Recession Threat!
09/30/06
Two weeks ago I had commented on commodity prices falling and opined that the likelyhood that falling yields in conjunction with falling commodity prices predict an approaching recession is not very high. Today, two weeks later, the danger of an appraoaching recession has become twice as high in my opinion. I have reached this conclusion by frantically compiling opinions from as many sources as possible. You see, I can not just ignore the biggest and most liquid fixed income market in the world which seems to be screaming that 2007 will see rate cuts and a recession. If the smartest fixed income managers with proven track records and billions upon billions of Dollars under management are voting with their feet, I can not just look the other way. So here we go:
John Mauldin, whom I will be eternally indebted to for turning me on to so many smart publications not least of which is his own Newsletter, has alerted me some time ago to this indicator. It has become very important to me and it has raised my caution level considerably over the last four weeks. The picture above shows the difference between long term (10-yr) yields, which closed Friday at 4.60% and short term (90-day T-Bill) yields, which closed Friday at 4.77% and take the 90-day average of that difference. If long term yields trade below short term yields (inversion) for longer than 90 days, the average dips into the blue danger zone, which often predicted recessions in the past. Several research projects conducted by various Federal Reserve Districts (the most recent one is here) seem to indicate that a 90-day average shows good predictive value. Five of the last 6 recessions were preceded by an inverted yield curve that lasted 90 days or longer. This month, the indicator went into negative territory. The last time it did that was September 2000. It emerged from this prolonged yield curve inversion in Ferbruary 2001. The recession started two months later in April 2001. Now, the marekts are saying again, "Watch out! The Federal Reserve will be lowering the short term interest rates in 2007". The only reason for Bernanke to lower short term interest rates would be a looming recession. Last month the title of this newsletter was "Recession Watch". Today the title morphed into Recession Threat. Ignore the markets at your own peril. The economy is coming in for some sort of landing, that's for sure. Optimists say it will be the much sought after "soft landing" when the economy slows but doesn't skid into recession. But some economists now are forecasting a bumpy landing, or even worse. Last month I made the case for a soft landing myself and I still can not make up my mind, but I am starting to sweat. Let’s look at some more data:
Consumer Spending Fridays' economic news showed that spending by consumers in August rose just 0.1 percent, less than forecasts and down from a 0.8 percent rise in July. When adjusted for inflation, consumer spending actually slipped in August, an important month for retailers due to the back-to-school shopping season.
GDP Thursday's government report on gross domestic product, the broadest measure of the economy, showed growth slowed to a 2.6 percent rate in the second quarter, down from the 2.9 percent rate estimated a month ago and down from 5.6 percent in the first quarter. Durables Earlier in the week another report showed orders for big ticket items fell unexpectedly, with a key measure of business spending in that report showing a sharp drop.
The weakness in the durable goods orders was widespread, and there are no particular quirks within the data that allow for a dismissal of the report. Excluding transportation, durable goods orders fell 2.0%, the most since July 2005. The widespread weakness included categories such as computers (-4.7%), electrical equipment (-9.2%), machinery (-2.1%) and primary metals (-2.1%). Non-defense capital goods orders fell 0.3% in August. The decline in durable goods orders is the second in a row and only the second back-to-back decline since April-May 2004. Of course, there are also indications that the economy might gather steam in the future. The ECRI's Leading Economic Index seems to find its footing again. Consumer confidence rose in August coincident with falling gasoline prices. Stocks certainly have been acting recently as if there is no slowdon in sight. Markets however have a way of sorting conflicting information out for us if we care to look and listen. On this count, Goldman Sachs and Merrill Lynch are the only big Wall Street firms that correctly predicted a second-half rally in Treasuries and they say that the gains are just getting started. Bill Gross from PIMCO is also announcing a new bull market in bonds. Even though there might be mitigating factors (I mentioned some in our August newsletter), which might prevent a recession, a soft landing has become a remoter possibility now than only four short weeks ago. Goldman says the Fed will cut rates to 4.75 percent in the second quarter of next year. Merrill Lynch's Rosenberg is more aggressive, saying a reduction to 4.75 percent will come in the first quarter. Be that as it may, a slowing economy can not be good for stocks in the long run, even when valuations are being propped up by low and falling interest rates. The Fed Model has rendered stocks already more attractive than in August or July, despite the recent rally. Investors, however, need to be aware that future earnings streams which are discounted and compared with riskless treasury yields, sometimes disappear overnight, whereas Uncle Sam's interest payments are not. In a recession, one should be careful to base one's valuations on actual earnings. Potential earnings sometimes have a way of evaporating into thin air.
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.
