I'm guessing it would be 100% legal for the neighbors to fence their yard as long as it's along the property line. if your property is small, it's not the fault of the neighbors, besides what if they want a pet, then they would certainly need a fence for that.
...personally, i like fences because i like my own privacy. if you have a small yard, don't go against it, instead embrace it.. grow a beautiful vine up your neighbor's new fence (you have every right to do so as long as it's on your side), pot some beautiful flowers and herbs of different sizes and colors, get a little fire pit and place a couple of nice comfy chairs around it. you'll have your own little backyard retreat. here's a photo of one idea http://homeemoney.com/backyard-retreat-ideas/backyard-retreat-ideas-photo-3/