Whirl Is King
John Lonski, Moody's senior economist in New York
Considerable volatility suggests that the US equity market has been wound into a "ball of confusion". Valuations seem to be
dictated more by fancy than by fundamentals. A possibly overvalued equity market -- especially for the internet/high technology
sector -- has again proven to be the Treasury bond market's best friend.
Among long-term bonds, the 7.8% yield of single-A corporates looks very attractive compared to the 6% 30-year Treasury yield.
Equity market volatility, however, has prompted fixed-income investors to approach even quality corporate bonds with caution.
Earlier last week, or before rebounding sharply on March 16th, the Dow Jones Industrial Average (DJIA) has dropped by nearly 14%
over a three-month span -- its worst quarter-long showing since tumbling lower by 15% during the three months ended August 1998.
Amid 1994's notable interest-rate uprising, the DJIA incurred a three-month slide no deeper than the 7.5% of the span-ended April
1994. Amid the Persian Gulf crisis, recession, and surging oil prices, the DJIA would ultimately sink by 15.9% across the three
months ended October 1990.
Corporate bond yield spreads widened following 1998's plunge by the DJIA. Similarly, the latest marked retreat by the US' major
index of blue-chip stock prices has provoked another broadening of investment-grade corporate bond yield spreads.
Holders of earnings-sensitive securities realize that first-quarter 2000's prospective 9.5% annual upsurge by corporate revenues is
probably unsustainable. The big question concerns the severity of the impending slowdown by corporate sales. Provided that the
recent 8.4% long-term Baa-grade industrial company bond yield does not rise by more than a percentage point above the annual
increase of business sales, US expenditures might hold on to a lively pace.
Most Borrowing Costs Are Down From 2000's Highs
Treasury bond yields seem to have disconnected from the real economy. Quite possibly, investment-grade corporate bond yields
are now more indicative of underlying economic fundamentals than Treasury yields are. The informational content of Treasury yields
has been distorted by the ongoing reduction in the supply of outstanding US government debt.
Movement by Treasury yields seems to be offering an increasingly less reliable indication of changes in private-sector borrowing
costs. For 2000-to-date, a recent 19 basis points decline by the 10-year Treasury yield to 6.24% and the 13 point dip by the 30-year
FNMA yield to 7% contrasted with the 9 basis points rise by the long-term, investment-grade industrial company bond yield to
7.87%.
Alan Greenspan senses that the Baa corporate yield average offers a fair representation of the business sector's cost of debt. To
minimize distortions stemming from early redemption risks, the Baa industrial company bond yield is chosen ever the Baa
corporate bond yield. Moody's corporate yield averages include public utility bond yields, which often are skewed higher by
compensation for the utility bonds' greater susceptibility to early redemption.
For 2000-to-date, Moody's long-term, Baa-rated industrial company bond yield has increased by 29 basis points to 8.41%. For
March-to-date, the Baa industrial yield has averaged 8.37%, topping all of its previous monthly averages going back to the 8.52% of
April 1995.
When placed in a broad economic context, the latest Baa corporate bond yield seems to be much less of a hindrance to business
activity than it was in early 1995, or when the previous extended monetary tightening had slowed US economic activity significantly.
For the quarter ended April 1995, business sales had slowed to a 3.1% annualized rise from the contiguous quarter and were in the
process of declining from their then 8.3% year-over-year growth rate. For 2000's first quarter, business sales should record much
livelier growth rates of 11.3% annualized from 1999's final quarter and of 9.8% yearly.
Regarding the spring of 1995, the much smaller quarter-to-quarter annualized gain by business sales compared to the concurrent
yearly gain highlighted a deceleration of US economic activity that was understandably very constructive for high-quality bonds.
Today, business activity has yet to slow by enough to fundamentally justify the latest slide by Treasury yields. To the degree,
Treasury yields have dropped in anticipation of significantly slower domestic expenditures, Treasury yields might ultimately move
sharply higher if the inevitable deceleration of US spending is not severe enough to end the more intensive utilization of productive
resources. The slew of upbeat corporate earnings forecasts from respected industry analysts questions whether or not the US
economy will slow to the degree that is now implied by both sharply lower Treasury yields and by an inverted Treasury yield curve.
Contrary to the claims of some, both high- and medium-quality investment grade bond yields probably declined, on average, during
the week ended March 17th, although the decline by corporate yields has been shallower than the retreat by Treasury yields. As
shown by the stock market's recovery, the latest drop by Treasury yields was not prompted by a broad-based flight-to-quality.
Current worry over corporate earnings lacks the depth and urgency of late-1998's bout of profits' anxiety.
It's time to worry about profitability whenever business sales are in danger of incurring a pronounced deceleration. February's steep
advance by retail sales supports a possible 9.5% annual advance by business sales. The still very rapid growth of business sales
reinforces expectations of a better-than-12% annual increase by recurring corporate profits. In terms of moving four-quarter sums,
the showing by business sales has offered a very reliable indication of profitability's likely path. The Federal Reserve's effective
determination to slow business sales growth for the purpose of containing inflation risks warns against adhering to especially
ambitious earnings forecasts. Nevertheless, corporate earnings over the next 12 months could benefit considerably from an
acceleration of expenditures outside the US.
The latest unexpected slide by Treasury yields should prompt a significant upturn by corporate bond issuance over the next several
weeks. Too deep of a decline by private-sector borrowing costs could stoke expenditures by enough to finally give rise to faster
pace of price level growth. As the credit market's inflation fears subside, the greater is the danger that price acceleration might
materialize.
In addition to corporate bond yields, other important private-sector borrowing costs have risen for 2000-to-date. Since year-end 1999,
the FHLMC's 30-year mortgage yield has increased by 18 basis points, to 8.24%, while the 1-year adjustable rate mortgage yield
grew by 12 points, to 6.68%. Further, the recent 6.19% rate for three-month LIBOR was up from year-end 1999's 6%. Although
three-month LIBOR has steadily moved higher in response to Federal Reserve tightening, the 30-year mortgage yield has
descended from its February 18th peak of 8.38%.
The real cost of repaying a mortgage will be lower, the faster home prices appreciate. Just before housing activity slowed
significantly in 1995, 1994's annual average 30-year mortgage yield of 8.36% towered over the unchanged reading for the market
value of homeowners' equity in residential real estate.
By contrast, 1999's 7% annual increase for the value of homeowners' equity in residential real estate was almost equal to last year's
7.43% average for the FHLMC's 30-year mortgage yield. Underscoring how low mortgage yields have been relative to home equity
appreciation consider how the 10.8% average 30-year mortgage yield of 1975-1995 topped the accompanying 8.3% average growth
rate for home equity appreciation by 2.5 percentage points.
Rich Stock Market Might Spur Private-Sector Debt Growth
At the end of 1999, the market value of all US equities reached a record 135% of the US' private nonfinancial-sector debt
outstanding. During 1975-1995, the market value of US equities had instead averaged a much smaller 51% of private,
nonfinancial-sector debt.
Indebtedness might be expected to rise as an economy becomes wealthier. However, it might be reasonable to question the
durability of the spectacular advances staged by equities during the last 5 years. The climb by the market value of equities from
year-end 1994's 66% to year-end 1999's 135% of private-sector debt helps to explain why the yearly growth rate of private-sector
debt would realize a corresponding advance from 5.9% to 10.3%.
The US' private-sector now prospers, in part, because of 1999's 2.1% annual contraction of federal indebtedness. Not since the
mid-1950s has federal debt steadily receded. When federal debt was pared by 1.9% in 1956, private-sector debt was able to jump
higher by 10.1%. In 1999, the federal government's net retirement of debt lessened the upward pressure put on interest rates by
enough to allow for a steep 10.3% yearly advance by private-sector indebtedness.
Higher Stock Prices May Diminish Buyback Programs
The latest recovery by blue chip stock prices reflects greater confidence in the near-term performance of corporate earnings.
Corporate bonds also stand to benefit from how sharply higher equity prices should diminish equity buybacks that otherwise erode
corporate debt protection. Moreover, higher stock prices lessen the incentive to conduct leveraged buyouts (LBOs) that can be
especially harmful to credit worth.
As measured by the Federal Reserve, the net equity buybacks of US corporations sank from third-quarter 1999's $155.8 billion
annualized to the $73.2 billion annualized rate of 1999's final quarter, which was also the slowest pace since the $5 billion of 1996's
second quarter.
The equity market's downturn of early 2000 might be partly ascribed to fourth-quarter 1999's drop in net equity buybacks. Moreover,
the latest rebound by stock prices can be partly credited to the recent marked upturn by both the announcement and
implementation of stock buyback programs.
Just several weeks ago some were too quick to deny the influence of equity buyback programs on stock prices. Regardless of what
transpires immediately, asset prices will be higher than otherwise whenever you simultaneously increase the demand for and
reduce the supply of an asset.
US stock prices benefited considerably when the annualized pace of net equity retirements jumped up from the $125 billion of
1998's first half to the $426 billion of 1998's second half. Equity buybacks swelled in response to the plunge in stock prices that
followed from the global financial stress of 1998's second half.
Do not give all of the credit to the great stock price surge of the past five years to a spectacular improvement in productivity. During
the five years ended 1999, stock buybacks matched the record 1.8% of GDP that was first set during the five years ended 1989.
Financial asset buybacks now lower Treasury bond yields and boost stock prices. Pity those poor corporate bonds that have not
been benefiting from extraordinary efforts to simultaneously boost demand and cut supply.
Once a profound diminution of credit worth ended that previous surge in equity buybacks, the price performance of equities would
falter. If the capacity to fund stock buybacks were again jeopardized by a loss of credit worth, stock prices would become
increasingly vulnerable to a deep and protracted slide.
Retail Sales' Breakneck Pace Continues
Back amid the gloom and doom of the "seizing up" of some of the world's major financial markets, the annual growth rate of retail
sales had sagged to the 3.9% of 1998's third quarter. Arguably, the anemic 4.3% year-over-year rise by US retail sales for the
12-months ended September 1998 contributed to the global financial convulsions of late-1998.
A flight-to-quality inspired descent by the 10-year Treasury yield from July 1998's 5.5% to October 1998's 4.5% and a remedial
cutting of the federal funds rate target from August 1998's 5.5% to 4.75% by November 1998 would quickly invigorate household
expenditures. In a powerful acceleration, retail sales' annual increase had jumped up to 6.3% by 1998's final quarter. Since then US
consumers have been spending with near abandon. Over the next 14 months, or through February 2000, retail sales surged higher
by 10.4% year-over-year. Not since 1984 has the annual growth rate of retail sales been engaged in such a dramatic upswing.
Neither a hiking of the federal funds rate to its latest 5.75% nor a recent 6.4% 10-year Treasury yield managed to bring an end to a
now legendary consumer spending spree. Also, sharply higher energy prices have done little to curb consumer outlays.
Household expenditures' robust pace should be sustained until an ebbing of profitability brings an end to labor market tightening.
Otherwise, a brisk pace of hiring activity will both stoke the growth of personal income and underpin consumer confidence by
enough to supply a distinctive liveliness to consumer spending.
Household expenditures have been outrunning earned-income by a wide margin. For the quarter ended February 2000, the projected
6.5% annual increase of wages and salaries lagged well behind retail sales' 10% annual gain. Part of this shortfall may be
accounted for by the US government's underestimation of earned income. After all, the growth of employment-related taxes at all
levels of government have proceeded at a pace which questions whether or not the annual growth rate of wages and salaries has
actually receded from its 7.9% peak of 1998's third quarter to the latest 6.5%.
The much faster rise of consumer spending relative to income might be partly attributed to a well-above-trend pace for home sales.
The year-to-year increase of real consumer spending dropped from the 3.9% of 1994's first-half to the 2.8% of 1995's final quarter,
as the annual change of total home sales fell from the 13% of the year-ended June 1994 to the -7% of the year-ended June 1995.
A climb by the annual growth rate of total home sales from 1997's 5% to 1998's 13% may have helped to boost real consumer
spending's annual increase to the 4.9% of 1998 and the 5.3% of 1999. In view of how the annual increase of total home sales has
slowed to the 2.8% of the 12-months ended January 2000, the extra lift supplied to real consumer spending by the homebuying
boom may be fading. Homebuying's deceleration has been less jarring than what transpired in late 1994 and early 1995.
Housing's Down From The Ceiling, But Far From The Cellar
The US' current account deficit widened to a record 3.7% of GDP in 1999. However, the financial markets have yet to be put off by
the current account gap's now unrivalled girth mostly because of both the dollar exchange rate's strength and inflation's mild pace.
Once foreign investors have had their fill of dollar-denominated assets, down will go the dollar exchange rate and up will go the
anxiety surrounding the ultimate cost of a record current account deficit
Higher mortgage yields have not been without effect. The housing market index of the National Association of Home Builders
(NAHB) fell from February's 69 to 61in March -- the lowest score since the 59 of January 1998. The housing market index set a
record high of 78 during November-December 1998.
The housing market index is a diffusion index, where a reading of 50 reflects a neutral outlook for housing. As those holding a
favorable assessment of home sales further outnumber those holding a negative assessment, the housing index will climb higher
above the breakeven mark of 50.
Thus, the NAHB's March index for the housing industry was down, but far from out. March's housing market index seemed to
indicate a noticeably slower, but still above-trend, pace for home sales. Remember, homebuilding has not subsided by enough to
end shortages of labor possessing construction-trade skills.
The housing market index was last under 50, or at a level showing more housing professionals deeming market conditions to be
poor than the number describing conditions as being good, in June 1995. June 1995's score of 45 ended a string of eight
consecutive readings under 50. That sequence of decidedly downbeat assessments of housing's prospects beginning with a
housing market index of 48 for November 1994, which was exactly when bond yields peaked during the last major upswing by
interest rates.
Because of the many nonrecurring expenditures that follow from the purchase of a home, a slower pace for home sales should
imply likewise for consumer spending in general. Nevertheless, not only did March 2000's housing market index top its 1996-1997
average of 56, but mortgage applications from potential home buyers bettered their 52-week average by 3% for the week-ended
March 10th, as derived from Mortgage Bankers Association (MBA) data.
During the four weeks ended March 10th, mortgage applications from potential home buyers were off by 2.9% from the contiguous
four weeks, but were up by 11.4% annually. The annual increase by home buyer mortgage applications has been quite impressive
considering that the MBA's effective 30-year mortgage yield climbed higher by 127 basis points annually to 8.54%, while the
effective 1-year ARM yield advanced by 111 basis points, to 7.47%.
In the US, February's housing starts were exceptionally strong, growing by 1.3% monthly to a pace that was up by 2.5% yearly and
which bettered its lagging 12-month average by 6.5%. Nevertheless, February's 8% monthly drop by building permits warned of a
March retreat for housing starts. For the quarter-ended February 2000, the 3.8% annual drop by building permits was deeper than
the 0.5% yearly dip by housing starts.
The latest declines by both initial state unemployment claims and the number receiving state unemployment benefits reflect the
continued firming of the US labor market. Moreover, although early-March readings on consumer confidence slipped under their
February averages, they still bettered their 1999 means, which were among the highest ever.
The US economy will probably not sag noticeably in immediate response to the imposition of a 6% federal funds rate. A
broad-based weakening of profitability may be necessary if labor market tightening is to end and, thereby, bring about a
retrenchment of household expenditures.
Household-Sector: Value Of Stocks And Mutual Funds Hits 172% Of Debt
A stock market rally of unprecedented magnitude has also facilitated the more rapid expansion of consumer spending relative to
personal income. In 1999, the sum of the market value of equities plus mutual funds held by households advanced by 25.7% to
$11.1 trillion which was much faster than the 9.4% annual increase of households indebtedness, to $6.5 trillion.
In 1989, the market value of the sum of the market value of household-owned equities plus mutual funds approximated 74% of
household debt. After having previously peaked at 1968's 218%, the market value of equity plus mutual fund assets would eventually
bottom at 1984's 50% of household debt. Not until 1995 did the market value of equities plus mutual funds rise and remain above
the amount of outstanding household debt. In 1999, the market value of stocks and mutual funds that belonged to households
reached 172% of household debt -- the highest such percentage since 1968's 218%.
Also in 1999, household net worth rose to a record 633% of disposable personal income. Prior to 1996, not too long after cresting at
1968's 519%, net worth would drop to a 54-year low of 425% of disposable personal income in 1974.
The now atypical strength of household balance sheets helps to explain why 1999's consumer confidence index was the highest
since 1968 according to the Conference Board. Strong household balance sheets could underpin consumer spending indefinitely.
Equities and mutual fund shares are not households' only liquid financial assets protecting the sector's indebtedness. Adding
household-owned debt securities plus deposits to holdings of stocks and mutual funds, the liquid financial assets of households
approximated 269% of household debt in 1999, which was the highest such ratio since 1972's 322%.
Nevertheless, the more financially conservative might note how liquid financial assets excluding both equities and mutual fund
shares fell to 97% of 1999's outstanding household debt, for its lowest such share on record. During 1975-1995, liquid financial
assets excluding both equities and mutual funds averaged 141% of household debt.
According to Federal Reserve data, the price appreciation of household-owned equities and mutual fund shares reached an unheard
of $2.5 trillion in 1999, which approximated a record 56% of wages and salaries. Capital gains arising from stocks and mutual funds
previously set records in 1997, reaching $1.8 trillion, or 45% of 1997's wage and salary income.
During the five years-ended 1999, capital gains accruing from household holdings of stocks and mutual funds approximated an
unmatched 41% of wages and salaries. Prior to the 20% of the five years ended 1995, the price appreciation of household-owned
stocks and mutual funds peaked at the 19% of wages and salaries for the five years ended 1968.
Wealth matters. Real consumer spending's average annual growth rate climbed up from the 2.4% of the five-years ended 1994 to
the 4.1% of the five-years ended 1999, which was proportionally greater than the accompanying climb by real disposable personal
income's five-year average annualized growth rate from 2% to 3.4%.
The acceleration of household debt outstanding from year-end 1996's 6.8% annual increase to the 9.4% annual increase of year-end
1999 has yet to give rise to a deterioration of household debt repayment. Moody's credit card index revealed that the change off rate
of consumer credit card debt fell from January 1999's 6% to January 2000's 5.6%. Also, credit card holders have been paying off
their balances more rapidly.
CPI Inflation Can Be A Lagging Indicator Of Price Level Growth
February's 3.2% year-to-year increase by the CPI fell to 2.1% after excluding the increases of 1.8% for food prices and of 19.9% for
energy product prices.
For the month of February, the core CPI grew by a mild 0.2%. Not since the second quarter of 1995 has the core CPI posted
back-to-back monthly increases of at least 0.3%. Nevertheless, the more bondholders take comfort in the apparent containment of
inflation, the greater is the longer-term danger of an extended surge by prices.
Many Americans will express incredulity at the Labor Department's February estimates of relatively mild year-to-year gains of 3.2%
for rent and of 2.5% for owners' equivalent rent. Residents of San Francisco, Silicon Valley, and metropolitan New York probably
found the CPI's estimated 2.8% year-to-year increase for February's shelter costs to be on the low side, all the more so because
shelter-cost inflation has declined from February 1999's 3%.
The Federal Reserve estimated that the market value of owner's equity in residential real estate climbed higher by 7% annually in
1999. Other indicators put home price inflation around 5% annually.
The CPI's methodology has merit in that most may not feel the brunt of any acceleration of shelter costs unless they change
residences. If the price increases on residential real estate hold, then the CPI is very much a lagging indicator of inflation. When the
annual increase of the value of owners' equity in housing jumped up from 1983's 2.7% to the 12.5% average of 1984-1985, the
annual increase of owners' equivalent rent would eventually rise from 1983's 2.5% to the 5.5% of 1985-1986.
Much more so than "Marlboro Friday", the disinflation of the second half of the 1990s was perhaps preordained by the jarring plunge
in the average annual rate of change for the value of owners' equity in housing from the +8.9% of the five-years ended 1989 to the
-0.3% of the five-years ended 1994. The 5.7% average annual gain by the market value of homeowners' equity for the five-years
ended 1999 may be the harbinger of an extended upturn by inflation. Reinforcing the notion that the faster expansion of wealth can
only put upward pressure on price level growth would be the startling imbalance between the 25% average annual increase by the
market value of US equity shares during the five-years ended 1999 versus the core CPI's much flatter average annual gain of 2.4%.
During 1990-1994, homeowners' equity endured its worst performance since the 1930s. The trend of owners' equity in housing has
entered into its steepest uptrend since the second half of the 1960s. The average annual rate of CPI inflation would rise from the
1.3% of 1961-1965 to the 4.3% of 1966-1970. The five-year average annual growth rates of homeowners' equity market value and
CPI inflation would peak together during the span ended 1981 at 16.4% and 9.8%, respectively.
Perhaps even more so than the behavior of homeowners' equity, the latest surge by household net worth may be warning investors
no to become overly dismissive of inflation risks. Just recently, the five-year average annualized growth rate of household net worth
set a post-1930s low of 4.3% for the span ended 1994. In fast and furious fashion, the average annual growth rate of household net
worth has zoomed up tot he 11.1% of the five-years-ended 1999. The five-year average annual growth rate of household net worth
has been engaged in its steepest ascent since climbing up from the 6.7% of the span ended 1974 to the 12.7% of the stretch
ended 1979. Granted that inflation will not soon again soar higher as it did during 1980-1981, the rapid acceleration of household net
worth still favors a higher rate of price inflation, barring any appreciable slackening of the US labor market.
US price inflation has generally lagged expectations because of an often sub-par pace of consumer spending among the 15 member
countries of the European Union (EU-15)-the world's largest economic activity. The annual growth rate for the EU-15's real consumer
spending slipped from 1998's 2.9% to 1999's 2.8%. Far different was the acceleration of US real consumer spending growth from
1998's already robust 4.9% to 1999's scintillating 5.3%--the steepest since 1984. During the eight years ended 1999, the EU-15's
1.8% average annual rate of real consumer spending lagged far behind the US' 3.8% average annual increase. If, as expected,
European consumer spending gains speed, the prices of internationally tradable goods should firm.
Expansion Of Production Capacity Ebbs
Time and again, too much competition has gotten part of the blame for a credit rating downgrade. Competitive pressures have been
intensified by an earlier surge in production capacity. However, just as demand appears to be quickening globally, production
capacity's expansion has been ebbing in the US.
A still relatively low rate of industrial capacity utilization has helped to contain inflation. For the quarter-ended February 2000, the
US' rate of industrial capacity utilization averaged 81.5%, which, though up by 1.3 percentage points year-to-year, was still well
under its 84.2% peak for the quarter ended February 1995.
Nevertheless, the annual increase of core profits has climbed higher with the rate of industrial capacity utilization. Many upbeat
forecasts of profitability implicitly assume a further climb by the rate of industrial capacity utilization, as well as an even lower
unemployment rate. The more intensive utilization of productive resources that appears to be necessary for a continued rise by
annual rates of corporate earnings growth would probably add to inflation worries.
Roughly speaking, the rate of labor market utilization is close to a 30-year high. If the utilization rates for the labor market and for
industrial capacity were both at 30-year highs, rising inflation would probably be more than a threat. Industrial capacity utilization
climbed higher as the 5.4% annual increase by industrial production for the quarter-ended February 2000 outran the accompanying
4% yearly expansion of industrial capacity.
Industrial capacity's annual growth rate crested at the 6.4% of he quarter ended July 1998. Outright price deflation and the global
financial stress of 1998's second half have subsequently curbed the expansion of production capacity to the future benefit of
profitability.
The slower growth of industrial capacity could lift inflation risks. The previous long-lived climb by the annual growth rate of industrial
capacity from the 1.1% of 1988's second quarter to the 6.4% of 1998's third quarter has helped to pare product price growth. Price
inflation would trend higher for many years after the annual increase of manufacturing capacity peaked at the 7.6% of 1966's third
quarter. The annual increase of manufacturing capacity most recently crested at third quarter 1998's 7.2%.
45% Of World Economy Grew By Just 1.8% Yearly During 1995-1999
Lost amid the "sturm und drang" of Japan's economy has been the miserly 1.5% average annual gain for Germany's real GDP
during the five-years ended 1999. In actuality, the performance of Germany's real economy was not that much better than the 1.2%
average annual increase by Japan's real GDP during the five years ended 1999.
However, the possibly more telling measure of Japan's nominal GDP barely inched up by 0.7% annually, on average, during the
five-yea |
