple effect on consumer confidence, already battered by the shock of the attack, and could ultimately hit the economy through lower consumption and more personal saving. It also has implications for the global economy. Already Europe is bracing for contagion effects. Global trade may well slow as new barriers are erected to combat terrorism.
The bad economic news pounded the markets this week. After being closed for four days the stock market got hit especially hard, despite various efforts to mitigate the damage, including a 50 basis point rate cut by the Fed. Long dated bonds also took it on the chin as inflation expectations far off into the future rose. On the other hand, the short-end of the Treasury curve rallied smartly as flight-to-quality drove investors toward this safe haven. In fact, two-year Treasuries traded below the Fed funds target rate for most of the week as investors anticipated even more help from the Fed in weeks and months to come.
And more help is on the way. Congress has already addressed the immediate emergency needs of New York, the Capital and the Nation, sending the President a $40 billion supplemental budget package, which he signed. In addition, the government is actively working out a relief package for the airlines. It also appears that Congress will throw out the social security “lockbox”, freeing up the surplus for additional fiscal stimulus. That could mean another tax cut for companies, consumers and investors. Currently, the government is considering changes in corporate taxes, a reduction in payroll tax rates and a cut in the capital gains rate. While it’s too early to tell what combination will survive the negotiations, the final package could prove to be a confidence builder for the economy.
We now believe that the cyclical recovery that lies ahead will be more V-shaped than U-shaped. That means a sharper contraction with less inflation in the coming few quarters, followed by a stronger economic snapback after that and mounting concerns about inflation down the road. How long consumer confidence remains depressed will determine when the transition point between the down-leg and up-leg occurs. As we approach that point, plenty of opportunities will arise for investors to resume taking risks in corporate, emerging and even high yield bonds as markets trade down to bargain levels. |
