23 Feb 2007 The Best or the Worst of Times?
Just a couple of weeks ago it looked as if the economy was going to re-accelerate after only modestly slowing to a respectable 2.5% growth in the fourth quarter. But more economists are now reducing their estimates for growth and saying that fourth quarter GDP will likely be revised downward from 2.5% to 2.0%. In several speeches, Fed governors and district-bank presidents yesterday pared their estimate of economic growth for 2007 to 2.5% – 3%.
They also re-iterated their concerns about rising inflation and made it clear that they aren’t close to cutting interest rates. In their semiannual forecasts they predicted that inflation would stay above the top of their tolerance range this year before slowing in 2008. If there was any doubt that this Fed places its mandate to contain inflation higher than economic growth, it is steadily waning.
The big drag, housing continues to pull harder despite hopeful predictions of an impending turnaround. Toll Brothers, the bellwether builder announced today that its net income plunged 67% in its first quarter due to write-downs and an impairment charge. They are still wrestling with a huge inventory of unsold homes. Orders were 33% lower than they were a year ago, and its cancellation rate was 29.8% according to the company.
The confidence that our Fed demonstrates that the US economy can withstand continued high rates is shared abroad as Central banks continue to embrace a continuing restrictive monetary policy. On Wednesday, the Bank of Japan boosted its benchmark short-term interest rate by a quarter percentage point to 0.5%, seven years after the last increase. Earlier in the month, the Bank of England unexpectedly raised its benchmark interest rate by a quarter-point, the third increase since August, saying inflation may accelerate from the fastest pace in a decade.
Stock markets, on the whole, have been relatively upbeat even with the likelihood that interest rates may stay higher longer than hoped. The higher relative value of stocks to bonds remains continues. We certainly do not see the speculative element in the markets that was so prevalent in the late 90’s. In fact, the average investor still remains largely on the sidelines when it comes to investments outside of those typically in the markets such as IRA’s and 401K’s. The SentimentTrader tracks several Rydex ratios that follow the positions of bullish and bearish investors. Their data suggest that bullish investors are nowhere near the speculative levels of recent years and bearish investors appear quite sanguine on the market.
The same is true in the bond market. According to Bloomberg the perceived risk of owningU.S.corporate bonds fell to a record low today as a survey showed economists are more optimistic aboutU.S.growth, according to an index of credit-default swaps. “There’s very little in the way of default risk, and there’s no bad news out there,” said Mike Mutti, co-head of corporate credit strategy at Bear Stearns Cos. inNew York. “People keep saying spreads are going to go wider because they are so tight, but that’s what everyone was saying last year.”
While some central bankers like Europe’s Jean-Claude Trichet fear the worst for the global economy, global CEO’s meeting in DavosSwitzerland’s 37th annual World Economic Forum could not have been more upbeat. Sunil Mittal, CEO ofIndia’s largest mobile-phone operator said “I’ve never seen a mood like this.” Morgan Stanley Chief Global Economist Stephen Roach said “the consensus here in Davos is everybody’s thinking it’ll be another booming year.” While not oblivious to the signs of slowdown, leaders said they were confident in their ability to cope with the inevitable slowdown of the world’s strongest economic growth in three decades.
The optimism seemed to incur even more negativity and warnings from the Central bankers. Axel Weber, head of Germany’s Bundesbank said interest-rate increases inJapanwill mop up the global liquidity that has helped fuel the financial-market boom of the past four years. “It is time for financial markets to move back to more adequate risk pricing and maybe forego a deal even if it looks tempting,” he said. “There’s a danger of a `rush to the exit’” if investors wait too long. Malcolm Knight of the central bank of the world’s central banks, said he was concerned about overcrowding of an increasingly popular trade in which speculators borrow Japanese yen at near-zero interest rates and buy higher-yielding assets.
Both business leaders and policymakers appear to base their positions on the facts, but perhaps both are a bit overzealous. Business CEO’s are rolling in the euphoria of record profits and commensurate bonuses. Policy makers worry, perhaps too much about the world’s record levels of liquidity, much of which is beyond their control as it is outside of the traditional banking system. Maybe the truth lies somewhere between the two poles.
Maybe just maybe the markets (bond and stock) have it right and neither disaster nor easy street is right around the corner. Maybe inflation is not going to flare up, and stock speculation is not going to run amuck, and the global economy is not going to roll off a cliff. Maybe the US consumer can slow spending to a more moderate pace and maybe housing will find a floor soon (if not already). Some areas in the country are actually seeing improvement. Brokers around here say the Triangle market is picking up dramatically.
We remain optimistic that the markets have adequately compensated for risks in the global economy. Current valuations are not out of line, so any correction in stocks would likely be relatively small and short-lived. For now, aside from considerable geopolitical risks, business risk is contained and priced into markets. We are ready to make adjustments though if events suggest it.