New World Order

The US federal reserve chairman, Alan Greenspan, has repeatedly referred to the low level of ten year US Government bond yields as a 'conundrum’. The conundrum is: why have 10 year bond yields fallen whilst the Federal funds rate has risen from 1% to 3.25%? Indeed, we have seen a dramatic flattening in the US yield curve over the last 12 months. (Please see Chart 1)

Historically, such a flattening has preceded a significant economic slowdown. Similarly, an 'inversion’ of the yield curve has been followed by a recession within six to twelve months. If you look at Chart 1 you will note that the yield curve inverted prior to the 1980-82, 1990-91 and 2001 recessions. Is this time different? Why are so many commentators, including Greenspan himself, suggesting that the yield curve has lost its predictive powers? This to me is the real conundrum. We will come back to this issue later.

At the present time the US economy is growing much faster than I thought it would back in January 2005. The primary explanation for the better than expected US economic performance is the remarkable strength of the US housing market. Even Greenspan, who hates admitting the existence of 'bubbles’, remember he could not bring himself to admit that the dot.com bubble was a bubble, suggested that there was evidence of 'froth’ in some regional housing markets.

The following anecdotes may help illuminate the 'bubble’ issue. Some areas in Florida have seen house prices rise 45% Q1 2005 versus Q1 2004. The first examples of real estate 'day trading’ in Florida have been reported. Evidence suggests that 'bubbles’ now exist in Florida, California and areas in the North East. But is there a national bubble, arguably not. Are national prices well above their historic trends? Absolutely!

Charts 2 and 3 below highlight the 'valuation’ story which strongly suggests that US house prices are significantly ahead of their historic trends. (See Charts 4 and 5 for other house bubbles)

Why is this so important? The issue, of course, is the linkage between house prices and consumer spending, which accounts for 70% of GDP. Americans - in common with many homeowners in Australia and the UK - have used their homes as glorified bank ATM’s. The amounts are staggering and without precedence. In the USA, approximately US$800 billion has been withdrawn from the equity in their homes over the past two years. The US housing market has been the 'locomotive’ driving the US economy.

Here in Australia and the in UK, we have seen house prices drop and our economies weaken significantly. We have similarly seen in Australia a significant reduction in home equity withdrawals and a simultaneous decline in retail sales. Australia, in my mind, is the canary in the coalmine for the US housing market. Let’s go back to the US yield curve. It is my firm belief that the US yield curve is telling us that current growth has been borrowed from the future. In this fundamental respect the current rate of economic growth in the US is simply unsustainable since the rate of appreciation in American house prices is completely unsustainable.

The surge in US house prices, however, presents Greenspan with a very serious 'conundrum’. It now looks like the Federal Reserve Board will need to raise rates to a level higher than it appeared earlier in the year, because of the strength in the housing market which in turn has propelled the economy. The problem for the Fed is that as they have raised short-term rates, long-term bond yields have fallen. US mortgage rates are largely priced off long term bond rates rather than short rates, hence as Greenspan has placed his foot firmly on the 'monetary brake’ the bond market has placed its foot firmly on the 'mortgage rate accelerator’. Now that is a conundrum. The bond market message is clear. The housing, and in turn, debt financed growth in household consumption can only go on so long and hence long term yields have fallen in anticipation of slower growth in the future. In this fundamental regard the Fed and monetary policy is helpless and in essence, ineffective.

The imbalances, whether they be household debt and/or the current account deficit, both of which are obviously related, grow ever larger. In my opinion, the US housing bubble is far more serious than the tech bubble and history shows us that house price declines are far more damaging to economies than declines in equity markets. The effective hibernation of the Japanese economy over the last 15 years is a powerful reminder of the damage that can be done by a decline in house prices. But, we are not yet at that point.

In the meantime, equity markets have recovered from their second quarter tantrum and moved higher. How do we reconcile all these conundrums? In a world where everything looks expensive something has to be less expensive. In a relative valuation framework equities look less expensive than bonds or real estate. Bonds according to any measure look very expensive. Credit spreads are near historic lows, government bond yields across the whole world are near all time lows. Real estate prices, excluding Japan, are at all time highs and have risen dramatically over the last five years. Equities versus bonds are very cheap. Equities versus real estate are unbelievably cheap. The world is awash with money and the cost of money is cheap. Investors have, therefore, elected to buy equities. In a relative valuation world this makes sense. So long as earnings remain reasonable and the discount factor for future earnings does not rise too much. Remember a stock price is the Net Present Value (NPV) of future free cash flows. A lower discount factor (the long term bond rate) serves to inflate the NPV and hence the stock price. This is very evident in Europe where bond yields are at post war lows and similarly P/E ratios are relatively low. So despite anemic growth (Italy is actually in recession and Germany is awfully close to it) investors would rather buy equities than invest in 10-year government bonds yielding just over 3%.

What about Japan? The relative valuation argument is even more compelling. For example, Japanese 2 year government bond yields are just 9 basis points and 10-year bond yields are 1.3%. Similarly, Japanese households have a stunning 1,400 trillion yen in household assets (this excludes the value of their homes). Approximately fifty per cent is in bank/postal accounts earning zero. The Japanese, therefore, have approximately six trillion US dollars sitting in zero interest bearing accounts!!

There is growing and compelling evidence that the Japanese economy has emerged from its fifteen year hibernation and that the consumer has both the intent and financial firepower to spend. Deflation is coming to an end, the banking system is improving and the real estate market show signs of life, which will help, underwrite economic recovery (see Tokyo house price chart).

Some brief remarks on China. The Chinese economy grew at an annual rate of 9.5% in the second quarter. This was despite evidence of a slowing in auto sales, Shanghai house prices and various 'administrative’ attempts to slow the economy. The recent revaluation of the yuan, albeit miniscule, is the beginning of a process. Whilst at first glance it appears 'glacial’, it is a first step. A gradual strengthening in the yuan will serve to redress some of the glaring global imbalances. It will, over time, lead to greater domestic consumption and hence reduce the trade surplus. Similarly, a more expensive yuan should lower Chinese exports to the US etc, and hence help address the US current account deficit. The yuan revaluation must, on balance, be viewed as a positive development, albeit that the pace of appreciation is likely to be determined in a very Chinese manner. So there is some good news around. I would suggest there is more good news outside of the US than in it. I still believe Japan looks to be very exciting and similarly India. I still believe the East will outperform the West. I still believe that the massive indebtedness and massive imbalances in the US will end up in a serious bout of 'economic tears’. And, I still do not believe that we should repeal the laws of economics and say that America is not a debt bubble just because it hasn’t burst yet. I believe the charts on the US housing market speak for themselves. I fear that Greenspan’s successor is going to have to deal with a particularly painful economic reality when he or she runs the mother of all central banks after January 31, 2006.

So, in summary, my views are that the US housing market is at or near its peak. The US economy will fade into the remainder of this year and slow significantly through 2006. You will remember I thought it would be much weaker this year. I have been wrong, although there are still five months left to go. The West needs to save and Asia needs to spend. Such a process will serve to restore a better balance to a very 'unbalanced’ world. At the margin, and very much at the margin, the revaluation and 'managed float’ of the yuan will serve to move the world in this direction. At the time of writing, there is talk of the 'Goldilocks’ economy in the US, not too hot, not too cold. Such talk brings back painful memories. The US stock market has performed well over the last three months and the S&P 500 is now up 2% and the Dow is down 1% for the year so far. The Europeans have performed very well, rising 16% in France, 14% in Germany and 9% in the UK. Japan, as measured by the TOPIX is up 4.5%. The ASX 200 is up nearly 8%. The best performance has been in Asia with Korea, India and Singapore, up 23%, 15% and 13% respectively.

Moving ahead it would appear that the relative valuation argument will continue to support equities in general versus other asset classes. In this respect Asia and Europe look the most attractive. In terms of the broad economic outlook I see the housing induced weakness in the UK and Australia continuing over the next 12 months at least, with an increasing prospect of a recession in the UK and hence I believe the Bank of England will cut rates at its next meeting.

The Federal Reserve Board, as we have discussed, is now likely to raise rates somewhat more aggressively and levels around 4% are now expected. The housing market strength and evidence of 'froth’ in some regions will, on balance, steer the Fed towards a tighter stance. This cannot be viewed as positive for US equities.

By the end of 2006 however, I anticipate the Fed may have to cut rates as the inevitable weakening in the housing market serves to slow the US economy. Add to this the negative impact of sustained high oil prices, which will further weaken the US economy. Some brief comments on the Middle East. My grandmother used to say 'If you haven’t got anything nice to say about someone, don’t say it’. I, therefore, will not say anything about the recently elected President of Iran, Mahmoud Ahmadinejad.

On oil prices my view was that we would see $60 a barrel, and we have achieved that level. To date, I must admit that it has had only a limited apparent impact upon economic activity. In the medium to long term, however, high oil prices will serve as an additional 'headwind’ to growth. My view looking ahead is that demand will be driven primarily by China (See Chart 7) and India and that the supply side will be dominated by the ever increasingly complex and volatile politics of the Middle East.

The oultook for oil - Higher for longer!

Jonathan Pain, is the chief investment strategist at HFA Asset Management.
Website: http://www.hfainvestments.com.au