It has been our view for some time that we are heading into the latter stages of what is, with one or two notable exceptions, a fairly normal economic cycle. Equity markets performed strongly over 2005, despite sharply rising US short-term interest rates. Financial markets are now waiting for a steer from Mr Greenspan as he steps down after eighteen years as Fed Chairman, or from Mr Bernanke, as to where the peak in the US rate setting cycle might be.
Investors should not forget that, unlike the Bank of England or the European Central Bank, the Fed sets monetary policy to regulate the level of nominal demand in the US economy. Having acted aggressively, the Federal Reserve is now widely regarded as having brought the Fed Funds rate back into neutral territory. The economy's reaction is also broadly typical of what might be expected in the wake of ultra-low short-term rates two years ago. The steeply upward sloping nature of the yield curve was indicative of increased activity around the corner. Now the yield curve has inverted a very different picture of what might happen over the next twelve months is being created, a picture investors would be well advised to take on board.
Growth rates normally remain strong in the early part of the monetary tightening cycle because, under historically normal circumstances, central banks try to tighten monetary policy only very gradually. Short-dated interest rates are thus at stimulatory levels while the economy is picking up momentum. The impact of rate tightening hits the economy with a lag. In a typical cycle, real growth rates remain high until roughly a year after the rate tightening process has begun.
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So goes the theory. With the benefit of hindsight we can now see that, although the US Fed has raised short rates by 200bp over the past two years, activity has remained buoyant. Evidence from the testimony of a number of regional Fed chairpeople indicates that the prolonged period of monetary tightening may be close at hand. On Friday 20th, Richmond Fed Chairman Lacker intimated that there might be just "One more bullet in the chamber", while over at the San Fransisco Fed, Janet Yellen stated that the rate setting FOMC might be "Close to the end of the road". The futures market is undecided on the March FOMC result, split 50:50 on whether rates might be raised yet again.
In a normal economic cycle inflation tends to rise only gradually and not to peak until a couple of years after the process of monetary tightening begins. As things stand, inflation appears to be reverting to type, pressures abating as the North Atlantic economic cycle rolls over.
Financial Markets Face "A Winter of Discontent"
A number of significant geo-political and macro economic themes are building up significant headwinds for a mature equity bull run to tack into.
The oil price is spiking again. At one stage it jumped up to $69 per barrel, its highest level since Hurricane Katrina struck in late August / early September 2005. Political unrest in Nigeria, uncertainty regarding Iran's nuclear programme and what might be done about it, couple with a cold snap in Europe to cause futures traders to run for cover. Nigeria is perhaps the most significant story as it represents a source of sweet crude, not sour!
The Inverted US Bond Yield Curve
We keep coming back to this but, taken at face value (and there are plenty of dissenters out there!), the yield curve, a leading indicator of economic activity to come, tends to indicate a period of slower growth ahead. Whilst accepting the depressing impact at the longer end of the curve caused by overseas (largely Asian) investors, we find investor insouciance surprising.
Slower Output Growth = Slower Growth In Corporate Earnings
Hands up how many readers can remember reading business headlines referring to a 46% fall in GE's Q4 earnings or the decision by Ford to cut 25% of its capacity and in the next sentence read about the Federal Reserve planning to raise base rates by a further % point?
Strategists around the financial markets are right to warn that these kinds of headlines cannot but have an effect across the industrial sector, worker confidence and consequently, consumer spending and house prices.
These are the kind of comments which indicate to us that those reports of a prospective capital expenditure spree circulating around the turn of the year will turn out to be nothing more than another red herring. Equally they lend more weight to our ongoing leitmotif that the US consumer is likely to be severely tested over the next eleven months.
Global equity markets are beginning to factor in the likelihood of slower corporate profits growth ahead. The UK and European reporting season is about to grind into action. The US reporting season is well underway but equity markets are so far under whelmed by what they've seen. Apple, Ebay, GE, Google, Intel, Motorola have all disappointed and whilst Fed officials and others may scoff at the adverse implications of an inverted bond yield curve, their derision hasn't cut much ice with Citigroup and other financial businesses over the past few weeks.
US Small Caps Losing Their Appeal
The New York Times ran an article on 22nd January highlighting the rotation theme which we picked up on two weeks ago. The article quotes Steven Leuthold, chairman and CEO of The Leuthold Group as saying that the period of small cap outperformance is drawing to a close. Reviewing numbers as far back as 1926, Mr Leuthold has found that small caps outperform their larger counterparts over 68 months or roughly six year periods and that the latest cycle is drawing to a close. He cites valuations which were, on average 40% cheaper than their larger equivalents at the beginning of the cycle and are now around 10% more expensive while earnings momentum has slowed.
This view supports our contention that an inverted bond yield curve brings with it increased volatility and a desire on the part of asset allocators to switch away from momentum-driven beta plays, towards those larger companies with more reliable cash flows and more dependable earnings progression profiles.
Given that Europe and Japan export relatively little (as a % of total exports) to the US, the impact of an economic slowdown in the latter is regarded as having only a passing impact on domestic growth rates (Europe's exposure to the US is c9%, Japan's is around 12%), overall activity is likely to be only passingly impacted (inter-regional trade counts for a far larger percentage of the total). While financial markets would be adversely impacted by a US economic slowdown, the question still remains as to whether growth in either region is sufficiently robust to pick up the baton were US growth to slow markedly.
Typical US Cycle Over the Next 12 Months
Growth Current Typical 12 months from now
Real GDP growth 3.6% 3.0%
Unemployment Rate 5.1% 5.0%
CPI (Y/Y) 3.3% 1.7%
Bond Yield (level) 4.5% 4.5%
Short Rates 4.25% 4.5%
Equity Market (S&P) 1266 1350
From the above it can be seen that, at present, the markets are anticipating that the economic slowdown should get underway later this year and continue (not shown) into 2007 (real growth forecast to slow to c2.0% in 2007). They also expect inflationary pressure to abate, reflecting lower energy prices and an absence of "second round" effects, but for interest rates to remain at prevailing or even marginally higher levels.
The latter is, perhaps, controversial but reflects recent statements from Mr Bernanke regarding interest rates to control asset price inflation. The incoming Chairman has stated, on the Minneapolis Fed web site (of all places!) that in his view: "It is rarely, if ever, advisable for the central bank to use its interest rate instrument to try and target or control asset price movements". Mr Bernanke goes on to say that: "History has shown us clearly that that type of policy has more often than not led not only to a large decline in asset prices but also to a large decline in the general economy".
We take from this that US monetary policy may plateau over 2006 and that the Fed may use micro measures, such as issuing new lending guidelines to financial institutions to curb what some, including Stephen Roach at Morgan Stanley, suspect is becoming structural complacency on the part of investors. The absence of any decline in US base rates over 2006 is likely, in our view, to limit the scope of the US equity market to make much headway. Without this engine and in the face of gently rising base rates in Europe and Japan, generating significant returns from equities (as an asset class) may prove tough going over 2006.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley
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