The reason for the uncertainty is because we are in a transition period for interest rates and the economy. We are walking a tightrope between inflation and growth with one wrong move having severe consequences. I wear the shaded glasses of an economist when I look at these issues and believe the simple laws of supply and demand dictate the end game. Severe down turns are caused by disruptions in supply and demand. In the late 90’s, we had the convergence of the Telecom Reform Act, Y2K and the Internet. This led to massive amounts of investment and supply of technology. Demand however could not keep pace, and eventually we experienced a massive imbalance of supply, inventory and capacity that we are still working off today. Today, housing is poised to replace technology as the scapegoat of our next big folly. Hardly a day passes without the media advertising the next bad housing statistic.
Housing again topped the headlines last week. According to the National Association for Realtors their expectations for housing prices in Q4 is expected to drop by 0.9%. And this estimate is a little on the low side -- I’ve read other reports suggesting the numbers may be as high as 4%. The thing to keep in mind here is that year over year since July, the average home price is up 13.43% according to the Office of Federal Housing Enterprise Oversight. Merrill Lynch and Goldman Sachs both suggest that we could see the housing slowdown deduct 2-3% off GDP in the next year. I would find this surprising since residential housing spending makes up less than 5% of GDP.
The employment report showed job market stability and probably the Fed’s most important measure of inflation, wage growth, contained. The Monster Employment Index depicted a less stable picture by showing the lowest percentage up tick in job postings since the index was created three years ago. The Fed released its minutes from the last meeting which suggested lower 2007 GDP growth estimates and a likelihood that their wait on the sideline attitude will stick. Meanwhile the 10 Year Treasure continues to sell off driving yields lower and lower confirming economic uncertainty.
Although these statistics all seem negative, I see nothing that makes me fear a meltdown. My net take away from this is that equity versus bond yields continue to favor equity exposure even into an economic slowdown. According to the probabilities published by the Fed in 1996 based on evaluation of the spread of yield curve inversion, there is still less than a 40% chance we will enter a recession. The most likely case scenario right now is a moderate and controlled slowdown with plenty of opportunities in the equity markets for diligent and disciplined investors.