Inversion and reversion

Sep 5th 2006 | LONDON
From Economist.com
Some things are too good to last

THE outlook for financial markets over the next 12 months depends on the answers to two questions. First, what does it mean for the American economy that short rates are above long bond yields—that, in the jargon, the yield curve is inverted? Second, can companies continue to earn today’s high level of profits as a share of GDP?

Take the optimistic view and you can construct a bullish case for equities. The yield curve is not a signal of impending recession, simply a reflection of greater confidence in the ability of central banks to control inflation. And with the balance of power in the global economy having shifted from workers to employers, there is no need for corporate profits to come under pressure.

The pessimistic view is that the yield curve does indeed signal economic troubles as it has in the past—and at a time when profits are already cyclically high. If so, profits and share prices could be in for a double blow as the economy slows and margins come under pressure.

Buttonwood is a great believer in reversion to the mean. Because the optimistic school implicitly argues that “things are different this time”, it is tempting to side automatically with the pessimists.

But the facts are a little more complex. The standard assumption in finance textbooks has been that long-term rates should be above short rates because borrowers must pay a premium for illiquidity, just as UK building societies pay higher rates to savers willing to lock away their money for 90 days.

An upward-sloping yield curve has come to be perceived as “normal”. Hence the use of the term “inverted” to describe the situation today.

But as Andrew Smithers, of the economic consultancy Smithers & Co, points out, in the 19th century an inverted yield curve was the norm. It was only in the 20th century, when inflation unexpectedly surged, that the curve became upward-sloping. Bond investors demanded a premium for the risk that inflation would erode the real value of their holdings. Now that inflation has receded, perhaps this premium can disappear.

Another way to think about this is to remember that volatile assets should carry a risk premium. Over the short term (less than 12 months), bonds are usually more volatile than cash. But over a period of several years, this may not be so, since short rates are adjusted frequently by central banks in an attempt to damp the economic cycle and keep long-run inflation stable. Investors, such as pension funds, with a long-term horizon, have no need for bonds to offer a risk premium. Indeed, in Britain, because of actuarial theory and accounting regulations, the very longest-dated government bonds are much sought after and offer lower yields than cash or short-term bonds.

A flat, or inverted, yield curve could well become much more common than in the past 50 years. Even the recent direction of bond yields does not necessarily provide support for the pessimists. Ten-year Treasury bond yields have dropped from 5.24% in June to 4.74% this week. But if that is because investors are nervous about global growth, then it is hard to explain why emerging markets have rebounded so strongly from their June lows or why commodity prices are just 6% below the year’s high.

The case for profits to revert to the mean looks rather more clear cut. After all, in both the United States and Britain, profits are at a 40-year high as a share of GDP. Figures from UBS show that corporate profits are taking their biggest bite of GDP in the G7 countries in the past quarter of a century.

Optimists say that globalisation has changed the rules. The entry of China, India and the ex-Soviet block into the global economy has, in effect, doubled the labour force. That has enabled companies to expand without meeting one of the normal constraints of the economic cycle: rising wages. In the early part of this decade, lower interest rates also slashed debt costs.

Neither the increases in commodity prices nor the recent tightening of monetary policy seems to have made much of a dent in this: profits in America and Europe are still rising at double-digit percentage rates.

But how long can this trend continue? Theory would suggest that, even if the odds have shifted in favour of capital, balancing factors should come into play. If returns on capital are high, more companies will be created and existing companies will invest more money. The resulting competition should drive down returns. Only if new businesses face barriers to entry could high returns be sustained. That is unlikely given how competition seems even more intense in a globalised world.

However, reversion to the mean could take years and, in the interim, investors will not be too concerned if companies are returning cash by the fistful in the form of buy-backs, higher dividends and takeover deals.

People typically see corporate cashflow as a strong support for the market and James Montier of Dresdner Kleinwort says that buy-backs could add three percentage points to the American dividend yield in 2006.

However, today’s high level of buy-backs may indicate that companies are aware their earnings strength is temporary. Managers are reluctant to increase dividends in the face of a transient boost to profits, lest they have to cut their payments in later years—a signal that is taken badly by the markets.

Mr Montier finds a close correlation between net repurchases of equity in the American market and the deviation of earnings from their trend value. Both are at their highest level in the past 20 years.

So perhaps investors should not read too much into the inverted yield curve. On the other hand, they should be concerned about profits, which look unsustainably high. With the Conference Board’s measure of chief-executive confidence showing a recent decline, it looks as though companies are starting to fear that the best years of this cycle are behind them.