Prevailing market action gives the indication that investors are throwing caution to the four winds. Equities are hitting new 4 year highs and medium dated bond yields are down to levels where investors feel that there's nothing to be gained by committing funds to that market.
At the short end of the yield curve, bonds have reacted to tighter monetary policy in the United States, the likelihood of a couple of further rate increases in Europe and the distinct possibility that the Bank of Japan might be stirred from its prolonged slumber by increasingly clear evidence that the country's economy is, at long last, re-emerging into the sunlight!
Higher short-dated bond yields and anchored medium / long dated yields can mean only one thing and unlike other indicators, bond yields tend to be leading predictive instruments (not lagging), a precursor to uncertain times ahead.
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Eat Yer Heart Out, Paul Samuelson
Nobel prize-winning economist Paul Samuelson was once famously attributed with a quip pertaining to the financial markets' ability accurately to forecast forthcoming economic events. The quip "The financial markets have accurately predicted 12 of the past 9 recessions" was in fact never made, at least not by him, yet it has stood the test of time and is regularly wheeled out when independent forecasters are at their lowest ebb.
But financial market forecasting has become more scientific over the past thirty years and back-tested analysis has become a more empirical process, providing hard evidence of cause and effect.
For example, there have been eight periods in which the Federal Reserve has tightened policy over that period. On five occasions the bond yield curve inverted. On each occasion the economy slid into a growth recession (at best) or recession (at worst). The Federal Reserve itself has published research going back to 1950 indicating that every time the bond yield curve inverts (with one exception) an economic slowdown followed shortly thereafter.
Economists now consider that the extent of the inversion acts as an important predictive indicator of how long it might take for a technical recession to ensue (two consecutive quarters of negative real GDP growth). The analysis indicates that the average period between the steepest point of the yield curve's inversion and the arrival at recession is approximately fifteen months.
For those who might be interested the analysis works the other way too. Suffice to say that the booming US economy is behaving in exactly the way one might have expected given the steep upwardly sloping curve of twelve eighteen months ago. Although the statement accompanying the Fed's December meeting indicated that the rate tightening process may be coming to an end, most believe there still to be a further two 25bp hikes in the pipeline as new Fed Chairman Mr Ben Bernanke establishes his credentials. With every basis point the yield curve inverts further, so the likelihood of a sharp slowdown in 2007 draws ever closer.
Prevailing financial market insouciance is driven, in our view, by the fact that to the casual glance everything appears to look fine. Scratch the surface, however, and fissures begin to emerge.
We would draw investors' attention to the strong likelihood of increased equity market volatility. Readers should note that year-on-year growth in the US monetary base is just 3.3%. It has never been this low heading into a period of yield curve inversion.
As base rates rise and liquidity is mopped up, so volatility levels increase. After several calm years we would expect the global developed equity markets to deliver more +/- 2% days than were witnessed in 2004 (there were none in 2005!). This in itself is likely to result in investor rotation away from beta-led growth investing, back into the more dependable defensive counters. Little surprise that two of the Dow's best performing stocks over 2006 to date are Merck and Pfizer!
US housing looking wobbly
After writing about the vulnerability of the US residential property sector back in the late autumn, three pieces of data released since the New Year provide an important update and some serious food for thought.
Firstly, new home sales declined by 11.3% in November, a 10-month low. Simultaneously, unsold inventory spiked 20% year on year to more than 500,000 units or 4.9 months supply. At the same time, both the median and average house price have not moved since January 2005!
Secondly, November's existing housing sales data revealed a 1.7% month on month decline, following a 2.7% drop in October, an eight month low. The number of houses sold onto the market increased by 1.2% on the month and 14% year on year (to 5.0 months supply, the highest since June 2003).
Finally, condominium sales are being hammered. Sales have now fallen sharply for three months in a row and, since mid-2005, have fallen by 24% annualised. The backlog of unsold condominiums has risen by 25% year on year, to stand at a new record 5.9 months supply. Investors should note that pending home sales (a leading indicator for existing home sales) have now declined for three straight months and mortgage applications for new purchases have also fallen sharply (to levels more than 20% below the mid-2005 record). The worst is yet to come.
Something for the optimists
To conclude, we would point out that the extent to the yield curve's inversion may be tempered by significant line-up changes at the Fed's Open Market Committee over the next few weeks. Mr Greenspan's departure has captured all the headlines, however, investors may not have picked up on the fact that the more dove-ish Janet Yellen (San Fransico Fed) joins the board, while the more hawkish Santomero, Moskow and Stern are all leaving. The fact that two empty governor positions exist provides Mr Bush with an important opportunity to shape policy in what could prove an important year for the Republican Party.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley
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