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The US economy is heading for recovery. I don't say this because the data are improving. They're not. Retail sales and industrial production are falling; business surveys are at best mixed; and the best we can say about the housing market is that it's deteriorating more slowly than a few months ago.
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Nor do I say it because the tax rebates reaching Americans' pockets will have a big impact. Ricardian equivalence - a fancy way of saying people can see tomorrow coming - says they won't.
Instead, there's just one reason for hope - the yield curve is now steeply upward sloping; 10-year Treasuries yield 1.4 percentage points more than two-year ones do. And the yield curve is the best economic forecaster of them all.
This recovery should, obviously, be good for profits. Margins typically expand in upswings because unit costs fall as output expands from a lower cost base. This fall should also help reduce inflation, as should the fact that upswings begin with companies having lots of spare capacity and little pricing power. Inflation typically falls most early in an upturn.
Both these effects might be weaker than usual in the coming upturn, simply because the downturn itself has been unusually mild.
No matter. The fact is that if the coming upswing is at all typical we should have a period of rising profits and still-low interest rates, as the Fed sees little urgent need to fight inflation. And this combination should be great for shares.
Common sense, of course, says the market should see this coming. You could read the S&P's rise in recent weeks as a precisely a sign that investors are looking ahead to the upswing.
But history suggests common sense is wrong. Since January 1995, there's been a close correlation between annual changes in industrial production and in the S&P 500. Which suggests investors are often surprised by upswings and downturns. I suspect this is because people are bad at predicting their future tastes, and so fail to see that a stronger economy will raise their appetite for risk.
None of this means the economic recovery will begin soon - there's a long and variable lag between the yield curve and activity - or that the market is out of trouble yet. It's just that there is a good reason for optimism.
Read more of Chris's columns on his IC home page...
...or read his blog at http://stumblingandmumbling.typepad.com
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-IC-1.5.4a-prod - 31/10/2008 13:11:34 - carlos.princz
