US financial markets have a well founded fear of inverse yield curves.  They usually do presage economic weakness but this time could be different. 

Longer term interest rates normally incorporate a risk premium over cash rates so that, as the latter rise, the former also move higher.  Generally, both would also respond to changing views about inflation.  As inflation moves higher, both long term and short term rates should go higher. 

If policy makers are seeking to curtail inflation pressures, they might aggressively raise short term rates.  However, the more market driven longer term yields might not move up by as much.  Investors would generally assume policy will work and that longer term inflation rates will be lower than the short term expectation policy makers are trying to counter. 

In this case, the yield curve will flatten and it might go as far as to become inverted (i.e. where short term rates are pushed higher than long term rates).  Depending on how aggressively this policy is pursued, cash rates may be pushed up sufficiently high that they have an adverse effect on economic activity. 

The chart has been adjusted to emphasize the connection between the two series.  The yield curve today is deemed to have an effect on growth rates four quarters later and the lines have been moved accordingly by four quarters to highlight the fit. 

In the past, a sharply positive yield curve has been associated with relatively strong rates of economic activity.  When the yield curve has been unusually flat (or inverted), weak growth or even recession has ensued. 

Based on this history, the position of the yield curve now implies an imminent deceleration of activity.   

Meanwhile, there is some evidence of the US bond market being supported by Asian savings.  With the US economy as the linchpin of the global economy, its highly liquid capital markets have been a magnet for Asian savings. The flow of funds from Asia has supported the bond market and yields have been lower than they otherwise might have been. 

Consequently, the flattening of the curve in this cycle has not been associated with generally rising rates.  Moreover, the Fed has shown that it is conscious of the impact of its decisions on growth.  It seems unlikely to become more aggressive in its pre-emptive action against inflation. 

That said, there is always some risk in ignoring history and suggesting that this cycle will be different when they have rarely been different in the past. 

However, the Australian data suggest more clearly that the speed of a yield curve change might have more to do with the resultant activity outcome.  Over the past few years, the Australian curve has been flattening gradually without a marked effect on activity rates. 

Large US current account deficits potentially threatened the US dollar and national economic stability.  However, compensating capital inflows have been strong and US investment income has been unexpectedly resilient. 

Over the past six years, the US has experienced a dramatic change in its international capital position.  Based on data for the middle of 2005 from the latest official statistics which are available, the USA has been sucking in capital from the rest of the world at an annual rate of $750 billion to cover its current account deficit.   

And, yet, contrary to the conventional wisdom, the dollar has remained remarkably resilient and US government bond yields have been edging lower. 

Partly, the US has benefited from the flip side of its trade deficit, namely, a build up of savings outside the US with nowhere to go except back to the largest economy in the world and the possessor of the most liquid capital markets. 

Another perspective on the failure of the more pessimistic warnings to be realised has been the surprising strength of US foreign income.  The second chart shows net foreign income flows to the USA (i.e. the difference between income receipts on US assets held abroad and income payments on assets held in the USA by foreigners).   

This has been verified recently by research conducted by economists at the Federal Reserve Bank of New York.  In a paper entitled “The Income Implications of Rising U.S. International Liabilities” Matthew Higgins, Thomas Klitgaard, and Cédric Tille have concluded that although the United States has seen its net liabilities surge in recent years, its investment income balance has remained positive largely because U.S. firms operating abroad earn a higher rate of return than do foreign firms operating in the USA. 

This throws some doubt on the more pessimistic views about the US dollar and the direction of US interest rates.  However, the authors of the research also conclude, more ominously, that “only a series of fortunate – and possibly temporary – events prevented a substantial deterioration in U.S. net income receipts.”  They cited three. 

• Lower interest rates over the past four years meant lower net payments to foreigners than would have been the case otherwise.

• Since 2000, the U.S. rate of return on foreign direct investment has risen from 5.4% to 8.6%, an increase of 3.2 percentage points, according to the authors.  The rate of return on foreign direct investment in the United States has risen from a low 2.0% to 4.3%, an increase of 2.3 percentage points but still leaving it at half the return US companies are getting on their investments.

• On a trade-weighted basis, the dollar declined 20 percent from the end of 2000 to the end of 2004.  A weaker dollar automatically increases the value of income receipts denominated in foreign currencies.

Moreover, the authors conclude that, in any event, the net income balance will likely soon turn to deficit.  Even if the U.S. current account deficit narrows substantially in the years ahead, income payments to foreign investors are likely to take up a growing fraction of U.S. income.  Preliminary data for the first three quarters of 2005 were already showing a surplus of only $4 billion, with higher interest rates likely to increase payments substantially on the large stock of interest-sensitive U.S. liabilities. 

AGL has become the latest in a long line of Australian companies to adopt the motto of “when in doubt, reorganize”.   

AGL directors announced at the end of October 2005 that they would seek to split the company into two parts: an energy business and an infrastructure developer. 

According to the chairman, investors were increasingly seeking to price the two types of businesses differently and that splitting the company up would facilitate this outcome.  The strength and diversification which came from the spread of business interests did not satisfy investors, in his view.  Hence the Board had decided to split the company in a continuation of the trend among companies to become more focused on single lines of business and eschew tendencies to being a conglomerate. 

Arguably, if managers are generating exemplary returns, investors would have little reason to be ungrateful and they would be content with the continuing advantage of strength, diversification and good investment returns. 

A comparison with Wesfarmers, the archetypical conglomerate in the Australian market, is hard to resist.  Wesfarmers has been hailed widely as offering investors a highly successful business model.  There have been few complaints that coal and retail are too different to be housed under the one roof.  And, even if some have baulked at the combination, the Wesfarmers management has been able to deflect criticism by pointing to the superior returns from the company’s assets. 

In the year to June 2005, Wesfarmers achieved a 13.5% return on its funds employed, in line with its 13.7% average return for the past four years.  The Wesfarmers performance was significantly ahead of comparable companies.  thebigpicture Economics has calculated that the 50 largest industrial companies listed on the ASX returned 12.2% in the year ended June 2005 and had an average rate of return of 11.2% over the last four financial years. Being a conglomerate is not necessarily a path to ruin.

Meanwhile, AGL’s return, calculated on the same basis, was only 8.3% in 2005 with an average return on its funds of only 8.5% over the last four years.

Investors seem justified in asserting that AGL’s performance should have been better than it was.  However, the problem AGL had was not a lack of recognition by the market of what it could achieve.  The problem was that its achievements were falling short of what was needed to make it a competitive investment option. 

Too often there is the suspicion that blaming investors is a convenient smokescreen for otherwise unpalatable conclusions.

Meanwhile, shareholders will again be disadvantaged by the burden of large transaction costs which inevitably accompany the sort of restructuring proposal which AGL has initiated. 

Of course, the market sometimes recognizes these subterfuges and, in this case, the wake up call comes from a competing offer from Alinta whose interest seems to suggest that there is value in keeping the business together if the assets can be forced to do more than in the past. 

thebigpicture is published by thebigpicture Economics (ABN 71 040 787 936). The author, John A Robertson, while working in Australia, London and New York, has had over 25 years experience in international financial and commodity markets, corporate strategy, financial and business evaluation and government policy.

As Chief Economist and a director of a leading Australian investment bank as well as a top-rated institutional equity analyst, he has marketed investment advice in all the major international financial centres.  As a professional economist, he was also a senior member of John Howard's personal staff when the current Prime Minister was Commonwealth Treasurer.

His work as a senior corporate finance executive in several public companies in the mining, consumer goods and IT industries complements a unique perspective in analyzing Australian companies and the environment in which they operate.

John Robertson provides investment advisory services to wealth managers including advice on asset allocation methodologies, portfolio construction and client communication programmes. He also advises companies on their capital market communications and financial strategies.

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