Charles Ross, Contributor
THE UNITED STATES economy went into recession in the latter half of 2001 and, since the beginning of 2002, it has been sending out mixed signals as to how the recovery from that recession has been coming along.
In fact, there was some debate initially about whether the U.S. economy had in fact gone into recession - defined as two consecutive quarters of negative growth - or whether it had just slowed down considerably. After various revisions of earlier economic data, the consensus has emerged that there was indeed a recession, albeit a mild one, and attention has now shifted to the recovery and what form that will take.
Double-dip recession and the equity market
Early in 2002, after comparing the 2001 recession with historical data, some economists suggested that there might be a double dip recession - that is, the U.S. economy might slip back into recession before entering a period of sustained recovery. The jury is still out on this proposition and the Federal Reserve is trying desperately to avoid it. However, the latest data does point in that direction. The contending theory is that the U.S. is undergoing a U-shaped recovery and the economy will pull slowly but steadily out of recession.
These issues might seem arcane and academic but in a developed market like the U.S., they have a direct impact on the financial markets and the performance of investments in both the stock and bond markets. The bottom line is that the U.S. economy has been oscillating between good and bad news for much of 2002 and this has been causing a great deal of volatility in the stock market. The major U.S. stock indices like the Dow Jones and NASDAQ, have trended down for most of the year but have been doing so with sharp upswings, followed by even greater falls in value, as investors respond to the rapidly changing news on the economy.
Bond market a beneficiary of market volatility
Until mid-October, the bond market had been a major beneficiary of the problems in the equity markets, as the Federal Reserve has reduced its benchmark interest rates to levels not seen for 40 years in its efforts to revive the economy.
In fact, despite the very low coupons offered, investors in U.S. Government bonds have enjoyed very attractive returns in the first three quarters of 2002. An investor who bought some medium term U.S. bonds in March and sold them in September could have made an annualised return of just under 13 per cent on his investment, even though the coupon on those bonds could have been as low as 3.5 per cent.
As bond yields fell to historic lows, bond prices rose and the holders of U.S. Government bonds enjoyed considerable capital gains on their investments.
However, this happy state of affairs could not last forever and, in early October, the U.S. bond market experienced a sell-off which resulted in prices falling significantly and yields rising.
The profit-taking occurred in response to signals from the economy which suggested that the recovery was strengthening, that interest rates were at their low point and that the next move by the Fed would be an upward nudge in rates.
Within two weeks, that sentiment had made an about turn as new data showed that consumer confidence had hit a seven-year low and turned out to be substantially below the analysts' expectations.
Consumer spending has been the main motor of the U.S. economy for some time now and its role has increased in importance in the wake of the recent recession, which was primarily due to a fall off in corporate investment.
A reduction in consumer spending could send the economy into another recession, giving rise to the dreaded double dip recession that some analysts had predicted earlier in the year.
This new, more pessimistic assessment of how the U.S. economy is performing has shifted expectations towards the possibility of a further reduction in interest rates by the Federal Reserve as it struggles to get the economy onto a path of sustained growth.
The expectation of a more sluggish economy has sent stock prices into retreat again and the prospect of lower interest rates has sent bond prices up again.
Recovery uncertainties impacting bonds
The uncertainty regarding the recovery of the economy, which has caused a great deal of volatility in the stock market, seems to now be having a similar effect on the bond market.
This will increase the risks associated with investing in the U.S. bond market, although it will also increase the opportunity to make trading profits on your investments in that market.
Fortunately, many of the non-investment grade emerging market bonds are not very closely correlated with the yields on U.S. Treasuries, so investors in these securities are not likely to be significantly affected by the volatility in that country's bond market.
Charles Ross is Managing Director of Sterling Asset Management Ltd.
