Macro Man

The dissonance between economics and markets was amply demonstrated yesterday by the US bond market, which closed the day a few ticks lower despite the release of a substantially lower than expected (and as importantly, sub 50) ISM survey.

In fairness, the market rection was not as perverse as first appeared. Virtually the entire decline in the ISM was prompted by the inventory component, which collapsed from 48.5 to 39.9, its lowest level since tech bust. This, it is thought, will ultimately prove bullish for US growth as production eventually recovers. Indeed, the ISM chief economist was quoted as saying that the US economy is "holding up quite well."

OK, that's fine. But Macro Man is still slightly troubled. If the manufacturing sector were really robust, an inventory unwind would not have been sufficient to drag the ISM below 50. Moreover, while the inventory build (relative to sales) has been concentrated in the manufacturing sector, it nevertheless represents the largest rise in the manufacturing inventory/sales ratio since 2000-2001. And we know how that ended.

Thus, while Macro Man remains comfortable with the resilience of the US economy and expects solid growth for 2007 as a whole, he wonders if Q1 won't relapse into weakness. In addition to the inventory drawdown in manufacturing, rising commodity prices (and the concomitant terms of trade shock) should put upward pressure on imports. As a result, the impact from net exports should be less positive in Q1 than it was last quarter.

Of course, Macro Man needs to be careful and not make the same mistake that the housing market bears have made, i.e. to think that their issue is the ONLY or the DOMINANT issue driving economic activity. The chart below illustrates where and how the housing market doom-mongers have gone awry.

While it is the case that household equity has declined on a year-on-year basis, rising financial assets have more than made up the slack. The latest data (Q3 2006) suggests that household net worth rose 7.7% y/y, despite a 2% decline in household equity.

Of course, this can cut both ways; one could argue that the recent deceleration of the equity rally will take the wind out of financial assets' sails. More perniciously, an outright decline in equity prices would exert a 'double whammy' impact on household balance sheets. Perhaps, but the threat won't keep Macro Man awake at night. After all, income growth on an aggreagte level remains very strong- up 5.9% y/y according to yesterday's data.

The obvious rejoinder to this argument is that the distributions of household and financial assets are radically different. Housing equity (the thing that is going down) is widespread, whereas financial assets are heavily skewed towards the top decile of investors/plutocrats (depending on your politics.)

Macro Man does have some sympathy for this view, and it remains a threat to the soft landing thesis. Nevertheless, the consumer confidence surveys should capture Joe Sixpack's mentality better than any aggregated macro data. And the message there is comforting: both the Conference Board and Michigan numbers are at or near their highs of the past several years.

Therefore, roll on the range trade in fixed income. There perhaps may be some downside risk to USD/Europe but also for risky currencies and equities, though these dips should ultimately be bought for the real re-acceleration in the spring.

Macro Man will therefore look to buy TIPS today after the payroll figure, which is of course a crapshoot. He will bid 99 for $25 million of the on-the-run 10 year TIPS (Jan-17), with a stop entry at 99-28. Should the payroll be inconclusive, he may well go straight to market.