Is The U.S. Headed For A Japan-style Lost Decade?

The U.S. Federal Reserve has said that growth was considerably slower than expected and it does not expect that outlook to change. Is the U.S. economy about to enter a period similar to Japan’s Lost Decade?

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The U.S. Federal Reserve offered a grim assessment of the U.S. economy on Tuesday, promising to do what it can to help matters by keeping the Federal funds rate – the rate at which banks lend to each other – near zero until the middle of 2013.

The announcement on Tuesday afternoon marked the first time that the Fed has affixed a specific timeline to its interest rate policy. And to the extent that the Fed’s Open Market Committee looked to reassure investors, and restore some confidence, the move worked. The Standard & Poor’s 500 rose 4.8 percent by the end of a wildly volatile day, reversing much of Monday’s 6.66 percent decline. It was the biggest rally in two years.

Yet the subtext of the Fed’s announcement was sobering. The central bank said data compiled since June indicate that growth is “considerably slower than it expected,” and that temporary factors earlier this year, such as the disasters in Japan , were only part of the story. The slowdown in the U.S. is fundamental.

“The Committee now expects a somewhat slower pace of recovery over coming quarters than it did at the time of the previous meeting,” the FOMC said in a statement. It anticipates that the unemployment rate will “decline only gradually” and that inflation will settle below levels consistent with its mandate, as recent commodity price increases dissipate. Looking ahead, “risks to the downside have increased.”

The theory that the U.S. is facing a lost decade, similar to that of Japan, looks stronger.

“Are we turning into Japan? In the short end of the yield curve the answer is yes, and not just T-bills. Out to 3 years the curves are very similar. That’s what happens to economic hegemons in decline, Jonathan Lewis, principal of Samson Advisors, said Tuesday afternoon in a note to clients.

How are investors going to fare? Here’s look at how investors across an array of asset classes reacted to the Fed’s forecast for slow growth.

Public equities: The rally on Tuesday included valuation plays, banks that benefit from low interest rates, and large dividend paying companies yields that now looks like an appealing alternative to fixed income and credit.

In this environment, equities may benefit from a flood of money transferring from low-yielding fixed income markets. And the U.S. may continue to benefit from an exodus of capital from Europe, which is in even worse shape. But growth stocks are going find that generating revenue is a challenge, and they will continue to grapple with weak demand.

Private equities: The economic slowdown highlighted by the Fed will have a chilling effect even in the private markets, which has been funding a boom in consumer Internet companies such as Facebook, Groupon, Zynga, Twitter and dozens of smaller startups. That growth may soon slow down.

“The volatility over the last few days has been just insane, and the private markets can’t ignore the public markets. I have heard from lots of entrepreneurs who are rushing to close their deals before funding becomes more difficult to obtain,” said Jay Levy, principal with New York-based venture capital firm Zelkova Partners. “If the economy continues to slow, you will see fewer VC deals funded, and those that do get funded will be at lower valuations,” he said.

Fixed income: Low yields in the Treasury market may force investors to take on a bit more risk as they search for returns. “If you are earning nothing in Treasuries, you can afford to take on some risk to find a 4 or 5 percent yield,” said Steve Johnson, the U.S. chief investment officer for DB Advisors, the institutional asset management business of Deutsche Bank. Johnson, speaking on a conference call, said that corporate bonds, which likely will escape the downgrades of the U.S. sovereign and related credit, are a good place to start. He says high yield market and the muni bond market are attractive, too.

While state and municipal governments may have to settle for fewer federal dollars, “we think they will be able to cope pretty well.”

Currency markets: So far, the signals are mixed. The Swiss franc, a safe haven currency, rallied, but so did the Canadian and Australian dollars, which are more closely associated with the “risk-on” trade, according to Lewis. “The (currency) market has not entirely made up its mind if its happy or unhappy,” he wrote.

Investors will be pressed to find returns in an an environment of slowing growth. Now the question is whether the US can hang onto what little growth it has or whether it slips into recession. The odds of recession? Up to one in three, according to DB Advisors.

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