The economic outlook is good, and that's not so good for bonds.
Stocks and bonds in 2007 are likely to remain
"uncoupled" or "de-coupled," to use two of the descriptors popular
these days. Equities should rise in response to continued if not
especially robust economic growth and the concomitant expansion of
corporate earnings, albeit at a slower rate than in 2006. That same
basic environment, however, should allow the Federal Reserve (Fed) to
hold rates up at their present levels. Without the support of
short-rate cuts, bonds have a less than inspired outlook; not
especially negative, to be sure, but not especially promising either,
offering little more return than the coupon.
This disparate stock-bond behavior may confuse those
investors who earned their stripes during the last 20 to 25 years. From
the 1980s to 2000, equities and bonds moved pretty much in tandem, not
at all in the disparate way expected in 2007 and observed commonly
during the past two or three years. It is natural enough to look for a
return to the old pattern. But that pattern has broken, largely because
the inflation situation has changed so drastically from the 1980s and
1990s. During the 20-year stretch from the early 1980s to the end of
the century, the inflation situation improved on more or less a
continual basis. The annual rate of inflation dropped from 13.2% in
1979 to 2.4% in 2000. With less and less need for bond yields to
compensate investors for the effect of rising prices on the real value
of nominal returns, bond yields could fall almost as consistently as
inflation did. Ten-year Treasury yields, for instance, fell by more
than 1,100 basis points from 16.0% in 1982 to a low of about 5.0% in
late 2000, producing a tremendous, ongoing capital gain for bond
investors. Equities rose, on balance, along with bond prices because
falling bond yields allowed higher valuations and because a continued
economic expansion boosted corporate earnings.
With that inflation adjustment complete, however,
and little likelihood that inflation will fall any farther, such common
movements for stocks and bonds are much less likely going forward. On
the contrary, now the issues of economic growth and Fed policy
dominate, and they will tend to push these markets in opposite
directions. Because any sign of economic strength lessens the
likelihood that the Fed might cut short-term interest rates, the
expected growth in the economy in 2007 should prevent much further
decline in bond yields. But the same expected growth that will tend to
block capital gains on bonds should foster enough earnings growth to
lift equity prices. True, the two markets are not quite expected to
move in opposite directions, but neither are they forecast to move
together.
Of course, if the economy were to falter, as some
suggest it will, the markets would behave differently from these
expectations. They would remain de-coupled, but their respective
prospects would reverse. In the unlikely event that the economy does
falter, the Fed would almost certainly cut short-term interest rates,
an action that would promote a decline in bond yields and, of course, a
rise in bond prices. The relief from lower interest rates might help
the stock market, but probably not enough to counteract its poor
reaction to the deteriorating earnings that would almost surely
accompany such economic weakness. But while such a situation is
possible, it is, nonetheless, far from probable.
For one, the main source of weakness in this
economy, the housing adjustment, looks contained. To be sure, housing
is already in decline and the economy has already suffered a
significant drop in construction activity. Still, even in the face of
such a substantial downward adjustment, the pace of decline by late
2006 was already beginning to moderate. And with both short- and
long-term interest rates now stable, including mortgage rates, that
market looks likely to avoid any additional pressure. Housing will
continue its downward adjustment, probably through the end of the year.
It will tend to slow the pace of economic growth. But the intensity of
the housing cutbacks surely will continue to moderate. On that basis,
the housing situation seems incapable of precipitating a general
economic decline all by itself.
Meanwhile, continued employment growth and annual
wage gains averaging 4% to 4.5% should sustain enough growth in
household income to promote at least a moderate advance in consumer
spending through 2007. Consumer spending may not lead the economy
forward, as it has during the past two to three years, but the
additional spending allowed by this income growth will nonetheless do
much to counteract the adverse effects of the housing adjustment. At
the same time, the corporate sector has so much surplus cash that
capital spending should grow at nearly double-digit rates, truly an
engine of growth.
With this balance of forces generating at least an
adequate economic expansion in 2007, if not an especially robust one,
it is highly unlikely that the Fed will cut rates, as some forecasters
seem to believe, especially those enthusiastic about bonds. Many, who
look for a reversal by the Fed, expect policy makers to respond to a
mere slowdown in the pace of the real economic expansion. Such
reasoning ignores the Fed's only two objectives: inflation and
unemployment. It is on these fronts that Congress questions the Fed
chairman. His and the Fed's reputation rest almost entirely on success
in keeping unemployment low and keeping inflation contained. As long as
unemployment remains as low as the 4.5% of the workforce last recorded,
Fed policy makers should feel absolutely no pressure to cut rates.
Indeed, they will doubtless feel little pressure to cut rates if and
until unemployment rises above 5% of the workforce, hardly likely in a
growing economy.
On the other side of the ledger, there is inflation.
If inflation were to pick up significantly, then both the stock market
and the bond market would again move in tandem, as they did in the
1980s and 1990s. Except in such an event, the common movement would go
in reverse from the patterns of those last 20 years of the century.
Intensified inflationary pressures would drive down bond prices and
raise yields, perhaps more than proportionately. The rise in bond
yields would probably be enough to depress equity prices, even in a
continued economic expansion.
But, as with the risk of a faltering economy, this
inflationary prospect, though a risk worthy of consideration, is not
especially likely. To be sure, the low unemployment rate and its
implication of a tight labor market have raised understandable fears
about rising wage gains and a kind of cost-push impetus to inflation.
But against that prospect stand three other critical considerations.
One, crude oil prices have dropped, falling some 30% during the past
six months. Though oil has remained somewhat isolated within the
inflation picture, this price drop can only auger well for the general
inflation outlook. Second, inexpensive imports, largely from Asia,
should keep a lid on pricing leverage in the United States. Even in the
face of rising wages, this import pressure should prevent business from
fully passing on cost increases. Third, even the prospect of import
price hikes from a decline in the foreign exchange value of the dollar
is limited. The Chinese have proved that they will prevent much dollar
decline against their currency, the yuan, and that fact will limit how
far the dollar can fall against other currencies. Besides, China and
the rest of Asia are the primary source of most of the inexpensive
imports.
Clearly, there are risks on either side of the
economic and financial likelihoods. Concern about a softening economy
and inflation have adherents in the forecasting community. But there is
a huge difference between risks and probabilities. The probabilities,
in fact, favor continued economic growth, albeit slowed from 2006, and
a still-contained inflation environment. In such a context, the Fed
should hold the line on rates that it established in mid-2006, keeping
short-term interest rates steady and fostering an environment in which
bond yields (and prices) remain in a fairly tight trading range. With
that rate and yield backdrop and enough economic growth to support a
continued rise in corporate earnings, equities can stay de-coupled from
bonds and make additional gains.
Milton Ezrati is a partner and the
senior economic strategist at Lord Abbett. He is also an affiliate of
the Center on Economic Growth at SUNY, Buffalo, a 30-year Wall Street
veteran, a contributor to On Wall Street, and an expert on global and
domestic financial issues. From 2000-2001 he was a guest commentator on
CNBC's Morning Call, and is currently a host of "Open Exchange" on
Bloomberg TV.