HBS Insider : Financial Markets and Investments

So What Does the (Financial) World Look Like in 2006 So Far? The economic data seems to point to a global slowdown. Although the effects are unevenly distributed among the majors, clearly a soft patch is upon us. Pick GDP, for example, which took a dive and fell unexpectedly to a disappointing 1.1 percent in the U.S. and 1.75 percent in the U.K. in December. Continental Europe witnessed sluggish growth amidst the ECB’s misplaced worry about M-3 growth (which led to a surprising – if not counterproductive – rate hike to 2.25 percent late last year).

In addition, housing markets across the board showed signs of softness, from flat prices in the U.S. to falling prices in Shanghai. To that point, there was no growth in FDI in 2005 in China for the first time since 1999 (although China remains the largest recipient of FDI flows among developing countries).

What about Japan? It seemed to be the lone shining star in the economic cycle, with its inflation, industrial production and exports all on an uptrend and employment in full throttle. Unfortunately, consumer confidence in January turned out surprisingly soft.

But do not despair: equity markets do not seem to care. The S&P 500 was up +2.55 percent in January, and the Dow Jones Industrial Index +1.37 percent and the Nasdaq +4.56 percent, reflecting strength across sectors. On the currency front, the Euro finished strongly at $1.22, having started the month at $1.18. The British Pound also appreciated against the USD from $1.72 to $1.78.

However, currency players beware: central bank watchers are expecting the ECB to remain sane (at least for now) and keep rates on hold, similar to the Bank of England, which should keep short rates at 4.50 percent or possibly lower them to 4.25 percent. As a result, the USD has shown some strength due to the expected interest rate differential. Although the Bernanke-led Fed will not make a rate decision until March, expected rates are already driving currencies. The view is a bit more mixed about Japan. On one hand, the recent economic pick-up leads some market participants to expect the Bank of Japan to change its monetary policy stance. On the other, it may be too early for the BoJ to act, so many think interest rates on Japanese government securities will stay near 0 percent on the short end.
On the fixed-income front, the U.S. yield curve is flat overall and even inverted in some places (2-year vs. 10-year, for example). As stated in the previous article, a fully inverted yield curve has been a predictor of recession without fail since the 1950s.

However, there generally needs to be an inversion of 200 basis points between 3-month and 10-year rates for the prediction to hold, which has not happened yet. The next Fed action may push the curve further in that direction, unless the economic data is weak enough to convince Bernanke & Co. to keep rates on hold.
In the world of commodities, crude oil continued to be a puzzle. Geopolitical concerns kept the pricey liquid between $62.00 and $68.00 in January. But can the picture get any bleaker?

Venezuela is threatening to stop shipping oil to the U.S.; parts of pipelines between Russia and Eastern Europe were blown up; Nigeria witnessed similar actions; and the Iraqi situation is not getting any better in terms of production. With renewed unrest in the Middle East in recent days, we may truly have hit the worst geopolitical point for oil prices. If so, lower prices in 2006 may give the global economy the bit of relief it needs.

February 13, 2006
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