This week most investors will have focussed on Friday’s non-farm payroll figure as the key data point. In December the US economy added 292,000 new jobs which was well ahead of market expectations. Unfortunately employment and unemployment are lagging indicators and at Stratton Street we are more interested in what will happen in the future. We were therefore more focussed on the the weak US ISM manufacturing figure which at 48.2 was not only the weakest reading in six years, but also below the level recorded when the US last entered recession in December 2007.
We are not yet forecasting a US recession, but are concerned about the ultimate consequences of the Fed raising rates with manufacturing at already depressed levels. Never before has the Fed started a tightening cycle with the ISM below 50 (the average of the past three is 57.2) which suggests to us that rate increases will be very modest. The median estimate from the Fed is for 4 more rate hikes this year to give a target range of 1.25-1.5% by the end of 2016. We are more pessimistic on the outlook for growth and expect a Fed Funds rate of 1% at the end of the year at most.
The US ISM is one of the inputs into our global growth model and this too is showing worrying signs for global growth. In addition to the US ISM, the model uses Japanese inventories / shipments ratio and the German IFO to predict OECD industrial production. The advantage of a such a model is the leading nature of the forecasts. Unlike the backward looking payroll data which suggest a strong US economy, both the ISM data and the global growth model suggest a more difficult time ahead. With that in mind, it’s worth noting that the both the S&P and the Dow had their worst ever start to the year in a month; that usually witnesses strong gains.
In this environment investors should be very wary of sub-investment grade bonds which have tended to perform badly in weak growth environments. In contrast high grade bonds, particularly at the long end, tend to perform much better. From discussions with clients it seems that most investors have too little in high grade bonds given the stage of the economic cycle so a continuation of heightened volatility in equity market could see a stronger flight to quality than might otherwise have been the case. We will be keeping an eye on both the Japanese yen and the US 10 and 30 year Treasuries for confirmation.