More on the Economy

08/11/2006 12:00 am EST

Focus:

Joe Battipaglia

Market Strategist-Private Client Group, Stifel Nicolaus

Joe Battipaglia, chief investment officer at Ryan Beck, further expands the economic and market consequences of the current inverted yield curve and updates us with his recommended changes to investments in defensive and cyclical sectors…

 

The weaker than expected data on second quarter GDP growth and last Friday’s employment report contributed to a further drop in the term spread, or difference between the yield on the ten-year Treasury bond and the three-month Treasury note, putting it deeper into negative territory. This phenomenon suggests excessive tightening by the Federal Reserve and raises the odds of a recession within our forecast horizon of 12-18 months. A recession or significant slowdown in economic activity has followed every sustained inversion of the term spread.

 

Here in the United States, for example, residential investment has risen to 6.3% of gross domestic product from 3.3% in 1991 and an average level of 4.57% over the 1991-2006 period. This expansion contributes to a multiplier effect in the economy by creating employment in a wide number of areas, further fueling income and consumption.

 

As a percent of total household net worth, real estate now represents a record 38%, after falling to near record low levels by the late 1990s when equity markets captured a larger share of wealth. The resource-intensive nature of a synchronized global construction boom has put great pressure on resource utilization evidenced in the CRB commodity price index. Led by energy prices, rising commodity prices, coupled with rising cost of capital, are expected to cool demand for raw materials at the same time producers are seeking to ramp up global capacity for materials to correct the supply / demand imbalance.

 

With rate increases in place and the ultimate effects of which still in the offing, and with residential real-estate prices cooling rapidly, we expect the cyclically-tied sectors of the economy will experience a more challenging environment compared to less economically sensitive defensive sectors going forward over the next few quarters.

 

We are increasing our recommended sector weights among defensive sectors (financials, telecom services, consumer staples, utilities, and healthcare) to 2/3rds of recommended sector portfolio weightings from roughly 50% and cyclically tied sectors (energy, information technology, materials, industrials, and consumer discretionary) are being reduced.”

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