Economic Review and Market Perspective*

July 24, 2006

 
While market commentators found it convenient to blame new Fed Chairman, Ben Bernanke, for poorly communicating the Fed’s stance on interest rates, thereby adding to the uncertainty of the markets, it is fair to say that the markets had gotten ahead of themselves on the heels of average annualized returns well into the teens for 2003-2005 and were ripe for any excuse to correct. Equity indexes that had risen the most during earlier years and for the first four months of the year corrected the most in May and early June, after which a late June rally recovered a portion of the depreciation. Additionally, Fed rate increases continued unabated during the first six months of the year. They combined with increasing inflation to put significant pressure on bond returns for all but the shortest maturities.


Economic Review

By way of historical perspective, the Fed created new threats when it acted decisively after the Internet bubble and the 9/11 tragedy to avoid world recession and even deflation. The long string of interest rate cuts, aided by the fiscal policy stimulation of income tax cuts, limited economic contraction and allowed developed western countries to avoid the dreaded “D” word. However, the policy direction threatened to over stimulate the economy and reignite inflation, as short-term interest rates were decreased to 1%, a 45-year low. Accordingly, in early 2004, the Fed reversed course and began a series of increases in the Fed funds rate that have continued unabated to the present, hoping to engineer a “soft landing” and simultaneously reduce the U.S.’s twin deficits and housing bubble.

On July 20, 2005, former Federal Reserve Chairman Alan Greenspan reiterated his concern about low long-term interest rates, which had stayed down despite the Fed’s hikes in short-term rates. That situation, which Greenspan called a “conundrum,” had depressed mortgage rates, helping to create what Greenspan called “froth” in the housing market. This easy credit and low cost of financing also contributed to the U.S. trade deficit by encouraging demand for imported goods. 

Numerous economists explained the conundrum of low long-term interest rates and also the surprising strength of the U.S. dollar as a massive global recycling of U.S. deficit spending, particularly by China. This recycling in effect extends liberal trade credit to us, keeping U.S. interest rates low and supporting the value of the U.S. dollar on international currency exchanges, while simultaneously facilitating the huge growth of Chinese manufacturing. 

Moving our perspective to 2006, although second quarter declines in the financial markets seemed to be forecasting a slowing U.S. economy; economic reports released during the quarter were describing a healthy economy. GDP growth has remained solid, rising a reported 5.6% during the first quarter, paced again by strong consumer and steady corporate spending. After rising more than expected in the first quarter, job growth moderated slightly in April and May, but the rate of unemployment continued to move lower to 4.6%. Manufacturing showed some mixed signals. While growth in shipments remained steady in the 6% to 7% range, year-over-year growth in new orders declined to below 5% for the first time since early 2004. The Institute for Supply Management (ISM) survey dropped modestly in May, but remains roughly in the same range it had been throughout 2005.


A key factor affecting the financial markets currently is inflation. The Consumer Price Index (CPI) rose at an annual pace of more than 4% in May, driven by increases in the price of energy and other commodities. While this was not, in itself, surprising, investors have been keenly interested in whether or not the high cost of energy would flow through to other goods and services. The CPI, less food and energy, had been moderating since mid-2005, however the reports for April, May, and June showed significant up-ticks, and the cumulative twelve month increase was 2.6%. 

In news hot off the press, new Federal Reserve Chairman Ben S. Bernanke on Wednesday presented a favorable interpretation of economic data and a benign forecast for the U.S. economy. In his semiannual economic assessment to Congress, Bernanke predicted a happy combination of slower but sustainable expansion and gradually moderating inflation. Growth “should moderate…both this year and next,” Bernanke told the Senate Banking Committee. “Should that moderation occur as anticipated, it should also help to limit inflation pressures over time.” 

Bernanke acknowledged that inflation had outpaced his previous semiannual forecast, presented in February, his first month on the job after replacing Alan Greenspan. He pointed out that the inflation measure favored by the Fed, personal consumption expenditures, had risen at an annual rate of 4.3% during the first five months of this year. But much of this increase in prices occurred while the economy was growing at the unsustainable 5.6% rate in the first three months of the year. Since that time, Bernanke said, economic growth had eased to a pace that would not generate inflation. Consumer spending has slowed, he said, and the housing market has cooled.

Markets welcomed Bernanke’s congressional testimony. The U.S. stock market, which had been struggling during most of July amid fears of slowing growth caused by restrictive monetary policy and rising geopolitical tensions, responded with a robust rally on strong trading volume. 

Meanwhile, foreign economies continued to improve during the second quarter. While growing at rates slower than the U.S. economy, the European and Japanese economies continued to trend higher. Both the Tankan survey of Japanese business conditions and the Euro Zone Business Climate Indicator improved in the second quarter. Unemployment rates fell in all developed markets except the UK. Even with the expansion of the labor base from emerging markets, these trends are creating tighter labor markets, which may impact inflation going forward. While emerging market economies in general also continued to expand, a sharp pullback in commodities prices from historic highs put a dent in the meteoric rise of natural resources producing economies.

Looking ahead, the best case for the global economy may be occurring, namely a soft-landing in the U.S., a picking-up of the slack by other developed countries, and a continuation of stimulation of the global economy by the twin emerging economic giants, China and India. In the U.S. economic conditions are reenacting the “Goldilocks” economy of the late 1990’s-not too hot, not too cold. Further, the Fed appears to be on target with a difficult balancing act. Bernanke made some observations in his congressional testimony that could be used to support a pause in the rate-raising drive. In particular, he suggested that the recent hikes might not have had enough time to take full effect. “The lags between policy actions and their effects imply that we must be forward looking…” he said. “We must take account of the possible future effects of previous policy actions – that is, of policy effects still ‘in the pipeline.’” This stance would guard against overshooting in the campaign to halt inflation. Some analysts have worried that the final measures taken before inflation is tamed not only would be unnecessary but would stifle growth.

The mention of China reminds us that shorter-term data trends and central bank policy initiatives are occurring against a longer-term backdrop of globalization and what is termed “stable disequilibrium,” both generally positive phenomenons so far. The assembled brainpower at PIMCO in Newport Beach, including the well-respected bond gurus of the firm as well as prominent outside economic and financial experts, has concluded that the symbiosis between the U.S. and China (the recycling referred to above) has legs. Therefore, there will be only a gradual decline of the dollar, not a crisis, and long-term interest rates will stay low. Mr. Greenspan was also sanguine during his last year as head of the Fed. Capitalist economies, he believes, always have imbalances but are also continuously reallocating resources and capital to correct them. Thus, imbalances seldom become crises. “The number of forecasts of crises…is far in excess of the number of crises that actually occur,” Mr. Greenspan told an audience in Chicago in June 2005. 

Nonetheless, economists agree that change must come to correct the twin trade and government deficits, most notably respecting the U.S., but also occurring in several other major developed countries. The debate is over how, not whether, the global economy rebalances, with all favoring a smooth, gradual transition through some combination of declining dollar and accelerating foreign demand. 

Happily, there is evidence that an orderly transition is beginning. One good sign is increased economic activity in Japan and Europe. In conjunction with the 3.2% decline year to date in the value of the U.S. dollar, which lowers the price of our exports to foreigners, these foreign economies are increasing their purchases of U.S. goods and services. The result is improvement of the U.S. trade deficit, at last. Additionally, increased export demand occurs at a good time for us, when our economy is otherwise slowing due to a long period of Fed tightening and rising energy costs sapping both consumers and corporations. Thus, the increased demand helps us avoid recession and is a benign way for unbalanced global economic forces to begin to unwind.

As an economic endnote, the long-term U.S. fiscal challenge of reducing deficit spending and bolstering the funding of Medicare and Social Security, while at the same time maintaining relatively stable economic growth, remains our biggest concern and eventually will overshadow the near-term analysis. Presently, this challenge is beyond our time horizon and can be put on the side burner.

 

Market Perspective

For most of 2006, investors had been hoping the Fed would stop raising short-term rates, and the Fed’s comments that went along with its 25 basis points (0.25%) raise at the end of March gave the market a glimmer of hope that the Fed’s campaign was near an end. Firming inflation statistics along with the comments that came out with the Fed’s May 10th 25 basis points (0.25%) hike in policy rates disheartened the equity markets and fueled uncertainty about inflation, the Fed’s future actions, and the resiliency of the economy. For the first time in several years, the markets were unresolved as to what the Fed’s next move would be until very late in the cycle when evidence and certain comments made it clear that the Fed would again raise rates by 25 basis points (0.25%), which it did on June 29th. Notwithstanding, and perhaps as a prelude to Bernanke’s congressional report, the Fed’s commentary that accompanied that most recent rate hike was decidedly less hawkish about fighting inflation compared with past guidance.

The U.S. stock market moved sharply lower and showed increased volatility throughout the second quarter as investors tried to decipher Fed policies and whether the economy was reaching an inflection point. While many investors have laid the blame for this increased volatility at the feet of new Fed Chairman, Ben Bernanke, it is important to note that the early year market rally was in the face of an aging and possibly maturing economic growth cycle along with negative geopolitical news, such as both Iran’s and North Korea’s pursuit of nuclear weapons technology, degeneration in Iraq, sustained higher oil prices, and steadily rising interest rates. Increasing volatility is typical of the later stages of an economic cycle when market participants become extremely sensitive to the movements of certain key indicators in order to anticipate the direction of the economy and corporate profits.

Evidence that the heightened volatility and price pullback were not purely the result of poor Federal Open Market Committee communication is reflected in the similar declines within foreign developed and emerging equity markets. Up until mid-May, these markets had been performing even better than the U.S. stock market.

To wrap up, the global economic picture presented by Bernanke, PIMCO, and others, if not convincingly sound, has at least a good probability of supporting reasonable returns for stocks and bonds, but there are two main dangers. First, as usual, are potential outliers, or departures from the base case. Among the numerous possible causes, two key ones include 1) geopolitical crises, especially involving terrorism and/or the supply of oil, and 2) a sudden collapse of the “stable disequilibrium” regime, upon which relatively low, accommodative long-term U.S. interest rates depend (as I mentioned, PIMCO does not think such a collapse will occur). The second danger is the reduced liquidity engineered by the Fed and other central banks. Gone are the days of a 1% federal funds rate and a zero interest cost for borrowing from the Japanese central bank. We must remember that easy money was a major cause of the big run-up of worldwide stock, bond, and real estate values from their precarious levels in 2001-2002. Easy money supported a very prosperous “carry trade” for many investors, especially hedge funds (they carried lots of short-term debt at low rates to finance purchases of higher yielding long term debt and equity). A flat yield curve has virtually ended conservative versions of the carry trade, and central banks have gone from being the investor’s “friend” to at least non-supportive and even “the enemy”. Additionally, stocks, bonds, and real estate are now competing with money market yields of 5-6% instead of 1-2% at the height of easy money. Accordingly, markets have just recently awakened to the higher risk facing investors. Perhaps belatedly, they are demanding higher premiums for risk-bearing, thus producing the sharp downturn markets experienced in May-June. Even higher premiums may be needed, so investors need a healthy dose of defensiveness and should limit exposure to the riskiest asset classes.

* Thanks and credit must go to the many sources for this writing, including Managers and PIMCO mutual fund families, the Wall Street Journal, and the Los Angeles Times.
 
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