November 30, 2005
THE EUROPEAN RATE DEBATE
The dollar has found a reprieve in the last three months, in part due to the stillness that has characterized the monetary policy of the European Central Bank. The ECB has kept the Continent's benchmark rate at 2% for the last 30 months while the Fed has incessantly raised the price of money since June 2004 to the current 4.0%, thereby creating a tidy premium in dollar assets over euro-based counterparts. Although that premium isn't about to evaporate any time soon, the ECB may start lifting rates, giving dollar bulls new reason to worry.
Indeed, with such a hefty incentive to own dollars and related assets, it's been easy to overlook the fact that the United States has a massive trade deficit with the rest of the world. Normally, such a mountain of red ink would foster selling the afflicted currency. But these aren't normal times, and so the dollar has enjoyed a potent rally in recent months.
Expecting more of the same may be up for review, although the notion that the ECB would raise interest rates tomorrow has been a staple of chatter in trading rooms the world over for some time now. Nonetheless, reaction to the anticipated event has been mixed, with some arguing that the ECB needs to nip inflation in the bud by moving rates up a bit.
A counter argument came yesterday when the OECD weighed in and advised the ECB to do no such thing and instead keep rates at 2%. Yes, global economic growth has been "especially vigorous," the OECD observed in its Economic Outlook No. 78, November 2005. But that doesn't necessarily warrant higher rates, the Paris-based institution reasoned. Global growth has pushed up energy prices, and that's added another weight on Europe, which is still struggling with relatively sluggish growth.
"The fledgling European expansion has been facilitated by low long-term interest rates, euro depreciation and buoyant export markets, although final domestic demand is still growing below trend," the OECD explained. Ergo, keeping euro rates low, in the face of rising U.S. rates, would help keep the euro weak and thereby boost European exports.
We'll know tomorrow if the ECB will buy into the OECD's policy prescription, but the pressure for a European rate hike is growing. Bloomberg News today reported that the ECB raised its 2006-2007 inflation outlook for 12-nation eurozone countries to an average of 2.1%, up slightly from a 1.9% made back on September 1. The eurozone economy, by contrast, is expected to grow by 1.9%, or below the inflation rate.
An outlook of growth that's below the inflation rate is all but expected to insure a rate hike tomorrow. "A more favorable growth outlook and upside risks to inflation are going to be the justifications for higher interest rates,'' Guillaume Menuet, senior economist at Moody's Investors Service in London, told Bloomberg News. "For the first time we have 2006 and 2007 inflation forecast above the ECB's limit.''
But wait--there's more. Today, European Union statistics office announced that eurozone inflation in November is projected to be an annualized 2.4%, down slightly from 2.5% in October. How will that impact the ECB's decision tomorrow? On the one hand, inflation seems to be slowing at the moment. But even a drop to an annual rate of 2.4% is nothing to take lightly in an economy that's growing well below that rate.
Warranted or not, the prospect of higher European rates after a 30-month lull has caught the attention of bond traders in the U.S. The 10-year Treasury yield yesterday surged by nearly 8 basis points to 4.48%, the highest closed since November 16. The dollar bulls are becoming cautious too, with the euro gaining against the buck in recent days.
Arguably, the pressure remains on the Fed to keep raising interest rates too, thereby locking in the current premium in dollar rates vs. euro rates. The government's latest estimate of third-quarter U.S. GDP released today shows a revised 4.3% annualized real rate of expansion, up sharply from the initial 3.8%. The economy, in sum, may be growing faster than previously recognized. But while U.S. economic growth has been revised upward, inflation (as per the implicit price deflator number in today's GDP report) hasn't followed, and in fact has been revised downward slightly to 3.0% from 3.1% in the previous government estimate for the third quarter.
Perhaps that explains why the market is warming up to the notion that the Fed rate hikes may soon come to an end sometime in the first half of 2006. The March 2006 Fed funds futures contract is currently priced for a rate of 4.5%, or 50 basis points above the actual rate at present. In fact, the March 2006 Fed funds contract has been more or less predicting 4.5% now for a month.
Yes, dollar-based assets still carry a sizable premium over their euro counterparts. But the prospect that the Fed may be nearing the end of its rate hikes, combined with an ECB that may be starting to hike, promises to be the new new thing in currency and bond trading rooms around the world. At the very least, the prospect of an ever-widening yield premium in the U.S. vs. Europe seems destined to end in the foreseeable future.
November 29, 2005
IN CORE WE TRUST?
The divergence between core and headline inflation has divided pundits for some time, on the one hand giving hope and rationalizing low interest rates, and on the other giving cause for buying gold and selling bonds. The optimists say that the relatively low core rate of inflation, which excludes energy prices, is the true measure of price trends. The pessimists say otherwise, claiming that the higher headline rate of inflation, which factors in energy, more accurately depicts the real world.
Talk, of course, is cheap, which is to say that fans of the core rate seem to have won out, at least when it comes to pricing bonds. Headline inflation, measured by the consumer price index, advanced by 4.3% for the 12 months through October, more than twice the 2.1% rate of increase for the core CPI, according to the Labor Department. Meanwhile, the 10-year Treasury yield at roughly 4.47% as we write, which is to say more or less unchanged from the end of 2003. If the core rate of inflation is used as a guide, 4.47% doesn't look at that bad.
The bottom line: headline inflation has been rising, while the core rate has stayed fairly stable at around 2% a year. If the pessimists were pricing bonds, the 10-year Treasury would carry a much larger premium over headline CPI. Sans such a premium, it seems safe to declare that the optimists have won.
Not so fast, suggests Alan Levenson, chief economist for T. Rowe Price Associates, the Baltimore-based mutual fund company. At a press conference today in New York, Levenson explained that while rising energy prices have fueled the rise in headline inflation, falling energy prices could do the same for core inflation.
As it happens, oil prices just happen to be declining these days. Although that's unlikely to last as a long-term proposition, the trend may have legs in the short run, perhaps as long as several years. If so, core inflation may be due for a climb, Levenson effectively advises. "We'll have a greater underlying inflation problem if oil falls." In that case, what might the inflation optimists think of the 4.47% current yield on the 10 year? If a low core rate inspires buying the 10 year, might a jump in the core rate spawn a bout of selling?
Oil, in any case, is falling these days. The January 2006 futures contract for crude has been slipping since late August, when it closed above $71 a barrel. At one point today, it was under $56.
Levenson explained that labor costs are the key driver of core inflation. As the price oil and other energy costs decline, the trend fuels higher consumer spending and economic growth generally, which in turn drives up labor costs.
In fact, the government reports that unit labor costs were in virtual freefall in 2004 when the energy bull market took off in earnest. Although unit labor unit costs rebounded in 2005, it was a tepid bounce, in part because energy prices continued to surge upward, or so one could argue.
Keeping a lid on unit labor costs, according to Levenson, has been central for keeping core inflation under control of late. Meanwhile, consumers have shown no modesty in spending in one form or another in 2005, oil bull market or not--a fact that's kept the economy humming in the face of any number of challenges that would trip up smaller countries. Imagine what a sustained decline in oil prices might do for Joe Sixpack's already indomitable spending spirit. Actually, you don't have to imagine. Consumer confidence soared this month as energy prices declined, the Conference Board reported today. Now, imagine what a re-energized Joe might do to the core CPI.
November 28, 2005
GOING FOR THE GOLD
Gold is poised to break the $500-an-ounce barrier for the first time in 18 years. But you don't need a new price milestone to realize that the surging price of the precious metal has raised questions anew about the integrity of paper currencies, the dollar in particular.
On first glance, one could reason that the surge in gold prices virtually assures that the Fed will keep raising interest rates. The bull market in gold is partly a reflection of growing anxiety over the dollar's value, an asset that's managed by the Fed.
But the anxiety recently has been limited to pushing up gold's price. The dollar, by contrast, has suffered no fallout from the enhanced popularity of the precious metal. Indeed, the U.S. Dollar Index has been in a mini bull market of its own in recent months.
The dollar's rally can be attributed to America's ongoing economic expansion and, more importantly, the interest-rate premium that continues to inhabit U.S. bonds. The 10-year Treasury currently yields 4.44% vs. 3.45% for the equivalent in Germany or 1.46% in Japan, according to Bloomberg. As long as the Fed keeps signaling that it'll continue raising interest rates, the dollar bulls will likely ignore gold and instead focus on current yield. Until and if they find reason to do otherwise, that is.
BCA Research offered the dollar bulls an excuse for cashing in last week with a commentary that threw cold water on the outlook for continued interest-rate hikes, opining...
First, there are signs that the Fed is nearing the end of its rate tightening cycle. Second, U.S. economic growth is set to slow. Third, speculators are already heavily net long the dollar, which is in stark contrast to one year ago when speculators held huge net short positions. Given these factors, FX traders are increasingly likely to shift their focus back to the massive current account deficit once the Fed finishes tightening. Bottom line: while an overshoot is possible in the near term, there is limited sustainable upside in the trade-weighted U.S. dollar.
When and if the dollar's rally ends doesn't change the fact that the gold bulls are celebrating. What's more, they're predicting that the rally's far from over. The reasons vary, but collectively they add up to a powerful psychological force. And that's nothing to sneeze at since gold is largely driven by psychological forces, having lost its official sanction as "money" in a world of fiat currencies. What are those reasons? Here's a few:
* The money supply, despite recent Fed rate hikes remains inflationary. “The money supply has been extremely loose – the loosest in 30 years,” Mary Anne Aden, co-editor of The Aden Forecast, said at a gold conference last week in San Francisco, reported ResourceInvestor.com.
* Predictions are rampant that central banks will start buying gold. In fact, the Russian Central Bank earlier this month announced plans to double its gold reserves, according to the Russian News & Information Agency. First Deputy Chairman of the Central Bank Alexei Ulyukayev is quoted as saying that the bank would be purchasing gold "on all markets on which it is available." Michael Kosares of USA Gold, a precious metals dealer, says the implications are bullish, telling Gold Price News last week that "we should not forget that it was central bank buying that broke the back of the anti-gold cartel in the late 1960s early 1970s. This paved the way for the massive bull market of the 1970s."
* "Investors are increasingly concerned about the possibility of a housing collapse,'' Adrian Day, president of Annapolis, Maryland-based Adrian Day's Asset Management, tells Bloomberg News today. "Everywhere one looks, there is a reason to own a little insurance," which for a growing number of people includes gold.
November 23, 2005
There's a lot of cash sloshing around in the global economy, and a fair chunk of it's coming to America. That's hardly news, of course. Indeed, it's getting easier to take all the liquidity for granted. And why not? For all we know, the river of cash may keep flowing indefinitely to these United States.
Relying on the kindness of foreigners has been no trivial trend in finance in recent years. But how long will the kindness last? Indeed, self-interest is no stranger to governments and corporations overseeing large pots of money. If that benefits America, so be it. But if not, fair weather friends are the rule.
With that in mind, the trend of late in generating cash comes from oil exporting governments. Oil exports from the ten leading Middle East exporters, for example, will more than double this year to $450 billion from $200 billion in 2003, yesterday wrote Mohsin Khan, director of the Middle East and Central Asia Department at the IMF, in Dar Al-Hayat, a Beirut news site. Next year, the ten exporters will pull in even more, perhaps $500 billion, he added.
That's a lot of money, even by the global economy's standards. Indeed, this year's $450 billion of oil-exporting revenues for the Middle East ten dwarfs $188 billion that the Economist recently reported is expected as the current-account surplus for China and other emerging-market nations in Asia.
Arguably, a lot of the petrodollars are returning to the United States and rolling into Treasuries. "While it is difficult to determine how these funds are invested," Khan opined, " we can say that a large share has been likely invested in U.S. dollar financial assets." Some say such purchases go a long way in explaining why long yields are lower than some they arguably should be. Indeed, the benchmark 10-year Treasury yield of 4.42% has essentially remained unchanged since the Federal Reserve began raising interest rates in June 2004.
So, what's the problem? Oil exporters seem to be helping keep U.S. interest rates low. Stop complaining, and go borrow some money, right? More than a few consumers have done just that. And optimism is infectious.
Ed Yardeni, chief investment strategist at Oak Associates, this morning wrote in a report to clients that the stock market is coming around to the belief that inflation's not a problem after all, and so the Fed's cycle of tightening may soon end. In fact, the rally in the equity market of late (the S&P 500 is up 4.5% this month through yesterday) is, to quote Yardeni, broadening. Yesterday's jump in stock prices "left almost no industry behind," he noted.
Indeed, nine out of ten sectors that comprise the S&P 500 show gains so far this month, ranging from a 1.5% climb in consumer staples up to 7% for materials. The only slacker in November has been utilities, a sector that shed 0.8%.
Meanwhile, the bullish aura has spread to the dollar as well. The U.S. Dollar Index has confounded the bears in recent months and climbed 6% since September 2.
What worries some, however, is the fact that the price of gold has been rising too. The precious metal's up 11% since September 2. Gold and the dollar historically have moved in opposite directions, and so the fact that they're both moving in tandem has spawned talk about what it means.
David Gitlitz, chief economist at TrendMacrolytics, advised in a note to clients yesterday that the bull market in gold "stands as a stark reminder that any talk of the Fed nearing the terminus of its policy normalization program remains premature." In other words, interest rates are going higher still because inflation hasn't yet been quashed as a threat. "We continue to expect Alan Greenspan to leave office on January 31 having put the funds rate at 4.5% [from the current 4.0%], and see Bernanke as more likely than not to push through rate hikes at two of his first three meetings, leaving the rate target at 5% at mid year," Gitlitz predicts.
Alan Kohler of the Eureka Report worries that the twin dollar/gold rally can't last, and that the dollar's headed for a correction. "The US dollar is rising at present — along with gold — because of a short-term arbitrage on cash rates as the Fed continues to push them towards 4.5%," he wrote today via Australia's The Age. Simply put, American short rates are among the highest in the world, which is attracting capital, and thereby pushing up the dollar.
But foreigners, including the oil exporters, are buying gold as well, Kohler advised. Therein lie the seeds of a future dollar tumble. "The Arabs are less inclined to finance American consumers than are the Chinese and are more worried, as investors, about the sustainability of the U.S. current account deficit," Kohler continued. All of which convinces him that "American financial assets will have to be repriced eventually, either directly or through a devaluation of the currency, or both."
But for the moment, petrodollars are working to America's advantage. And on the eve of the Thanksgiving holiday in the U.S., investors aren't about to squawk.
November 22, 2005
Hurricanes, terrorism, budget deficits, and any number of other threats haven't pulled the U.S. economy off track. And if recent momentum is any indication, continued if moderate growth looks like the path of least resistance for the foreseeable future.
Yesterday's release of the Conference Board's leading index for October says as much. Seven of the ten indicators that comprise the leading index increased last month, the Conference Board reports, which boosted the gauge by a robust 0.9%.
Impressive, but for how long? David Resler, chief economist at Nomura Securities in New York, wrote yesterday that while the October bounce was dramatic, it's probably a one-time event. "The nine-tenths increase in leading indicators was propelled by the drop in initial claims--the chain reaction from Hurricane Katrina--that will not be long lasting," he wrote in a note to clients on Monday.
Yes, some of the rise can be attributed to a rebound from the stumble in September, which suffered the effects of Hurricane Katrina. But a rebound's a rebound, and it's clear that worries that the hurricane would trigger a national recession have turned out to be a big wind. As Resler concludes, "Moderate growth is still the most likely economic course despite this oversized increase."
A survey of economists released today echoes the point. "Our forecasters expect strong real GDP growth of 3.3% next year..." said Carl Tannenbaum, vice president of National Association for Business Economics in a press release accompanying the NABE's November outlook. The economists polled also raised their full-year 2005 GDP prediction slightly to 3.6% from the 3.5% in the September survey.
Okay, so there's a fair amount of optimism on the economic outlook. Nothing stellar, but respectable just the same. In fact, the current economic expansion is now four years old, based on the National Bureau of Economic Research's data that dates the end of previous recession as November 2001.
With dismal scientists saying the train will keep rolling, we wonder what might possibly threaten a derailment? Housing seems a likely candidate for causing trouble. Indeed, it's widely thought that the Federal Reserve is raising interest rates until and if the housing market cries "uncle." When that cry emerges in no uncertain terms, goes this line of thinking, the Fed will cease and desist in its quest to tighten the monetary strings. At that point, the central bank's job will be done, namely, injecting a fresh dose of humble pie into the real estate sector.
Are we getting close to a turning point for real estate? It's easy to find economists who think so. One example: "We are seeing some anecdotal signs that the housing market is cooling off and that could be a damper on economic growth in the year ahead," Greg Thayer, chief economist for A.G. Edwards and Sons, told Reuters yesterday. But let's not get ahead of ourselves, he added, preferring to hedge his forecast by noting that "the positives are still outweighing the negatives in today's [Conference Board] report."
Nonetheless, the guessing game of what will constitute the Fed's definition of crying "uncle" for the real estate market promises to be new new thing in central bank watching going into 2006. Arguably, the beginning of the end in the great real estate boom has already arrived, or so the October housing data suggests. U.S. housing starts dropped 5.6% last month vs. September while building permits dropped in October by the most in six years, the Commerce Department reported.
"The supply of new homes for sale, relative to the pace of sales, has been rising for well over a year, and builders are now reacting by slowing the pace of new construction,'' Ian Shepherdson, chief U.S. economist at High Frequency Economics, told Bloomberg News last week. And in the end, cyclical turning points, whether it's money supply, real estate or a national economy, are all about supply and demand.
Nonetheless, despite the mounting signs that real estate is cooling, some in the industry remain optimistic that housing's not about to suffer any massive drop any time soon. “This cooling down period should extend into 2006 but not lead to a major contraction in the housing markets,” David Seiders, chief economist of the National Association of Home Builders, told RISMedia.com yesterday. “NAHB’s forecast shows a 5.5% decline in housing starts for 2006, basically retracting the increase expected for this year.”
The question, of course, is what repercussions a softening housing market will have on the U.S. economy. Real estate has been booming for so long, and in such dramatic fashion so that it's boosted consumer confidence and household assets. The Fed seems intent on taking away this particular punch bowl. Finding out what that means exactly is on track to be the great question for 2006. And just to keep things that much more complicated, the new man who'll soon be installed at the central banking helm, Ben Bernanke, is untested.
November 21, 2005
THE NORWEGIAN FACTOR
Norway is on the frontline of non-Opec oil production, and the front is under attack.
Norway is the world's third-largest oil exporter, after Saudi Arabia and Russia, according to the Energy Information Administration. The Saudis are the number-one exporters, and Russia is number two. That leaves Norway as the planet's largest reliable source of crude outside of Opec.
In 2003, Norway exported an average of 3.0 million barrels of oil a day, or roughly 90% of its production, which comes exclusively from the North Sea. For context, Saudi Arabia exported 8.3 million b/d and Russia exported 5.8 million b/d.
The problem for Norway, and oil-importing nations everywhere, is that North Sea production has almost surely peaked and is now in irreversible decline. As the EIA advises, "most of the country's flagship oil fields have peaked, with production remaining flat or declining slightly."
A graph of Norway's 32-year oil-production history (courtesy of Norwegian Petroleum Directorate) tells the story of the rise (and now) fall. The country's monthly production history this year only confirms the larger trend. In October of this year, for instance, total production was 2.5 million b/d, well below the all-time peak of over 3.0 million b/d.
Ah, but what a ride it's been. From nothing in the early 1970s to more than 3.0 million b/d of gross production in 2001, Norwegian oil has been a strategic silver bullet for consumers in the West in keeping Opec from casting an even greater influence over crude prices. But nothing lasts forever, including oil wells. Norway's production has been slipping in recent years, and it's widely expected that the decline will continue indefinitely. Rest assured, that Norway's fading oil output will be sorely missed, particularly when oil traders wake up to this fact.
Indeed, the world of crude exports can be divided into Opec and non-Opec supplies. The former suffers from any number of potential problems, starting with a political backdrop that's something less than stable. Meanwhile, virtually all the Opec oil is under tight government control. To the extent those governments are willing and able to help the West with its petroleum addiction, all's well with the world--at a price.
Anticipating the decline and fall of Norwegian oil production will affect Norway first and foremost, and the country's already reading the writing on the energy wall. Norway's oil and energy minister, Einar Stensnaes, back in 2004 told BBC News that it was time to start planning for the inevitable. "Not only is it essential to look for other energy sources. It is also important to look for other industrial activities to develop alongside the petroleum activity," he said.
It's worth mentioning that North Sea oil was discovered in the 1960s, but production of substance didn't begin until the 1980s. Discovering oil takes time, and so does developing the infrastructure for pumping it and exporting it. Of course, without new discoveries, the wait is infinite.
So, what does Norway's decline and fall as an oil exporter mean for America? A slow, but sure squeeze until and if a) a substantial replacement for North Sea oil is found; b) technology makes up the difference by materially boosting efficiency and/or alternative energy sources.
Meanwhile, there are the numbers to ponder. U.S. imports of crude oil have been rising for many years. In 2004, America imported a record 12.9 million b/d, which was up 5.1% from the year before, according to the EIA. The good news is that Norway's share of U.S. imports last year was just 1.8%. The bad news is that the absolute amount of Norwegian imports into the U.S. dropped nearly 12% from the year before.
In fact, Norway's relatively small share of U.S. imports gives false comfort. Oil is a global commodity, which means it's priced globally. Trouble over there means trouble here. There's no place to hide in the global market for oil. Norway's challenges for future production are America's challenges.
In short, all consumption roads eventually lead to Opec. The only question: how bumpy will the ride be?
November 18, 2005
Energy's hot and telecom's not. That's the unambiguous and consistent message in year-to-date total returns for equity sectors across Standard & Poor's three main capitalization spectrums.
The soaring price of oil, gasoline and natural gas in 2005 explain the surge in stocks tied to the production and distribution of those fuels. But with crude's price in decline since late August, there's reason to wonder if the bull market in energy stocks is due for a lengthy consolidation/correction beyond what's already unfolded. The
While the market ponders the future of energy stocks, there's no debate about telecommunications services, which is to say that the latter could hardly look less enticing as an investment. That may attract hard-core contrarians, but most investors will probably stand clear until and if a bottom reveals itself. Although telecom returns are firmly in the red year-to-date across the capitalization field, the losses are especially deep in the small-cap realm of the S&P 600, where the telecom sector's shed more than 15% this year through November 17. That's by far the biggest loss for any sector in any S&P capitalization bucket.
Moving from the clarity of the past to the uncertainty of the future, we turn to a report published today from Joseph Abbott and Ed Yardeni, Oak Associates' chief quantitative strategist and chief investment strategist, respectively. After crunching the historical numbers on the ten S&P 500 sectors, they offer a few tidbits about what may be in store in the future, albeit tidbits that fall short of surprising, as Yardeni writes in an email to clients today. Among the report's highlights:
* The consumer discretionary sector "usually outperforms significantly near the end of [interest-rate] easing cycles and significantly underperforms when the Fed is tightening." Since the latter has been the prevailing trend for more than a year, it's no wonder to learn that Abbott and Yardeni recommend an underweight position (relative to its weight in the S&P 500) for this sector.
* Energy tends to lag during easing cycles and has been a mixed performer when the central bank tightens. Despite recent declines for energy sectors, Abbott and Yardeni recommend an overweight position here.
In addition to energy, Oak Associates advises just two other overweights among the S&P 500 sectors: healthcare and industrials. The underweights, along with consumer discretionary are: financials, materials, and telecom. The remaining sectors--consumer staples, information technology, and utilities--all receive market-weight recommendations from Abbott and Yardeni.
Only time will tell if such recommendations will yield alpha relative to Mr. Market's weights, which can always be had by purchasing an S&P 500 index fund. On that note, we'll leave you with the only sure thing when it comes to analyzing the stock market: yesterday's numbers. As such, here's how the sectors in the three market-cap groups compare for year-to-date total returns (in descending order by sector) through yesterday:
S&P 500 2.55%
Health Care 2.83%
Info Tech 2.35%
Cons Staples 1.51%
Cons Disc -6.74%
Telecom Svcs -7.55%
S&P 400 9.61%
Health Care 15.71%
Cons Staples 12.14%
Info Tech 6.62%
Cons Disc 1.10%
Telecom Svcs -6.27%
S&P 600 6.26%
Health Care 14.15%
Cons Disc -1.43%
Info Tech -1.52%
Cons Staples -4.18%
Telecom Svcs -15.10%
Source: Standard & Poor's
November 17, 2005
SHOW ME THE MONEY
Yesterday's Treasury release of international capital flows for September was a warning sign that foreigners may be losing their appetite for U.S. government bonds. But if such data is inherently frightening, you wouldn't know it by watching Treasuries of late. Indeed, the 10-year Treasury bond's yield in late-morning trading today was 4.47%, down from nearly 4.7% back on November 4.
Yesterday's tame inflation report via consumer prices for October is the latest catalyst for convincing bond traders that erring on the side of the bulls is once again the only game in town. It's unclear if foreigners will continue to share in that brand of optimism, as they have in the past. But there's new reason to wonder, judging by the recent trend in international capital flows as it relates to U.S. securities.
Net foreign purchases of Treasury bonds dropped 14.9% to $247.5 billion this year through September vs. the same period for 2004. In sharp contrast, net foreign purchases of corporate bonds in the first nine months of 2005 jumped 24.4% to $277.0 billion over the same stretch last year.
In search of reasons why the foreigners seem to be developing a taste for U.S. corporates over Treasuries there's at least one clue worth considering. Indeed, while America's trade and fiscal accounting ledgers continue to run red with deficits, corporate America is moving in the opposite financial direction, namely, toward enhanced cash on the balance sheet.
For evidence, dive into the Federal Reserve's latest quarterly Flow of Funds report, a dry and tedious document of endless numbers but a revealing one just the same. One revelation comes in Table L.102, which measures assets in nonfarm nonfinancial corporate businesses. In the second quarter of 2005 (the latest data available), the sector's financial assets (which includes a range of cash and cash-equivalent holdings) rose 4.8% over 2004's second quarter.
That's hardly surprising if you also read Table F.102 in Flow of Funds, which states that profits for nonfarm nonfinancial corporations soared 51.7% in this year's second quarter over the year-earlier period.
Indeed, many a pundit has noted that corporations are banking a relatively high share of their profits these days. That may not be the smartest strategy for long-term growth, but it sure goes a long way in convincing buyers of corporate debt securities that the bonds are secure.
That compares with the United States government, which looks set to go begging for more loans for as far as the eye can see to fund its budget deficit, all the while struggling to manage a large and growing trade deficit.
Comparing the balance sheets of corporate America with the U.S. government is a study in contrast. Foreigners seem to be picking up on the numbers. Will the inclination spread to trading in the 10 year Treasury?
November 16, 2005
DOES M3 MATTER?
Conspiracy theories shadow the Federal Reserve like moths to a flame. That's the price an institution pays for life at the top of the monetary feeding chain, or so one might conclude after reading William Greider's Secrets of the Temple: How the Federal Reserve Runs the Country, a dense tome that does the central bank no favors on downplaying the notion of conspiracies and the Fed.
True to form, the conspiracy minded were inspired to vent after last week's announcement that the Federal Reserve would cease publishing its broadest measure of money supply numbers, otherwise known as the M3 series. The official reason is that M3 is a dud. That is, M3 offers little information above and beyond M2. Dave Skidmore, a spokesperson for the Fed, told CS today. M3 adds sparse, if any insight to monetary trends that's not available in M2, a narrower definition of money supply, he continued. Skidmore also said that there's a cost to compiling M3 data. (Yes, he really did say that.) As a result, eliminating the broadest measure of money supply seems to be reasonable, or so went the drift. As Skidmore explained, "The cost of collecting [M2 data] outweighs the benefits of publishing it."
In fact, there's no shortage of agreement among mainstream economists, investors and other consumers of money supply data that M3's death will be a yawn. The demise of M3 is no great loss, Michael Cosgrove, an economist who runs The Econoclast, a Dallas-based consultancy, told CS today. "The fact that the Fed will not report M3 any more probably won't make much difference." The M2 series is an able substitute, he added.
In any case, when it comes to monitoring the Fed on matters of monetary policy, Cosgrove said that he prefers the monetary base numbers published by the central bank, which is a narrow measure that's even more constrained than M1. As a result, the monetary base figures provide a much better reading of the Fed's monetary activities because it's more directly influenced by the central bank compared to M1, M2 or M3.
Concurrence comes from Wrightson ICAP, an independent research outfit that monitors the Fed for clients. On its website earlier this week, Wrightson advised that M3 had become "increasingly irrelevant."
But step outside the mainstream of economic thinking and you'll get a spicier dose of opinion on the M3 announcement, namely, one laced with conspiracy implications. For example, James Turk of the Free Market Gold & Money Report smells a monetary rat, as noted by MarketWatch via ResourceInvestor.com: "Why does the Fed no longer want to report the total quantity of dollars in circulation?" Turk asks. "They know what's coming -- massive amounts of dollar creation to fund the worsening trade and federal government budget deficits. The Fed is just doing what other government agencies already do when they don't like the result of their statistical calculations. Like children, they play ‘make believe."
One George J. Parrish Jr. also sees nefarious reasons for killing M3. Writing on his blog, he asserted:
If an increase in the money supply is the cause of a rise in the general price level then M3 is an important measure of price inflation simply because it is considered to be the broadest measure of money and, hence, the best measure of price inflation. With M3 crossing the $10 trillion level the Fed has decided to stop publication of this important data. The Fed by nature is an inflation machine built to support limitless spending by the government. Yet the Fed also enjoys the reputation of being an inflation fighter. In order to protect its image the Fed has found it necessary to cease publication of M3 data.
With all the back and forth, we decided to take a look at the numbers for what we hope might approximate objectivity. As such, we compared the monetary base with M2 and M3, courtesy of data on the Federal Reserve's web site. Using the latest data releases for the series, the monetary base has rose 3% for the year through November 9. In fact, looking at rolling 52-week percentage changes for the monetary base on a weekly basis reveals that the rate of change has been steadily falling for several years, and 3% represents the lowest pace of increase in recent history.
M2 is rising at a faster pace (4% over the past year through October 26), but the general trend mirrors that of the monetary base, i.e., the pace of increase has been falling for some time.
Then we come to M3, and here's where it gets interesting or, conspiratorial, if you will. M3 money supply rose 7% for the 52 weeks through October 31. Not only is that rate of advance dramatically higher than M2 or the monetary base, the pace of increase is heading upward as well. Indeed, a year ago, M3 was consistently increasing at around 4% a year.
Superficially, at least, it looks a bit suspicious when the Fed says it'll soon bury a series of money supply numbers that contradicts the central bank's public relations effort to convince the world that it's squeezing the monetary system and thereby taking a hawkish view on fighting any and all future inflation. Of course, as Cosgrove observed, the Fed has relatively lesser influence on M3 vs. M2, or certainly the monetary base. Nonetheless, the Fed's only explanation for the planned demise for M3 boils down to sparse interest in the series and the allure of saving money by discontinuing its publication. The former is a reasonable, but ultimately unpersuasive point. After all, the Fed publishes a massive amount of data, and much of it is obscure for all but a few economics geeks. As for the bit about saving money, well, that one just rings hollow from the outset. How much could the termination of M3 save the Fed? Measured against its annual budget, it's barely a rounding error, if that.
All of which convinces some that there's a conspiracy afoot. Proving conspiracies, unfortunately, is notoriously difficult, and the M3 caper promises to be no less immune to definitive conclusions, short of a confession from Alan Greenspan that he's intent on cooking the books. (Don't hold your breath.)
Nonetheless, some in the marketplace have already made up their mind, or so one could argue. Gold, to cite the obvious barometer of doubt, fear and conspiracy talk on matters tied to paper currencies, is doing well these days. The precious metal jumped sharply today, for instance, rising to around $479 at one point, a level last seen more than a month ago. Not bad, considering that the monetary doves received a fresh dose of optimism with today's release of consumer prices for October--the government's unofficial gauge of inflation. The CPI advanced just 0.2% last month, down from September's hurricane-induced surge of 1.2%.
But it'll take more than a docile CPI report to convince the conspiracy theorists that the Fed's being straight with Mr. Market. By that logic, M3 does matter after all.
Indeed, for an institution that prides itself on managing perceptions, as Ben Bernanke explained so persausively yesterday in his Senate testimony, it's odd that the central bank is blind to potential for conspiracy mischief that inevitably accompanies the killing of M3. Managing expectations about inflation, the designated successor to Greenspan said, is at the core of the Fed's job. A little bit of that sprinkled elsewhere in the central bank couldn't hurt.
November 15, 2005
The S&P 500's materials sector has been one of the worst performers this year, posting a 6.5% loss for the year through last Thursday vs. a 0.7% gain for the market generally, as measured by the S&P 500. But with news that Koch Industries will buy the paper maker Georgia-Pacific Corp., the materials sector is getting a fresh look from Wall Street.
The S&P Materials Sector SPDR ETF (Amex: XLB) jumped 3.9% as of last night's close since the end of trading last Wednesday, November 9. Traders are wondering if there's more to come as the market revalues the formerly languishing materials sector.
Georgia-Pacific is a member of the materials fraternity, and the stock's price surge (it jumped by more than one-third yesterday) has contributed to the double-take on the sector. Indeed, Georgia-Pacific's 2.8% weighting in XLB (as of September 30) was a relatively distant 13. At the top of the ETF's weighting roster was Dow Chemical (12.6%), followed by EI DuPont (12.2%), and Alcoa (6.7%).
But in looking at the other stocks in the sector that caught fire, it's clear that the paper connection is the spark that's fired up investors' imaginations. Notably, shares of paper/timber firm Weyerhaeuser (with the sixth highest weighting in XLB) soared yesterday before pulling back a bit. Dow Chemical, EI DuPont, and Alcoa, by contrast, were either flat or down slightly.
In any case, the sight of Weyerhaeuser shares soaring is hardly common. The stock has essentially gone nowhere in the 21st century. In addition, valuations on such companies, which are typically rich in land and timber holdings, have been relatively low, according to some analysts. No surprise there, in part because valuing real estate and trees isn't a Wall Street forte. Thanks to the proposed Georgia-Pacific deal, however, a revaluation may be in the works.
"Georgia-Pacific was our top pick in North America," Don Roberts, a CIBC World Markets analyst in Tornonto, told AP via BusinessWeek yesterday. "We thought it was undervalued. Obviously, Koch agrees."
The wider world of finance stood up and took notice as well. “When you have a catalyst like this, it causes investors to look at the stocks in terms of merger-and-acquisition multiples and less so in terms of cash-flow multiples,” Daryl Swetlishoff, a Raymond James analyst, explained in a story from Globe and Mail yesterday. “The Georgia-Pacific acquisition has focused investors to identify situations where the underlying asset value is out of whack with its current share price.”
Industry-specific sentiment shifts born of one merger deal can nonetheless be fleeting, in part because there are only a handful of companies on a scale comparable to Georgia-Pacific in the timber/paper business. As a note of caution, consider that while the large-cap materials sector has taken flight recently, the mid-cap and small-cap counterparts aren't less than bubbling in the wake of the Georgia-Pacific news. The large-cap materials sector climbed nearly 1% yesterday, but mid-cap materials could manage only a 0.1% gain, and small-cap materials actually lost ground, shedding nearly 0.8% yesterday, according to the relevant S&P benchmarks.
Wall Street is eager for some good news, and Georgia-Pacific delivered. But there's a thin line between finding undervalued assets and searching desperately for reasons to push equity prices overall higher in an era of uncertainty.
November 14, 2005
THE WEEK AHEAD...
The Fed's minions have a full agenda this week, with scheduled appearances for both movers and shakers as well as those who toil away in relative obscurity. Inevitably, Fed chatter becomes speculation on interest rates, and this week promises to live up to that tradition.
The fun starts with tomorrow's Senate testimony from Ben Bernanke, the chosen man to fill the shoes of Alan Greenspan, who retires at the end of January. The Financial Markets Center has come up with 70 recommended questions for the Fed chairman-designate on anything and everything that might conceivably be of relevance in vetting the mind of the man who'll soon take the helm at the most powerful central on the planet. We have no doubt the Senate's affinity for propagating queries will add to the laundry list.
If the Bernanke inquisition doesn't manage to roil the markets for a time this week, perhaps the lesser names in the central banking system can do the trick. The lineup of monetary opining includes scheduled talks by Chicago Fed President Michael Moskow and his counterpart at the Dallas Fed on Tuesday; Philadelphia Fed President Anthony Santomero on Wednesday; St. Louis Fed President William Poole on Thursday; and none other the Maestro himself today, who counsels on things far and wide via video conference at a Bank of Mexico confab today.
And just to keep things bubbling on the data front, there's tomorrow's release of October wholesale prices and on Wednesday the update for consumer prices. The consensus forecast, as per TheStreet.com, calls for a relatively mild 0.1% rise in headline CPI and 0.2% for core CPI for October.
The bond market may be alert to the possibility of surprise, but based on last week's trading the 10-year Treasury Note has regained a modicum of calm. Last week's session ended with a yield below 4.6%, reversing what had been a run on higher yields earlier in the week. But behind a front of relative clam, the spread between the 10-year and 2-year Treasuries continues to tighten. As of Friday, a mere 10 basis points separates the two.
It's a week, in short, that holds the potential for volatility, courtesy of a yield curve that's virtually flat, a Senate debate on the merits of the proposed successor to Alan Greenspan, a fresh batch of inflation due for release, and an array of speeches due from Fed representatives.
Speaking of volatility, there's less of it these days--again--in the stock market. The VIX Index, a volatility measure of the S&P 500, has been falling sharply in November after rising from August through mid-October. Assuming relatively tame inflation reports on Tuesday and Wednesday, as the market's expecting, the fading volatility is in sync with equities' recent climb. Over the last month, the S&P 500 has posted a nice run higher, rising about 5.5% as of Friday's close from October's intraday low. The stock market's summer highs are, as a result, within shouting distance once again. The question of whether the S&P 500 is still within a trading range will weigh heavily until and if an upside breakout occurs in the 1245 range (the S&P closed Friday at 1235). If the 1245 ceiling, or thereabouts, holds, all bets are once again off.
In sum, the equity market's upward bias, and the bond market's relatively calm suggest all's right with the world. What, then, are the catalysts that might confirm such optimism, or send it crashing down onto the rocks of surprise? Perhaps one of the Fed heads, or a Fed-head wannabe, will lend a clue.
November 11, 2005
RESEARCH ROOM UPDATE: THE DEARTH OF SAVINGS...AGAIN
Kevin Lansing, a senior economist at the Federal Reserve Bank of San Francisco is worried. Well, not worried exactly but concerned, to use his term from an essay published yesterday, titled "Spendthrift Nation," which of course is focused on Joe Sixpack's unfailing fondness for spending, consuming and otherwise running up his debts. A smoking statistical gun, among many, is the latest trend for saving, which is to say the lack thereof. "In September 2005, the personal saving rate out of disposable income was negative for the fourth consecutive month," Lansing wrote. "A negative saving rate means that U.S. consumers are spending more than 100% of their monthly after-tax income." So what else is new? Everyone's doing it, and it's barely caused a ripple. Indeed, as Lansing reminds, declining personal saving rates have been the convention for the better part of the past 20 years. Why start worrying now? Lansing gives a few reasons in his essay, which we've added to the Research Room. If you're inclined toward pessimism regarding Joe's capacity to spend going forward, read on....
November 10, 2005
STRATEGIC THINKING TAKES A HOLIDAY
The United States doesn't have an energy policy to speak of, but the government isn't idle on the matter of oil and gas. Washington's latest effort on the energy front includes scolding oil companies for the bull market in crude and killing the idea of drilling in Alaska and thereby tapping America's largest supply of untapped domestic crude. Welcome to "progress" on the energy front in 21st century America.
It's any one's guess if the Senators who grilled the oil company execs yesterday understand the long lead times required for developing oil supplies. Today's oil production is the result of planning in years, in some cases decades previous. At some points in that planning, oil prices were low and the idea of investing large sums of money to increase production required strategic thinking. It's also unclear if the Senate as an institution can grasp the fact that the five big oil companies represented in yesterday's hearing--ExxonMobil, Royal Dutch/Shell, BP, Chevron and ConocoPhillips--are collectively on the front line in an uphill battle of keeping non-Opec oil production from falling, as it almost surely is destined to do in the coming decades. And it's unclear if Senators appreciate the reality that spare production capacity is extremely low in the world, and that the only excess of any magnitude resides with Saudi Arabia, whose crude supplies are managed exclusively by Saudi Aramco, the world's biggest oil company and one that was most definitely not in attendance at yesterday's energy inquisition.
Although we don't know what the Senators know, we can read what they said. Alas, all too many of the questions posed yesterday in the Republican-contolled body inspire less than confidence that the American government is prepared for the strategic energy challenges that lie ahead. Indeed, big-picture strategic issues were hardly the priority at yesterday's hearings. Consider the question from Senator Barbara Boxer (D-Calif.) that was personally directed at the oil execs: "Will you consider making major personal contributions or corporate contributions to help Americans get relief from high prices?'' she asked, via the San Francisco Chronicle.
Republicans are the majority party, of course, and so any praise or blame ultimately goes to the GOP. So far, there's more blame than praise to go around.
Perhaps the most chilling evidence that what passes for energy policy in America is out of step with reality came in an exchange between Senator Ron Wyden (D-Ore.) and the execs regarding the $2.6 billion of tax credits in energy legislation that was signed into law a few months back. As a bit of background, Wyden has made it clear that he wants to repeal the credit, and as it turned out he found some unlikely support for doing so when the execs said that the tax credit has limited, if any relevance for their companies. "The tax breaks will have a minimal impact on our company," Chevron's David O'Reilly said, according to McClatchy News Service via Winston-Salem Journal.
The good news is that yesterday's chatter didn't frighten the oil market. Oil prices closed under $59 a barrel yesterday for the first time since July. But politicians will do America no favors in the long term by demonizing oil companies as the cause of America's energy woes, an ill-advised idea that's akin to attacking the messenger for bad news. Yes, price gouging, corruption and all the other evils that inhabit the human condition no doubt have infected the oil industry to a degree, much like any other business. Capitalism is many things, but perfection isn't one of them. Still, it's the only system that has any chance of reasonably allocating finite resources in an efficient manner, and Big Oil is the least worst alternative for bringing crude oil from remote locations to American consumers. In any case, an investigation of price gouging, whether it's tied to gasoline or bananas, is separate and distinct from solving long-term challenges.
Speaking of long-term challenges, the current problem with tight global supplies didn't happen overnight, or spring from the fact that oil company executives make millions of dollars. Lots of corporate chiefs pull down huge salaries. Some don't deserve it. But if the heads of Big Oil magically started earning no more than $50,000 a year from here on out, the same challenges that confront America on energy would remain. And if the oil industry started donating massive sums of money to help Americans pay for energy consumption the effect on global crude supply would be exactly zero.
There is a potential crisis brewing for the U.S. on the energy front, as the recent price spike in oil, gasoline and natural gas makes clear. Indeed, today's report on the surge in the U.S. trade deficit, to a new record provides yet another piece of evidence that the energy challenge is a broad economic challenge. One reason for the jump in red ink, the Commerce Department reported, was increased gasoline imports to compensate for the loss of production due to Hurricane Katrina.
Big Oil, like it or not, is America's best resource at the moment for increasing energy supply--other than relying on the kindness of Opec--in the quest to mitigate the pain that awaits in the decades ahead. Even under the best of circumstances, satisfying the America's growing energy consumption threatens to be the oil industry's biggest challenge yet. There are almost certainly no new super-giant oil fields waiting to be discovered. Meanwhile, the relative share of global supplies under Opec's control is growing. And unlike the scenario of a generation ago, America and the developed world won't have the equivalent of a new Alaska or the North Sea to pull out of a hat to counteract Opec's rising power and influence.
Big Oil, in short, needs America's help to keep what could be an energy squeeze in the years ahead from becoming an energy crisis. Judging by yesterday's political theater, the jury's still out on whether the U.S. government is up to the challenge.
November 9, 2005
EQUITY INDEX SCORECARD
MONTH-TO-DATE PERFORMANCE THROUGH NOVEMBER 8
(Ranked in descending order)
Capitalization/Style (total returns)
Russell 2000 Growth Index 1.99% <-- An early sign of growth's rebound?
Russell Midcap Growth Index 1.73 <-- Midcap growth rolling as well
Russell 2000 Index 1.52
Russell Microcap Index 1.5
Russell 1000 Growth Index 1.35 <--Large cap growth looking good too
Russell 1000 Index 1.07
Russell 2000 Value Index 1.05 <-- The start of value's stumble?
Russell Midcap Index 0.95
Russell 1000 Value Index 0.8 <--Large cap value looks tired
Russell Midcap Value Index 0.22
S&P 500 Sectors (total returns)
Information Technology 2.53% <--Tech continues to rebound in Nov
Consumer Discretionary 1.73 <--Who says consumer spending is history?
Energy 0.82 <--Energy stocks still cooling off
Health Care 0.49
Telecommunications Services 0.42
Consumer Staples -0.24
Utilities -2.14 <--Interest-rate sensitive stocks take a hit
* * *
S&P Equity REIT 2.1% <--Yield sensitive but still holding up
* * *
S&P 500 0.96
International (price change, in US$)
MSCI JAPAN 3.2% <--Equities are still hot in Japan
MSCI EMERGING MARKETS 3.0% <--Emerging markets continue to climb
MSCI LATIN AMERICA 2.9%
MSCI EASTERN EUROPE 2.6%
MSCI PACIFIC 2.5%
MSCI CHINA 1.7%
MSCI EAFE 1.1%
MSCI EUROPE 0.4% <--Sluggish economic growth takes its toll
November 8, 2005
CRUDE TALK IN THE SENATE
Big Oil's scheduled for a session in the hot seat in the Senate tomorrow. The rhetoric may soar and the charges will definitely fly, but it's anyone's guess what catalysts will spawn in the proceedings.
One can only hope that the Senate has studied and learned from the past on the subject of incentives and the blunt tool of taxes. Imposing punitive taxes as a means to promoting a secure and stable future of energy supplies is a bit like raising levies on developers in and around New Orleans as a tool for insuring against the next natural disaster.
This much, at least, is clear: some in the world's greatest deliberative body are burning for new laws that force oil companies to cough up more taxes as penance for the record profits of late.
The oil industry is no stranger to inside-the-beltway chatter and the ebb and flow of government efforts to penalize the world's biggest business. And that's what irks some in the petroleum game. "I, for one hope that the industry's response [in tomorrow's Senate hearings] will include a 'We told you so' component," Bob Landreth, regional director, Texas-Permian for the Independent Petroleum Association of America, told the Midland Reporter-Telegram today. "In 1999 in congressional testimony, when the industry was being dismantled by a brutal market share fight among OPEC producers that drove the price oil down to $9 a barrel, we said then that the fallout from that fight would eventually be $45 oil. Unfortunately, we missed it on the low side."
In the same article, Morris Burns, executive vice president of the Permian Basin Petroleum Association, charged that the huge windfall profits of late in the oil industry are in part a reaction to drilling restrictions, which artificially crimp supply. "We can't drill on the East Coast, we can't drill on the West Coast, half of the Rockies is off limits, we can't build any new refineries," he said.
Politics, not geological access, will be in the driver's seat tomorrow when the oil hearings convene in Washington. That's largely because the party in charge at the moment is feeling the heat to do something, anything in regards to high energy prices. Never mind that the government's been largely asleep at the switch for the better part of the last 30 years on the matter of a national energy policy. All the oversight and errors of the past can be turned around with one quick windfall profits tax, or so some think.
Indeed, that mindset is generating calls for "action" in the GOP ranks, inspiring Republican, Sen. Judd Gregg of New Hampshire, for example, to jump on the Democratic bandwagon that's pushing for a windfall profits tax on the oil business. "Republicans are trying to get in front of this issue because it is clearly an anchor around their ankles at the moment," Marshall Wittmann, a former Senate Republican aide now with the centrist Democratic Leadership Council, told the LA Times today. "There's no doubt that the high gasoline prices are contributing to the low popularity numbers of both the president and the Republican Congress."
That's setting the stage for a legislative reaction, say oil industry representatives. "We recognize that high earnings reports and high prices puts a lot of pressure on lawmakers to show they're taking action," Sara Banaszak, senior economist with the American Petroleum Institute, explained in a Journal News article today. "Letting markets work isn't always perceived as action, so we recognize there's a lot of pressure on lawmakers right now."
In any case, the stakes are high, and getting higher. With global production capacity tight, the potential for tapping vast new supplies in doubt, and demand continuing to grow, this isn't a good time for major policy mistakes on the energy front. The risk of a mistake may be rising, however.
History, as always, offers a bit of a guide. Neil McMahon, who heads up oil analysis at Sanford Bernstein & Co. in London, yesterday penned a research report that reviewed the last time windfall taxes were used to punish the oil business in 1980-87. The results were pretty ugly:
"With the high prices in the 1980’s there was not much more the US producers could do," McMahon wrote. "Rapid exploration and development were happening not just in the Lower 48 of the US, but also in Alaska and the North Sea, and drilling activity had reached frenzied levels. However, although the oil price remained high during early 1980’s drilling activity, oil production dropped rapidly as taxes set in and marginal investment slowed."
In the here and now, McMahon thinks a windfall profits tax would have little beneficial effects for consumers. "Today, we believe that even a small increase in taxes would have a large negative impact, driving the price of crude and natural gas higher, not lower. Additionally, the production from the basins in the U.S. is now more sensitive to changes in crude and natural gas prices, and we would argue that with increased taxes decline rates in these basins would accelerate, increasing the U.S.’s dependence on foreign oil and gas imports."
The prospect of a new disincentive for the oil industry could hardly come at a more inopportune moment. A new report from the International Energy Agency warns that large amounts of investment are needed to satisfy rising demand. Roughly $17 trillion in new investment is needed by 2030 to keep crude and other fuels flowing from the ground to consumers. Perhaps the Senate will consider what legislative policy change, if any, would promote such a massive spending program. Hope, in short, springs eternal at CS.
November 7, 2005
DECONSTRUCTING S&P 500 EARNINGS
Earnings reports for S&P 500 companies have continued to impress in 2005. Will the good times keep rolling in 2006? There's reason to wonder, in part because interest rates are expected to rise further, and it's not clear if the stock market will be able to shrug off the trend indefinitely. The United States economy faces other challenges as well, ranging from trade and budget deficits to next year's arrival of a new and therefore untested Federal Reserve chairman as replacement for the retiring Alan Greenspan.
Michael Krause, who runs the ETF-focused consultancy AltaVista Independent Research (www.altavista-research.com), reports in the firm's latest analysis that S&P 500 earnings per share are on track to rise 11.8% next year. Slower than last year, but still a handsome rise. But a closer look at the S&P 500 sectors suggests that there's more than a little variation in the sources of the predicted earnings growth. In search of some perspective on what's bubbling beneath the S&P 500's hood, we posed some questions to Krause via email over the weekend.
Q. In your latest report ("No need to get all defensive: a look ahead at 2006," Nov. 2005) you write that the S&P 500's earnings per share look "set to grow" by 11.8% in 2006. That's a bit slower than the 14.3% estimated for this year, but a decent advance just the same. What sector or sectors are likely to drive next year's EPS rise, and why?
A. Financials (Amex: XLF), by virtue of the sector’s sheer size, are expected to contribute up to one-fourth of the S&P 500’s earnings growth next year, despite the fact that its own growth rate of 11.4% is basically in line with that of the overall index.
According to current consensus estimates, stocks in the Consumer Discretionary sector (Amex: XLY) are forecast to grow earnings the fastest, at 20% next year. However, I have little faith in this number. Part of the reason is that as estimates for this year have slid 8% since January, estimates for next year have barely budged, giving the stocks that much of a higher hurdle. And, combined estimates for sales and earnings next year imply a huge margin expansion—-greater than for any other sector—-despite already being at historically high levels.
Q. You also warn that "disturbing signals" are emerging in the consumer staples sector of the S&P 500. What are those signals, and what are the implications?
A. Among the warnings signs we see are falling earnings estimates, declining margins, falling asset turnover, and declining return on equity, which is ominous for a sector with such a high price-to-book value (P/BV). Further, the sector trades in line with its historical forward P/E of about 17x, and so it’s not a bargain. Deteriorating fundamentals are particularly disturbing in the case of Consumer Staples (Amex: XLP), since investors often look to it as a defensive sector, a place to hide when fundamentals in more economically sensitive sectors start to head south.
Q. Energy has been a hot sector recently. What's been the contribution of energy-sector earnings to the S&P 500 recently, and what's your analysis for energy's role in S&P 500 earnings next year?
A. For most of the year, it was primarily Energy (Amex: XLE) profits that were driving S&P 500 EPS estimates higher, though not entirely. While we make no predictions as to the price of oil next year, it appears that earnings estimates have now caught up with sustained, high oil prices. Therefore we expect earnings estimates to fluctuate more closely with oil prices going forward, whereas earlier this year estimates rose even on pull-backs in oil prices, since analysts were behind the curve.
4. On a fundamental basis, which of the ten S&P 500 sectors looks the most attractive, and which one looks the worst?
A. Over the next year we particularly like Industrials (Amex: XLI) and Technology (Amex: XLK), which is a bit of a departure for someone who usually has a value tilt. However, the analysis we do shows consistent signs of fundamental strength for these two sectors, including positive estimate revisions, higher margins, and improving return on equity—-the only two sectors for which this is true. But what makes these attractive investment risks to us is the fact that they also trade at a discount to historical forward P/Es. These discounts are also larger than those for most other sectors.
Longer-term we like Financials (Amex: XLF) for valuation. A sector that consistently earns a return on equity (ROE) in the mid-teens (15.2% estimated for 2006) in our opinion deserves a P/BV multiple of 2.1x, rather than the 1.7x pro forma it currently fetches, or a roughly 25% increase. This is based on a trend line of where all other sectors fall on the ROE vs. P/BV spectrum, and given the consistently strong correlation between those two variables.
On the negative side, we dislike Consumer Discretionary (Amex: XLY). Not because we think the American consumer is about to collapse, but because as mentioned above consensus estimates for 2006 are simply unrealistic in our opinion. Analysts made the same assumptions about big increases in margins at this time last year; but 2005 has not panned out that way. If, as we suspect, earnings are flat to slightly down in 2006 instead of gaining 20%, then forward P/E is at least 20x. That is a premium to historical levels, not to mention the rest of the S&P, even Technology.
Q. Switching from sectors to style, the value slice of the S&P 500 has been a strong performer relative to growth in recent years. Some strategists say that growth will soon take the lead again. Based on the fundamentals, what do you expect next year for growth vs. value in regards to S&P stocks?
Here we have a definitional problem, since when most investors talk about growth, they mean fast earnings growth, and they generally expect to pay-up for that growth. However, in a report from last year called “Dirty Little Secret” we found that companies in the iShares S&P 500 Value fund (Amex: IVE) actually had faster earnings growth than did those in the Growth fund (Amex: IVW). The reason for this is because the funds divide S&P 500 stocks into two camps based on price-to-book value, with high P/BV stocks assigned to the Growth fund and low P/BV stocks assigned to the Value fund.
As mentioned above, P/BV is highly correlated to return on equity, but it actually has almost no relationship to earnings growth! This is because many mature firms such as Altria in the Consumer Staples sector are nonetheless able to maintain high ROE (and thus enjoy a high P/BV) by paying out a large dividend. As a result, many of these mature firms end up in the growth fund.
So, to answer your question, the methodology behind those iShares will change soon and the jury is still out as to whether the new rules will result in a growth fund that actually has faster earnings growth. However, your point at the beginning is well-founded: that despite slower earnings growth next year, 11.8% is still a decent advance. In fact, it is nearly double the historical growth rate of 6.2% since World War Two, and rather remarkable in the fifth year of a robust profit expansion. So, with economically sensitive sectors like Industrials and Tech showing enduring fundamental strength, and traditional defensive sectors like Consumer Staples facing their own challenges, I would have to conclude that now is not the time to “get all defensive” and that growth stocks hold plenty of appeal.
November 4, 2005
With less than three months to retirement, America’s monetary demigod yesterday warned that deficits do matter after all. Alan Greenspan scolded that the red ink on the government's budget ledger is a ticking time bomb. "Unless the situation is reversed, at some point, these budget trends will cause serious economic disruptions," the Fed chief said yesterday in Congressional testimony, according to AP via BusinessWeek. He want on to remark, "I find it utterly inconceivable, frankly" that ongoing budget deficits in the long run "will not have a significant impact on long-term interest rates."
It's anyone's guess whether the budget deficit will persist, or if the red ink will push up yields higher than they otherwise would be. History is a bit mushy in that regard, with deficits sometime accompanying rising yields and sometimes not. The bond market, however, seemed in no mood to take any chances yesterday, with the yield on the benchmark 10-year Treasury Note ascending to a 16-month high on an intraday basis when it reached 4.649% at before pulling back a bit to close at 4.644%.
The allure of higher long rates in the U.S. didn't go unnoticed elsewhere around the world, including among that species of speculator who toils in the land of forex. The U.S. Dollar Index shrugged off its recent lethargy yesterday to close near its recent highs set back in the summer. Suddenly, the notion of a dollar rally is alive and kicking. If and when long rates in the U.S. move higher still, the dollar will almost certainly post further gains at the expense of the euro, yen and other currencies. If so, the rally will be no small triumph for a currency whose economy is the target of reprimands from the nation's top central banker.
Investors the world over are many things, but stupid isn't one of them. When faced with the choice of higher yields in government bonds vs. lower yields in comparable securities even a half-asleep investor will pick the former. As such, a 10-year Treasury that offers a 118-basis-point yield premium over its German equivalent, for instance, according to Bloomberg, is too inviting to ignore. The same is true, and then some, for the Treasury's 300-plus-basis-point edge over a 10-year Japanese government bond at the moment.
Back in the U.S., the newly emboldened rise of long yields is in serious of danger of being no fluke. Rather, one could argue that the fixed-income set is simply looking at the data that puts a current yield into proper perspective. That includes an inflation rate (measured by the latest consumer prices report) that shows prices advancing at 4.7% annual rate through September. That's still a bit higher than the 10-year's yield. The argument that the core inflation rate (less food and energy) is significantly lower doesn't seem to hold much sway at the moment.
The debate over whether the core vs. headline inflation rate was always destined to be settled by the market. Is the market now dispensing a verdict?
A definitive answer is still forthcoming, and that of course will be determined by what economic data drips out. On that note, there's a mixed message in today's release of October's employment report. On the one hand, job growth was less than expected, although hourly earnings growth surprised many economists with a relatively high 0.5% advance last month.
Like the choice between the lower core and headline rates of inflation, there are two ways to read today's employment report. Indeed, there is any number of trends these days to fit every lifestyle and bias. Absolute truths are a slippery concept in the dismal science, but perspective as defined by the crowd is often everything, and perspective looks set for a retread in the coming weeks and months. Even Mr. Greenspan seems compelled to speak bluntly these days, no doubt because his tenure is nearly up. But clear speaking is intoxicating, if sometimes awkward. Perhaps the fixed-income will take the hint in the pricing of risk. Stranger things have happened.
November 3, 2005
WAITING FOR THE NEXT BIG THING
BCA Research advised on Tuesday that an economic slowdown was coming. The bond market, the research shop continued, would see the approaching stumble before the Fed got wind of the trend. "Bonds have already discounted a lot of hawkish Fed rhetoric in recent weeks. Moreover, the selloff at the long-end of the Treasury curve is growing tired, according to our short-term momentum measure. Valuation has improved and there should be strong technical support near the March high of 4.65%."
In fact, the 10-year yield as we write is 4.63%, or just about the highest since March. Will this range hold, as BCA predicts? Or, is a breakout to higher yields the next big change for the fixed-income markets?
Judging by this morning's release of the ISM's report on non-manufacturing activity for October there's reason to think that yields could take out the March highs. The non-manufacturing index rose to 60 last month, moving sharply higher from September. The rebound returns the non-manufacturing sector--which includes such industries as construction, retail trade, and finance & banking--to a pace of growth on par with the first half of 2005, writes David Resler, chief economist for Nomura Securities in New York, in a research note today. "Overall, the sector's business activity is steady," he opined.
Is this what the onset of an economic slowdown looks like? Perhaps not, although if you're intent on finding support for the BCA gloomy forecast, consider today's release of orders for manufactured goods to consider, which fell 1.7% in September, the Census Bureau reported. That's the lowest since July. But this is a thin reed for rationalizing that the economy's set to stumble since the Katrina and Rita hurricanes probably caused widespread shipping delays, which raises questions are the relevance of September's factory orders.
Meanwhile, this morning's news that retailers had a surprisingly strong month in October is harder to dismiss. The 4.4% rise in same-store sales last month, according to the International Council of Shopping Centers, is hard to interpret other than to recognize that Joe Sixpack's still reaching into his wallet and confounding some dismal scientists who expected less our hero on the subject of spending. "This is great stuff," said Richard Hastings, retail analyst at Bernard Sands LLC, speaking of the retail numbers via a story from Marketwatch.com. "It shows again that you can't bet against the consumer."
But if Joe keeps on buying, which in turn keeps the economy bubbling, the Fed's likely to keep pushing up short-term rates, an action that's seems to have finally caught the attention of the fixed-income set.
Of course, higher interest rates, if they ascend far enough, will eventually deliver the outcome that BCA predicts. The timing, however, is open to debate. To be fair, BCA's hardly alone in its forecast that a slowdown will arrive sooner rather than later. Bill Gross of Pimco, in his November "Investment Outlook," published a chart showing that over the last generation, when the spread between the two-year and ten-year Treasuries has narrowed to roughly parity, as describes the current spread, recession followed.
Is history fate? Perhaps, but there are more than a few things that have changed in recent decades to insure that obvious trends may not be so obvious after all. Ergo, there's a surplus of things that could go right--or wrong in a global economy that's become amazingly complex. In the meantime, there's a number of question to which no one yet has satisfactory answers.
Consider, for instance, the topic of a global savings glut that Ben Bernanke, the next Fed chairman, has discussed. Does such a glut in fact exist? And if it does, are the implications cut and dry? On the one hand, a surfeit of cash sloshing around the world in search of a home implies that interest rates will be lower than they otherwise might be. But as a Wall Street Journal story today (subscription required) points out, excess cash may be imprudently promoting risky behavior and thereby setting up the capital markets for another bubble-popping event. Then there's the debate over the Bretton Woods II, a reference to the currency markets that allow (promote?) a relatively strong dollar in the face of rising government and consumer debts in the United States. Daniel O'Connor of Catallaxis describes BWII "Stable Instability," although the capital markets, for the most part, think it's just fine as it allows America to finance its debt and keep Joe spending to a degree that breaks every rule we learned in economics 101.
What does the bond market think of all this? For the moment, the jury's still out. That said, the 10-year's yield is inching higher. Our guess is that it'll take another catalyst to trigger a breakout to higher rates, or pull yields down sharply and thereby keep the trading range of recent months intact. What might this catalyst be? The choices, it would seem, are infinite at the moment.
November 2, 2005
A DOZEN TO DATE, AND COUNTING
The Fed raised interest rates for the 12th time yesterday, pushing Fed funds up another 25 basis points to 4.0%. Now what? More of the same, of course.
The central bank assured the world that "that policy accommodation can be removed at a pace that is likely to be measured." That's central banking-speak for: 25-basis points for as far as the eye can see remains the mantra for monetary policy, much as it's been since the tightening began in June 2004.
But while the Fed continues to tighten like clockwork, the bond market's confidence is in question. The 10-year Treasury yield rose a bit yesterday, ending the session at roughly 4.58%, near the highest levels since March.
The Fed's persistent, if cautious effort to tighten the monetary strings seems finally to have taken root in the hearts and minds of the fixed-income set. Indeed, the 10-year's yield is up nearly 60 basis points since the end of August.
Yet while the 10-year's yield is up sharply since August 31, the all-important "spread," or rate differential between the two- and ten-year Treasuries hasn't changed all that much, and in fact has slipped ever so slightly in the past two months. At August's close, the spread was 18 basis points; as of yesterday, it had inched lower to 16 basis points, according to Treasury Department data.
So much for the time value of money. The lack of a significant premium for locking up principal for ten years as opposed to two is part and parcel of a flat, or near-flat yield curve. What does the perseverance of a flat world order in yield curves say about the Fed's war to convince the bond market that inflation is under control? Clearly, the bond market is convinced.
But how does one square that with the fact that the central bank, by its own testimony, remains "accommodative," a description that's supported by the usual array of numbers. Consumer prices advanced by 4.7% in the year through September, a pace that's higher than both the current yields on the 10-year Treasury Note and Fed funds. In other words, the real (or inflation-adjusted) yields are negative, which is to say, accommodative.
How long will the bond market live comfortably with a flat yield curve and negative real rates? For an answer, keep on eye on the next batch of economic data. An economy that continues to surprise on the side of growth will add to the pressure on the bond market to reprice inflation risk.
The bond bulls have in fact been pummeled of late, but their cause is hardly hopeless. Indeed, recent economic data has been of two minds, alternatively supporting predictions of a slowdown and continued growth. Yesterday's factory orders report for September fed the fears of the slowdown school of thought. But then the October ISM Report on Business offered a bit more optimism that the economic expansion still had a head of steam. Although the so-called PMI index that tracks the manufacturing economy slipped a bit in October, falling to 59.1 from 59.4 previously, it was still far above the critical 50 mark (a reading below 50 indicates a contracting state of manufacturing activity; above 50 points to growth). Long gone is the reading of 51.4 logged back in May that raised the specter of recession.
"The U.S. economy is in good shape which is why the Fed is going to have to keep raising rates,'' Graham McDevitt, global head of government bond strategy at ABN Amro Holding NV in London, tells Bloomberg News today. "Yields will keep pushing higher.''
Of course, higher rates may be just what the markets want, to judge by the fairly stable two/ten-year spread. A further rationalizing for staying bullish on bonds stems from the argument that higher rates will tone down any emerging inflation. One could argue that the bond market looks inclined to be bullish no matter what the Fed does, and thereby risks a correction of major magnitude at some point. Yet for the moment, even the gold market is looking less anxious of late, with an ounce of the metal changing hands for about $460, down $20 from the highs of October.
In fact, the bond market can take heart in the realization that the Fed yesterday effectively announced that it would keep raising interest rates until the economy slowed. And with Fed funds futures contract for next May currently priced at 4.725%, that's a threat that some are taking seriously.
November 1, 2005
THE CASE FOR PLAYING DEFENSE IN CONSUMER STOCKS
Investors can't pay too much attention to the consumer. In good times, consumer spending is the fuel that drives bull markets. But the trend has been known to work in reverse as well. The challenge is figuring out which side of the coin will dominate, and for how long. Turning points, as always, are the tricky parts.
For the moment, Joe Sixpack and his counterparts across the nation continue to generate the lion's share of economic activity in the U.S., representing about 70% of GDP as of the third quarter, according to the Bureau of Economic Analysis. Although the consumer will almost certainly remain the economy's primary engine for the foreseeable future, if not indefinitely, recent trends in sentiment measures raise questions for the short term.
Consumer expectations this year have fallen to lows last seen in the recession of the early 1990s, as measured by the widely followed series produced by the University of Michigan via an October 31 research note published by Safian Investment Research. It's interesting to note, that consumer confidence by age groups sharply differ. Citing another data series from the Conference Board, Safian observes that the under-35 crowd is substantially more optimistic about the future compared with the relatively gloomy 35-plus crowd. Nonetheless, all three age-based consumer confidence indexes remain in downtrends.
Is this a sign that Joe's about to end his penchant for spending? Perhaps, but the signs are still mixed from a quantitative perspective. Personal income, Joe's ace in the hole that allows him to keep spending, soared by 1.7% in September, BEA reported. Was that a surprise? Absolutely, with some economists expecting a rise by as little as 0.2%.
But if the sharp advance in personal income was an excuse to go on a spending spree, Joe wasn't biting. Personal spending rose but at a substantially slower rate in September--0.5%. That reverses the 0.5% decline of August, but it pales in comparison to the 1.0% and 1.4% of June and July, respectively.
Joe arguably needs to curtail his spending anyway. Personal savings as a percentage of disposable personal income declined by 0.4% in September, the fourth consecutive month of descent.
Does this all add up to a warning of things to come from an investment perspective? It's starting to look that way to judge by a a performance comparison between the consumer staples and consumer discretionary sectors of the S&P 500 stock market index. This year through October 31, for instance, consumer staples posted a 1% total return. That's slightly better than the S&P 500's slightly loss over the same period (down 0.4% year to date). More importantly, the consumer staples sector (which includes such stocks as Colgate-Palmolive, Campbell Soup, General Mills and other firms whose sales are relatively immune from economic cycles) handily beats the nearly 10% loss for consumer discretionary equities, whose fortunes are more closely tied to sales of items that aren't essential and thus subject to the winds of expansion and recession. Buying a new widescreen TV is fun, but it's a purchase that can be delayed. Don't try that with food.
No wonder that money manager Michael Farr of Farr, Miller & Washington favors the defensive plays among the consumer-oriented companies. "We agree that the consumer is becoming more pinched," he told BusinessWeek today. "The negative savings rate and record levels of credit-card debt worry us. We take a somewhat defensive approach, in that we believe that the consumer in almost any economic condition will continue to buy certain staples, such as toilet paper, soap, and toothpaste." Among his picks: Colgate-Palmolive, the drugstore chain CVS, Staples, Anheuser-Busch, and the tobacco company Altria. "The tobacco stocks are always fairly safe. People will continue to spend when they're addicted. The problem with these addiction stocks is the ongoing liability, but some of that seems to have been removed from the tobacco stocks in this country."