Which way blows the economic wind?

Anyone with substantial (and no-brainer) energy holdings likely enjoyed an outperforming half-year and Q2 compared with any main index. The scribe is sort of content to report that the holdings he manages are up 7% year to date and over 4% in the quarter (the S&P500 is down (1.4)% and up 1.2% over the same periods). "Sort of content" because: this result was less skill than, well, going with the obvious; and measuring performance over 6 months is arbitrary and hardly informative.

Nonetheless, next quarter and the full year may prove more awkward terrain: the macro-economic outlook is slowly but surely deteriorating (see the 5 point matrix below). Even energy prices cannot remain robust indefinitely within a weakening economy (unless the demand curve really has shifted outwards, and the jury will be out on that for awhile yet):

Possibly the most significant message of this matrix is that the flattening US yield curve (the June 10 year note minus 3 month Treasury bill yield is now down to 0.9 points) has begun to signal a small chance - around 8% - of a recession one year out. This is derived below from the reliable Estrella-Mishkin recession probability model.

Additionally, equities are modestly but bearishly weaker versus 6 months ago; and the ISM Purchasing Managers Index continues its decline towards the key "50" mark. A surprise drop to less than that with July 1's release (08h30 EST) would be a huge red flag (consensus is 51.5).

On the other hand, risk aversion - as measured by a widening spread between AAA rated bonds and the 10 year Treasury note - has not increased: the spread narrowed over the last 6 months and, it seems, indicates continuing risk appetite for non-sovereign paper.

Another positive is the last reading of the excellent Philadelphia Fed "Anxious Index". This shows professional economists confident of decent GDP growth 2 quarters forward. The intuitive reaction of anti-economists that this ought to be a contra-indicator does not, on the index's historical record, yet bear scrutiny.

So, bar a shock, no tipping point looks probable in the second half of 2005 although, clearly, the possibility should be kept in mind. But the US economy does have vulnerabilities: employment, sales, inventories and order data were all weaker in May (see the Chicago Fed National Activity Index for detail) and may be harbingers of the slippery slope. An unexpected piece/trend of bad data - a personal favourite being rising inflation, the chance of which is being almost entirely ignored by financial markets - could hasten any descent.

NB: The triggers shown in the matrix are consistent with calibrations that have marked the conditions for every US recession since 1962.

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