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Investor Alert — Beware of Ris­ing Confidence!

For the first time in this recov­ery, gen­eral eco­nomic con­fi­dence seems poised to improve sig­nif­i­cantly— a trend which will likely dom­i­nate major invest­ment themes through­out 2012. Investors should there­fore con­sider the poten­tial rewards and risks asso­ci­ated with a mean­ing­ful improve­ment in confidence.

Ris­ing Con­fi­dence… Why Now?

While not a per­fect rela­tion­ship, Exhibit 1 shows change in the unem­ploy­ment rate is a very impor­tant deter­mi­nant of con­fi­dence. It over­lays the Con­sumer Con­fi­dence Index (solid line) with the U.S. unem­ploy­ment rate (dot­ted line, shown on an inverted scale). Con­fi­dence has not yet improved much in this recov­ery mostly because the unem­ploy­ment rate remains stub­bornly high.

This may finally be chang­ing. Although still dis­ap­point­ingly slow, the pace of job cre­ation is now suf­fi­cient to slowly but steadily lessen the unem­ploy­ment rate. In 2010, pri­vate monthly job gains aver­aged slightly less than 100 thou­sand whereas in 2011 (through Novem­ber) monthly job gains improved to 155 thou­sand. Fol­low­ing this slow pro­gres­sion, pri­vate monthly job gains dur­ing 2012 seem poised to aver­age more than 200 thousand.

For the unem­ploy­ment rate, some­thing mag­i­cal hap­pens once job gains per­sist in the 150 to 200 thou­sand range—labor demand exceeds labor force growth pro­duc­ing a slow but steady fall in the unem­ploy­ment rate. This may already be under­way. In recent months, the unem­ploy­ment rate has declined to its low­est level of the recov­ery at 8.6 per­cent. We expect the unem­ploy­ment rate to decline fur­ther to between 7.5 and 8.0 per­cent by the end of this year. Using Exhibit 1 as a ref­er­ence, such improve­ment in the labor mar­ket would be con­sis­tent with a Con­sumer Con­fi­dence Index (cur­rently at about 65) of about 85!

If eco­nomic con­fi­dence in the U.S. recov­ery does finally embark on a slow but steady rise, what are the impli­ca­tions for investors in 2012? Specif­i­cally, what would a revival in con­fi­dence imply for bond, com­mod­ity, and equity investors?

Con­fi­dence and Trea­sury Yields?

Exhibit 2 over­lays the Con­sumer Con­fi­dence Index with the “real” 10-year Trea­sury bond yield (10-year yield less the annual core con­sumer price infla­tion rate). Sim­i­lar to the after­math of the dot-com cri­sis, “fear” has proved the bond market’s best friend since 2007. In the last recov­ery between 2003 and 2007, the real Trea­sury bond yield oscil­lated between 2 and 3 per­cent. How­ever, as con­fi­dence col­lapsed to record lows in early 2009, the real bond yield declined briefly below 0.5 per­cent. Real bond yields were quick to recover, how­ever, once con­fi­dence bounced from its record low reached dur­ing the dark­est days of the cri­sis in March 2009. Indeed, even though con­fi­dence improved only mar­gin­ally, by early 2010, the 10-year real bond yield surged higher by almost 2.5 per­cent! In 2011, the U.S. eco­nomic slow­down and esca­lat­ing Euro­pean con­ta­gion con­cerns pro­duced another “fear-based” col­lapse in the real 10– year Trea­sury bond yield. As we begin 2012, the dom­i­nance of fear is cur­rently illus­trated by Trea­sury investors will­ingly accept­ing a “neg­a­tive” real 10-year Trea­sury yield.

Exhibit 2 high­lights a grow­ing poten­tial risk for Trea­sury investors. Even though the real bond yield remains at its low­est level since the cri­sis began, con­fi­dence has bounced again in recent months. Some­thing seems likely to give in the next few months. Either renewed con­fi­dence in the eco­nomic recov­ery is about to fade or Trea­sury yields are likely to suf­fer a sig­nif­i­cant rise.

Should eco­nomic con­fi­dence improve this year, the bond mar­ket is at risk for two reasons—decaying calamity fears and ris­ing infla­tion fears. If a con­sen­sus agrees the U.S. eco­nomic recov­ery is sus­tain­able and risk of an immi­nent calamity has dimin­ished, Trea­sury investors would likely reestab­lish a nor­mal 2 per­cent real bond yield (and with a cur­rent core infla­tion rate of about 2 per­cent, a 2 per­cent real bond yield implies a 4 per­cent 10-year Trea­sury yield—ouch!). How­ever, if the eco­nomic recov­ery is per­ceived as sus­tain­able, because both mon­e­tary and fis­cal poli­cies have been too accom­moda­tive in recent years, calamity fears would likely be quickly replaced by inten­si­fy­ing “infla­tion fears.” For these rea­sons, high-quality bond investors should be par­tic­u­larly con­cerned with the like­li­hood of a steady rise in eco­nomic con­fi­dence this year.

Con­fi­dence and Gold Investors?

Ris­ing eco­nomic con­fi­dence would cer­tainly be good for com­mod­ity investors. A sus­tain­able eco­nomic recov­ery would raise com­mod­ity price prospects and also heighten infla­tion expec­ta­tions. How­ever, as sug­gested by Exhibit 3, gold may lag other com­mod­ity invest­ments (note, the rel­a­tive price of gold is shown on an inverted scale).

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