The real economy and markets are so far apart they look like 'two parallel realities'

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Depending on where you look the outlook for the economy is either serene or a total disaster.

That is according to Ken Leech, chief investment officer at Western Asset Management.

Leech wrote in a recent market commentary that the real economy and the markets have diverged so intensely it appears they are in two different dimensions.

“The savage pummelling taken by credit markets is so out of proportion that there appear to be two parallel realities,” wrote Leech, whose firm manages $466 billion as a subsidiary of Legg Mason.

The note said:

The first is that the US economy is in reasonable shape, exhibiting modest growth. Unemployment continues to fall, the consumer is fine and the US Federal Reserve is considering how to continue on its path to normalizing interest rates. The credit markets are tightening in contrast. Credit markets are not only pricing in a recession, but have gone even further, pricing in a premium for systemic stress.

To Leech, the market is overreacting. “We believe such extreme pessimism is unwarranted,” he wrote.

Despite the strong labour market and calm economy, Leech does not expect the Fed to raise interest rates at its March meeting. If that were to happen, the already spooked markets would face even tighter lending conditions, and the pessimism might spread to the rest of the economy.

“Tightening into markets suffering broad-based credit stress is likely to stifle growth,” wrote Leech. “Tightening into markets with clear bank credit stress is dangerous. The lesson of the 1930s, the 2007-2008 crisis and the European crisis of 2011 seems pretty clear: banking stress is a sign of potential systemic risk. Tightening needs to be off the table.”

Leech added that the Fed should wait until markets settle down and economic growth gets further along before resuming their march toward interest rate normalization.

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