martedì 23 marzo 2010

The Fed and the markets

This is an excerpt from our weekly Top Down Outlook:

International financial markets extended a particularly warm welcome to the Fed's decision at the end of last week’s monetary policy confirming that rates will remain unchanged for an extended period, which was widely expected by economists. Major international stock indices have in fact protracted the upward trend of recent weeks, and Government bond yields remained unaltered despite the overall better-than-expected economic data published over the past week in the U.S.
The Fed’s Fund Rates are likely to remain unchanged for at least another 4 to 6 months (the horizon construed by the markets under the term "extended period" without contradicting the Fed), thus the conditions for a continued upward trend in U.S. equity markets are still well in place, despite the slight S&P500’s overvaluation after the recent rally: the ratio P/average earnings for the past 10 years rose over 20 versus a long term average of 18.
The confidence seen in the stock market’s outlook is mainly bolstered up by the fact that until the Fed Fund Rates have begun to rise, the yield curve will continue to be very steep, with the differential between the 10-years and 3-months Government Bond yields remaining well above 300bp. As we highlighted in Global Strategy Weekly’s January 18 report "What Is The Yield Spread Telling Us" (see here for an excerpt), a very steep yield curve is in fact a positive sign not only for economic growth (according to econometrics model presented in past academic studies, the chances of recession under current conditions are almost as high as 0) but also for the U.S. stock market itself.

Since 1953 a strategy consisting in buying the S&P500 when the yield curve is positive and exiting the equity market and investing in T-Bill when the yield curve is inverted has produced a 7.7% average annual compound return against +7.3% of a buy and hold strategy – without considering the returns delivered by T-Bill when no position has taken on equity markets. The average monthly return stands at 0.74% when the yield spread is positive and at -0.2% when it is negative. When the yield spread is above 3% as it is now (this has occurred in 64 months since 1953, 10% of the total), the S&P500 sees a 0.5% monthly return. For this reasons, should the yield spread remain above 3%, we would expect a positive performance for the S&P500, though lower than the historical average monthly return (+0.65% since 1953). A positive performance but slightly below the average would be in line with the slight overvaluation of the S&P500.
The main reason for the S&P500’s good performance, though more generally for all equity markets, is that the presence of a very steep yield curve is historically accompanied by sustained growth of corporate profits in the years ahead. This correlation is clearly shown in the chart below, taken from national accounts data, comparing the spread between the 10-year and the 2-year government bond yields with the developments in corporate profits in the following three years.

Set to be published on Friday 26, the final national accounts data for Q4 (the GDP growth is likely to be confirmed at 5.9% q/q annualized) should confirm that corporate profits, following the sharp decline in the last two and a half years, are returning to healthy growth: having grown by 10.7% q/q in Q3 '09, profits may rise by 3.8%, remaining almost 15% below the peak in Q3 '09.
Even the bond market will be strongly influenced in the short term by Fed's decision to leave rates unchanged for an extended period. The flattening of the yield curve that we expect in the coming months is likely to be delayed. Moreover, a very steep yield curve has usually been followed by a decline in long term rates and an increase in short term rates.
Nevertheless, we believe that the expectations of the consensus of economists in the Livingston survey, conducted by the Federal Reserve Bank of Philadelphia last December (rating the U.S. 10-years government bond yield could rise to 4.1% at the end of 2010, and 4, 64% by the end of 2011), reflect assumptions too optimistic about US economic growth perspective, and too pessimistic on inflation in the next few months.
Indeed, despite economic recovery signal emerged in the last few months, the last two years crisis is likely to have reduced the growth potential of the U.S. economy. In particular, the deleveraging process that would take place both in the households and business sector should take its toll on economic growth for several years.
Data released this week indicated that there are no signs of inflationary pressures in the short term. In contrast, in February, core inflation fell to 1.3% y/y, the lowest level since February 2004, while overall inflation has fallen from 2.6% y/y to 2.1% y/y.

Unless an unexpected surge in inflation, the causes of whom are very difficult to envisage, we do see the potential for long-term Government bonds to gain positive returns in the next few months.

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