Hoisington 2008 Outlook, 2007Q4

Quarterly Review And Outlook, 2007Q4

By Hoisington Investment Mgt | 6 February 2008

In our April letter last year we opined the high probability of a recession beginning in the latter part of 2007 or early 2008. This judgment was based on the predictive history of the yield curve and Leading Economic Indicators (LEI). The latter has a 100% batting average on a quarterly basis in calling economic slumps since 1969, and appears to be on the mark for the 7th perfect call in a row as economic conditions are signaling the cessation of economic expansion.

Normally back to back declines in quarterly GDP must occur to constitute a recession. However, in the 2000 recession, alternating quarterly contractions were observed. This pattern could well develop in 2008 since bloated inventories, the typical driver of consecutive quarterly declines, is not present. Also, the 'relatively stable' private service sector constitutes a record share of the U.S. economy [[but see Stocks Hammered By Service-Sector Weakness and Services Data Jolt Investors: normxxx]]. Rather, a slow contraction of credit availability will cause the consumer to feel the impact of declining wealth from falling home prices, fewer employment opportunities, faltering wage gains, and a monstrous debt burden [[but this has already dominated the latter part of 2007 and has caused the falls in consumer confidence: normxxx]]. This should cause the U.S. economy to rotate in a pattern of stagnant economic conditions, recessionary at times, and growth recessionary at others[!?!] [[But still possible for 2008 due to the waves of monetary and fiscal stimulus being poured on.: normxxx]] The growing excess capacity of our capital structure, along with falling profits [[the E in the P/E ratio!: normxxx]], will hinder capital spending increases, reinforcing slower consumption. Increases in federal government spending, along with improvement in our trade balance from shrinking imports, will provide stability in the aggregate economic statistics, while the domestic private economy contracts [[But see 2008 World Economic Outlook— Muddle Through: normxxx]] and Money Matters: In Earning Season, Does Analyst Outlook Work?.

In this environment, short-term interest rates will continue to move downward, reinforced by several reductions in the administered Federal funds rate. The long end of the Treasury market will benefit from two factors. First, investor desire for risk-free assets will increase at a time when default rates will be soaring on other fixed income securities. Second, the overall reduction in credit market instruments will mean fewer alternatives for those desiring a fixed rate of return. By the end of 2008 we would expect new record low yields in Treasuries for this cycle.

As a firm, we have been accused by some with large vocabularies of being ever-lugubrious (mournful, dismal, or gloomy in plain terms). Indeed softer economic conditions do bring lower interest rates, which generally are beneficial to those who hold long duration, high quality portfolios. Notwithstanding our personal predilections, the following unbiased statistical research clearly points to a considerable period of subdued economic activity.

Leading Indicators Inconsistent With The Consensus Forecast

The consensus forecast issued in late 2007 calls for the economy to slow to roughly a 1% annual rate in the first half of this year, and then accelerate to a 2.5% pace in the second half [[aka, "that [in]famous second half recovery": normxxx]]. This view is based on the assumption that the Federal Reserve is on the job, providing considerable stimulus to the pipeline. The Fed’s support, it is argued, will allow the economy to overcome headwinds mentioned earlier. The LEI, however, suggests this conventional wisdom is faulty since it is still accelerating to the downside. In the twelve months ending November, the LEI fell .9%, the steepest drop since the recession year of 2001. The ratio of coincident to lagging economic indicators, also a leading indicator of economic conditions, contracted an even greater 1.1% over this span. Historically, the LEI has turned positive on average seven to eight months prior to economic accelerations. No such signal is in sight, so there is little support for supposing a strengthening of economic activity in the latter half of 2008.

Yield Curve

Three considerations— the shape of the yield curve, the velocity of money, and the economy’s credit elasticity— suggest that the Fed has yet to adopt a stimulative stance by late 2007. The yield curve remains inverted. The ten year note less the Federal funds rate (that measures the slope of the yield curve and is included in the LEI) has been inverted for 18 months. This is one month longer than the average of all yield curve inversions since 1945. An inverted yield curve is one of the most prescient leading indicators, as highlighted by recent research of the Federal Reserve Bank of San Francisco. Importantly, the yield curve is not only predictive but is also causative in that it helps to create slower growth since the carry trade is eliminated.

Financial sector liquidity cannot be restored until the curve moves to a positive slope. However, a return to a positive yield curve does not immediately restore healthy financial conditions and economic growth since long lags can be expected. From the month when the yield curve returned to a positive shape to the start of the recovery, the average lead time has been 7.4 months (excluding 1980). The lead time extended to an average of eleven months in the last two recoveries since the economy has become more leveraged and more time is required to improve weakened balance sheets. Hence the yield curve is a long leading indicator on the way up, as well as a long leading predictor of downturns. Until a positive yield curve is realized, monetary restraint is still hampering the economy. Thus, fledgling signs of recovery that will naturally occur from time to time in 2008 will prove ephemeral. The lags are just too long to get any meaningful result from monetary stimulus until 2009 or 2010.

Normxxx    
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