Goldilocks or Recession - All or Nothing
10/31/06
October 2006 is now history, the seasonally worst stretch of the year has come to an end. This, however, does not mean that money managers can relax now. On the contrary, after a miserable start of the year, - new highs in the first quarter, a seemingly clear breakdown in the second, which seemed to be the prelude to a full blown bear market and then this unexpected recovery in the third quarter has left most money managers whiplashed and woefully underwater. The S&P 500 delivered a total return of 5.7% in third quarter, but the average general domestic stock fund gained just 2.5%. Real estate and Utilities gained the most, while natural resources lost the most in a quarter that seemingly defied logic, the calendar and all other conventional wisdom. The result is a thoroughly bifurcated set of market participants. The bulls are encouraged by the "soft landing" scenario and a moderation of inflationary expectations. The bears are pointing to decelerating growth,the fact that the housing sector is still declining and that decelerating inflation might just be a temporary relief. Money managers meanwhile have to make up their minds. They can not sit there and wait for clarity. They have to put up decent performance numbers whether the waters are murky and potentially dangerous or not. Investors want gratification, NOW! Throughout the quarter, market reactions to economic data shifted dramatically. In July stocks and bonds jumped each time weak statistics were reported because it increased the odds of the Fed delaying further interest rates hikes. After the last hike and the growing certatinty that further interest hikes were not to be expected, the reaction of stocks and bonds diverged. "Bad is good" for stocks before the Fed pause, changed to "Bad is bad" after the Fed pause, since now that the pause is here, we could do with a little growth. Bonds started to react the opposite way: Bad economic news was good for bonds (falling yields) and good economic news became bad for bonds (rising yields). Throughout the quarter however, stocks continued their relentless rise.
The yield-curve inversion has been pretty relentless lately. A spate of weaker-than-expected economic news has sparked new worries about the economy, something that is evident in the curve, the Treasury Inflation-Protected Securites (TIPS) market and the foreign exchange market, where the dollar is falling. Today, the yield spread between three-month bills and 10-year notes reached 50 basis points (bills yielding more than 10-years), the most since December 2000. A spread of -80 basis points would put recession odds at 50%, looking one year out, according to a Fed study. The left picture above shows the 90 day average of yield difference between T-Bills and 10-year T-Notes. The inversion is now well established and a recession in 2007 seems unavoidable to me. This was also borne out by las weeks GDP report, which came in at 1.6% growth and therefore below the consensus of over 2%. The data reflected weakness the market already knew about. The automobile sector unexpectedly added to GDP in the third quarter, contributing four-tenths of a percentage point to the tally. In other words, GDP (ex autos) increased by only 1.2%. The contribution is highly likely to reverse in the fourth quarter given the announcements by major automobile manufacturers. Ford's cutback in particular will be very sharp, judging by its Aug. 18 announcement of a 21% cut in the current quarter. Forecasts are for industry-wide production to fall to a pace not seen since the early 1990s, shaving close to a percentage point from GDP. All these numbers are not very friendly and as a result today we saw intense selling for the first time since August. Today’s selling was caused by the ISM Index, which fell precariously close to the recession line. Liz Rappaport wrote today on TheStreet.com: "In light of Wednesday's weaker-than-expected manufacturing and construction spending data, a slew of economic indicators that began with Friday's 1.6% reading of GDP have pushed traders and economists into distinctive camps: Those who believe in the soft landing are on the defensive, while those who've called for recession all along are feeling rather prideful and puffed up." Nicely said.
News of a slowing economy weakened the greenback but helped gold breach the psychologically vital $600-an-ounce level. Subdued economic activity increases the likelihood of a near-term interest rate cut by the Federal Reserve. Other things being equal, that would be bearish for the dollar but bullish for gold, which tends to move in the opposite direction to the U.S. currency.
As you can see, the dollar index is close to breaking a two year old trendline. If we close substantially below 85.20 or so the dollar will begin a new leg down. Perhaps that is what the strength in gold is telling us. The weakening dollar short term signifies economic weakness in the U.S and is now (just like falling yields) being viewed as a negative sign by stock and bond investors. As recently as last Friday, a rate cut wasn't anticipated until May of next year. As of today, the market prices in 20% odds of a rate cut in January. All or nothing, Wall Street Style!
Liz Rappaport said today: "Treasuries have rallied sharply and the yield curve inverted further as fixed-income investors put their recession trades back on. The fed funds odds point to a potential rate cut in early 2007 after pricing in greater chances of a hike just last week, and stocks are faltering as the soft-landing scenario slips through their fingers."
We had quoted Mr. Anirvan Banerji from the Economic Research Institute (ECRI) in May as saying: "Underlying inflationary pressures are less of a problem today than they were a few months ago, but economic growth may now be about as good as it gets in this cycle", when he commented the institute's Leading Economic Indicator (LEI) index. Here is what he had to say today: "Industrial production peaked in June and has gone straight down from there." Banerji says that Wednesday's weak 51.2 ISM reading means there is more slowdown in the industrial space yet to come, "...but it still doesn't mean hard landing or recession. This economy is difficult to tip into recession. There is a huge service sector which hardly ever contracts. We have an economy that just tends to grow." The industrial part of the economy indeed is slowing down. Whether the consumer, which makes up 70% of the economy is equally weak remains to be seen. Whoever bet against the American consumer over the last 20 years has lost money in the long run.
Hermann Vohs
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
