Outlook for stocks and bonds may depend on PMI
For all the fears about a slowdown in the global economy, stock markets around the world did not fare too badly in the first half of 2005. And against the expectations of many, neither did bond markets.
It turned out that among the major stock markets, the one in the strongest developed economy -- the United States -- performed the most poorly. Markets in the moribund and much-maligned European economies, on the other hand, performed very well.
Then again, divergence between the performance of an economy and its stock market is hardly uncommon. In fact, many fund managers had been expecting European equities to do well -- or at least better than those in the US. That they proved right shows that going contrarian is not always a good idea.
One asset class where the consensus have not been so fortunate is bonds. Fears of accelerating inflation at the beginning of the year had many investors shunning them. Those fears have turned out to be somewhat misplaced. Inflation globally remains relatively muted.
As a result, long-term bond prices have risen as yields have fallen. US 10-year Treasury yields have fallen from over 4.2 percent at the beginning of the year to just over 4 percent on 1 July, while over the same period, German 10-year bund yields have fallen from about 3.7 percent to below 3.2 percent.
The fall in yields have been all the more remarkable when seen in the light of the Federal Reserve raising its target federal funds rate since the middle of last year. Federal Reserve Alan Greenspan calls the declining yields in the face of his rate hikes a "conundrum", especially when, in his view, the US economy remains robust.
Well, maybe the US economy is not as robust as he thinks. While the US economy has been growing at close to a 4 percent rate over the past few quarters, the Conference Board's index of leading economic indicators for the US has been declining over the past year or so, as has the purchasing managers' index (PMI) monitored by the Institute for Supply Management.
Historically, the 10-year Treasury yield does tend to track the PMI. In fact, so does the spread between the 10-year yield and the federal funds rate. What the latter implies is that the 10-year yield can fall in the face of a rising federal funds rate if the PMI falls fast enough.
The chart below shows the 12-month changes in the PMI, the 10-year Treasury yield and the spread between the 10-year Treasury yield and the federal funds rate over the past two decades.
Having said that, the latest PMI number shows a rise in June to 53.8 from 51.4 in May. The improvement was quite comprehensive. Most of the sub-indices showed increases, with the new orders index in particular surging to 57.2 in June from 51.7 in May.
And the improvement is not just confined to the US. The global PMI rose too -- to 52.4 in June from 51.1 in May. And like for the US, the new orders index rose strongly -- to 54.4 in June from 51.6 in May, its highest level so far in 2005. The rise in the global PMI was supported by improvements in the PMIs for Japan (from 53.5 in May to 54.0 in June), the euro zone (from 48.7 to 49.9), the United Kingdom (from 47.0 to 49.6) and Australia (from 50.5 to 55.2).
Other recent indications of an improvement in the global economy include the findings from the Tankan survey in Japan and the Ifo survey in Germany.
If the economic outlook continues to improve and the PMI continues to rise, we may get the rise in long-term yields that many had expected at the beginning of the year. So it may be good for equities but not for bonds.
Of course, it is a big "if" anyway. Especially with NYMEX light sweet crude oil prices hovering around US$60 a barrel and a Federal Reserve seemingly determined to keep raising interest rates, a continued rebound in the PMI cannot be taken for granted.
Investors should probably keep a close watch on it.
(Update on 7 October 2005: Chart revised to correct error in spread data.)
It turned out that among the major stock markets, the one in the strongest developed economy -- the United States -- performed the most poorly. Markets in the moribund and much-maligned European economies, on the other hand, performed very well.
| Close at end 2004 | Close on 1 July | Percent change | |
| S&P 500 | 1,211.92 | 1,194.44 | -1.4 |
| Nikkei 225 | 11,488.76 | 11,630.13 | 1.2 |
| FTSE 100 | 4,814.3 | 5,161.0 | 7.2 |
| DAX | 4,256.08 | 4,617.07 | 8.5 |
| CAC 40 | 3,821.16 | 4,269.62 | 11.7 |
| Hang Seng | 14,230.14 | 14,201.06 | -0.2 |
| Straits Times | 2,066.14 | 2,209.95 | 7.0 |
Then again, divergence between the performance of an economy and its stock market is hardly uncommon. In fact, many fund managers had been expecting European equities to do well -- or at least better than those in the US. That they proved right shows that going contrarian is not always a good idea.
One asset class where the consensus have not been so fortunate is bonds. Fears of accelerating inflation at the beginning of the year had many investors shunning them. Those fears have turned out to be somewhat misplaced. Inflation globally remains relatively muted.
As a result, long-term bond prices have risen as yields have fallen. US 10-year Treasury yields have fallen from over 4.2 percent at the beginning of the year to just over 4 percent on 1 July, while over the same period, German 10-year bund yields have fallen from about 3.7 percent to below 3.2 percent.
The fall in yields have been all the more remarkable when seen in the light of the Federal Reserve raising its target federal funds rate since the middle of last year. Federal Reserve Alan Greenspan calls the declining yields in the face of his rate hikes a "conundrum", especially when, in his view, the US economy remains robust.
Well, maybe the US economy is not as robust as he thinks. While the US economy has been growing at close to a 4 percent rate over the past few quarters, the Conference Board's index of leading economic indicators for the US has been declining over the past year or so, as has the purchasing managers' index (PMI) monitored by the Institute for Supply Management.
Historically, the 10-year Treasury yield does tend to track the PMI. In fact, so does the spread between the 10-year yield and the federal funds rate. What the latter implies is that the 10-year yield can fall in the face of a rising federal funds rate if the PMI falls fast enough.
The chart below shows the 12-month changes in the PMI, the 10-year Treasury yield and the spread between the 10-year Treasury yield and the federal funds rate over the past two decades.
Having said that, the latest PMI number shows a rise in June to 53.8 from 51.4 in May. The improvement was quite comprehensive. Most of the sub-indices showed increases, with the new orders index in particular surging to 57.2 in June from 51.7 in May.
And the improvement is not just confined to the US. The global PMI rose too -- to 52.4 in June from 51.1 in May. And like for the US, the new orders index rose strongly -- to 54.4 in June from 51.6 in May, its highest level so far in 2005. The rise in the global PMI was supported by improvements in the PMIs for Japan (from 53.5 in May to 54.0 in June), the euro zone (from 48.7 to 49.9), the United Kingdom (from 47.0 to 49.6) and Australia (from 50.5 to 55.2).
Other recent indications of an improvement in the global economy include the findings from the Tankan survey in Japan and the Ifo survey in Germany.
If the economic outlook continues to improve and the PMI continues to rise, we may get the rise in long-term yields that many had expected at the beginning of the year. So it may be good for equities but not for bonds.
Of course, it is a big "if" anyway. Especially with NYMEX light sweet crude oil prices hovering around US$60 a barrel and a Federal Reserve seemingly determined to keep raising interest rates, a continued rebound in the PMI cannot be taken for granted.
Investors should probably keep a close watch on it.
(Update on 7 October 2005: Chart revised to correct error in spread data.)
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