Today, President Hu Jintao of China is in Washington to discuss a range of issues with President Bush. Among these, the topic of oil stands out as a critical strategic concern for both nations, who are key players in the global energy landscape.
China’s demand for crude oil continues to rise sharply and is expected to be addressed through significant market shifts and geopolitical changes. The Bush administration has indicated that China must abandon outdated approaches that fuel regional and global concerns. This cautionary note is articulated in the National Security Report released last month, which identifies several outdated practices, including:
* Ongoing military expansion in secrecy;
* Attempting to monopolize energy supplies while restricting market access, as if adhering to a discredited economic philosophy;
* Supporting resource-rich nations without regard for their internal mismanagement or international misconduct.
Accordingly, higher oil prices are anticipated, reflecting the rising tensions associated with these developments. The modern version of the Great Game is playing out across the globe, with emerging conflicts in regions like Central Asia, where the initial Great Game was fought.
In this context, it is not surprising to see crude oil prices exceeding $72 a barrel in New York futures trading this morning—a new high. This surge in oil prices coincides with President Hu’s visit to Washington. Domestic oil production cannot keep pace with the rapidly growing demand in China, which is reflected in the chart below, highlighting the stark difference between consumption and production in this booming economy, the world’s second-largest oil consumer after the United States.
Source: CBO
In a perfect economic scenario, a central bank would remove excess liquidity when the economy starts to overheat, encouraging a cooling off period. In time, this would allow for a return to favorable financial conditions. However, such straightforward dynamics are elusive in 2006, where traditional economic teachings are being debated intensely.
The notion of controlling liquidity—often symbolized by the metaphorical punchbowl—was actively applied in previous years, resulting in bull markets across multiple asset classes. This phenomenon is still evident today, with various investments showing impressive gains. Here’s a snapshot of market performance up until yesterday in 2006:
Large-Cap Stocks: +5.24% (S&P 500)
Small-Cap Stocks: +14.68% (Russell 2000)
REITs: +10.03% (Morgan Stanley REIT)
Commodities: +8.17% (Oppenheimer Real Asset Fund)
10-year Treasury: +1.12% (10 Year Constant Maturity Treasury)
Junk Bonds: +2.98% (ML US High Yield Master II Index)
The Federal Reserve has been subtly attempting to tighten monetary policy without alarming investors. This delicate approach may be nearing its conclusion, as indicated by yesterday’s release of the minutes from the Fed’s March FOMC meeting. The minutes suggest a consensus that the tightening period is approaching its end.
Janet Yellen, President of the San Francisco Federal Reserve, echoed this sentiment during a speech, cautioning that tightening measures might have gone too far, as reported by TheStreet.com.
Gold and oil, while fundamentally different in nature, share a notable connection: inflation. Gold, often revered as a timeless asset, typically offers a hedge against rising prices. Conversely, oil can act as a significant inflation driver if its prices increase substantially and persistently.
The correlation between these two valuable commodities can provide insight into future economic conditions, although this relationship is not always conclusive. Historically, simultaneous bullish trends in both gold and oil alongside increasing inflation are somewhat rare, with the last prominent example occurring in the late 1970s through the early 1980s.
The relevance of this connection ultimately depends on individual perspectives and interpretations.
Today marks tax day in the U.S. — file your return or request an extension. Fortunately, thanks to the IRS extending the filing deadline to April 17 this year, you have an extra two days. However, once the deadline arrives, the tax collector will not settle for less than their due.
Unfortunately for taxpayers, the usual tax burden is increasing again, as per the latest calculations from the Tax Foundation, which tracks “Tax Freedom Day”—the day when the average American earns enough to cover their annual taxes. For example, if Tax Freedom Day falls on April 1, earnings from January to March cover the various taxes for the year.
In 2006, Tax Freedom Day is set for April 26, according to the Tax Foundation’s current study. “This year’s Tax Freedom Day arrives three days later than in 2005 and fully ten days later than in 2003 and 2004,” notes Tax Foundation President Scott Hodge in a press release, indicating a troubling trend of increased tax burdens.
Source: Tax Foundation
Cole Porter admitted that champagne brings him no joy, and similarly, the stock market is currently indifferent to rising interest rates. In contrast, earlier bulls would have reacted differently. The pressing question is whether today’s market optimists can maintain their bright outlook despite renewed pressure from the bond market, which is beginning to see a rise in interest rates.
In particular, the benchmark 10-year Treasury Note closed above 5% yesterday for the first time since June 2002. This milestone served as a warning to the stock market, yet it prompted a wave of buy orders. The S&P 500 may have slipped recently, but it still managed a slight gain yesterday despite this increase in yields.
Year-to-date, the S&P 500 is up 3.3%, while the small-cap S&P 600 has seen a remarkable increase of 10.5% so far in 2006. Perhaps the stock market remains buoyed by optimism, partly due to comments from Fed Board Governor Donald Kohn, who hinted that the central bank’s tightening measures may be excessively cautious. “Overshooting is one of the risks we are very aware of in our current policy,” Kohn said after a speech, as reported by Reuters.
Nevertheless, the Fed appears eager to preempt any inflationary pressures. While the risks of overreaching in rate hikes are present, they currently seem minor when weighed against the potential dangers of curbing monetary tightening prematurely. The futures market implies that the 25-basis-point hikes will likely continue, pushing the current Fed funds rate of 4.75% up to 5.25% and possibly more. If this occurs, the bond market, having adopted a more hawkish stance, may continue to push the 10-year yields higher.
While commodities may be surging in popularity, the financial sector is also thriving. The question that arises is whether this upward trend can sustain itself.
Presently, the outlook appears positive, as indicated by the recent performance statistics. For the year to date, the S&P 500 Financials Spider ETF (XLF) ranks second among the nine sector Spider ETFs, with a robust total return of 17.1%. The energy sector, represented by the S&P 500 Energy Spider (XLE), has outperformed with a 28.3% return over the same period.
It’s impressive for financial stocks to post such gains against a backdrop of rising interest rates, as typically, an industry that relies on lower borrowing costs would struggle during periods of liquidity tightening. However, this expectation hasn’t materialized. Indeed, XLF has recently reached new heights, which contradicts concerns regarding future volatility.
Moreover, Wall Street anticipates that strong earnings in financial stocks will persist in the upcoming quarters. According to a report from AltaVista Independent Research, “financial earnings are expected to grow faster than any other sector within the S&P 500 in 2006.” The consensus predicts a year-over-year earnings growth of 10.5% for XLF in the second quarter, ranking it third behind energy’s anticipated 17.6% and utilities’ 17.5% growth.
This enthusiasm for financial stocks is not surprising given their significant contribution to the financial performance of the S&P 500, as they represent over one-fifth of the index’s market capitalization.
The option to secure a real, or inflation-adjusted, interest rate is one of modern finance’s standout innovations. However, timing these financial decisions can often lead to pitfalls, regardless of the security involved.
Thankfully, historical perspectives can offer valuable insights, particularly regarding the recent performance of the 10-year yield on 10-year inflation-indexed Treasuries, commonly known as TIPS. The chart below illustrates that patience can yield higher returns.
As of the close last night, a 10-year TIPS offered a real yield of 2.37%, near its highest level in several years. Last Friday’s closing yielded 2.43%, the highest since September 2003, a notable rise from yields below 1.7% last September.
The crucial question remains: Is locking in a real 2.37% yield now enticing enough to weather future uncertainties? Or could even higher real yields emerge in the months to come?
Finance theory posits that higher-risk assets are more volatile in price, resulting in greater volatility in returns as well. Stocks, for example, typically offer higher returns than bonds due to their relative volatility. However, finance theory doesn’t provide guidance on how to act when these relationships become unraveled. This is where common sense and instinct take over.
These days, some volatility ratios are appearing atypical. This is particularly evident in the real estate investment trusts (REITs) sector compared to other asset classes. The chart below highlights these trends.
It appears that REITs are currently the most volatile asset class. (Volatility is measured through the trailing 36-month standard deviation of monthly returns through March 2006.) High volatility indicates higher risk. But are REITs deserving of their label as the most volatile asset class?
There are no absolute answers to these questions; however, it can be argued that commodity markets, emerging market stocks, and high-yield bonds merit consideration for this mantle instead of REITs. In fact, REITs have proven to be relatively stable investments and may not deserve their current reputation.
It’s essential to consider that the ongoing high volatility in REITs largely results from a bullish market. Since 1999, the Dow Jones Wilshire REIT Index has experienced positive returns consistently each year. So far this year, the index is up 10% as of yesterday’s close.
The prevailing narrative claims that the economy is thriving. A recent employment report supports this notion, suggesting that growth is stronger than previously thought, even convincing the bond market of its robustness. However, this creates apprehension regarding inflation as the labor market heats up. This sentiment is reflected in a sharp rise in the yield on the 10-year Treasury, which soared to 4.96%. The last instance of such high yields occurred in the summer of 2002, when the Fed focused on deflation concerns.
Currently, inflation is the looming risk. Although many believe it is prudent for the bond market to be vigilant, some remain contrarian, cautioning against presuming a slowdown is close and that inflation might not be as pressing a concern as anticipated.
To dive deeper into this contrary perspective, we spoke with Lakshman Achuthan, managing director of the Economic Cycle Research Institute, a firm specializing in identifying economic turning points through quantitative analysis. Achuthan mentioned two potential weak spots that could diverge from current expectations: housing and global industrial sectors. He also noted that ECRI’s FIG (Future Inflation Gauge) indicates that inflationary pressures may soon dissipate.
Such forecasts may be easy to dismiss given the recent bullish economic news. However, ECRI is renowned for its accurate predictions regarding economic turning points. For a deeper understanding of ECRI’s methodology, their book Beating the Business Cycle offers detailed insights.
Today brings another series of economic data points highlighting a robust economy. The Labor Department’s latest March Employment Report reveals that the labor market is far from stagnating. This raises questions about the validity of the previously inverted yield curve’s forecasting ability.
Last month, the unemployment rate dropped to 4.7%, its lowest since July 2001. Lynn Reaser, chief economist at Bank of America’s Investment Strategies Group, commented that “businesses are regaining confidence and are actively hiring new workers,” as reported by AP via MSNBC.
Furthermore, 211,000 new nonfarm payroll jobs were created in March, reflecting a 1.5% growth compared to February. While this figure may not match the booming economy of the late ’90s, it is consistent with recent trends, as shown in the chart below. Importantly, this growth rate has been stable over time, dispelling fears of an impending downturn.
Additionally, the majority of job growth stemmed from the service sector, which represents the largest segment of the economy. This suggests that the primary engines of the labor market are performing well.
If a slowdown is on the horizon, the current employment data does not provide early warning signs, contributing to the rise in the 10-year Treasury yield. As of this morning, the 10-year Treasury yield stands at 4.93%, the highest level since June 2002.
The pivotal question now is whether the spread between the 10-year and 2-year yields will increase. Given the current trajectory of the formerly inverted yield curve, this outcome appears increasingly probable.
If the economy continues to thrive, there seems to be reasonable agreement that a return to a normal yield curve—where longer-term rates are higher than short-term rates—might be justified. However, what seems reasonable in theory doesn’t always reflect market realities.
Copyright 2006 by James Picerno. All rights reserved.
