Globalization Print E-mail

The Economy

It is only possible to review the performance of the US economy in 2005 and consider the possibilities for 2006 in the context of globalization. I rely heavily on my education when interpreting the economic and social change that is sweeping the world. There are times when I must remind myself that I have learned the skills of analysis and that past is not prologue. This is particularly true in the shifting landscape of the techno-global revolution. Some economic theory I learned so long ago seems strained to the breaking point when applied in today’s world. Ricardo’s “comparative advantage” taught us that when a nation and its economy can produce a good more efficiently and cost-effectively than others that it benefits all for that nation to do so and for competitors to seek more profitable endeavors. The idea is that when each economy is free to focus on what it does best all trading partners gain. But what happens when a “comparative advantage” becomes an “absolute advantage”? For instance does Ricardo’s idea hold up in the context of 21st century manufacturing when technology combines with cheap Asian labor to displace millions of American workers? The fall out from this is quite painful for communities that lose their tax base, consumers that lose purchasing power and retirees whose pensions fall to the ultimate protection of the taxpayer. The inability of corporate America to honor its pension promises may be one of the biggest stories of 2006. More than 44 million pensioners are protected by the Pension Benefit Guaranty Corporation, an insurance company that is technically insolvent. The PBGC absorbed 120 pension plans in 2005. Ricardo could not have predicted digitized technology and the power of the world-wide web. In the long run, the techno-global revolution and its fierce competition will likely lead to greater efficiency and lower costs for consumers. In the short run the strain on workers, retirees, communities and their financial resources will continue to be staggering. 2006 may well be another year where we see the manufacturing sector enjoy higher profits, an increase in capital expenditures and falling domestic employment and wages. The US faces a generation of displaced middle aged workers sorely in need of re-education. The slope of the yield curve is a tried and true economic indicator that has predicted recessions with tremendous accuracy over the past 50 years. When short term interest rates exceed long term interest rates economic activity slows as consumer and working capital dries up. The yield curve currently flirts with inversion on a daily basis causing some economists to predict a recession for late 2006 or early 2007. But two changes to the modern global economy may have altered the predictive powers of the yield curve, potentially rendering it an economic relic. The first change occurred in credit creation. Liquidity for lending, or credit creation was formally the domain of banks and was controlled by the Federal Reserve. The Fed could add or drain liquidity from the banks and control the cost of lending through the money supply and the funds rate. In today’s post Glass-Stegal, finance based economy loans are securitized and credit has become the domain of the securities markets. The availability and cost of credit is determined by the market and the risk associated  with lending is laid off on investors in mortgage and asset backed securities and derivatives markets. A flattening yield curve no longer means less credit is available or that the economy will necessarily slow. The second change that has occurred that threatens the usefulness of the yield curve is in large part a function of the international trade imbalance. Simply put, the US buys and borrows far more than it produces and earns. This creates a currency fund imbalance that leaves our trading partners holding a large surplus of dollars that they currently choose to invest in long term US bonds. The Fed believes these foreign purchases depress 10 year Treasury yields by 1.5% thus creating a “false” curve inversion. Other factors contributing to the “false” inversion include demographically driven pension fund demand as baby boomers approach retirement age. Another consideration is that inflation is so well contained that the risk premium demanded by long term fixed income investors has been dramatically reduced.  Any way you slice it arguments can be made that the inverted yield curve may not be the high quality recession indicator the text books claim it to be. Has yield curve logic been reversed in the global economy? If foreign investors decide to repatriate their surplus capital because they view stretched US consumers as a poor lending risk, long rates would theoretically rise. A traditional positively sloped yield curve with long rates higher than short would indicate economic weakness not strength in this scenario.  We will likely get an answer to the yield curve question in late 2006. Twenty-five percent of the economists surveyed by the Wall Street Journal at year-end identified the housing market as the biggest risk to the economy in 2006. Few believe that there is a NASDAQ type bubble waiting to burst; but many think that the slowing housing market will be a drag on consumption and economic growth. Latest reports show that housing prices were up 12% year-on-year in the third quarter of 2005 alone. This kind of explosive price gains has led to the creation of about 1 million jobs since 2000 and allowed homeowners to extract $887 billion worth of equity in 2005. The amount of home equity available for withdrawal is expected to drop under $400 billion in 2007.  Rising rates will affect the home market and equity withdrawal with a lag and should start to hit marginal borrowers as 2006 progresses. Total household mortgage debt in the US stands at $8.2 trillion, up from $4.8 trillion at the start of the last recession in 2000. 45% of these mortgages are floating rate tied to the same short term interest rates the Fed has helped push higher over the past two years. It can be worrisome to think that 80% of the California mortgages written in 2005 were “exotics” meaning  interest only, negative amortization or contained pay options that allowed borrowers to forgo payments for periods of time. You see, mortgages have increasingly left the traditional domain of the banks and have become products of ever more creative lenders who push  loans off their balance sheets and into the hands of mortgage backed securities investors happy to accept higher yields with perhaps insufficient regard for risk. Even with securitization, banks remain over-weighted in real estate assets that represent $2.9 trillion, up 76% since 2000. The flip side of this coin is that capital reserved for loan losses is at historic lows. Love him or hate him, billionaire George Soros understands a few things about market psychology.  George coined the phrase “reflexive demand” and applied it to  the real estate market. When demand outstrips mortgage rates on a relative basis, momentum players (speculators) chase prices higher creating bubbles. These same players are also prone to create “reflexive supply” as they race to lock in profits and dump real estate back on the market. The risk to the economy in 2006 is that consumers will be hit with a double whammy: they face higher payments to remain current on mortgages and they lose the ability to tap rising values to supplement purchasing power. As Mark Whitehouse opined in the Wall Street not long ago, “A housing slowdown alone would hack away a big chunk of economic potential.” Finally, few things represented the alacrity of globalization like the near total absence of macro-economic impact of the twin disasters of Katrina and Rita. Local economies were obliterated on the gulf coast and despite a little good old fashion price gouging at the pumps the American economy barely broke stride posting a 4.1% growth rate for the third quarter of 2005. Energy prices begin 2006 up 40% year-on-year. The additional outlay for petroleum products will certainly compound the economic drag of higher rates discussed above and should slow consumer spending especially if winter decides to show up in the mid-west. At ICM we expect the economy to slow in 2006, particularly in the second half.  While globalization strains the application of economic lessons learned long ago the rules of the game have not changed. The field has gotten larger and the number of players has expanded but in the capitalist game we still put points on the board the old fashioned way-With Profits! As some of you may know yours truly turned 50 late in 2005. No big deal. I looked myself up and down in the mirror on the anniversary of my birth to asses the wear and tear of half a century. No significant changes were readily apparent. But then my eyesight has kindly deteriorated with age enabling my self-delusion. I reminded myself that as one matures true value is found on the inside, in the wisdom and character developed through years of keen observation and penetrating introspection. What I have lost in hair I have made up for in experience. I thought of the wonderful gifts I’d been given through the years. I could remember few material things. What emerged were memories of family and friends, love and loss.  Among my gifts there is one that stands out. It can’t be touched nor valued in currency yet it has enriched my life these 50 short years. The gift I refer to was in no way free and to be honest came quite hard to me. An education is a gift that rewards like no other because the more it is watered with curiosity and sweat the more it grows. This gift carries with it a responsibility to stand on the shoulders of those who have taught and questioned and challenged us, to see farther and more clearly and to share what we see so that others may gain a vantage point superior to our own. It is my hope to provide a better view for you, my client, so that you may leverage your wisdom and better serve your responsibilities.

The Fed

Where does the time go?  2005 came and went in the blink of an eye.  Although the year’s fly by as fast as those long holiday weekends, 2005 was an eventful year for Alan Greenspan and the Federal Reserve.  As we began the year, the Fed Funds rate was at 2.25% after five consecutive interest rate hikes to close 2004.  By the end of 2005, the Fed Funds rate had been steadily increased in 25 basis point increments to its current level of 4.25%.  We are currently in the midst of 13 consecutive interest rate hikes over the course of the last 18 months.  The next Federal Reserve meeting is slated to be held on January 31st, where another 25 bps increase seems likely.  And that my friends is where the old path ends and a new trail will be blazed. The January 31st meeting of the Fed will mark the final meeting that will be chaired by Alan Greenspan.  Mr. Greenspan has been a fixture in the world of Federal Reserve policy making since 1987.  Greenspan was formally reappointed to a 14 year term on February 2nd, 1992.  That term will expire on January 31st, 2006; the same day as the next Fed meeting.  While this may not seem to be big news, to those of us who closely follow the credit markets, this is a major transition.  For the past 18 odd years, and more specifically, the five for which I have been actively following the Fed, Mr. Greenspan has been the anchor to which the U.S. economy has been moored.  The Greenspan Fed has seen its share of calamity during his tenure.  Beginning just two months after his appointment, Mr. Greenspan was faced with one of the largest single day percentage drops in the Dow Jones Industrial Average’s history on Black Monday, 1987.  Not a bad way to get your feet wet.  More recently, the Fed has had to chart a course through turbulent waters, beginning in the late 1990’s with the bursting of the stock market bubble and culminating at the next session where it is safe to say that Mr. Greenspan has managed the fallout from 9/11 and the ensuing recession; while at the same time, the world and its economies have become globalized thus multiplying the intricacies and responsibility of being Fed chairman. While I could spend all my time reviewing the progress that the Federal Reserve has made under the watchful eye of Alan Greenspan, this piece is not about where have we been, it is more about where are we now and where are we headed?  After the 31st and Mr. Greenspan’s subsequent retirement, Dr. Ben Bernanke will assume the chairmanship.  The name Ben Bernanke may be new to some of you, but he has been on the radar at ICM for the past few years now and in all frankness, he co-authored one of my first Macroeconomics textbooks.  Dr. Bernanke was born in 1953 and received his B.A. in economics from Harvard and a Ph.D. in econ from M.I.T.  After receiving his Ph.D. Dr. Bernanke was a Professor of Economics and Public Affairs at Princeton University beginning in 1985, rising to Chair of the Economics department from 1996 until 2002. During the past several years, the Greenspan Fed has developed a policy of transparency that has revolutionized the manner in which Reserve policy is set.  Currently, the Fed shares its intent and expectations by way of its meeting minutes.  The minutes statement, which is the record of Federal Reserve meetings, is carefully worded to remove as much vagueness as possible and its intent is to remove speculation from the credit markets.  As the makeup of the Federal Reserve changes over the course of the next month, this vital tool employed by the Greenspan Fed will remainand possibly blossom into further transparency under Dr. Bernanke. In the opinion of ICM, Dr. Bernanke is the right man for the job at the right time.   As noted throughout this report, the tired and true rules of interest rates and yield curve analysis may be changing due to the interconnectivity of the global economy.  Dr. Bernanke is a major proponent of transparency within Fed policy and he is also known for his research on the role of international economies and the effect they have on the domestic economy.  With Bernanke as its head, the Federal Reserve seems poised to chart a new course through not only the U.S. economy, but also through the muddy waters that is the global economy.  As far as interest rates are concerned where we stand today (January 7th), the current Fed Funds rate is 4.25% on its way to 4.50% on January 31st.  From there, the picture is still a little hazy.  According to the most recently released minutes, Federal Reserve officials have become less fearful of inflation, due in part to current economic indicators suggesting that the economy may be facing a mid to late year slowdown.  For these reasons, the belief of the Fed and market participants and economists alike is that the tightening of monetary policy is nearing its end.  At ICM, we are expecting the Fed to raise rates at the last meeting of the Greenspan Fed, and we also look for the Fed to limit its policy expectations within the next minutes in order to provide the incoming chairman the flexibility needed to set future policy as necessitated by the state of the economy.  At the beginning of 2006, the 2 year treasury was yielding approximately 4.30%, 4 basis points less than the ten year treasury’s yield of 4.34%.  While in the past, this inversion of the yield curve signaled an imminent slowdown in the U.S. economy, there is a slow change in philosophy suggesting that this is no longer the case.  The hypothesis today is that the large amount of foreign capital being poured into our economy is most likely suppressing long term interest rates by as much as 1.50%.  Although it is not yet possible to prove this hypothesis, it seems that there is an evolution occurring in the credit markets which will provide Dr. Bernanke and his brain trust with a new set of trials and tribulations unlike those faced previously.

Market Recap

In 2005 the bond market treated investors to a classic yield curve flattening with short rates rising in tandem with Fed policy, while 10 and 30 year maturities remained pegged slightly lower. Our benchmark Two Year Treasury began the year at 3.09% and climbed 131 basis points to finish 2005 at 4.40%, the Ten Year note gained only 18 basis points for the year ending at 4.39% and the Long Bond yield gave back 27 basis points. (Chart 1) The yield of the Two Year Treasury stair-stepped higher interrupted by two pronounced dips, one in early April due to softening economic numbers and the second in late August in sympathy with the devastation of  Hurricane Katrina . When the damage to off shore refineries proved to be relatively minor, yields marched higher from September 3rd, peaking on November 14th and settling into a trading range between 4.3% and 4.5% for the remainder of 2005. (Chart 2) Yield spreads between US Treasury securities and Agency and high grade corporate bonds were relatively tight for most of the year offering little in additional yield.

Market Outlook
Most long term ICM clients know that our investment strategy is tied to business cycles. It is our belief that the business cycle of  contraction and expansion referred to as recession and recovery and the resultant deflation and inflation pressures play a predominate role in determining Federal Reserve policy. We also know that Fed policy and the related borrowing costs greatly influence bond market interest rates in maturities out to about 3 years. So our opinion about where we are as a nation in our business cycle determines our target duration or the maturity structure in our investment portfolios. In December, 2004’s Market Outlook this investment philosophy led us to predict the following for 2005,”Rates will rise gradually through most of the year. Fed funds should settle near 3.5% and the two year (treasury) will likely follow suite nearing 4%-4.5%. We expect the yield curve to flatten in the coming 6-9 months signaling an end to the tightening cycle and slower economic growth”. So how did we do? Chart 1 displayed earlier in this report shows the Two Year Treasury yields rose 131 basis points in orderly fashion, following the Fed’s “measured” approach to tightening policy. We were low on the year-end Fed Funds rate which finished 2005 at 4.25%. We nailed the year-end Two Year Treasury yield which finished at 4.4%. The yield curve spread between Two Year and Ten Year Treasurys began the year at +112 and ended the year at -1; a complete flattening. The minutes of the Fed’s December meeting indicate the end of the tightening cycle is near. Another pretty good call.  My mother used to advise me that it was easy to injure one’s shoulder patting one’s self on the back and that self-praise stinks. So to avoid violating the teachings of a woman prone to hitting me with whatever might be in reach I will credit the accuracy of these predictions to the teachings of some pretty good Econ professors and a fair dose of luck. But that was last year. What about 2006? Despite the economic stimulus of low interest rates and tax cuts, the US economy has spurred weak capital investment and slow hiring throughout this economic recovery. With short rates 300 basis points higher than their trough in 2003, a budget deficit screaming out for some fiscal sanity and significantly higher energy costs the economic headwinds in 2006 are considerably stronger than they have been at any time in the past four years. The Fed’s preferred inflation indicator, the core personal consumption index, stands at a benign 1.8% for the year ending November 30th, posing little pricing threat. The flat yield curve and slowing housing market also point to a slowdown in economic activity. For these reasons and others discussed earlier in this report we believe that the tightening phase of this interest rate cycle is very near its end. Fed Funds should peak no higher than 4.5% - 4.75% with the Two Year Treasury yield following  suit. We have had nearly two decades to grow comfortable with the current Fed Chairman Alan Greenspan’s actions and his version of the English language. But with Greenspan passing the baton to Ben Bernanke in January 2006, calling a turn in policy is certainly more difficult. In any event it is quite probable that the Funds rate will not stray far from the 4.5%-4.75% level and may begin to fall by the end of 2006. In 2005 the bond market treated investors to a classic yield curve flattening with short rates rising in tandem with Fed policy, while 10 and 30 year maturities remained pegged slightly lower. Our benchmark Two Year Treasury began the year at 3.09% and climbed 131 basis points to finish 2005 at 4.40%, the Ten Year note gained only 18 basis points for the year ending at 4.39% and the Long Bond yield gave back 27 basis points. (Chart 1) The yield of the Two Year Treasury stair-stepped higher interrupted by two pronounced dips, one in early April due to softening economic numbers and the second in late August in sympathy with the devastation of  Hurricane Katrina . When the damage to off shore refineries proved to be relatively minor, yields marched higher from September 3rd, peaking on November 14th and settling into a trading range between 4.3% and 4.5% for the remainder of 2005. (Chart 2) Yield spreads between US Treasury securities and Agency and high grade corporate bonds were relatively tight for most of the year offering little in additional yield. In 2005 the bond market treated investors to a classic yield curve flattening with short rates rising in tandem with Fed policy, while 10 and 30 year maturities remained pegged slightly lower. Our benchmark Two Year Treasury began the year at 3.09% and climbed 131 basis points to finish 2005 at 4.40%, the Ten Year note gained only 18 basis points for the year ending at 4.39% and the Long Bond yield gave back 27 basis points. (Chart 1) The yield of the Two Year Treasury stair-stepped higher interrupted by two pronounced dips, one in early April due to softening economic numbers and the second in late August in sympathy with the devastation of  Hurricane Katrina . When the damage to off shore refineries proved to be relatively minor, yields marched higher from September 3rd, peaking on November 14th and settling into a trading range between 4.3% and 4.5% for the remainder of 2005. (Chart 2) Yield spreads between US Treasury securities and Agency and high grade corporate bonds were relatively tight for most of the year offering little in additional yield. In 2005 the bond market treated investors to a classic yield curve flattening with short rates rising in tandem with Fed policy, while 10 and 30 year maturities remained pegged slightly lower. Our benchmark Two Year Treasury began the year at 3.09% and climbed 131 basis points to finish 2005 at 4.40%, the Ten Year note gained only 18 basis points for the year ending at 4.39% and the Long Bond yield gave back 27 basis points. (Chart 1) The yield of the Two Year Treasury stair-stepped higher interrupted by two pronounced dips, one in early April due to softening economic numbers and the second in late August in sympathy with the devastation of  Hurricane Katrina . When the damage to off shore refineries proved to be relatively minor, yields marched higher from September 3rd, peaking on November 14th and settling into a trading range between 4.3% and 4.5% for the remainder of 2005. (Chart 2) Yield spreads between US Treasury securities and Agency and high grade corporate bonds were relatively tight for most of the year offering little in additional yield. In 2005 the bond market treated investors to a classic yield curve flattening with short rates rising in tandem with Fed policy, while 10 and 30 year maturities remained pegged slightly lower. Our benchmark Two Year Treasury began the year at 3.09% and climbed 131 basis points to finish 2005 at 4.40%, the Ten Year note gained only 18 basis points for the year ending at 4.39% and the Long Bond yield gave back 27 basis points. (Chart 1) The yield of the Two Year Treasury stair-stepped higher interrupted by two pronounced dips, one in early April due to softening economic numbers and the second in late August in sympathy with the devastation of  Hurricane Katrina . When the damage to off shore refineries proved to be relatively minor, yields marched higher from September 3rd, peaking on November 14th and settling into a trading range between 4.3% and 4.5% for the remainder of 2005. (Chart 2) Yield spreads between US Treasury securities and Agency and high grade corporate bonds were relatively tight for most of the year offering little in additional yield. In 2005 the bond market treated investors to a classic yield curve flattening with short rates rising in tandem with Fed policy, while 10 and 30 year maturities remained pegged slightly lower. Our benchmark Two Year Treasury began the year at 3.09% and climbed 131 basis points to finish 2005 at 4.40%, the Ten Year note gained only 18 basis points for the year ending at 4.39% and the Long Bond yield gave back 27 basis points. (Chart 1) The yield of the Two Year Treasury stair-stepped higher interrupted by two pronounced dips, one in early April due to softening economic numbers and the second in late August in sympathy with the devastation of  Hurricane Katrina . When the damage to off shore refineries proved to be relatively minor, yields marched higher from September 3rd, peaking on November 14th and settling into a trading range between 4.3% and 4.5% for the remainder of 2005. (Chart 2) Yield spreads between US Treasury securities and Agency and high grade corporate bonds were relatively tight for most of the year offering little in additional yield. In 2005 the bond market treated investors to a classic yield curve flattening with short rates rising in tandem with Fed policy, while 10 and 30 year maturities remained pegged slightly lower. Our benchmark Two Year Treasury began the year at 3.09% and climbed 131 basis points to finish 2005 at 4.40%, the Ten Year note gained only 18 basis points for the year ending at 4.39% and the Long Bond yield gave back 27 basis points. (Chart 1) The yield of the Two Year Treasury stair-stepped higher interrupted by two pronounced dips, one in early April due to softening economic numbers and the second in late August in sympathy with the devastation of  Hurricane Katrina . When the damage to off shore refineries proved to be relatively minor, yields marched higher from September 3rd, peaking on November 14th and settling into a trading range between 4.3% and 4.5% for the remainder of 2005. (Chart 2) Yield spreads between US Treasury securities and Agency and high grade corporate bonds were relatively tight for most of the year offering little in additional yield. In 2005 the bond market treated investors to a classic yield curve flattening with short rates rising in tandem with Fed policy, while 10 and 30 year maturities remained pegged slightly lower. Our benchmark Two Year Treasury began the year at 3.09% and climbed 131 basis points to finish 2005 at 4.40%, the Ten Year note gained only 18 basis points for the year ending at 4.39% and the Long Bond yield gave back 27 basis points. (Chart 1) The yield of the Two Year Treasury stair-stepped higher interrupted by two pronounced dips, one in early April due to softening economic numbers and the second in late August in sympathy with the devastation of  Hurricane Katrina . When the damage to off shore refineries proved to be relatively minor, yields marched higher from September 3rd, peaking on November 14th and settling into a trading range between 4.3% and 4.5% for the remainder of 2005. (Chart 2) Yield spreads between US Treasury securities and Agency and high grade corporate bonds were relatively tight for most of the year offering little in additional yield. In 2005 the bond market treated investors to a classic yield curve flattening with short rates rising in tandem with Fed policy, while 10 and 30 year maturities remained pegged slightly lower. Our benchmark Two Year Treasury began the year at 3.09% and climbed 131 basis points to finish 2005 at 4.40%, the Ten Year note gained only 18 basis points for the year ending at 4.39% and the Long Bond yield gave back 27 basis points. (Chart 1) The yield of the Two Year Treasury stair-stepped higher interrupted by two pronounced dips, one in early April due to softening economic numbers and the second in late August in sympathy with the devastation of  Hurricane Katrina . When the damage to off shore refineries proved to be relatively minor, yields marched higher from September 3rd, peaking on November 14th and settling into a trading range between 4.3% and 4.5% for the remainder of 2005. (Chart 2) Yield spreads between US Treasury securities and Agency and high grade corporate bonds were relatively tight for most of the year offering little in additional yield. In 2005 the bond market treated investors to a classic yield curve flattening with short rates rising in tandem with Fed policy, while 10 and 30 year maturities remained pegged slightly lower. Our benchmark Two Year Treasury began the year at 3.09% and climbed 131 basis points to finish 2005 at 4.40%, the Ten Year note gained only 18 basis points for the year ending at 4.39% and the Long Bond yield gave back 27 basis points. (Chart 1) The yield of the Two Year Treasury stair-stepped higher interrupted by two pronounced dips, one in early April due to softening economic numbers and the second in late August in sympathy with the devastation of  Hurricane Katrina . When the damage to off shore refineries proved to be relatively minor, yields marched higher from September 3rd, peaking on November 14th and settling into a trading range between 4.3% and 4.5% for the remainder of 2005. (Chart 2) Yield spreads between US Treasury securities and Agency and high grade corporate bonds were relatively tight for most of the year offering little in additional yield. In 2005 the bond market treated investors to a classic yield curve flattening with short rates rising in tandem with Fed policy, while 10 and 30 year maturities remained pegged slightly lower. Our benchmark Two Year Treasury began the year at 3.09% and climbed 131 basis points to finish 2005 at 4.40%, the Ten Year note gained only 18 basis points for the year ending at 4.39% and the Long Bond yield gave back 27 basis points. (Chart 1) The yield of the Two Year Treasury stair-stepped higher interrupted by two pronounced dips, one in early April due to softening economic numbers and the second in late August in sympathy with the devastation of  Hurricane Katrina . When the damage to off shore refineries proved to be relatively minor, yields marched higher from September 3rd, peaking on November 14th and settling into a trading range between 4.3% and 4.5% for the remainder of 2005. (Chart 2) Yield spreads between US Treasury securities and Agency and high grade corporate bonds were relatively tight for most of the year offering little in additional yield.