June 27, 2007
STILL WAITING, WATCHING & WONDERING WHAT COMES NEXT
The government updates the first-quarter GDP tomorrow, but till then we're told that the economy expanded by a scant 0.6% in the first three months of this year, based on a real, annualized calculation. Meanwhile, the real yield on the 10-year TIPS closed yesterday at 2.70%, which is to say that inflation-indexed Treasuries offer a considerable yield premium over the pace of economic expansion.
By that standard, U.S. interest rates are tight by more than a little relative to recent economic growth. Of course, the relationship between the price of money and GDP's pace evolves, sometimes dramatically. GDP rose by a strong 5.6% in real, annualized terms in Q1 2006, a quarter that witnessed real yields on the 10-year TIPS in the low-2% range. In other words, the price of money in early 2006 appeared loose, but has since given way to looking tight.
The challenge to that theory comes by surveying the price of money internationally. BCA Research yesterday published a provocative chart showing that globally defined bond yields generally are low relative to the world economy's rate of growth. Interest rates, the research shop opined, "are not yet restrictive." From that analysis comes the counsel that global equities looked poised to rise. "It will take a much sharper rise in the cost of debt to curtail the bull market in global equities. Until then, our outlook for higher stock prices remains intact," BCA counseled.
So far, so good. But the human mind is subject to what's only just passed, and on that score there's the issue of red ink to assess. A look at MSCI's suite of benchmarks for various slices of developed foreign markets shows a trend of unmistakable consistency: down. For the past month, virtually all MSCI indices in the developed world are in varying states of loss. Representative of the trend is MSCI EAFE, which is off by 1% for the past month, in dollar terms.
But even here, selectivity in how one reviews the world's equity markets offers alternative results. Emerging markets continue to bubble. MSCI Emerging Markets is up 3.6% for the past month, in dollar terms. Regions within EM are doing even better over the same period, with MSCI EM Asia rising 5.6% for the past month and MSCI EM Eastern Europe adding 7.2%.
Into this mix comes tomorrow's Federal Reserve announcement on its latest thinking for monetary policy. The ongoing belief that the current 5.25% Fed funds will remain the standard finds wide appeal, as reflected in Fed funds futures prices.
But nothing is written in stone. The incoming economic data continues to challenge the belief that the future is transparent as defined by the bulls. Yesterday's news on new home sales gave fresh support to the view that the housing market is still correcting, which in turn adds potency to the fear that the subprime mortgage turmoil may yet bring bigger headaches to the economy overall. Meanwhile, this morning's news of a robust decline in durable goods orders for May only heightens worry that economic weakness is the path of least resistance for the United States.
Ours remains a period of transition. There's a case to be made for both bullish and bearish predictions as to the final outcome of the current climate. But a broader, objective analysis suggests that there are still too many variables, both pro and con, weighing on the future to say with any confidence what's coming. The potential for surprise and shock from isolated events looks uncomfortably high to your editor's eyes--all the more so after several years of virtually non-stop bull markets in nearly everything. We could cite any number of examples that lead us to caution, but we'll close with just one reminder of how precarious the morrow appears to this reporter.
The news that Exxon Mobil and Conoco Phillips are prepared to abandon their energy investments in Venezuela in the face of an increasingly hostile business climate imposed by the Chavez regime reminds that formidable threats to stability and calm that prop up bullish visions continue to lurk in the shadows. Energy prices are currently high, and there's little reason to think that they couldn't suddenly and unexpectedly go much, much higher tomorrow.
Yes, there's a persuasive case to be made that the outlook is modestly encouraging for the U.S. economy. On balance, momentum retains the upper hand across the mix of variables that collectively define and drive U.S. and world GDPs. The problem is that the outlook is largely dependent on looking backward. With so much change unfolding in formerly trending variables, the future presents, in our humble opinion, a higher-than-normal risk to forecasting confidence.
As a result, the current climate only strengthens our view that broad diversification across asset classes, combined with a slow but sure rise in the allocation to cash, remains the best game in town. We're avoiding heavy bets on any one asset class or tactic. Better opportunities are coming, we believe. Another boring analysis, perhaps, but that's our story and we're sticking to it. Sometimes the best strategy is one of waiting. Patience is famously said to be a virtue. It may also be the secret to future performance success.
Yes, we may be wrong. It wouldn't be the first time. That said, we prefer to be wrong in a defensive posture and watch the markets rally further rather than find ourselves mistaken while loaded up on aggressive portfolio bets. Every investment climate sends a different signal, and the current one is no different. As such, we're reading the tea leaves and making a value judgment, replete with all the usual caveats and limitations that go with the job.
Posted by jp at June 27, 2007 10:26 AM
The most sensible and balanced article I have read on this issue thus far. Geopolitical volatility in the Middle East and terrorist activity are perhaps the most dangerous unknowns in this equation and we should prepare for the worst.
Posted by: Carol Ann at June 28, 2007 9:03 AM