December 29, 2005
As we write this note, the yield curve, i.e. the spread between short term and long-term interest rates, has already inverted. In other words, the 2-year Treasury note is offering a higher yield than is the 10-year Treasury bond. This is in stark contrast to 18 months ago (see 6/30/04 yield curve above) when the Fed started its tightening cycle and the 10-year bond was yielding some 190 basis points more than the 2-year note. As a result, the markets are watching the yield curve with baited breath due to the fact that, historically, every economic recession has been preceded by an inverted yield curve. Because history often does repeat itself, investors today may begin to question the sustainability of the current economic expansion.
Generally, the yield curve will invert when the Federal Reserve begins an aggressive campaign to slow economic growth and ward off potentially high levels of inflation by raising short- term rates. Such action often times results in a greater reduction in economic growth than desired as lenders become unwilling to lend long-term. However, not every inverted or flat yield curve has preceded a recession. The last two times that an inverted yield curve did not precede an economic recession, in 1966 and 1994, the US economy was in a period of subdued inflation, so the Fed was not aggressively trying to control its effects. Therefore, because long-term interest rates reflect expectations for future inflation, long-term rates remained relatively low, resulting in an inverted yield curve.
Over the last 18 months, steady increases in the federal funds rate and a decline in longer-term bond yields have combined to flatten the yield curve. The Federal Reserve has control over the short end of the curve and will likely continue to raise short-term rates through the first half of 2006 as inflation remains in a modest uptrend. It does not control the long end however, and global liquidity forces will continue to put downward pressure on those rates. Accordingly, we do not disagree with predictions that the yield curve will remain inverted (see our 12/31/06 projection on page 1), but we do assert that the inversion is not a precursor of impending domestic recession. It is merely a reflection of current world economic conditions.
The unique global economic situation that we have just alluded to is known as the Cycle of Complementary Demand. Foreign economies, principally fast growing Asian nations, are producing consumer goods at low cost due to their abundance of cheap labor and are selling them at very low prices into the global marketplace. One of the largest buyers of these goods over the past several years has been the U.S. consumer. In fact, one might say that the U.S. consumer has been largely responsible for the rapid growth rates of emerging nations like China and India. As a by-product of all these purchases, the producing countries are left with a surplus of U.S. dollars to invest. To date, these dollars have been used to purchase longer-term U.S. Treasury bonds. Due to the inverse relationship between a bond’s price and rates, the outcome has been artificially low long-term interest rates in the U.S. It is in the best interest of the foreigners to buy U. S. debt because the resulting low longer-term interest rates act as a source of stimulus to U.S. consumers. Even though the recent rise in short-term interest rates has reduced much of the stimulus enjoyed by consumers over the past two years, low longer-term rates can offset some of this pressure by affording consumers the opportunity to lock in low long-term rates and continue spending. Without the U.S. consumer, these emerging economies, which currently have limited domestic demand for their products and high domestic savings rates, would not be able to generate the tremendous growth rates they’ve enjoyed over the past few years.
The continued expansion of the global economy is the real key to our yield curve forecast, as well as our economic outlook for 2006. The rapid growth in the developing world has created huge demand for commodities such as steel, copper, and crude oil, as well as an increased need for industrial products and services as they build out infrastructure to support the massive migration of people from rural areas to the booming urban centers. An expanding middle class is a key objective of the governments of these nations, who see widespread economic prosperity as the key to civil order. In addition, low interest rates around the globe have created a great deal of liquidity. This liquidity, which is further compounded by 9%-10% economic growth rates in many countries, means that there is a lot of money to be invested. And the market of choice for investment remains the United States. In fact, foreign investors poured a record $735 billion into our capital markets during the 12-month period ended 10/31/05. Not only do these investments finance our twin deficits, they also play a large part in the continued growth of the emerging world. However, as our deficits demonstrate, the U.S. is no longer the driving force in the global economy but is now merely a participant.
As a result, there is a complementary relationship – U.S. consumers have the wherewithal to satisfy their appetite for cheap foreign goods, the U.S. has a willing creditor for its budget and trade deficits, and emerging nations can generate high rates of growth, which creates a better quality of life for their citizens. Because of this complementary cycle, we continue to seek out investment opportunities that are leveraged to growth in the fast growing economies of Asia, South America, and Eastern Europe.
As a real world example of how an economy can work through an inverted yield curve, we cite what has occurred in the U.K. Similar to the U.S., the U.K. has shifted from a driver of world economic growth to a participant in its growth. As it has become subject to the same global forces that are pressuring U.S. rates, its yield curve has inverted (see chart below). However, the U.K. has not fallen into a recession and has actually shown positive growth and rising rates of inflation. Notably, the U.K. has posted real GDP growth rates better than 2% for the last ten years. And after experiencing a “real estate bubble” similar to ours, home values did not collapse but merely leveled off and began to appreciate at a more moderate pace.
Our domestic economic outlook for 2006 is heavily influenced by the phenomenon of global growth and liquidity. Specifically, we expect the yield curve to invert, with the Fed raising the Fed Funds rate to 5% while the 10-year Treasury bond remains in the 4.5% range as a result of the aforementioned Cycle Of Complementary Demand. However, the inverted yield curve will not result in recession, as the same global forces keeping long-term interest rates low will have a relatively positive impact on domestic GDP, inflation, and corporate earnings growth. Despite the fact that the U.S. consumer will continue to be a significant, but less dominant, factor on U.S. economic growth, we look for domestic real GDP to slow somewhat, but still come in at a healthy rate of 2.75%. The industrial portion of the economy, which is heavily leveraged to emerging market growth and includes producer durable, energy, and materials/commodity companies, will continue to expand faster than the consumer-led service segment. Core inflation will remain relatively benign, in the 3.0% range, thanks to both the Fed’s successful efforts to cool growth as well as the deflationary impact of cheap imported goods. We expect corporate earnings to slow from the torrid pace of the past two years, but still grow at a very healthy rate of 10%, as the industrial parts of the economy mentioned above produce strong growth, while the end of the Fed’s tightening cycle coupled with tame core inflation should result in a modest degree of P/E multiple expansion. Therefore, we believe the market will react favorably to continued strong earnings growth, and stocks will perform well next year despite an inverted yield curve.
Clearly there are risks to this projection. One such risk is the potential for emerging economies to continue posting strong growth and become major economic forces in the world. These emerging countries are likely to begin to invest more of their funds in needed infrastructure, including commodities like steel, crude oil, and copper, and less in U.S. Treasuries. As the Third World and the developed economies compete more and more for resources, the potential for commodity prices to continue to rise is very real. Such “competing demand” could well generate significant inflationary pressures, much higher interest rates, and greater challenges to global economic prosperity. However, as is our custom, we have examined the potential impact on the financial markets under a variety of scenarios and are prepared to react quickly to protect our clients’ capital if we are proven wrong. Ultimately, though, it’s reasonable to believe that equities, currently trading at a forward P/E multiple of roughly 16x, represent the best risk/reward trade-off of the major asset classes. In fact, domestic stocks today look quite attractive when compared to bonds, real estate, and gold. Investors reacted very rationally to the rise in short-term interest rates this year by applying lower P/E multiples to stocks based on an expectation for a slower rate of future growth. Consequently, stocks are now priced for reality.
As all Chicken Littles should know, a diligent review of the evidence can lead to a conclusion that causes no distress. Foxy Loxy may try to trap us with fear, but investors who conduct a prudent analysis of all the data available will find that sometimes an acorn is just an acorn. And that acorn could well grow, if given time, into a magnificent oak.
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