By Clive McDonnell Like their American counterparts, European investors have been transfixed by the pictures of devastation in the U.S. Gulf Coast after Hurricane Katrina. Following the storm's landfall on Aug. 29, S&P's U.S. economic and strategy teams issued a number of reports on its impact (see BusinessWeek Online's special report, "Katrina: The Aftermath").
The message on the U.S. economy is clear: S&P sees the risk of a 0.5% hit to third-quarter gross domestic product, followed by a 0.2% gain in the following three quarters. For domestic equity markets, the crucial factor will be how high oil prices rise in the short term. In the government fixed-income market, the reaction has been swift, with investors dramatically scaling back expectations of rate hikes by the Federal Reserve.
WIDENING SPREADS. David Wyss, S&P's chief economist, notes that the increase in economic activity associated with the reconstruction effort counts as an addition to GDP. Moreover, history suggests spending will be displaced rather than deferred -- for example, conventions slated in New Orleans will move to Atlanta. On balance -- and assuming oil prices fall back from recent highs -- the outlook for the U.S. economy hasn't changed radically based on S&P's central case forecasts.
But judging by the reaction of the fixed-income market alone, one could assume the impact will be significant. The recent trend of the yield curve -- the yield spread between shorter-dated Treasury issues and longer-dated ones -- implied traders were pricing in the possibility of a recession in 2006.
This has since been reversed. Yield spreads between two-year notes and 10-year notes widened from 12 basis points on Aug. 29, to 31 basis points on Sept. 1. The Fed fund futures market indicates investors have scaled back rate-hike expectations. Futures are now pricing in just one further 25-basis-point increase by March, 2006, but the market remains in a state of flux.
PRICIER EXPORTS? For European investors the real worry hinges on developments in the foreign-exchange market. Until now, the main support for the U.S. dollar has been the yield spread between euro-denominated 10-year notes vs. 10-year Treasuries. They peaked at 105 basis points in August but have since slumped to 97 basis points, which has undermined the greenback.
Looking forward, if the slump in the U.S. currency continues, there could be a negative impact on Euro-zone export competitiveness. And that could be a real problem.
As export competitiveness has been one of the main drivers of the better-than-expected second-quarter economic growth in the region, any weakness in demand for goods in the U.S. is bad news for auto, capital goods, and shipping companies in Europe. We note that companies in these industry groups have performed much better than expected year-to-date and could be at risk of a correction.
Finally we should emphasize that these are preliminary views, as asset markets remain in a state of flux. The key variable to watch is the fixed-income markets trend in the coming days, as traders try to make sense of the ultimate effects of Katrina's considerable fury.
McDonnell is European equity strategist for Standard & Poor's