The economy may be slowing, but the accumulating evidence doesn’t convince every last analyst that the future will bring a stumble.
At the leading edge of contrarian thinking on where the economy’s headed is one dismal scientist who thinks the consensus is wrong and headed for a train wreck. Bonds are “riding for a fall — the economy isn’t weakening and the Fed’s not going to ease,” wrote David Gitlitz, chief economist at TrendMacrolytics, in a note to clients last Thursday.
The bond market paid no attention, opting instead the next day to rally and dropped the 10-year Treasury yield to under 4.6% for the first time since February. The message could hardly be more direct. The inversion of the yield curve now amounts to Fed funds at roughly 65 basis points above the 10-year. As inversions go, this one’s fairly solid and so its forecast can neither be misconstrued or accidental. That doesn’t make it right, but one can’t claim the signal was unclear.
But if a recession is now baked into the system, Gitlitz reminds that reasonable minds can look at the same data and come to wildly different conclusions.
Speaking on the opposite side of the analytical aisle is Nouriel Roubini of Roubini Global Economics. He warned on his blog last week that a “hard landing and recession” are now a 70% probability. Among the highlights (or low points) of his forecast:
* The economy will sharply decelerate in H2 (1.5% growth in Q3 and 0% by Q4)
* The housing market will experience its biggest bust in decades and home prices will sharply fall
* The US will enter into a recession by Q1 of 2007
Gitlitz isn’t entertaining anything even remotely close to Roubini’s vision. On the notion of a housing bust, for instance, he counters that the recent decline in mortgage rates might “ease the housing slump upon which rests so much of the bond market’s hopes for broader economic deterioration.” And when it comes to the yield-curve inversion, the traditional reading may not be relevant, he continues:
It’s true that significant inversions over the past two decades have correctly anticipated subsequent Fed rate cuts. But it’s also true that on those occasions policy was far tighter than it is now. The 2000 inversion came when the Fed pushed the real funds rate to 4%, with a 6.5% nominal rate against core inflation running at about 2.5% year-on-year. In 1989, the real rate got as high as 5%, with the Fed’s hikes topping out at 9.75%. By contrast, the current 5.25% funds rate amounts to a real rate of less than 2.5%. Rather than being tight, the Fed remains accommodative.
The bottom line for Gitlitz: “We don’t believe the Fed will ease without a precipitous growth slump, and we see no indication that such a slowdown is in the works.”
The Fed’s FOMC meets again on October 24 and 25 to again consider the right and proper level of money’s price. So far, the Gitlitz view of the world finds little support in the world of futures trading. As we write this morning, the November Fed funds contract is priced in anticipation of holding the Fed funds at the current 5.25%.
Then again, bulls and bears may both claim triumph if the pause remains intact at the next rate meeting. If the Fed truly thought a recession was coming, it would cut rates, right? On the other hand, some might reason that the Fed is worried that growth will stay stronger than expected and so prefers to keep rates unchanged for fear of cutting too early.
Perhaps, but for the moment the forces expecting economic moderation are in control, an influence that extends to the world of oil. A barrel of crude fell below $60 earlier today, a six-month low. When and if Mr. Market comes around to the Gitlitz view of the economy, oil prices are likely to be an early indicator. But today, at least, the slow-growth outlook prevails.
For the long-term strategic investor, the economic debate can be more than a little confusing. No matter, as we’re still of a mind that better opportunities will emerge down the road, and so we’re still overweighted in cash. At some point, valuations in one or more of the asset classes will present more compelling numbers. Meantime, we’re happy to stay diversified across all the usual suspects, albeit without making aggressive bets anywhere. That will change, perhaps soon. But first, Gitlitz or Roubini must be proven wrong, a task that can only be delivered by the data.
Our suspicion is that the future will favor something closer to Roubini’s outlook, if not quite so extreme. Nonetheless, the optimist in us still hopes for a scenario that tracks Gitlitz’s. Call us crazy, but we prefer growth over recession. Nonetheless, we’ll take what comes. More importantly, we aim to profit from it. Such is life in the cold, calculating and opportunistic trenches.