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The Bubble of Pessimism Deflates

09/07/2010

Fear rose during the month of August as deflationary economic signals weighed on equity prices. Investors aggressively purchased safe haven assets, U.S. Treasuries, in particular. Subsequent chatter surrounded the potential for a historic fixed income bubble. The reality is that the only bubble the capital markets have inflated during this baseball season of frustration is "the bubble of pessimism."

Last week's economic data surprised to the upside. The China PMI, U.S. ISM, and U.S. jobs reports all exceeded reasonably low expectations. The strong economic headwinds of early September quickly diminished, similar to Hurricane Earl. In the storm's wake, the capital markets began deflating the bubble of pessimism.

As the bubble deflates, keep in mind that "balance" is what will be achieved. Asset weightings will begin to balance as a correction in the fixed income market re-allocates capital into other assets. I do not, however, expect a complete unraveling in the fixed income space. The environment for ownership of non-government debt remains in the "sweet spot."  Tacticians may adjust weightings of high yield corporate bonds, while maintaining exposure to high yielding entities that are positioned to become investment grade.    
 
Unfortunately, the baseball season of frustration will play on. U.S. economic data is still in the midst of a slowdown in the recovery. The capital markets may still be in need of monetary and fiscal stimulus. I suggest that the policy response to this week's data will be as follows.

  1. The FOMC will meet on September 21; expect continued efforts to maintain the size of its balance sheet.
  2. Incumbents will return to D.C.; pressure for further fiscal stimulus remains very high. In fact, I would expect some sort of fiscal stimulus to be enacted before the mid-term elections.

Call my view simplistic, but "achieving alpha" is really all that matters as we head toward the end of 2010. The optimal strategy continues to be investing in front of the tailwinds. Nothing has changed on that front.  Manufacturing strength, corporate earnings strength, economic strength from the emerging markets, Canada, and Germany are the tailwinds. 

US 10 Year YTD

Source: Bloomberg

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