Risk never gives investors a break. It’s constantly baiting us, dispensing false signals and generally throwing landmines on the path that appears as a smooth trek to easy gains.
Consider that the past 20 years have been particularly fruitful in financial economics for identifying sources of partial predictability in certain data series. A few examples include dividend yield and other fundamental valuation measures that have shown robust results for estimating the equity premiums for medium- to long-term horizons. The shape of the yield curve and the spread between interest rates on corporate and Treasury bonds have also shown encouraging results as predictors.
In fact, there are a number of factors that are worth monitoring on a regular basis for estimating the price of risk in the major asset classes. No surprise, then, that watching dividend yield, the term structure of interest rates and a host of other metrics, and inferring risk premia and asset allocation from the analysis informs much of our work in The Beta Investment Report. The danger is thinking that the investment challenge has been solved.

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The cheering over the positive news from the global summit of the so-called G20 nations is well deserved, but no one should think that all’s well.
It’s one thing to pledge more stimulus money and promise tighter financial regulations. That’s all well and good, and the stimulus efforts are especially timely at this point. But let’s be clear: a new round of global stimulus will, at best, slow, perhaps stop the bleeding at some point, but probably not until later this year, at the earliest. As for economic growth, it’s far too early to think of such things.
In fact, a fair amount of the good news dispensed by the conference of the world’s biggest economies is related to what didn’t happen. If the talkfest had ended with recrimination and a muddled outcome, as some thought was likely, the global economy would suffer that much more. Think of Nero playing his fiddle with Rome in flames.

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March was kind to the broad asset classes, and not a moment too soon. After February’s across-the-board declines, and virtually the same in January, a respite from the turmoil was overdue. Even in a global recession, prices don’t fall continuously.
But they do fall, and it’s not clear that the markets are through with discounting additional economic troubles. One sign for concern is that as markets rose last month, the estimates for the world economy worsened. Both the IMF and OECD are now projecting outright declines for global GDP this year. The OECD’s projection is quite a bit worse, anticipating a 4% drop in the world economy vs. a relatively mild fall of 0.5%-1.0%, according to the IMF’s estimate. That may look mild on a single-nation basis, but in the context of the global economy it’s quite steep, not to mention unusual.
But for the moment, there’s March. As our table below shows, everything popped last month. Equities across the world delivered a stellar performance, with emerging markets soaring by more than 14%. U.S. equities generated a robust gain as well in March, advancing nearly 9%.

March, in fact, was one of the better months for stocks generally in many a moon, proving if nothing else that powerful rallies can and will show up in nasty bear markets. But let’s not forget that we’re in a bear market and it’s not yet over. Economically speaking, there’s not much confidence about where we are in the cycle. Yes, there have been some encouraging signs recently, as we’ve discussed, including here and here. But the full brunt of the global recession isn’t yet known. By our reckoning, coming to terms with the beast will take another quarter or two, perhaps longer.
The equity market will no doubt play its traditional role of anticipating the rebound, which means that prices will start turning up well ahead of macroeconomic data confirmation. But it’s still too early to assume that the turning point is in sight.
That said, there’s an enormous amount of money in cash and equivalents. At some point, perhaps sooner than we think, the crowd will grow weary of earning nothing. The appetite for risk is set for a rebound. But not yet. Strategic-minded investors will want to stay vigilant however, and take advantage of selling. But it’s still premature to call for outright buying.

What are professional money managers thinking these days? A new poll by Russell Investments offers an answer. Among the highlights:
• 67% of managers are now bullish on corporate bonds
• 61% are bullish on high-yield bonds
In both cases, the percentages are a bit higher compared with the previous poll from last December. “In this environment of caution and realism, managers are finding opportunity in spreads between high-quality corporate bonds and Treasuries that are at historic levels,” Erik Ristuben, Russell’s chief investment officer, says in the accompanying press release. Expectations for junk bonds are also higher from late last year.
U.S. equities, on the other hand, have fallen in the eyes of managers. Value and small-cap equities suffer the most in terms of the current outlook, according to the Russell survey. Here’s an overview of how the changes in expectations for the various asset classes stack up:

Jeffrey Lacker, president of the Richmond Fed, is a voting member of the FOMC and a card-carrying hawk on matters of inflation. So when he warns that monetary policy faces new hurdles, our ears perk up. As we’ve been discussing, minting money is easy.;taking it away is something else. The hazards on the latter have rarely been higher at this juncture. At a talk a few days back at the College of Charleston, Lacker summarized the approaching task on soaking up the massive liquidity that’s now in the system, albeit much of it sitting idle for the moment:
“Whether it has an inflationary impact or not depends on our skill at the Federal Reserve in withdrawing the stimulus in a timely way when the economy begins to recover. That is a very delicate, very hard policy…The economy when it recovers is spotty…Inevitably, we face this dilemma. Do we keep policy easy and stimulative because of the sectors that are lagging behind in this recovery or do we get ahead of the curve…it is going to be a tough call.”

Today’s update on personal income and spending reminds that the attack on the consumer rolls on.
As our chart below suggests, the recession is bearing down on Joe Sixpack and the pressure isn’t likely to ebb for some time. Disposable personal income was flat to slightly down last month on an annualized seasonally adjusted basis. Personal consumption expenditures fared a bit better, posting a roughly 0.2% rise in February, but that looks like statistical noise and a reaction to the sharp pullback from previous months. Given the sober outlook for the labor market, there’s little hope that we’ll see much improvement for spending or income any time soon. As the crowd comes to terms with the economic backdrop, we’re likely to see ongoing retrenchment in the late, great consumption binge.

But for the moment there’s another threat to watch: inflation. Yes, we’ve been talking about deflation these past few months, and based on the numbers published late last year it looked like the potential for a deflationary spiral was quite real. But it was only a true threat if the Federal Reserve dithered and let deflation take root. As we’ve discussed, the Fed did no such thing and instead has acted aggressively in combating the threat by flooding the system with liquidity. Given the economic context, a fair amount of the liquidity is sitting idle—i.e., the classic problem of pushing on a string, as they say. Indeed, quite a bit of the newly minted liquidity has been redeployed into nonproductive areas, i.e., safe havens, which is why short-term Treasury bill yields remain at roughly zero, if not slightly negative. When the liquidity starts to come out of hibernation, the potential for inflation will rise.

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The first order of business in repairing the economy is reestablishing a stable rate of inflation, ideally a small dose just above zero. There’s inherent danger in targeting higher inflation, but it’s a necessary evil at the moment, and there are signs that the effort is working.
Exhibit A is the yield spread between the nominal and inflation-indexed 10-year Treasuries. The spread is considered the market’s inflation forecast. Although no one should confuse this outlook with perfection, it does reflect market sentiment to a degree and it’s also monitored by the folks at the Federal Reserve, among countless other statistics.
As our chart below shows, this spread continues to exhibit an upside bias, and in the current climate that’s encouraging. As of last night’s close, the Treasury market is forecasting a 1.3% inflation rate for the next 10 years—up from virtually zero late last year. Certainly the extreme lows of last November and December appear to be history, at least for the moment. That’s heartening because it suggests that the market’s modestly encouraged that deflation’s threat is passing.

Insuring that deflation doesn’t take root has and remains the priority for stabilizing the economy and laying the foundation for recovery, as we’ve been discussing in recent months, including here and here. The good news is that progress in this battle continues to accumulate, and the above chart is but one example.

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In the long run, equilibrium prevails, supply matches demand and something close to pure efficiency in market pricing reigns. In the short run, on the other hand, stuff happens.
The idea that Mr. Market wins eventually crosses our mind as we consider the massive government intervention of late. There are some who are expecting something for nothing as the Federal Reserve, the Treasury and other state entities step into the vortex of market turmoil. In fact, there’s a cost to everything, and that includes the intervention du jour.
The rationale for intervening is compelling at the moment, but no one should think it won’t come at a price. The question is: What price?

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The March rally in the stock market has people talking, and asking questions, such as: Was that a bottom?
For the moment, the answer is “yes.” Deciding if the answer holds is debatable. We’re skeptical largely because the rally this month has drawn power primarily from a new round of hope that Washington’s various experiments to right the economy will finally hit pay dirt. Perhaps, but it’s not the stuff that powers sustainable rallies, much less secular bull markets. We’re closer to that point than we were 3 months ago, of course. But uncertainty still dominates.
The latest chatter may put a floor on equity prices, and for the moment that’s what we’re looking for, although it’ll only be obvious in hindsight. Clearly, the government is integral in the healing process. But expecting the latest press release from the Treasury or the Fed to unleash something more substantial than a bounce is probably expecting too much at this point.
Nonetheless, it’s tempting to look at the trend in recent weeks and draw an optimistic conclusion. As the chart below shows, March has been kind to owners of equity. After taking another drubbing in February, investors were primed for anything that even remotely looked like good news.

And more of it appears to be coming in today’s news cycle. The latest from the Treasury is yet another freshly hatched plan to subsidize private purchases of the toxic securities that are weighing on the banking industry’s balance sheets. The size of the plan is a tidy $1 trillion, which is to say it’s sizable. Asian markets responded positively to the news and as we write the U.S. stock index futures are up ahead of the opening bell on Wall Street. It’s not over till it’s over, but with just over a week to go, it’s looking as if the S&P 500 may post a modest gain for this month…maybe.

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Economic research published since the late-1980s tells us that watching the Treasury’s yield curve is a productive exercise for analyzing the outlook for the business cycle and interest rates. In 2006, for example, the New York Fed offered a primer on why the yield curve is useful as a forward-looking indicator. As it turned out, the yield curve was set to invert at the time, offering an advance warning that the economy was headed for trouble. Few heeded the warning, thanks largely to a bull market in virtually everything. The recent past, once again, has a habit of clouding the crowd’s ability to look ahead.
Normally, the Treasury yield curve is upward sloping: yields rise along with bond maturities. When the curve inverts—short rates above long rates—that’s often a sign of trouble brewing. For some thoughts on why that’s so, we recently talked with Bob Dieli, an economist who runs RDLB Inc, an economic consultancy that publishes research at NoSpinForecast.com.
On the new episode of the Inside View podcast, Dieli explains why the yield curve is a critical measure of current and future economic and financial trends…