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Others are concerned that housing market weakness could turn into a broader economic downturn. Increased price resistance and lender caution have made some slowdown in housing inevitable. But hurricane reconstruction should reinforce economic expansion in future months. And business investment and exports should perform quite well in future quarters. Economic conditions could even become robust if oil prices were to fall sharply.
Sustained economic expansion – and the new Federal Reserve Board Chairman Bernanke’s promise to make no radical shifts in policies – mean that the Federal Reserve would raise short-term interest rates further if needed to keep inflation contained – but not to levels that would risk recession. And with the federal funds rate now at 4.75%, a pause if not an end to further rate hikes seems near for the first time since mid-2004.
Economic prospects remain favorable on balance but there are risks and uncertainties centered on politics and oil. Investors should avoid over-concentrations in specific asset classes relative to their long-run strategies and hold or build well-diversified portfolios.
Economic and Market Update
Economic trends are critical to investors in several ways. Most sharp and sustained stock market declines occur before and in economic recessions. Long-term interest rates tend to rise (bond prices tend to decline) in economic recoveries and expansions. The Federal Reserve tends to raise short-term interest rates in recoveries and expansions to contain inflation. Here and now, recession risk remains low, inflation risk seems moderate and a pause if not an end to interest rate hikes seems imminent.
Economic Conditions Real GDP (inflation-adjusted Gross Domestic Product) rose just 1.6% in 2005’s fourth quarter. This ended a 10-quarter streak over which Real GDP’s advances averaged 4.1% – well above the 3.4% trend recorded in 1947-2005. Real GDP was not expected to be robust last quarter. One reason was that automobile sales fell when the third quarter’s deep price discounts ended. Another reason was that Hurricanes Katrina and Rita’s down-side impact on consumers and businesses remained quite intense in October. Other excuses could be made but the report was without question much weaker than expected. More recent evidence supports the view that this weakness has been reversed (Figure 1) .
Evidence that economic conditions have rebounded includes the Commodities/Claims Ratio. The bottom number in this ratio is Initial Unemployment Insurance Claims – a number that counts those who have just lost their jobs and filed for unemployment insurance for the first time. This number had drifted downward last summer, consistent with an upward trend in job creation and in the broad economic expansion.
Weekly first-time claims for unemployment benefits averaged 317,000 in August, spiked to 388,500 in September in the hurricanes’ wake and then retreated to average 285,750 in January and February – the lowest level since before the 2001 recession. The latest (late-March) four-week average has risen to 303,500 but the downward trend remains intact. Such a steep downward trend in jobless claims almost always coincides with an upturn in job creation and in economic conditions overall (Figure 2).
The top number in the Commodities/Claims Ratio is the CRB (Commodities Research Bureau) Spot Raw Industrial Commodities Price Index. This index measures prices for metals and raw industrial materials other than oil and food-related commodities. This number has soared since November. Such a steep rise in commodities prices almost always coincides with increased production demands (Figure 3).
The Commodities/Claims Ratio is a sensitive economic indicator because its components are quick to reflect shifts in the demand for the basic inputs to industrial production – raw materials and labor. When a broad economic slowdown or a recession loomed in the past, this ratio almost always declined in advance. That this ratio was on an upward path before Hurricanes Katrina and Rita struck meant that neither a recession nor even a slowdown had been indicated then.
The steep rise in unemployment claims overpowered the rise in commodities prices to pull the Commodities/Claims Ratio down sharply last September –the first time that had happened since the last recession. But the steep decline in unemployment claims since September and the sharp rise in commodities prices since November has now caused the Commodities/Claims Ratio to soar.
The Commodities/Claims Ratio indicates that there was a pronounced hurricane-related September-October slowdown and a subsequent sharp rebound. That rebound did not come in time to prevent Real GDP’s reported fourth-quarter weakness but the rebound has continued to accelerate into March. There is no indication here that a recession or even a sustained economic slowdown has been set in motion. There is an indication here that Real GDP’s first-quarter advance should be robust (Figure 4).
Inverted Yield Curve and Real Interest Rates Some observers believe that a recession could erupt because the yield curve spread has become “inverted” – the condition that exists when short-term interest rates are higher than long-term interest rates. The Treasury Note Yield Curve Spread measures the difference in basis points between the yield on the 10-year Treasury note and the yield on the 1-year Treasury note. In late-March trading, the 10-year T-note yield was 4.71%, the 1-year T-note yield was 4.77%, and the spread between them was -0.06% or -6 basis points.
This has been worth tracking because all recessions since 1954 started after the yield curve spread turned negative. The problem is that there is an exception to the apparent rule that negative yield curve spreads cause recessions. The yield curve spread was negative for 15 consecutive months in 1966-67 but no recession followed in 1966-1968. A negative yield curve spread alone is not a fail-safe recession indicator
A factor that seems never to have failed to produce a recession is high “real” or inflation-adjusted short-term interest rate levels. A real interest rate is determined by subtracting inflation from the “nominal” interest rate level that is quoted in the marketplace. For example, the Federal Reserve raised the federal funds rate to 4.75% in March. Based on former Federal Reserve Chairman Greenspan’s favorite benchmark (the Personal Consumption Expenditure Deflator Excluding Food and Energy Prices), the “core” inflation rate is now 1.8%. Hence, the real federal funds rate is 2.95% (the 4.75% nominal fed funds rate minus the 1.8% inflation rate) or 295 basis points.
The most important lesson from how the real fed funds rate has behaved over time is this: recessions did not occur in the past until after the real federal funds rate had risen above 425 basis points. A real fed funds rate above 425 basis points has been the level where the Federal Reserve’s policies became restrictive and halted further economic expansion. Recession risk remains low now – and the Federal Reserve’s policies remain stimulative to further economic expansion – because the current 295 basis point real fed funds rate is below the normal recession-inducing level.
The futures market expects the Federal Reserve to raise the federal funds rate from the 4.75% level adopted on March 28 and to 5.00% on May 10 or June 29. Assuming that inflation remains around 1.8%, this would raise the real fed funds rate to 3.20% or 320 basis points – still well below the historical recession-inducing 425 basis point level
Some have warned that increased debt burdens have made the economy much more vulnerable to rising interest rates. But the sharp rise in the Commodities/Claims Ratio shown above indicates that interest rates have not slowed the economic expansion so far.
Oil Prices Effective stimulus from the low real federal funds rate has offset the restraint from the sharp rise in oil prices since 2004 to sustain the economic expansion. This does not mean that the rise in oil prices has not hurt. Real GDP rose at an annualized 3.4% pace from December 2003 to December 2005. But Real GDP could have risen closer to 4% – and more new jobs could have been created – had oil’s price not soared well above $40 per barrel.
Oil’s price fell from almost $70 per barrel around Labor Day to about $58 around Christmas. Political threats to oil supplies in Nigeria and Iran raised oil’s price to about $68 in late-January. Diminished threats helped oil’s price fall below $58 in late-February but renewed threats have driven the price to almost $64 in late-March
If oil prices were to remain within the $55-65 per barrel range, then Real GDP should rise 3-3.5% or more on balance over the next 4-5 quarters. The sooner and further oil’s price drops below $55, the more probable it would become that Real GDP would rise more than 3.5%. If oil prices were to rise well above $65, however, then Real GDP’s advance could slip below 3% to 2.5% or so.
Oil’s current $64 per barrel price seems to include both a substantial premium for political risks to oil supplies and a speculative premium that has accumulated since mid-2004. For oil’s price to fall below $60 would require a decline in political risks. For oil’s price to fall below $55 would require a decline in speculative interest. That would in turn seem to require additional evidence that supplies have become better balanced with demands (the rise in oil inventories indicates movement in this direction). Oil prices will remain elevated and volatile until then but low real interest rates should continue to help economic conditions worldwide withstand them.
Housing Weakness Housing market data now confirm a slowdown since last summer. Existing home sales, for example, fell from 7.3 million units in June to 6.6 million in January but then rose to 6.9 in February. New home sales have fallen from 1.4 million units in July to 1.1 million in February. Other reports indicate that the time homes are on the market has increased and that listed prices are under downward pressure in numerous markets
The slowdown in the housing market can be traced not to the small rise in mortgage interest rates but to the outsized increase in home prices in 2004-5 (the median home price rose more than 30% over the 18 months that ended in August 2005 – the steepest rise on record since 1982). The net result was to make home purchases much more expensive and lenders much more cautious. The outsized rise in home prices in effect sowed its own destruction
Based on the historical record, home prices in the most inflated areas could well decline, but should on balance trace an extended plateau. The current home-price correction could be milder than the 1990-94 episode because there is no lender crisis now. Favorable population and economic trends should combine with low real interest rates to limit the current adjustment (Figure 10).
The 1990-94 home-price correction episode overlapped the 1990-91 recession but did not cause it. That recession occurred because the Federal Reserve had raised the real fed funds rate above 550 basis points in 1989 and because Iraq invaded Kuwait in August 1990. No recession threatens now because real interest rates remain low. Solid increases in exports and business investment should offset whatever weakness develops in housing to keep the broad economic expansion on track in 2006-7.
Asset Allocation Considerations
Fixed Income The likelihood that the Federal Reserve will raise the federal funds rate to 5% in May or June and then pause to assess the effects has been built into consensus expectations. This expectation makes sense and is accepted here. Models built on data from 1987-2005 predict that the 10-year T-note yield “should” be 4.7-6.4% in 2006. The current 4.71% level is just above the model’s low-end estimate.
The “savings glut” that seems to have accumulated in Asia since the 1997-98 “Asian-PacRim crisis” helps explain the fact that the 10-year T-note yield has remained near the lower end in the model’s predicted span in 2005 and 2006 to date. So does the notion that economic conditions have become “safer” – less volatile in real terms and less inflation-prone on balance – and made bonds more attractive to investors. It is less certain but still plausible that central banks around the world have created excess liquid assets that have been used to purchase bonds.
Absent a recession – and there is no hard evidence or compelling reason that a recession will occur in 2006 or 2007 – real interest rates seem too low, and the Federal Reserve too prone to keep the fed funds rate near 5%, for the 10-year T-Note yield to fall much below its recent 4.71% level. The 10-year T-Note yield could rise above the 4-4.75% trading span that has prevailed since mid-2004 if inflation rises more than expected and the Federal Reserve becomes more likely to raise the fed funds rate above 5%. The fact that Nominal GDP’s 6.4% expansion rate has remained above the Fed’s de facto 6% speed limit despite the 375 basis point rise in the fed funds rate since mid-2004 implies that inflation is a much more important risk than recession.
The implication is that the 10-year T-note yield is more likely to rise from 4.7% than it is to decline. Fixed income (bond) portfolio maturities should be kept somewhat shorter than normal until and unless the 10-year T-Note yield approaches 5-5.5% .
Common Stocks Common Stocks Above-normal risk-aversion toward common stocks continues to be reflected in the estimate that the stock market is deeply undervalued relative to interest rates. Interest rates would have to soar (the BAA corporate bond yield would have to rise from around 6.38% to 7.63%) or corporate profits would have to plummet in order to eliminate the market’s undervaluation at current prices.
Interest rates could rise more than expected but should not soar. Profits will not collapse unless an economic recession occurs and recession remains quite improbable. Current real interest rate levels stand well below levels that induced past recessions and bear markets. This plus the estimated undervaluation should both limit the market’s downside risk and support its further advance.
The stock market’s undervaluation seems to reflect increased aversion to shorter-term investment risks. This is understandable based on the market’s sustained and deep decline in 2000-3 and the uncertain economic-political climate since then. The pessimism that lies beneath the market’s estimated undervaluation is not without precedents in depth (1974-75) and duration (1976-79, 1988-90, 1993-96). It proved profitable to invest in stocks in those periods – and much more profitable to invest then than it was when extreme optimism and overvaluation prevailed (1987 and 1999).
The stock market’s undervaluation also seems to reflect “irrational pessimism” about economic prospects. The stock market has seemed to focus on worst-case economic scenarios since 2003. But the Commodities/Claims Ratio is not in freefall and real interest rates are nowhere near the 425 basis point level that has induced recessions and bear markets in the past. Neither measure poses a threat now or in the foreseeable future.
Investors should resist the temptation to join in the crowd’s apparent aversion to the stock market and its obsession with very short-run trends. Investors should instead focus on preparing long-run asset allocation plans, and on holding or adding to their positions in common stocks as those plans dictate. Economic and market prospects remain more favorable than not
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