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Markets look to US recovery

Created:
18 June 2008
Written by:
Chris Dillow

Financial markets are beginning to price in a recovery in the US economy. Since the end of February, the Dow Jones transportation index has risen 12.2 per cent, even though the industrial average has fallen a little. Such out-performance has been a portent of economic upswings; rises in the transportation index relative to industrials in 1991-92, 1997 and 2003-04 all led to good economic growth.

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This isn't the only indicator of an upturn. Since mid-March, credit spreads on risky corporate bonds have narrowed; the gap between the yield on Lehman's high-yield corporate bond index and on 10-year Treasury bonds has fallen from 7.7 to 5.9 percentage points. This suggests that investors are less troubled by the risk of companies defaulting.

And the yield curve is now upward sloping - which has traditionally been the best economic forecaster of all. Ten-year Treasuries now yield 1.2 percentage points more than their two-year counterparts.

Granted, this curve has flattened recently. But this is because short-dated yields have soared as investors have priced in big rises in official interest rates - something they wouldn't be doing if they expected the economy to remain weak. Fed funds futures contracts are now pricing in three quarter-point rises in the funds rate by December.

Such expectations have been bolstered by last week's figures showing that retail sales rose 1 per cent in May - even faster than prices - and by a report from Morgan Stanley saying that their index of business conditions has risen to an eight-month high.

Most data, however, suggest that the upswing hasn't begun yet. This week's figures showed unexpected falls in both industrial production and in the New York Federal Reserve's index of manufacturing activity. And next week is expected to bring news of more big falls in the S&P/Case-Shiller index of house prices and in sales of new homes.

This has led to Richard Berner, of investment bank Morgan Stanley, to describe signs of an upturn as "a false dawn". One important group of equity investors seem to share his caution. Official figures this week showed that non-US investors sold a net $15.9bn (£8.2bn) of US shares in April.

That's good news, because in recent years, such selling has often led to shares rising in the following 12 months.

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