September 2006
Economic "Soft" or "Hard" Landing?
Yield Curve – Interest Rates
We remain watchful of the markets, given the growing uncertainties with the economic outlook. Of particular interest when looking at the short-end of the yield curve vis-a-vis the longer-term 10-year U.S. Treasury yield is the deviation of these two rates at the end of June 2006. Longer-term rates have dropped steadily from July forward. Whether this divergence portends recession as the yield curve inverts is up for debate. The entire yield curve from 6 months to 30 years is fully inverted, albeit relatively flat. Given the downward price action in many commodities over the past month, one needs to remain alert to this possibility of a looming recession. Oil prices, gold prices, more recently housing prices are under some pressure.
In its meeting on September 20th, the FOMC decided to keep its targeted Fed funds rate unchanged for the second straight month at 5.25%. The Fed sighted, in particular, weakness in the housing market, lower energy prices and the signs of slowing inflationary pressures there from. We have believed for some time that the economy is a little less buoyant than many in the press would have you believe. And one reason for this belief is that the economy appears overly leveraged to low interest rates. With seventeen consecutive increases in interest rates, excepting the last two FOMC meetings, and the current Fed bias toward further interest rate increases, the fallout from a housing market bust and/or an over-indebted consumer unable to keep up with rising interest payments could ripple through many sectors of the economy should currently relaxed bank lending practices be halted.
“Soft-Landing”?
A concern for the market is whether the prevailing slower pace of economic growth will hasten and push the overall economy into recession or whether the slowing pace of economic growth will level off, inducing a “soft landing” and is merely the intended result of monetary tightening to date by the Federal Reserve? As my father use to say, “We will know [for sure] in the fullness of time.” Of course this is true and no one can foretell the future, but one should keep in mind that the track record of the Federal Reserve is not all that encouraging when it comes to the difficult task of manufacturing a “soft-landing” for the economy. Since WWII, most economists would agree that the Federal Reserve has succeeded only once in manufacturing a “soft-landing”. This was in 1994.
Housing
The housing market has been an underpinning to domestic economic growth for the past few years. It has been estimated that nearly one quarter of all new jobs during the past 3 to 5 years has been tied to the construction industry in one way or another. Durable goods orders have no doubt been also boosted by the robust housing sector over the past few years. Additionally, record numbers of home refinancing during the long period of declining nominal interest rates during the Greenspan era allowed consumers easy access to home equity and promoted less-than-prudent spending practices which eventually led to an increase in real estate speculation. Speculation in the housing market became an additional contributing element to the economic vivacity of the past many years. None-the-less, housing data over the past few months strongly indicate that the boom in the housing market appears to be over, particularly in the residential sector. An inevitable slowdown in the housing sector will undoubtedly push speculators to liquidate properties at a quicker rate exasperating the downward trend in prices. The totality of a weakening housing sector to the overall economy is unknown at this stage of the cycle but it weighs heavily on the minds of many economists.
Energy
With regard to energy prices, we believe that the demand picture for energy remains very bullish longer-term given the growth prospects of, in particular, emerging growth economies like China, India and certain regions of South America. The recent retraction in oil prices is likely the result of sector rotation (profit-taking) by hedge funds and large money managers than any change in the fundamental supply/demand picture. We believe that the days of $30 per barrel oil are over and we expect oil prices to see technical support in the $58 to $60 per barrel range, which we are rapidly approaching. Should we breach this support level in a significant manner on the downside in conjunction with lower gold prices, we will rethink our position. Meanwhile, with oil at the $60 per barrel level, prices remains well above earlier levels. Absent a global recession of any duration, oil prices should make their way to new highs in the coming years.
Gold-Related
Gold Fields Mineral Services (GFMS), which tracks global precious metal supply and demand data for the World Gold Council and others, in its latest report, announced that it expects gold to surpass the $700 per ounce level by year-end. The consultancy group reported that the first six months of 2006 saw a slump in jewelry and investment demand but expects the second half to pick up. Jewelry fabrication fell by nearly 30% in the first half of 2006 with the biggest drops in the typically high demand areas such as India and the Mideast. On a year-over-year basis, Gold Fields Mineral Services projects that jewelry fabrication to record a drop of nearly 20% for 2006 due to the upward price trend in precious metals. On the supply side, GFMS sees mining output in 2006 staying flat with 2005 production. On a global basis, mines produced 1.5% less gold in the first half of 2006 compared with year earlier levels at 1,168 metric tons. GFMS points out that gold is a hedge against a weaker U.S. economy, potentially higher oil prices and a decline in the purchasing power of the dollar. The company also noted that a “severe downturn in the U.S. and Chinese economies could put its projections at risk”.