recession specialWell, the market clearly isn’t looking for the light at the end of the tunnel.

Italian 10-YR bonds have surged, rallying 80 basis points (from a 6.09% yield on Friday to 5.29% yield today).

Spanish 10-YR bonds have also surged, rallying 88 basis points (from a 6.03% yield on Friday to a 5.14% yield today).

While we think this was the more important event over the weekend into Monday morning. The market is clearly on edge regarding the unintended consequence of the Standard & Poor’s sovereign debt downgrade. Standard & Poor’s also downgraded both Fannie Mae and Freddie Mac based on dependence on the US Government. A number of insurance companies and municipal bond issues will also be downgraded. If the US sovereign rating is not AAA, than nothing in the world is AAA.

The clear next focus will shift to US recession. Many market participants are seeing a recession as imminent by the end of the year. At macroeconomic inflection points, macro data tends to dominate returns. We will remain focused on trying to navigate this storm and remain very plugged in to the recession indicators for the US.

To be clear, the economy is not in a recession at present. Global growth is relatively solid.

The key items to watch over the next 1-3 months:

  • Credit conditions and whether they start to deteriorate rapidly? Corporate credit has been abundant at cheap rates and this needs to continue.
  • Housing markets. We all know they are in bad shape. But does the uncertainty around politics and financial markets in general cause another leg down in house prices and housing activity?
  • Corporate earnings have been robust and growing. Do more companies start to run into problems with aggregate demand? (i.e., miss sales plans)
  • Wealth effect impact – does wealth destruction flow into consumer spending?
  • Employment – will there be additional rounds of corporate layoffs and restructurings? (though this typically lags)

So far we are in ok shape on all of the above measures but we have only taken a look at July data, and economic data in general comes out with a bit of a lag. The August and September data points will fully reflect the issues with raising the debt ceiling, the European uncertainty, and the US sovereign debt downgrade. On the plus side, August and September data will also be influenced by a weak dollar, even lower interest rates, lower gasoline prices, and lower commodity prices in general, all of which are accommodative to the broad economy.

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