Serious Money:Do you believe in fairytales? The investment community is almost universal in the belief that financial markets will deliver solid gains in 2007. The US economy, the world's largest, is expected to show continued growth throughout the year, driven by lower long-term interest rates, cheaper energy prices and an imminent easing of monetary policy by the Federal Reserve.
Additionally, the housing market meltdown is not expected to have material consequences for the wider economy. Consequently, both equity and fixed-income investments are expected to record respectable returns in the year ahead. If it sounds too good to be true, there is every chance that it is. A rude awakening lies in wait for the current cheery consensus.
An imminent easing of monetary policy by the Federal Reserve is almost certainly off the table following the stronger than expected employment report released last Friday. Gains in payroll employment were well above market expectations while the year-on-year advance in average hourly earnings remained above 4 per cent, a high for this cycle. In contrast, during the mid-cycle slowdown of 1995, the increase in average hourly earnings never exceeded 3 per cent year-on-year and the unemployment rate was a percentage point higher than today. The labour market portrays an ageing economic cycle and not the mid-cycle correction suggested by the investment community.
Respected economists from the investment banks on Wall Street to the Federal Reserve in Washington argue that lower long-term interest rates will bolster the economy. Long-term interest rates are no higher today than when the Federal Reserve began its tightening cycle in 2004 and have dropped by half a percentage point since last summer. However, if bond yields alone are such an important driver of economic growth, then the smart people at the Conference Board do not appear to have noticed. Long-term interest rates are not a component of their leading economic indicators. Indeed, lower bond yields did not prevent a recession in 1990 or in 2001 and, furthermore, they did not prevent years of economic stagnation for Japan during the 1990s.
It is the spread between short-term and long-term interest rates that foreshadows future growth and not the absolute level of bond yields. The message emanating from this spread is clear - short-term interest rates exceed long-term rates by half a percentage point. Based on past experience, this suggests that there is a better than 50 per cent chance of economic recession within the next 12 months. Indeed, short-term rates have exceeded long rates before every economic downturn and the accompanying decline in corporate profits during the past 40 years.
Economists and investment strategists argue that the spread is no longer a reliable indicator of future growth as price-insensitive central banks recycle current account surpluses into dollars to prevent the appreciation of their own currencies. This hypothesis should be tested in 2007 as Asian central banks, notably China and Japan, continue to drain liquidity from the system and as a slowdown in global growth and lower energy prices reduce the demand for dollars.
The drop in oil prices from a record high of $78 a barrel last August to below $55 in recent sessions is undoubtedly a welcome relief for both businesses and households. However, just like bond yields, oil prices are not a leading economic indicator. Indeed, Economics 101 suggests that falling prices are indicative of weak demand relative to supply. Cheaper oil prices did not prevent a recession in 2001 so there is little reason to believe that they will bolster the economy today.
The current consensus believes that the well-publicised housing meltdown is near an end and that the ripple effects through the rest of the economy will be minimal. Unfortunately, this is unlikely. Over the past half century, the average decline in real residential expenditures from peak to trough is 25 per cent as compared with the current drop of just 8 per cent through the third quarter. Furthermore, record levels of American households tapped their home equity in recent years to boost current consumption. Consequently, outstanding consumer debt as a percentage of disposable income has reached record heights. Additionally, academic research shows that the housing wealth effect, unlike that of the stock market, is material. The full effects of the housing bust have yet to be felt.
The so-called "Goldilocks" economy - one which is neither too hot nor too cold - should face a stern test of its true credentials in 2007 and so too will the cheery consensus on Wall Street. An imminent easing of monetary policy in the US is unlikely as inflationary pressures emanating from the labour market are stubbornly high. Meanwhile, the economic slowdown should gather momentum as the year progresses leading to a sharp rise in financial market volatility and the first double-digit setback for stock markets in more than four years. As Baden Powell, the founder of the Boy Scouts, might say - be prepared.
