Bulls and bears running scared of recession

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When dashing young technology hedge-fund managers decide to sell everything and go into cash, you can tell that fear is stalking the market. That is exactly what Cody Willard – who combines hedge-fund managing with blogging, appearing on CNBC business television, writing columns for a number of outlets including the Financial Times’ US edition, and part-time work as a rock star – did back in May.

Formerly an ebullient bull, Mr Willard decided on May 10 to sell all of his considerable range of tech stocks except for small positions in Microsoft, Google and Apple Computer, and started to opine in his blog on the attractions of cash.

The call made him very unpopular, as a number of aggrieved responses to his blog made clear. But it turned out to be inspired. Mr Willard, who makes his CNBC appearances wearing a black leather jacket, is one of the more colourful and likeable figures on Wall Street today. But the market suggests his actions were copied by many others.

The technology sector suffered a sharp decline in May. In the US, the Nasdaq Composite, full of large technology companies, dropped more than 10 per cent, in a slide that was mirrored by emerging markets across the world. The chief reason was that investors started to worry about a coming “liquidity crunch”. With the Federal Reserve, under the new management of Ben Bernanke, talking aggressively about inflation risks, and the Bank of Japan raising its rates from zero, the fear was that an era of historically cheap money had come to an end.

In the last few weeks, the Fed’s decision to stop its campaign of rate rises, combined with data on US consumer and producer prices, which showed milder inflation than many had feared, has eased concerns about a liquidity crunch. That in turn has allowed virtually all the world’s big markets to stage what looks like a decisive recovery from the May swoon. Most are at their highest levels in three months, while the bond and futures markets signal confidence that the Fed will not be raising rates again.

The catch is that they can only be so optimistic about the outlook for interest rates because there is now an almost universal expectation of some kind of an economic recession.

The headlines on Friday morning’s regular round of pre-market economic research from analysts speak for themselves. RBS Greenwich Capital’s morning note was headed: “Stagflation bias and Fed fears”. From High Frequency Economics: “LEI [leading economic indicators] not yet suggesting recession, but it is headed that way”. Note the “yet” – it is an unspoken assumption that some kind of downturn is coming.

And from Action Economics: “US confidence showing another headline freefall in August”.

All other things being equal, a recession would be bad news for the markets – although for those more worried that central banks would squeeze liquidity from the system, it perversely appears to be good news. The markets also seem oddly detached from sentiments about the US economy at large. Friday’s survey of US consumer sentiment by the University of Michigan, the most closely watched survey of its kind, showed the population was growing starkly pessimistic, with expectations of higher inflation, while the general level of optimism fell 7 per cent compared with July. These numbers were in line with numerous other surveys of consumer perceptions.

Why the disconnect? It is partly because consumers on the ground hate high gasoline and other fuel prices, while Wall Street and policymakers tend to exclude them and look at “core” numbers. As far as consumers are concerned, gasoline is not a “non-core” item.

A second reason is the slowdown in the housing market, which has led to savage falls in the share prices of home-building companies. It has also gnawed at the confidence of consumers, while reassuring the market that the economy is not overheating.

There are further reasons for concern about the markets’ behaviour. While the headline numbers on US inflation looked benign, analysts’ reports suggested they suffered from a number of unusual quirks. In particular, there were complaints that the numbers had been fooled by car retailers’ standard practice of offering inducements and discounts during the summer. Thus slackening inflation may merely have been a measure of the continuing acute difficulties for carmakers in the US.

The markets also shrugged off without a reaction what appeared to be a considered attempt by the Fed to warn that more rate rises remained possible. Richard Fisher, the head of the Dallas Fed, made a hawkish speech on Tuesday in which he commented that he was glad about the slowdown but the “inflation pressure gauge needle is moving in the opposite direction”. The Fed should not be counted out yet.

And Mr Willard? He is considering re-entering the market. But he sounds sceptical. “The bulls are being crushed, and are terrified that there will be a recession,” he says, adding that the bears are also running scared. “Frankly, the concept of fear is running the show around here.”

The writer is the FT’s US markets editor

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