Markets & Finance

Same Track, Different Train


Worried about the inverted yield curve? Look at the bigger picture

From Standard & Poor's Equity ResearchMarket indicators are unfailingly accurate, until one day they're not.

Consider the inverted yield curve, which happens when long-term yields fall below those on the short end. Many market participants consider an inverted yield curve a harbinger of economic doom. Long-term investors, the reasoning goes, will settle for lower yields now if they expect the economy's growth to slow in the future.

The curve inverted in early 2006 during the Fed's rate-raising program. Long-term yields were already under pressure from moderating economic growth, benign inflation, and strong demand for Treasury securities from Asia and the Middle East. Although the Fed ended its tightening campaign in June, the yield curve remains modestly inverted because the factors pressuring long-term yields remain largely in place.

Given this indicator's past accuracy in predicting economic contractions, many investors believe a recession is near and corporate profits will deteriorate. And in light of Europe, Asia, and Latin America's dependence on U.S. consumer and business spending, investor confidence in international growth has also weakened. Many market watchers, assuming global profits have peaked for the current cycle, advocate significantly reducing, or hedging, equity allocations, both domestic and foreign.

S&P Equity Strategy believes that while modest portfolio rebalancing is certainly appropriate after recent gains, a major reduction in equity exposure might prove premature and costly.

In these times, capital flows around the world more freely than ever - meaning the global yield curve is far more relevant in assessing U.S. economic and profit trends than its domestic counterpart. Growing S&P 500 international revenue exposure (41% in 2005 vs. 32% in 2000), record cross-border M&A activity, and unprecedented outsourcing are but three examples of increasing global interdependence. Investors should therefore take the broadest possible view of the investment landscape. The sensitivity of U.S. multinationals to domestic interest rates has receded, thanks to their round-the-clock access to deep pools of global liquidity.

Unlike the U.S. yield curve, the GDP-weighted global yield curve is positive, with nine of the world's 11 largest economies boasting higher long-term than short-term interest rates. We believe this helps explain much of the recent resilience of both the U.S. economy and corporate earnings in the face of the inverted yield curve in the United States.

Recent economic data do not point to a recession. S&P Economics forecasts 2.6% real U.S. GDP growth in 2007, a far cry from a recession. Although sharply lower oil prices are helping the economic outlook, we believe the positive slope of the global yield curve is bolstering economic underpinnings, including a strong job market, robust non-residential construction, and historically healthy productivity growth, all of which depend heavily on ready access to financing. While S&P 500 profit growth is clearly slowing - to an estimated 9% in 2007 from a projected 14% in 2006 - it is still expected to be better than the long-term average of 7%.

We maintain our 60% equity allocation: 40% domestic and 20% foreign. Our U.S. allocation includes 34% in large-caps (SPY), 4% in mid-caps (MDY) and 2% in small-caps (IJR). The international allocation includes a 15% weighting in developed overseas markets like Europe, Japan, and Australia (EFA) and a 5% emerging market weighting (EEM), which includes China, India, South Korea, Taiwan, Latin America, Eastern Europe, Africa, and the Middle East.

Young is an equity strategist for Standard Poor's.

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