22 Jul 2005 Conundrum Solved?
Back in February of this year Mr. Greenspan labeled the unusual condition of falling long-term rates and steadily rising short-term rates, a ‘conundrum’. The rates generally move in parallel. Yesterday, he told the Congress that the reason long-term bond yields have continued to fall while short-term rates have tripled over the past year was that global savings exceeded investment, inflation expectations are low, and the world economy is stable. He also debunked the theory that an inverted yield curve signaled an economic slowdown, calling it a “misconception.” He said “the quality of that signal has been declining in the last decade, in fact, quite measurably.”
Greenspan said that “risk takers have been encouraged by a perceived increase in economic stability to reach out to more distant time horizons,” driving rates down. But he warned that “history cautions that long periods of relative stability often engender unrealistic expectations of its permanence and, at times, may lead to financial excess.” Bill Gross, manager of Pacific Investment Management Co., PIMCO, the world’s largest bond fund, offered a more optimistic perspective saying that “as long as this secular phenomena continues, and it probably will for years and years, interest rates will be permanently lower than they would have been.”
On Thursday China surprised the financial markets by saying that it would end the Yuan/Dollar peg and allow the currency to float for the first time in a decade. Unfortunately, the move byChinais relatively tiny compared to the amount the currency is out of whack with the dollar, by most economic estimates. Non-political officials, economists, and business leaders were quick to criticize the move as largely inconsequential. But world political leaders are calling it a good first step. The question on everybody’s mind is how serious the Chinese are and how fast will they allow the currency to approach a true valuation if it were allowed to float unrestrained? The U.S. Treasury market reacted strongly to the news as investors sold off long-term bonds sending the Lehman 20+ Index down 1.4%.
Among stocks, the quarterly earnings reports are off to a good start. Approximately a quarter of the Dow Jones U.S. Total Market Index have reported their second quarter earnings. For the most part they are quite good, averaging an increase of 18% over the same period last year. The top performing industries so far have included the Internet, real estate holding and development, airlines and fixed-line telecommunications. The worst performers have been automobiles, specialty and commodity chemicals. Companies in our models that have reported so far include Apple Computer (earnings up) 347%, Adobe 27%, General Electric 16%, Intel 22%, Johnson & Johnson 13%, Bank of America 14%, Caterpillar 36%, Cerner 34%, Kinder Morgan 13%, Coca Cola 6%, and Google 124%. Qualcomm and BellSouth saw their earnings decline, but beat analysts’ estimates.
As to interest rate expectations; it looks like the Fed will continue raising rates for the time being as reported by Chairman Greenspan to the Congress. But evidence surfaced yesterday in the Fed meeting minutes that there is growing disagreement among Fed governors as to how much higher they should go. That there is policy debate at this time is a very good thing. “You need to have that debate before you can get a consensus of that committee to say ‘enough is enough,’’’ said Paul McCulley, a managing director at PIMCO.
All considered, trends look positive for now. The big question is as it has been for several months – how high will the Fed go? The consensus among our experts is 4% (we are at 3.25% now). Earnings are generally quite good, but management guidance continues is generally cautious. Because of the cautionary notes stock prices tend to react more negatively than they might if only the past performance numbers were provided. But that is the way of earnings season – volatile.