January 09, 2008
Gerard Minack, Morgan Stanley Australia Limited+

Despite the chatter and worry, I still think most equity investors have not made a US recession their base case, and hence markets are not priced for the downturn. So far, in other words, the recession is all talk and no action.

Credit markets seem closest to pricing in a hard landing. This fits with the historical experience: Credit markets are often quicker to price in weakness than equities. Our European credit team calls this ‘stage 3’ of the debt-equity clock, where credit is in a bear market but equities are not. Stage 3 in the prior cycle extended over two years, 1998-99, but it seems likely that ‘stage 4′ – where equities and credit are in a bear market together – is not far away. (See Neil McLeish, 2008 Credit Outlook: Look for the Bear Complexities, 9 January.)

Credit aside, however, it’s hard to find strong evidence that a US recession is expected. It’s certainly not being forecast. Bloomberg last night reported its monthly survey of economists’ forecasts. The consensus forecast is that GDP growth will average 2.1% next year. More to the point, of the 65 forecasters, only three are forecasting recession. Our team of Dick Berner and David Greenlaw is one of those three (and the first to make the recession call).

Likewise, despite all the pessimistic headlines and poor macro data, arguably the surprise is the resilience of equities. In the US, the weakness has been sector-specific (financials); ex-financials, the market is within 10% of its bull market peak. That’s likewise true for global equities and emerging equities. The MSCI EM index is off its high, but given its sharp rise to the November high, the pullback over the past eight weeks has actually been more controlled than in the prior corrections seen over the past few years (Exhibit 2). This is not price action that smacks of recession-fear panic.

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