July 29, 2005
THE SONG REMAINS THE SAME
So, now what?
Today's 3.4% advance estimate of second-quarter gross domestic product arrived a touch short of the 3.5% forecast that the dismal-science consensus called for, and landed even further astray of the 3.8% pace registered in the first quarter. But today's GDP report wasn't weak enough for the bond market, which quickly interpreted this morning's data as being more of the same, namely, the continuation of an economic expansion that's been rolling along.
That's not what the fixed-income set wanted to hear, considering the recent sentiment in the bond-trading pits that lower yields were reasonable since many in those quarters assumed that the economy was poised to stumble. But no one was talking stumbling today amid the trading of the benchmark 10-year Treasury Note, whose yield pressed upward today, to slightly above 4.28%, the highest close since May 9.
The fact the U.S. economy has been consistently expanding at a rate north of 3% for nine consecutive quarters is now receiving more than mere yawns from bond land. The question is whether today's GDP report is the straw that finally breaks the bond bulls' collective backs?
It may very well be, suggests Tony Crescenzi, chief bond market strategist at Miller Tabak + Co., who moonlights as a columnist for TheStreet.com. Dispensing his opinion today in said digital medium, Crescenzi today lays it out straight: "Today's report on the second-quarter's gross domestic product clearly indicates that the U.S. economy is poised for additional strong growth in the quarters immediately ahead."
Meanwhile, Joseph LaVorgna, senior dismal scientist at Deutsche Bank, surveying today's economic news sums up the latest advance of GDP thus: "We would hardly categorize this as a weak quarter," noting that quarterly GDP growth has averaged 3.4% for the past 10 years.
The bond market seems inclined to agree, for the moment. Yet, one day a trend reversal does not make. Indeed, recent history proves, if nothing else, that the fixed-income market is a persistent system, particularly when it comes to thinking twice about jumping off the long-running train of bidding prices higher for debt securities, and the corresponding action of pushing their yields lower. As such, it remains to be seen if the bond-market sentiment today will carry through on to next week, next month, and next year.
For what it's worth, the stock market is taking the 3.4% GDP rise as something more than trivial in the matter of influencing the future path of interest rates. The S&P 500, closing at 1234 today, shed three-quarters of a percent in the session, a sign that some observers say isn't necessarily unrelated to renewed anxieties in the bond market. "I just don't see the [S&P 500] hitting 1300 without a clear sign that the Fed is going to stop raising rates," Brian Barish, president of Cambiar Investors, a Denver money manager, tells Bloomberg News today.
On that note, perhaps Monday's release of the ISM Manufacturing Index will bring fresh clarity as to what the Fed has in mind when it convenes next, August 9, on the matter of interest rates. As PIMCO's resident Fed strategist, Paul McCulley, advises, the ISM Index is a crystal ball of sorts in the game of predicting the future path of the Fed funds rate. By that reasoning, followers of the ISM will be all eyes when the July update for the index hits the streets on Monday. The question du jour will be whether June's ISM uptick, coming after nearly a year of mostly declines, is an orphan or the start of renewed upside momentum in manufacturing, and by extension the economy.
July 28, 2005
M IS FOR MOMENTUM
The government's first crack at second-quarter GDP hits the streets tomorrow. The crowd's looking for an inflation-adjusted annualized rise of 3.5% in the U.S. economy for April through June, according to The Street.com. If so, that would be slower than the 3.8% posted in the first quarter. What are the chances that the pace of second-quarter economic growth surprises on the upside? Something more than zero, to judge by recent measures of the economy's pulse.
Let's start with yesterday's durable goods orders, which rose 1.4% in June, the Census Bureau reports. That obliterated the consensus outlook for a one-percent decline. Also, May's initially reported 5.5% was revised higher by the Census Bureau to a 6.4% hike.
June's tally of new home sales was also released yesterday, and true to form of late the real estate market remains hot. Purchases of freshly minted houses rose to a record 1.374 million units last month, up from 1.321 million in May, according to the Census Bureau. The ascent is all the more impressive if you consider that June's total is higher by nearly one-third from the end of 2002. Real estate may be an overheated bubble, but the bull-market momentum shows no sign of slowing.
Yesterday was also the release of the Federal Reserve's so-called Beige Book, which is a summary of economic conditions in each of the 12 Federal Reserve districts. The general conclusion, the report advises, is that "economic activity continued to expand in June and early July." The Richmond and Dallas regions reported that the rate of economic growth increased in their respective districts while the Cleveland Fed said the rate of increase in economic growth was "stronger and more balanced than in the spring," quoting the Beige Book. Not all the news was bullish, although the New York district was the only region to report a slowdown.
This morning, the Labor Department reports that initial jobless claims rose a bit to 310,000 for the week through July 23, up from the previous week's 303,000. Nonetheless, jobless claims in July have been running at some of the lowest levels seen in the last five years. Indeed, the statistic of employment growth is corroborated in the unemployment rate, which has been falling for two years and at 5.0%, as of June is the lowest since late 2001.
The Fed will weigh the above-mentioned numbers, and more when it convenes again on August 9 to discuss interest rates. For the moment, it doesn't take much of an imagination to expect that another 25-basis-point hike in the Fed funds rate to 3.50% is coming. Considering the recent economic data, David Logan, an economist with Dresdner Kleinwort Wasserstein, tells the L.A. Times today:. "What it means for the Fed is that it is further evidence that the economy is on a firm footing and they can continue their steady tightening of monetary policy."
The Fed funds futures market expects no less, and is currently pricing the August Fed funds contract at around 3.46% in early trading today. The stock market too is erring on the view that economic growth will remain robust going forward. The S&P 500 at this morning's opening jumped to a new post-2002 high of 1240.
Life's more complicated in the bond market, where the yield on the 10-year Treasury Note hovers around 4.2%. That's just 30 basis points or so above the two-year Treasury's yield. Such a thin spread is within shouting distance of triggering an inversion in the yield curve, in which short rates exceed long rates. Historically, that's been an omen of an approaching economic slowdown, if not recession.
The fixed-income set remains insistent, if not defiant in its belief that trouble looms for the U.S. economy. How long can bonds hold out in the face of mounting evidence to the contrary? Tomorrow's GDP report for the second quarter may provide a fresh clue.
July 27, 2005
THE EARNINGS TRAIN CHUGS ALONG
The stock market in July has been setting new highs in the post-crash era. The S&P 500 for a time on Monday traded over 1238, the highest since mid-2001, and yesterday closed nearby that level at 1231.16. Yes, equity prices generally are still a long way from the glory days before the tech bubble burst. The close of 1527.46 set on March 24, 2000 still stands as the all-time high for the S&P 500, or roughly one-quarter higher than yesterday's close.
Since late-2002, when the final wave of selling washed over Wall Street, stocks have been rising, albeit inconsistently, but rising nonetheless. From the post-crash low of 776.76 of October 9, 2002, the S&P 500 has climbed 58%. A tidy ascent, to be sure. But with the current bull market approaching its three-year anniversary, the question is whether this upside momentum has run its course, or still has some life left in it?
To the extent recent earnings news is a factor, the bulls have reason to cheer on second-quarter reports continue rolling in. "Earnings season is proving to be ahead of the curve, certainly better than we generally expected," Stephen Pope, head of equity research at Cantor Fitzgerald in London, tells Bloomberg News.
Standard & Poor's reports that estimated second quarter earnings for the S&P 500 will rise by 8.9% over the year-earlier quarter. If that proves accurate, it will be a slowdown from the 13.4% year-over-year advance in this year's first quarter earnings from the comparable period in 2004.
But if earnings growth is slowing, perhaps as a prelude to something worse, the stock market is in no mood to worry of late. The bond market, on the other hand, still anticipates disappointment of some sort or another. Yes, yields have been on the rise in July, suggesting that the fixed-income set has been rethinking its spring rally that all but shouted out that a recession was imminent. But it's again looking like bond investors are expecting that economic growth will stumble. Notably, the spread in junk-bond yields over the 10-year Treasury Note has shrunk to around 2.8%, its lowest since early April, as tracked by the KDP High Yield Daily Index.
The bond market was able to point to some supporting data yesterday in rationalizing a lower risk premium in debt securities. The Conference Board's Consumer Confidence Index unexpectedly fell for July, thanks largely to rising energy prices. But there was nary a whiff of disappointment in the consumer outlook as measured by yesterday's existing home sales numbers for June, which reported a record turnover of 7.33 million units in the housing stock. The bond market, in a sign of the times, paid no attention to the latter.
Either the bond or the stock market is wrong. But that doesn't mean each can't be right for a while longer. The respective factors, or illusions, that have inspired bond prices higher, and now stock prices may stick around yet. For the moment, Wall Street could hardly be more comfortable with the hazards such as they are. As such, prices for both equity and fixed-income securities can climb the wall of worry together.
July 25, 2005
Government leaders so rarely speak directly that when they do embrace clarity it's a striking pose. And a sign of the times.
So it was last Thursday when U.S. Energy Secretary Samuel Bodman spoke his mind, or so it sounded when discussing the global economy's thirst for oil and the implications. To be sure, there was nothing earth shattering in his observations, at least not for any one who's been following the soap opera of the crude market. Nonetheless, when the Energy Secretary of the world's largest oil-consuming nation decides to speak without pulling punches the least we can do is sit up and take notice.
"The demand for oil in the world seems to be pressing the suppliers to the point of their having difficulty meeting the demand," Bodman declared last week, reports Dow Jones News Service via Rigzone.com. "It's hard for me to believe there will be a change in demand for oil. The demand for oil is created by economic growth, and the Chinese economy is already growing at a pretty good clip."
By "fair clip" he's referring to the 9.5% inflation-adjusted year-over-year advance in China's economy in the second quarter. That's impressive by almost any stretch of the economic imagination, considering that the Middle Kingdom's economy, at roughly one-third the size of America's, is growing three times as fast.
Ah, but won't high oil prices stimulate additional production? Yes, but don't hold your breath, Bodman advised. "The problem is, it will take a long time," he warned of what to expect in the quest to slay the dragon a low spare-production capacity in a high demand-growth world. "We're gonna be years if not decades getting out of it."
The assumption that the United States, and the global economy will in fact get out of it, to use Bodman's vernacular, is widely held. Whether it's also soundly researched is something else. On the surface, however, there's plenty of light and heat implying that a solution is coming, if not exactly tomorrow but vaguely sometime in the near future.
But even there there's a wide-ranging debate. The latest installment of skepticism that we'll be able to, once again, drill our way out of our current energy troubles by, say, Friday. was laid out by Christopher Edmonds, director of research at Pritchard Capital Partners, an energy investment firm in New Orleans. "Too few investors and pundits are mindful of the anemic supply response to the increase in drilling and exploration," Edmonds writes in TheStreet.com. "Doubling the number of rigs drilling for natural gas in North America has barely moved the needle on production. And in Saudi Arabia, Saudi Aramco has made little progress in boosting production even after nearly doubling the rigs working its major oil fields."
The solution? More of the same, namely, more drilling, more exploration, more of everything that is part and parcel of the energy business. "We just have to do what we have done for the last two decades faster and with more volume to keep up," Edmonds concludes. No wonder that the oil-service sector, which includes the likes of Baker Hughes, Schlumberger, and other firms that supply drill the wells and provide related technical support are enjoying the spoils of the current bull market in energy. The Philadelphia Oil Service Index, for example, has posted an impressive 27% annualized annual return for the two years through the end of this year's first half, or more than twice the return in the S&P 500.
But for all the drilling and exploring that's supposed to save us in the long term, there's the messy problem of keeping the SUV going through the weekend as well as ensuring that there's sufficient heat come January.
In fact, just in case there's, er, an event that temporarily derails the best-laid plans of mice, men and governments, the White House has taken the precaution of loading up the Strategic Petroleum Reserves to full capacity of 727 million barrels of oil, or about 35 days of U.S. consumption habits of late. But with the oil kitty approaching capacity for the first time, there are already calls for cashing in on the artificial crude bounty.
"American families have been pickpocketed by OPEC all year," Sen. Charles Schumer, D-NY, says, reports Detroit Free Press. "Now that the summer high travel season has started and our Strategic Petroleum Reserve is filled to the brim, President Bush should tap the reserve to lower gasoline prices."
As you might expect with oil prices near all-time highs, the Senator from New York has more than a few supporters for his recommendation. That includes several airline executives, who are trying to keep their planes in the friendly, and not-so-friendly skies amid escalating energy costs. There are some analysts who agree as well, such as John Kilduff of FIMAT USA. As he says in the article in the Free Press: release some SPR oil "would help drive down prices, at least in the short term. We're in a position right now where we need every available barrel" of oil "but the administration has been steadfastly against using the reserve to affect that. At the very least, they should at least stop filling it while at these high price levels."
Then there are those who argue the opposite, asserting that the SPR should be saved for true emergencies rather than short-term price relief. "The Bush administration promises not to succumb to the pressure to open the reserve, and that's good," writes The Birmingham News. "Using the nation's emergency oil supply for a short-term break of a few dollars per barrel in oil prices is a reckless disregard for national security concerns."
Perhaps, but whether the SPR is tapped or not, the fundamental problems that drove Washington to fill it up in the first place remain intact. And on that score, Bodman's comments aren't so easily dismissed, or even debated.
July 22, 2005
DISSECTING THE MANAGED FLOAT
The People's Bank of China announced yesterday the release of its currency from the chains of its former peg. Or, to be precise, the yuan will ebb and flow as defined by a managed float administered by its central bank master. Think of it as a cross between a peg and a true float: a little of each and something less than either.
Whatever label applies, the news was something less than, well, news other than the timing. Expectations have been widespread that China would soon allow the forces of supply and demand a greater say in valuing its currency. Indeed, Treasury Secretary John Snow has been pushing for no less for some two years, and financial journalists have been writing about it for just as long.
The fact that the news of the yuan float came yesterday as opposed to last week or next month captured the attention of the business pages around the world. And rightly so, as the ramifications for the long term are at once complex and enormous. That's to be expected, given the size of China's economy and its growing integration with the world economy. But if anyone was truly shocked, shocked to learn that the yuan had shed its peg shackles just hasn't been paying attention.
Among the markets that have arguably suffered from attention deficit disorder regarding the yuan is the bond market here in the U.S. Yesterday, the benchmark 10-year Treasury Note's yield jumped by 12 basis points to a close of 4.28%, the highest since early May in the wake of the Chinese currency news. If there's any criticism due fixed-income traders, one could argue that the market should have been elevating long yields all along in anticipation of higher prices tied to Chinese goods. "In theory, a stronger Chinese currency should raise import prices," Jay Bryson, global economist at Wachovia Corp., tells USA Today.
Another dismal scientist reminds that "over the past 10 years, Wal-Mart has been able to take prices down, putting pressure everywhere" by producing or buying 85% of its products in China, observes John Bott, chief economist of Tri-Star Financial, a Houston broker/dealer, in yesterday's Houston Chronicle. But if the yuan rises against the dollar, as it did on its first day of float, higher prices for dollar-based buyers of Chinese goods are a forgone conclusion. In that case, "we will import that inflation" born of a stronger yuan, Bott says of America's to-date rising appetite for items exported from the world's fastest-growing large economy.
There's also a fear that a strong Chinese currency will add one more reason for oil's price to rise. As Bloomberg News today reported, "Crude oil gained for the first day in three on speculation China's refiners will boost imports and increase output of fuels after the country yesterday let its currency rise against the dollar for the first time in a decade." The story also quotes analyst, Jonathan Copus of Investec Securities in London, saying that oil demand in China could increase because "in the near term, it increases the purchasing power for crude and other commodities."
To be sure, the government-approved 2% move that defined the first day of the yuan's new era of managed float isn't likely to have much impact on the TV sets and Barbies that routinely arrive on America's shore from the Middle Kingdom's factories. But almost no one thinks a 2% change is the end of the yuan's flirtation with market pricing; rather, it's only the beginning, and where it ends is anyone's guess.
The extent of higher prices depends on how much the yuan rises, and the options available for importing from less costly sources or, say a few optimists, producing more stuff on the home front. But if there's a chance that all will work out well for the U.S. economy, Euro Pacific Capital's president, Peter Schiff, doesn't see it. "China’s decision to change the nature of its currency peg means that it will no longer be in the dollar buying business, or by extension, the U.S. Treasury buying business," he writes in a commentary posted on the firm's web site. The implications, as Schiff see them, are as follows:
1. Higher consumer prices.
2. Higher interest rates.
3. Reduced profits for American companies, particularly those dependent on domestic consumption and consumer debt.
4. Lower stock prices, as earnings decline and multiples contract.
5. The busting of the housing bubble, as tighter credit standards and higher interest rates squeeze current home prices.
6. Rising unemployment, as higher interest rates and vanishing home equity slow consumer spending and reduce jobs dependant on that spending.
7. A severe recession as a result of all of the above.
8. Rising federal budget deficits, as recession reduces tax revenue, while higher interest rates and escalating outlays increase expenditures.
Schiff, a long-time pessimist on the dollar's future, finds the yuan's new status in forex as one more reason to stay bearish on the buck. But if the dollar's headed for rougher waters, it wasn't obvious today. The dollar rallied smartly today, as per the U.S. Dollar Index. Meanwhile, gold retreated a bit in sympathy. Even the 10-year Treasury reassessed its first reaction to the yuan news, with the yield on the benchmark bond pulling back in today's session.
All of which suggests that if an economic Armageddon triggered by the Chinese currency is coming, it'll have to wait till Monday. Enjoy the weekend.
July 21, 2005
DISSING THE GOLD STANDARD
In case you hadn't heard, gold's historical role as a monetary medium is no longer relevant. That's the message from Federal Reserve Chairman Alan Greenspan, who suggested as much yesterday during testimony to Congress, which is expected to be his last in an official capacity before his term as a Fed governor expires in January.
Greenspan's opining on gold came during a question-and-answer session that followed his prepared remarks before the Committee on Financial Services in the House of Representatives. (The fun continues today when he extends his official chit-chat in the Senate.) In essence, he asserted on Wednesday that central banks needn't bow to the gold standard any longer because they already act responsibly as stewards of money supplies. It was a theoretical point, to be sure, since the deployment of the gold standard in the 20th century is about as common as bartering in lower Manhattan. Nonetheless, Alan felt compelled to outline his thinking on the issue if only to dispel any notion that he still holds gold near and dear to his monetary heart.
"Since the late 70s, central bankers generally have behaved as though we were on the gold standard," the maestro explained yesterday in the House with his usual calm but assertive tone. "Central banking I believe has learned the dangers of fiat money. And I think as a consequence of that we have behaved as though there are indeed real reserves underneath the system."
As a swansong to his widely celebrated career as Fed chairman, Greenspan's snubbing of the precious metal officially brings him full circle from 1966, when he warned in an essay: "In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value." The government has an ulterior motive for keeping the gold standard suppressed, he concluded in a year when gold was artificially held to a price of $35 an ounce: "The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves." In sum, "Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard."
Three decades hence, Alan has a somewhat different perspective, and it extends in no small part from the reported decline and fall of inflation over the past generation in the government's official measures of price changes, he counseled. Speaking yesterday, he thereby advanced his view in no uncertain terms that a gold standard was unnecessary because the Fed was on the case, thank you very much, and doing a bang-up job of what would formally fall to the equivalent of adult supervision in matters of monetary management by way of a gold standard. "Would there be any advantage at this particular stage in going back to the gold standard?" he asked rhetorically before members of Congress. The answer came back without a pause: "I don't think so because we're acting as though we were there."
Gold may be irrelevant in the mind of the world's most conspicuous central banker, but traders in the metal foolishly keep trading. Perhaps they didn't hear the chairman. Or, could it be that the gold market doesn't quite accept the pearls of wisdom dispensed by the maestro in his waning days as head of the world's greatest printing press of currency?
In search of clues, we provide the following public service by noting that an ounce of gold was worth roughly $420 at the close of trading on July 20, which translates into a rise of roughly 63% from the end of 2001's first quarter. Misinformed though gold bugs may be on so-called state-of-the-art thinking in central banking, they're still clinging to their metal just the same. The fear of fiat money, in other words, springs eternal.
July 20, 2005
THE DEMAND TRAIN ROLLS ON
Oil demand will soon outpace oil supply, warned Matthew Simmons in a July 1 talk to the American Association of Professional Landmen, an oil and gas trade group. Simmons, an outspoken voice warning of looming energy challenges, is also chairman of Simmons & Co., an energy-focused investment bank in Houston. "Demand has become a runaway train," he warned, echoing a message in his recently published book Twilight in the Desert: The Coming Saudi Oil Shock and the World Economy.
It's a provocative theory, but it's unclear much influence, if any, such comments have in the wider world. But Simmons' point about demand shouldn't be dismissed too quickly, or so the latest news from China suggests, which surprised analysts with a stronger-than-expected expansion in its economy. "China's huge economy grew by a blazing 9.5 percent in the first half of 2005 from the same period a year earlier, surging ahead despite efforts to ease breakneck growth, the government said Wednesday," the Associated Press reports today via The Washington Post.
Economic growth, of course, is the engine pushing oil demand higher, as recent economic history suggests. Global demand for petroleum rose by 3.4% last year over 2003, reports the Energy Information Administration. That translated into an increase of demand amounting to an extra 2.7 million barrels a day, bringing last year's average demand to 82.8 million barrels a day worldwide.
The question is how much more oil will the global economy require? That depends on how fast the global economy expands. Taking a stab at an answer, or at least a guess, the Energy Department projects that world petroleum demand will ascend at a slower pace in 2005 vs. 2004, advancing just 0.9% this year. Then in 2006, demand growth will perk up a bit, the Energy Department predicts, rising by 1.6%. Assuming those projections prove accurate, oil suppliers will have to come up with additional seven million barrels a day to feed the global economy's habit. How much is seven million barrels? That's about one-fifth of Opec's total output last year.
If there's a respite in the demand growth it's likely to come from less-than-stellar economic growth. In fact, the high oil prices of late have slowed demand globally, advises a new report from the American Petroleum Institute via MarketWatch.com. A similar downward revision in projected global oil demand was noted last week by the International Energy Agency.
But how long will demand growth take a holiday? Not long, IEA suggests, explaining that the current slowdown in demand growth is partly due to a slightly less-thirsty China. But that won't last, the group says, predicting that Chinese demand will "rebound" in 2006. Indeed, the Middle Kingdom's strong economic growth in this year's first half suggests no less.
Assuming markets weigh the future and process that by spitting out a price, the question then becomes: when will futures traders factor in anticipated growth in the here and now, and by how much?
July 19, 2005
RESEARCH ROOM UPDATE
Is inflation targeting worth the effort? It's a topical question considering that a fan of the mechanical system for managing a nation's money supply is reportedly on the short list of potential successors to Alan Greenspan, who retires in January as chairman on the board of governors at the Fed. Meanwhile, a new piece from the St. Louis Fed weighs in on the subject of inflation targeting by way of an essay titled "The Effectiveness of Monetary Policy," which today joins the other tenants in the Research Room.
July 18, 2005
THE NEW NEW SENTIMENT SHUFFLE
The bond market today found more incentive to sell the benchmark 10-year Treasury Note. That includes fresh admonitions from Morgan Stanley's Richard Berner, the firm's chief U.S. economist, to "buy TIPS, sell bonds."
There's been a "remarkable turn in sentiment regarding the US economic outlook, one with significant consequences for fixed-income investors," Berner writes in a research note today. "Three months ago, investors were beginning to believe that soaring oil prices—unlike in the stagflationary 1970s—would both depress real growth and cap inflation."
But that's history, Berner relates. "Today, core inflation has slowed significantly but the economy appears poised to accelerate from a slightly-below trend pace in the spring quarter to one potentially above trend in the second half of 2005." That's at least half a buy signal, and strong enough to move minds.
Investors need to pay attention. Sentiment in the bond market is evolving faster than the thinking of a politician on the receiving end of a pile of new polling data. It was just last month that the yield on the 10 year fell to around 3.9%, inspiring some wags to proclaim that recession was just around the corner. But such thinking is so June. It's a new month, don't you know, and it's time to rethink, refresh, and (much to Wall Street's joy) trade again.
Informed or not, the bond market's current thinking seems to agree with Berner's view of the world. The yield on the 10-year inflation-indexed Treasury has climbed sharply this month and today approached 2.0%--that's a real yield of 2.0%, the highest since August 2004. "Following three years at depressed levels, real yields are finally starting to reflect the prospects for US growth…." he asserts.
Yields haven't quite soared as much in nominal land, but a more robust ascent can't yet be ruled out. Indeed, the nominal 10-year Treasury Note's yield moved higher again today, closing above 4.2% for the first session since early May. Stoking the fires of selling is the latest from the dismal scientists who're card-carrying members of the National Association of Business Economics. NABE this morning released they're assembled wisdom in the form of a survey, which expects "solid growth" in the economy.
“In the second quarter, demand and profit margins are both stable and strong by historical standards," Gene Huang, chief economist, FedEx Corp., says by way of the NABE release. "Hiring plans continue to improve. The growth of capital spending remains brisk with the expectation of further expansion ahead. There are continued signs of inflation, with a pickup in wage and salary growth and a rise in material costs and prices charged to customers."
But if the fixed-income set was alarmed by the NABE's findings, they may want to think twice before going off the deep end on this report alone, suggests Barry Ritholtz, chief investment strategist at the Maxim Group in New York. The economists polled by NABE have a less-than-stellar history as a collective in forecasting the future for growth, inflation, employment and capital spending, he opines today on his " blog The Big Picture.
Perhaps, although there are other reasons to sell Treasuries beyond perusing the latest NABE numbers. That includes the Fed itself, which seems inclined to stay the course when it comes to hiking interest rates. Or so the futures market suggests. The August Fed funds futures contract is priced in anticipation of another 25-basis-point hike when the FOMC meets again next month on the ninth. That would bring the Fed funds rate to 3.5%. Who knows? Rising short rates might very well induce something similar in long rates. But let's no go overboard, at least not yet.
Indeed, the debate in fixed-income circles has become a bit hotter, and a bit heavier of late, with bulls and bears squaring off against one another in ever more frantic pulses. For the moment, the bears seem to have the upper hand, although it's far from clear that the debate is over.
A test of whether the bonds or bulls have the stomach to go the distance may come on Wednesday, when the Maestro testifies to Congress on the state of the U.S. economy. "In a week with relatively little hard data, Mr. Greenspan's monetary policy testimony will be by far the most important event for investors," Ian Shepherdson, chief U.S. economist at High Frequency Economics, wrote in a research report, according to Reuters.
Of the sparse economics news otherwise scheduled for release in the coming days, the Conference Board's leading economics indicator promises to be a relative highlight for market influence this week after the Alan show concludes. If the trend in 2005 is any guide, the LEI for June will again post in negative territory, suggesting that the future path for the economy is a slowdown of some degree. Save for April's zero reading, every month through May has shown LEI in negative territory. Will the fashion hold true again? The bond bulls are hoping for no less as a weapon to beat back the bears' new-found momentum.
Then again, perhaps there will be no dramatic surprises either way, whether in testimony or data. But drama may nonetheless be needed to push the fixed-income set out of its sentiment see-saw of recent months. No matter, though, since if you're a trader a conclusion is required, even when none is obviously forthcoming. With that in mind, one practitioner of the dark art extends an effort at foresight, albeit one that's hedged. "Growth appears to be proceeding at a reasonable click and it will keep the Fed in the game,'' Stephen Miller, a fixed-income manager at Merrill Lynch Investment Managers in Sydney, tells Bloomberg News. "We've got a mild bearish disposition'' on Treasuries.
Miller's not alone in that thinking, as today's action suggests. Whether he'll still be in the majority of trading sentiment after Alan speaks is the question of the moment.
July 15, 2005
INFLATION BEATS A HASTY RETREAT
Inflation may or may not be dead as a long-term threat, but after digesting this week's serving of price reports for June it's harder to lose any sleep over this erstwhile enemy of central banks everywhere.
The fun started on Wednesday with news that import prices last month rose 1%, the Bureau of Labor Statistics reported. Hardly a reason to celebrate, but after taking out food and energy June's import prices actually fell by 0.4%. Not bad, as far as it goes.
Even more encouraging news came packed in yesterday's consumer price report for June, which revealed no inflation last month, otherwise depicted as 0%, the government explained. Nice data, if you can get it. But was it a fluke? Apparently not, or so this morning's wholesale price report for last month suggested. Producer prices for June were also unchanged, adding confirmation to yesterday's CPI dispatch.
Taking the obvious cue from the week's reports, Ed Yardeni, chief investment strategist at Oak Associates, today writes in an email to clients that the inflation scare is history. "The cyclical rebound in core CPI inflation appears over, with the rate dropping to 2% in June, and core prices little changed over the past three months," he predicts. "Our forecast of 1.5% inflation this year remains on track, no matter which core measure is used."
Reasonable, perhaps. But if the future path of inflation is so clear and it's prospective sting so seemingly mild, why has the bond market become so skittish this week? It's more than a little curious that in a week when the latest measures of inflation suggest pricing pressures are waning the bond market decides to respond with a collective "huh?" Consider that the yield on the benchmark 10-year Treasury Note closed a week ago, July 8, at roughly 4.1%. As of today, the yield's bumping up against 4.2%? What? No big rally? Are the bond boys anxious? Ill? Or simply inclined to buy on the rumor and sell on the news?
The stock market, by contrast, has found reason to buy this week. The S&P 500 on Thursday closed at its highest in four years, putting to rest for the moment any fears that equities this year had lost the upward momentum of 2003 and 2004 and were thus poised to continue moving sideways or worse in 2005.
Perhaps the news that the consumer is still spending, combined with the low inflation reports, convinced equity traders to throw in the towel and resume a bullish posture that makes no apologies. Indeed, the Census Bureau reported yesterday that retail sales for June rose by 1.7%, which ranks among the stronger monthly reports for the series in recent years. Meanwhile, the industrial side of the economy refuses to be left out of the current boomlet: industrial production advanced by 0.9% last month, the highest monthly increase since February 2004.
If the sight of continued strong spending by Joe Sixpack, economic strength in the industrial sector, and the June taming of inflation generally looks a bit incongruous, well, so be it. This isn't your father's economic expansion. That may or may not be helpful, but for the moment it's good enough for the equity market. But that still leaves the question: What does the bond market really think?
July 14, 2005
IRAQ'S FUTURE IS STILL THE WEST'S FUTURE WHEN IT COMES TO OIL
The bombings in Iraq go on and on, but the United States' resolve to go the distance remains unwavering, the President tells us. But is it reasonable to assume that the White House will keep the troops in Iraq through the end of Bush's term, which ends in January 2008? If so, will the U.S. military stay in Iraq on through the next administration? Or is there a chance that America will conclude that its presence should end sooner rather than later?
These are awkward questions politically, to say the least. They are also highly relevant ones when considering oil's outlook for the long-term. Nonetheless, the issue of Iraq as regards oil is something less than the world's most-discussed topic.
That needs to change, if only to weigh the implications of an unexpected exit of American forces from Iraq. Inconceivable? Perhaps, although far from impossible. The answer ultimately depends on how the American public reacts in the months ahead to the ongoing insurgency in Iraq. And with news today from the Wall Street Journal that public support for Bush generally is waning this is no time to be dismissive of what may come in regards to Iraq. Yes, it's just one more poll, which is something to take with a grain of salt. Still, it's less than encouraging these days.
The Economist (subscription required) recently broached the topic of pulling out of Iraq in not so subtle terms, observing that "America and its dwindling band of allies are entitled to consider whether the least bad option might now be, in the pejorative jargon, to 'cut and run.' A respectable case for leaving early can certainly be made."
If so, what, if anything, might an exit, inglorious or not, mean for the oil market? Better to calmly consider the question now, when something of a relative calm describes energy trading at the moment as the price of oil closed down sharply today, below $58, in New York futures trading. As a start, it pays to review what role Iraq currently plays as an oil supplier in the global economy. That includes noting that Iraq's 115 billion barrels of proven oil reserves rank third in the world, after Saudi Arabia's 263 billion and Iran's 133 billion, according to the Energy Information Administration. Quite possibly, Iraq's reserves are significantly higher, although that's an unknown that can only be resolved with additional exploration. Don't hold your breath any time soon considering the events on the ground.
Even third place ensures that Iraq's role in the oil markets will loom large for decades to come. Simply put, Iraq's known reserves are too valuable to overlook, for good or ill. That said, the country's oil production has been running well below its potential, courtesy of terrorism and other factors that flow from having the U.S. and its allies try to reinvent the political landscape. As such, Iraq's daily oil production last year was a bit above an average of two million barrels a day. That's still high enough to put the country into the upper ranks of producers, although it's significantly below what Iraq was producing in 1979, when daily production average about 3.5 million barrels a day.
It doesn't take a Ph.D. in economics to realize that Iraq is still critical to the world's oil supply. A substantial reduction in output, much less a complete shutdown of crude's flow from the country holds the potential to cause stress of no small significance in the global economy. Unfortunately, reasonable and not-so-reasonable minds know as much. Indeed, oil is no less important to Iraq domestically as it's still the primary economic engine for the country. Accordingly, its oil infrastructure, creaking though it is from years of neglect, remains a bulls-eye target for those who wish the country harm. No surprise then that Iraq has lost more than $11 billion in damages to its oil infrastructure since June 2003, says Assem Jihad, an Iraqi oil ministry spokesman via AsiaNews. Imagine what the losses would be without an American presence.
"The insurgents know that oil is the lifeblood of the Iraqi economy, and that keeping it from improving daily life is key to building up the frustration and sense of helplessness and lack of faith in the new government--all of which they are out to encourage," Gal Luft, codirector of the Institute for the Analysis of Global Security in Washington, tells the Christian Science Monitor today.
Alas, what's bad for Baghdad is bad for Washington, along with New York, Los Angeles, Des Moine and every town and city from Singapore to Sao Paulo. Oil, of course, is a fungible commodity, and so any thing that drives the price of crude up in Baghdad does no less in Bakersfield. If nothing else, the Americans help keep the Iraqi oil flowing. But for how long?
For the moment, there may be more pressing oil issues to focus on. But it will all pale by comparison if the U.S. beats a hasty retreat and Iraq's oil industry is left to the mercies of the jihadists. Will it happen? Could it happen? Unlikely…for the moment, although it wouldn't be the first time a world power surprised the pundits with a sudden bout of exodus from foreign terra firma.
If there's anything that the 21st century has taught investors it's to expect the unexpected, particularly when it comes to oil, where the stakes are high and so is the volatility. Maybe it's time to start monitoring the Pentagon's press briefings for the latest clues on where crude's future ultimately lies.
July 13, 2005
Tax revenues are rolling in faster than some had expected, but if you thought that would trigger widespread optimism on what it says about the underlying state of economic health, think again.
Still, on the surface, at least, it all looks like a favorable trend. Ben Bernanke, White House economic adviser, suggested as much yesterday when observed that the U.S. is "enjoying is higher-than-expected levels of tax collections so far this year which, if maintained with spending controls, will reduce the government's budget deficit for this year well below its projected level," Reuters reports.
The White House previously had predicted a $427 billion pile of red ink in federal government deficit in the fiscal year that ends this September 30. That estimate topped the reported $412 billion deficit for 2004--a record shortfall. But the Congressional Budget Office, Reuters relates, expects the 2005 budget deficit to be materially lower, falling perhaps to under $325 billion by the more optimistic scenarios.
So what's not to like? Plenty, according to some analysts. The Center for Budget and Policy Priorities, for instance, raises some questions as to whether the recent surge in tax revenues is a byproduct of a trend with legs. For starters, the jump in expected 2005 revenues isn't driven by economic growth, CBPP claims in a research note published yesterday. "Economic growth in 2005 has not been unusually rapid, nor has it been stronger than was projected earlier this year. Thus, the unexpected gain in revenues does not reflect faster-than-anticipated economic growth."
It gets worse, the think tank continues, opining that the factors behind the current elevation in revenues are "temporary," according to CBPP. "The expiration of a business tax cut at the end of 2004 is leading to an increase in tax collections of about $50 billion this year, according to past estimates by the Joint Committee on Taxation. In this case, the increase in revenue stems from the termination of a tax cut, not from a tax cut’s effect in spurring the economy."
Perhaps, although for the moment there's still reason to be optimistic. After all, how many pundits were predicting last year that tax revenues would surprise on the upside in 2005? Now some are saying the new-found revenue burst isn't long for this world. Nonetheless, even the Bush administration is staying cautious. As the New York Times today reports, Bernanke's remaining true to his dismal science training and refraining from any cheerleading that may get him into trouble down the road. "We need to wait for more data," Bernanke counsels.
What else is new? In the meantime, it's still a bit easier to argue that reports of the death of supply-side economics appears greatly exaggerated for the moment. In a sign of the times, the German finance minister, Hans Eichel, gave the much-debated concept of supply side thinking a nod of approval today when said that that the country's budget deficit as a share of GDP could fall if taxes are cut, according to AFX via Forbes.
Who would have guessed that Germany could be a breeding ground, however nascent, for Bush-like tax cuts to stimulate economic growth?
July 12, 2005
JUGGLING THE CONUNDRUM
Steady as she goes at the European Central Bank. Ditto for the Bank of England. And now, this morning, we learn that the Bank of Canada is saying no to raising interest rates too. Do we smell a trend here?
Yes, if you’re inclined to exclude the Federal Reserve from your banking survey. The Fed, of course, has raised Fed funds nine consecutive times over the past year, with the latest hike of 25 basis points (the prevailing standard thus far) coming on June 30.
Elevating the price of money has become a distinctively American pastime in monetary circles of late. Whether it's also the right thing to do in managing a nation's currency seems to be open to debate.
The Organization for Economic Co-operation and Development finds no reason to doubt the ECB's policy. "The recovery has been sluggish thus far and inflation has responded little to widening slack," the OECD observes in a new economic survey of the euro area published today. "It would seem reasonable for the ECB to hold its rate stable as long as the outlook for price developments remains in line with price stability over the medium term, although policy would need to act if the inflation outlook were to change."
Continental Europe's economy is decidedly weak, at least relative to the U.S. The big three euro economies—Germany, France, and Italy—are all growing at rates substantially below America's. That translates into real annualized GDP advances of less than 2%. In fact, in Italy, recession has reared its ugly head by way of the slight contraction in the country's economy in the first quarter.
Meanwhile, the higher rate of GDP expansion in the U.S. accompanies a higher rate of inflation. A coincidence? Perhaps not. The United Kingdom posts a relatively strong rate of economic expansion compared to its national neighbors across the Channel, and England also suffers a materially higher inflation rate. In fact, consumer price inflation rose to a seven year high last month, reports the Financial Times.
The counter argument that higher inflation invariably infests stronger economic growth resides in China, where so many new economic standards are being forged. The Middle Kingdom's real annualized rise in GDP exceeded 9% in the first quarter while consumer prices were rising by less than 2% according to the latest statistics for May 2005.
Back in the West, one dismal scientist assessing the mounting inflationary tide in the U.K. attributes the trend to the bull market in energy. "The current situation with oil prices not falling much below $60 a barrel is creating inflationary pressure,'' Kenneth Broux, an economist at Lloyds TSB Group Plc in London, told Bloomberg News today.
Presumably, the Fed agrees… to an extent. But the banking mavens elsewhere need more convincing. The ECB, for instance, finds cover for keeping rates low by pointing to the Continent's stumbling economy.
Back in the U.S., the balancing act of promoting economic growth and keeping a lid on inflation has, for the moment, been achieved. Can the central bank keep up its highwire act going forward? Perhaps, although the latest Blue Chip Economic Indicators newsletter suggests suggests there could bumps along the way. On the one hand, the prediction of real economic growth for 2005 was raised again, to 3.6% from 3.5% previously, the publication revealed, according to Reuters. But inflation forecasts were elevated as well. As Reuters reports of Blue Chip's latest published prognostications: "Forecasters believe the Consumer Price Index will climb 3.0 percent this year, the largest rise since 2000, up from 2.9 percent forecast a month ago. The inflation forecast has been ratcheted up four months in a row, from just 2.5 percent in March."
Curiously, the rate of increase for consumer prices in the U.S. dropped sharply in May to an annualized advance of 2.8% from 3.5% in April. Is that a sign that inflation's threat is receding? Absolutely, suggests Paul McCulley, managing director of the giant bond shop Pimco, in his latest missive on things monetary. There is no conundrum, he declared, referencing the oft-quoted word that Fed Chairman Greenspan deployed to describe the drop in long rates during a time when the central bank was raising short rates. "The fact of the matter is that there is no conundrum in what long rates have done since the Fed started tightening, if you look at what both the ISM Index and long rates did in the year before the Fed started tightening!"
What does McCulley see in ISM? Quite simply, it's the "single-best statistical indicator of the direction and pace of manufacturing activity in America, which is the single best cyclical indicator of the direction and pace of Fed policy," he advised. Although manufacturing represents a smaller and fading share of the American economy, it's still important because it drives the business cycle, which in turn casts a long shadow over Fed policy, he explained.
The bottom line, McCulley offered: "Bonds don’t wait for the Fed, but rather take their cue from the ISM Index." And on that score, the ISM cue has been issuing signals for more than a year that interest rates need to fall. Declining to the low 50s in recent months, from the low 60s in the first half 2004, ISM explains what Greenspan can't on the matter of the price of money. Or so McCulley told us. What then to make of the latest ISM report, with an unexpected jump in the index to 53.8 from 51.4? Another anomaly or just a pause in the accumulating evidence of economic slowdown?
Hold that thought. This, after all, is a week with fresh inflation news. Import prices, consumer prices, and wholesale prices for June will be revealed this week. Who, in other words, has monetary jam on their face? New clues await.
July 11, 2005
Oil, gasoline and virtually every other fuel price posts strong gains in the 21st century. But if you thought that would have an impact on the energy sector’s relative market-cap ranking in the S&P 500, you’ve been hornswoggled by Mr. Market.
Bull market or not, energy remains in seventh place in the perennial ten-horse race within the S&P 500. As of July 8, energy’s market cap was just shy of $1 trillion, according to Standard & Poor’s data. Although that valuation is up by 41% from a year previous, the seventh-place spot remains unchanged. Not even oil’s price rise of 48% in the year through July 8 could budge Mr. Market’s judgment on that slice of sector relativity.
Even more revealing is the knowledge that the oil sector’s seventh-status labeling stretches back more than a year. Four years ago, energy was stuck in its usual spot of seventh among, a point in time when crude was priced considerably lower in the mid-$20s.
All of which raises the question of what, if anything, might convince Mr. Market to reassess and thereby elevate the relative position of the energy sector in the S&P 500? $70 oil? $80? Or is the answer nothing short of $100 a barrel?
Whatever the reason behind energy’s failure to advance in the relativity rankings it’s not for lack of price performance in the underlying stocks. The Energy Select Spider (Amex: XLE), which represents the cap-weighted slice of energy stocks in the S&P 500, has climbed a sizzling 41% on a price basis for the year through June 30. The S&P 500 Spider (Amex: SPY) looks numb by comparison, inching higher by just a bit over 4%.
Affording a higher relative market cap may be the dream of some energy bulls, but for the moment there are a number of obstacles to overcome, starting with the market’s long-running love affair with financial stocks. Until, and if, that love affair falters, it’s hard to see energy moving up the relative totem poll in any dramatic fashion any time soon. Indeed, the financial sector’s market cap has been firmly entrenched as numero uno for some time. Arguably, it reflects a remnant of the days of wine and easy money. But no matter what you call it, cheap doesn’t apply. At $2.2 trillion, the financial stocks in the S&P 500 dwarf even the number-two sector, information technology, which resides at $1.7 trillion as of July 8.
For all the financial sector’s support from investors, its performance has been unmistakably mediocre of late. The Financial Sector Spider (Amex: XLF) trailed the S&P 500 for the year through the close of this year’s second quarter, posting a mere 3.1% price increase. That’s a notable reversal from the financial sector’s formerly high-flying returns. In the four years through June 30, 2004, for instance, XLF’s price ascended by 20% vs. a 21% loss for the S&P 500 Spider.
Old habits nonetheless die hard on Wall Street. The easy money policies that the Federal Reserve has so generously dispensed throughout the economy in the recent past are beginning to fade, as witnessed by the ongoing rise of the Fed funds rate. Financial stocks are still the darlings of investors. And who, after all, could argue? Certainly not the bond market, which has seen fit to chase bonds and thereby keep yields falling, or at least something other than rising. That’s been no small boost the fortunes of financial companies, many of which turn a profit with some form of borrowing short and lending long.
Yet a quick glance at the latest action in the fixed-income world suggests, for the umpteenth time, that the party may be about to end. True, many have been fooled by such “warning” signs in the past. But one day, maybe, the end really will be nigh. Meanwhile, the yield on the benchmark 10-year bond yield rose to 4.12%, the highest since mid-May. Is this the pause that finally sobers up the sentiment in the 20-year-old-plus bull market in debt?
Equity investors in energy and financial stocks are but two constituencies with a dog in this race and more than passing interest in the answer.
July 8, 2005
ANOTHER WEEK, ANOTHER SPLIT DECISION
The European Central Bank yesterday joined the bond market in reasserting the belief that the path of least resistance for the price of money, if not lower is at least sideways. The ECB kept its key interest rate at 2% yesterday, despite predictions by some pundits that monetary easing was imminent on the Continent. Standing pat at the ECB comes in the wake of the 25-basis-point hike in fed funds to 3.25% on June 30.
The diverging trends in rates between the U.S. and Europe is striking, and reveals itself in long as well as short rates. Lending the French and German governments money for 10 years will deliver current yields on the respective sovereign bonds in the neighborhood of 3.2%. The same transaction with U.S. Treasuries nets a juicier treat in the form of a current yield just over 4% as we write.
Perhaps the edge in Treasuries is no small reason for the dollar's rally of late, which has scored a technically bullish breakout above 90 in the U.S. Dollar Index this week.
More of the same may be in store if predictions of even higher fed funds comes to pass. "We see Fed policy raising the short rate," writes David Kotok, chief investment officer of Cumberland Advisors, today in an email to clients. The next stop: 3.5%, when the Fed meets again on August 9, he opines. But Kotok parts company with the bond market in seeing long rates moving higher too. "We look for 4-1/2% to 5% at year-end," he predicts. Curiously, Kotok isn't necessarily dismissing the idea that the economy will stumble. "We may get slowing but it will be inflationary."
Perhaps, but there was no overt sign of a slowdown in this morning's employment report for June. The nation's jobless rate slipped last month to 5.0% from 5.1% in May. At 5.0%, the unemployment rate is the lowest since the ill-fated month of September 2001. The decline was tempered a bit by the news that nonfarm payrolls advanced a slower-than-expected 146,000 last month. But as Nomura's chief economist David Resler notes today in a missive to clients, the job market continues to bubble along on average when surveyed over the longer term. "Nonfarm payrolls rose 146,000 but with revisions to prior months winds up being +190,000," he observes. That's "amazingly close to the average of about 183,000 for the past year and a half." As a result, "net, net, the June data show no deviation from trend employment growth as labor markets maintain their underlying momentum."
The main challenges overhanging the U.S. economy are still no less threatening. That includes the large and growing mountain of debt accumulated by consumers, the ever-expanding U.S. trade deficit, and the fallout from what could be a correction in real estate prices. Throw in the jokers of rising oil prices, an approaching change in management at the Fed, terrorism, and an assortment of other unknowns and there's no shortage of reasons to worry.
Yet the stock market seems inclined to climb a wall of worry. The S&P 500 has climbed 3% since the end of April. During that stretch, the yield on the benchmark 10-year Treasury Note has shown a tendency to fall to around 4.05% from 4.2% at April's close.
The great debate about whether the economy will sink or swim remains the sun, moon and stars for the capital markets. Par for the course of late is deciding which corner of the capital markets is right and which is wrong. Today's economic news gives believers in growth a reason to remain cheerful, but it's not compelling enough to convince the bond market to rethink its long-held assumptions. Indeed, rewiring the thoughts of either the pessimists or optimists to any degree will take time, and or some extraordinary event. Maybe next week.
July 7, 2005
VOLATILITY IN A VACUUM
Terrorism reared its ugly head again today, this time in London, the scene of a series of explosions this morning. In addition to more immediate concerns of safety, mourning the dead and caring for the injured, the lesser issues of what it means for the global economy and the world's capital markets inevitably come seeping back into the minds of traders.
Among the first market reactions to today's news from London was a sharp sell off in oil. From a record high of more than $61 a barrel at yesterday's close in New York to trades as low as $57.20 early today, volatility is alive and kicking in energy. The initial reaction of some observers is that terrorism renewed (as if it ever really went away) would lessen economic growth around the world and thereby cut demand for crude.
The reaction among oil traders was similar in the months following the events of 9.11 suggest as much. Oil in New York was trading just under $28 a barrel before the planes hit the World Trade Center; by the end of the year, oil changed hands for considerably less, dipping to under $20. Terrorism has "a huge impact on the psychology of consumers,'' Frederic Lasserre, the head of commodities research at Societe Generale SA in Paris, tells Bloomberg News today. "They become reluctant to spend, it has an impact on air travel, and at the end on oil demand. Today's price drop is explained by the reaction to the September 11 attacks.''
Ed Yardeni, chief investment strategist of Oak Associates, also advises in an email message to clients today that "energy traders may be anticipating that global tourism is likely to be depressed during the summer holiday season."
Informed or not, such views are having an effect in government bond trading today. The initial reaction to the London bombings in fixed-income land was to buy. That's partly a safety issue, of course. Treasuries and government bonds elsewhere, after all, are considered a safe corner to park assets, at least in the short term. The prospect of a terrorist-induced economic slowing may be playing a role as well.
But let's not get ahead of ourselves. Indeed, the oil market quickly recovered from its early morning sell off. Perhaps energy traders suddenly recalled that the U.S. economy, the world's leading consumer of oil, surged after the dust of 9.11 settled. But while history has been known to rhyme, it never repeats. Indeed, the super-easy monetary policies of 2001-2003 are gone, as are the immediate stimulative effects of the tax cuts. Will that make a difference this time around? Grappling with a guess promises to be the topic du jour. But as this morning's volatility in various markets suggests, consensus is nowhere to be seen at the moment.
July 6, 2005
A WINK'S AS GOOD AS A NOD TO A BLIND MAN
If China National Offshore Oil Corp., or CNOOC, wins the bidding war for Unocal, the El Segundo, Calif.-based oil company, does it follow that that the newly acquired energy will be diverted to China? Not necessarily. Oil is a fungible commodity, and so it's consumed by the highest bidder, the New Yorker's James Surowiecki argues. "In today’s world whether or not you own the means of oil production doesn’t affect your access to the stuff."
Perhaps, but then why is CNOOC, which is owned primarily by the Chinese government, so eager to buy the means of production? For some clues, we turn to Fu Chengyu, CNNOC's chairman and CEO, who writes in today's Wall Street Journal (subscription required): "We have made our offer because Unocal's asset base fits our business extremely well -- 70% of its oil and gas reserves are close to Asian markets where we operate."
Why not simply buy the oil and gas in the open market? Clearly, CNNOC believes that owning trumps buying on an as-needed basis.
As for the worries that CNNOC will redirect oil and gas to China, thereby depriving the American market of the energy, Fu dismisses the fear. In fact, he pledges the opposite. "I promise that we will continue Unocal's sales practice of selling all, or substantially all, U.S. oil and gas in U.S. markets."
In the meantime, it behooves the U.S. to tread lightly, if at all, when it comes to CNOOC's proposed purchase of Unocal. China, after all, holds an estimated $700 billion of in dollar-based foreign reserves. As Surowiecki notes, "China could inflict far more damage on the American economy by selling off bonds, or simply ceasing to buy them, than by merely acquiring an oil company."
But none of this changes the fact that demand for oil is rising and supply may not keep pace in the years ahead. What's more, all the talk of oil as a fungible commodity, whose price is set by a free and open marketplace ignores the fact that for most of the oil industry's history the price of crude has been manipulated in varying degrees, and the game continues today. Yes, the development of futures trading linked to oil has made manipulation tougher. But it's naïve to think that access to oil is unfettered and the pricing mirrors the idealized supply and demand curves found in economics textbooks.
Consider, for instance, the fact that China's eager to build a strategic petroleum reserve. And who can argue? The U.S. government, after all, holds more than 600 million barrels of crude in reserve in case of supply disruption. As China, India, and a few other countries build comparable emergency reserves the result will have no small impact on the price of oil. What's more, the impact will be unrelated to supply and demand at the moment.
History suggests that at critical moments there's a large and obvious benefit to owning oil supplies vs. trying to buy them in the open market. Sometimes the latter's just not possible. That's not necessarily a reason for the U.S. government to prevent CNOOC's purchase of Unocal. At the same time, America should recognize the motivation for China's growing interest in oil reserves.
To be sure, the Unocal deal is trivial in the grand scheme of the oil business. The true significance of CNOOC's attempt at acquisition is what it suggests for the future. China's $700 billion of dollar reserves are burning a whole in its national pocket. As fate would have it, China's demand for oil is also rapidly outpacing its capacity to produce it domestically, resulting in a sharp rise in imports, according to the Energy Information Administration. A confluence of events that may have more than trifling implications going forward.
Today Unocal, tomorrow….?
July 5, 2005
CHASING THE FOREIGN EDGE
Institutional investors are no strangers to international investing, but that doesn't stop the big boys from rediscovering foreign equities every so often. Are we in the middle of one of those rediscovery moments now?
Indeed we are, suggests a recent report from Greenwich Associates, a consultancy for institutional investors. International equity holdings rose 30% over the past 12 months to over $620 billion among U.S. institutions. Among the catalysts driving large investors offshore, Greenwich opines, is the 21st century's increasingly desperate search for performance that's something more than mediocre. Because so much money is so ambitious in chasing results, the usual suspects in asset allocation aren't doing the trick, namely, heavy domestic weightings in stocks and bonds.
Foreign stocks, relative to their U.S. counterparts, seem inclined to deliver a higher plain of satisfaction. Consider that for the 12 months through the end of June, the MSCI EAFE Index, a cap-weighted benchmark of non-U.S. developed equity markets around the world, posted a 14.2% total return. That's more than double the S&P 500's 6.3% total return over that stretch. The foreign edge was even stronger for equity markets in developing countries. The MSCI Emerging Markets Index delivered a 33.4% total return for the year through last month.
The obvious allure of foreign stocks these days is superior returns relative to the U.S. No one needs a reason to pursue greater performance. But it doesn't hurt the flow of dollars into offshore securities that in some corners of institutional investing there's an extra zing in the natural incentive to reach for yield and capital gains. Underfunded pension/benefits funds, for example, keep the strategists plying the investment waters for ways of circumventing mediocrity. In a press release distributed by Greenwich, John Webster, a consultant with the firm, advises that "U.S. pension funds are under significant pressure to generate alpha [returns above the benchmark], and there is a widespread perception among institutional investors that overseas stocks are undervalued." Webster goes on to say that an expected 50 to 60 basis points of additional return is lying around for consumption in the world of international equities relative to U.S. stocks.
The optimism that there's better hunting overseas is debatable, but no one's disputing the motivation that springs from underfunded pension/benefits funds as a reason to look beyond traditional asset allocations for performance deliverance, illusory or not. Clyde Milton of the Cheap Stocks blog dives into the gritty details by pulling apart General Motors' pension fund as an example. Milton, taking numbers from the automaker's public filings, observes that the company's benefit obligations globally are in the red to the tune of nearly $70 billion. But as frightening as that is, "Perhaps the most alarming aspect of GM's situation is the company's own expectations…" he writes. That is, return expectations for the company's pension/benefit plans around the world ranging from 8% to 9%. "While these projected returns seem achievable on the surface, in the context of GM’s asset allocation strategies, they are overly optimistic, at best," Milton charges.
How can a large institutional investor pull an 8%-to-9% nominal return rabbit out of its portfolio hat? Raising portfolio allocations to real estate and other so-called alternative investments is one way. Who knows? It may even work. No wonder then that GM's U.S. plan has 8% committed to real estate and 10% to "other." Equity, meanwhile, has just 47%, based on the firm's most recent annual 10K and 10Q reports filed with the SEC. Although GM doesn't break out its domestic and foreign mix of equities, arguably the firm needs an aggressive allocation of the latter if the Greenwich assumptions are accepted at face value.
Of course, even a strong performance from overseas stocks may not keep GM from tapping its earnings to keep its promises with benefits obligations. But the fact that GM isn't alone in needing to come up with some extra cash flow in its pension funds going forward suggests that more than a few of America's corporate titans may be looking to international equity allocations to keep shareholders happy, and earnings rising. As such, the allure of overseas stocks may roll on for some time.
July 1, 2005
A NEW QUARTER & THE SAME OLD QUESTIONS
The old logic that one shouldn't fight the Fed suffered yet another indignity yesterday. It was hard not to notice the divergence between the rise of the fed funds rate by 25 basis points to 3.25% and the decline in yield for the benchmark 10-year Treasury Note by roughly seven basis points to around 3.91%.
The reluctance of the bond market to support the central bank's efforts to raise the price of money across the yield and thereby move closer to inverting the yield curve is a familiar game of late. Therein lies the problem. Although the continued variance between short and long rates creates more tension with each passing day, the game must eventually end. The question is: which side will blink first? The Fed will either stop raising rates, and perhaps even lower them, as some are now predicting. Or, the bond market will send up a white flag and sell debt securities and thereby elevate long-term yields.
Once we know the answer with some degree of confidence, the implications for investment strategy will become clear. In fact, the bond market today is already reassessing its buying spree yesterday. The yield on the 10-year Treasury jumped above 4.0% in Friday for the first time in almost two weeks, in no small part due to the sharp rebound in the closely watched ISM Manufacturing Index for June after falling for much of the previous 12 months. Ergo: Is an even bigger blink in the bond market coming next week?
One day a trend does not make, of course. Meanwhile, the two opposing forces represent the frontline in the great debate as to whether the economy is poised to stumble or continue chugging along at a respectable, if not accelerating pace.
We know what the bond market's been saying on this score. But what of stocks? With the second quarter now history, it's a timely moment to review equity returns for clues about the future. An imperfect science, to be sure, and one that's further complicated by the ongoing conflict between short and long rates. Nonetheless, we dive in with eyes wide open and hubris trimmed to the nub in search of something, anything.
With that in mind, we're struck by the fact that the broad stock market indexes struggled to move higher in the second quarter. The S&P 500's total return was just 1.37% for the three months through the end of June, and year-to-date the benchmark is under water by –0.81%. If the economy's prospects remain encouraging, the equity markets have yet to be convinced.
Another sign that growth investing is stuck in neutral, at best, comes from a new report today that slices up the S&P 500 by factors (i.e., the key drivers behind success and failure in portfolios targeting the index). For the month of June, a fresh quantitative survey from CSFB reveals that price momentum and traditional value were number one and two, respectively, last month in manufacturing alpha, or the excess returns above the index's. What's more, CSFB informs that the biggest negative contributor to alpha creation last month was the expected growth factor followed by historical growth.
In other words, momentum and value are hot, growth is something less. That, at least, has been true via performance in the big-cap benchmarks of late. By contrast, the small-cap stock market is a bit more encouraging for both the economy and growth investing, or so one could reason by looking at the relevant indexes. Take note that the S&P Smallcap Index, otherwise known as the S&P 600, handily beat its big-cap sister in the second quarter with a 3.93% total return vs. 1.37% for the S&P 500. The small-cap premium also holds up year to date.
But when it comes to style investing, the race among the small caps is still too close to call. The S&P/Barra Small Cap Value Index won the race over its growth counter part in the second quarter, but not by much: 4.11% vs. 3.78%.
If investors still believe that growth will make a comeback relative to value, thereby reversing the trend of recent years, the best hope for confirmation at the moment resides in the small-cap market, according to S&P.
Quite often, confirmation of such a trend will be documented in other indexes. For example, value stocks' performance lead over growth stocks in recent years can found in benchmarks from the Frank Russell Co. Take the 12 months through June 30, 2005, a stretch when the big-cap Russell 1000 Value Index crushed its growth counterpart with a 14.04% total return vs. 1.67%. A similar outperformance for value can be seen in longer time frames too, and in the comparable S&P indexes as well.
But second-quarter results for Russell value and growth indexes contradict the message from the S&P style benchmarks. For the three months through June 30, Russell 1000 Growth posted a 2.46% total return, a comfortable margin over Russell 1000 Value's 1.67%. S&P, by contrast, says big-cap value won in the second quarter.
Some of the difference is simply differences in index construction. But if the growth factor is awakening from its long relative slumber, the case is still less than airtight and more than a little confusing. That said, given the extent of the bond market's reversal today, sending the 10-year Treasury yield well above 4% for the first time since mid-June, the forces of growth aren't dead yet.