Financial markets are giving divergent signals to investors and analysts at the midpoint of 2005. The flattening of the yield curve suggests a pronounced slowdown ahead, yet a number of commodity prices have reached record highs as traders perceive strengthening demand. Some economists argue that inflationary pressures should ease as money supply measures roll over. Conversely, a variety of credit measures suggest there is excess liquidity, for example feeding into a housing market bubble in parts of America.We analyse these potential problems by examining the key drivers of the business cycle, as well as valuation measures and the structural drivers of investment flows. As an example, chart 1 shows such investment flows – an amalgam of global purchases of mutual funds, cross-border equity flows, net issuance of bonds and levels of portfolio liquidity – which can be expressed as a sentiment indicator. A fall in the weekly indicator reflects signs of weakening cross-border flows and lower net purchases of equity mutual funds. However, both the weekly and monthly fund flow-based tactical indicators continue to suggest a modestly bullish view. In the past, such levels of sentiment have been consistent with forward 12-month returns of 5-10% (see chart above). Bond markets have been supported by an ongoing debate about the outlook for the global economy. America and Europe are clearly suffering the combined effects of higher energy costs, weaker overseas demand, greater competition from China and lower levels of business and consumer confidence. The key question is how extended and deep such a drawback will become. Certainly, the flattening we have seen in the yield curve seems to paint a fairly gloomy picture. Our research is more positive. First, the slowdown remains concentrated in the manufacturing sector, as companies get to grips with higher inventory levels. Consumer spending is coming under pressure in only a few cases, such as Britain and Germany. In America and most other economies, where the services sector is larger, the mood remains upbeat. Secondly, our analysis suggests that a variety of “leading indicator” measures, such as the money supply and the yield curve, are less useful signals about the business cycle than they were a decade ago. The reasons are twofold: the evolution of economies, which are less dependent on manufacturing, and the evolution of financial markets, where credit or liquidity is now available through a variety of channels. Indeed, we believe these credit channels are particularly strong at present. Liquidity is ample in corporate bond markets and credit spreads are tightening once again. Credit surveys in America, Europe and Japan show banks are more willing to lend than they were in 2004, while borrowing by corporate and household sectors continues to pick up in these countries. In America, the reduction in mortgage rates has begun to generate a surge in mortgage applications, pushing parts of the housing market to bubble levels that are a concern to the Federal Reserve. Alan Greenspan, the chairman of the Federal Reserve, has commented several times this year on why bond yields are so low, citing economic weakness, pension fund buying, buying from overseas central banks to protect their currency regimes, and buying from domestic and international investors seeking a more diversified yield. It is not a surprise to see yields in the 4-5% range in America and Britain, as this matches the experience of the last low-inflation decade, the 1960s (see chart below). Our analysis suggests that structural changes in capital flows offer the best explanation for low yields. The combination of the 1997/8 Asian financial crisis and the surge in commodity prices between 2003 and 2005 has turned the larger emerging economies into net creditors to the global financial system. Equity market losses and volatility in 2000-2002 forced more liability-driven investors, such as pension funds, to accelerate their decade-long switch out of equities. This process has been ratified and supported more recently by regulators in Britain, America and much of Europe. The end result is bond markets being driven to extremes irrespective of the underlying trend of the business cycle. Equity investors perceive the rise in oil prices as a sign of strengthening demand from Asia and Latin America, rather than the trigger for a marked slowdown in activity. Putting aside any major shocks, we expect investors to continue to take on more risk during the second half of the year. Monetary conditions are slowly tightening, but our analysis suggests they are sufficiently loose to allow riskier assets to outperform. Valuation models and measures of investor sentiment have combined to support our underweight stance on cash and global bonds and our overweight stance on equities and corporate debt.
Commodity prices continue to rise, but with the yield curve flattening, investors are receiving confusing messages. However, there is justification for a modestly bullish approach.