January 31, 2006
THE WIZARD STEPS DOWN
Alan Greenspan packs up his bags today and says farewell to the job he's held for the past 18-1/2 years. By several measures, he's leaving the financial system of the United States in better shape than he found it. The standard inventory of accomplishments on the maestro's watch includes lower inflation; milder and less frequent recessions; and greater transparency in the business of managing the nation's money supply.
Call us crazy, but that's progress by any reasonable definition of enlightened and successful central banking. That said, the maestro's hardly escaped criticism. Whether it's the rising trade gap, the march of red ink on the government's balance sheet, or consumer spending run amuck (by some accounts), critics find much to question. The Fed, of course, has a fairly limited mandate, and relatively few tools at its disposal. As such, we can argue about what exactly is, and isn't, relevant for assessing a Fed chairman's record. But this much is clear: Greenspan leaves his successor, Ben Bernanke, with a thicket of rising challenges for which there are no obvious or easy answers in the deployment of the traditional levers of central banking.
For all the triumph that surrounds the retelling of Greenspan's tenure over the past generation, it's less than clear that the Fed and its counterparts around the world will be as successful in managing what awaits. The challenge is compounded by the fact that the world is arguably too dependent on the American consumer, an economic force that will be increasingly threatened by its penchant for assuming ever greater piles of debt. Adding to the uncertainty is the fact that Greenspan leaves his replacement with no obvious blueprint for running a central bank. The man who today exits the most powerful job in global finance with his reputation intact has become notable for being a nimble steward of monetary management, espousing no central theorem or rules of play.
By some accounts, the United States has benefited from Greenspan's willingness to ponder any statistic, reconsider if not abandon formerly held beliefs when necessary, and generally go wherever the economic tide carried him. It's also true that the global economy is a far more complex and dynamic animal in 2006 than it was in August 1987, when Wall Street greeted Greenspan's arrival with skepticism and reservation.
Greenspan had the thankless job in 1987 of replacing Paul Volcker, who in the early 1980s engineered one of central banking's greatest victories in slashing inflation. But if there was but one obvious and immediate goal for the Fed back then, there is something less than consensus on how to proceed and which demons to attack in the 21st century.
Yes, there's little debate these days over the notion that conservatively managing money supply is essential for keeping a lid on inflation. The 1970s have been banished. As a policy matter, Milton Friedman-inspired thinking has effectively won in terms of the basic premise for how a central bank should operate.
But such consensus offers false hope that monetary management can now proceed on auto-pilot. Despite the advances in central banking in the Volcker and Greenspan era, the business is not physics or chemistry. Yes, inflation is still the nemesis, but measuring it and identifying it aren't getting any easier.
Meanwhile, if Greenspan is half as great as many say he is, then the capital markets should worry if Bernanke is up to the job of maintaining the standard. Indeed, Greenspan is feted in part because he's thought to be so extraordinary. By definition, then, no one can fill his shoes. Looking back over the maestro's record one might see him more as a wizard, drawing on a rotating mix of variables to concoct policy responses. If, as some assert, this capacity for a deft hand on the monetary tiller is necessary, one could rightly wonder if Bernanke's up to the job.
Indeed, Bernanke has a reputation as a monetary economist who favors inflation targeting. The argument in targeting's favor is its emphasis on a systematic approach to fighting inflation, thereby announcing in advance what is tolerable and what isn't for pricing trends. In exchange for that additional level of transparency, the bond market will require lower yields.
The targeting methodology stands in contrast to relying on the impulses, enlightened or otherwise, of one or several central banking minds. Does targeting work? Exhibit A in the case for a systematic approach is the European Central Bank, which boasts an inflation target and lower inflation relative to the United States. Yet the dismal science debates if Europe's lower inflation is a function of its target or the peculiarities of its economy, which struggles with growth compared with the United States.
Yes, Greenspan's central bank could be deemed superior, but there's only one Greenspan, and now he's headed for retirement.
Meanwhile, one might ask, how an inflation-targeting regime might fare in a world where economic precedent seems destined for reinvention on a recurring basis. Globalization is rewriting economic rules for what constitutes enlightened monetary policy. The virtue of Greenspan's a la carte approach to monetary policy was that it's nimble, and so can evolve for response to events as they unfold. A system of targeting inflation, by contrast, is said to be a relative straightjacket for monetary policy, a rigidity that may be impractical in the new world economic order.
Ah, but perhaps Mr. Bernanke will strive to be more Greenspan-like and pull back from the rigidity of a targeting system. Ok, but no one knows if Bernanke can pull it off. Damned if you do, damned if you don't.
No matter what Bernanke does, the facts on the ground are changing and so the policy responses, systematic or otherwise, are again open to debate going forward. Indeed, one of the great discussions in central banking is whether trying to prick speculative bubbles is informed or naive. Case in point: debate rages over whether the generally unchanging 10-year Treasury yield reflects an approaching recession or deflationary winds born of globalization in an otherwise robust period of growth.
Such grand issues may go unanswered, but so too do simple questions. Some pundits warn that monitoring the health of the American economy and any inflation by way of bond yields is no longer relevant. Cheap imports from abroad keep manufactured goods prices lower in the U.S. than they would otherwise be. In turn, the developing nations sending those goods receive dollars. Because the United States exports relatively little to China, for example, the Middle Kingdom's supply of greenbacks pile up. For safe keeping, China parks them in Treasuries, a purchase that helps keep America's long-term interest rates artificially low.
The global savings glut, as Bernanke labeled the phenomenon in a speech last year, has both benefits and risks. Indeed, the United States is now running a massive current account deficit, driven by the American urge to buy from foreigners by an increasingly large gap relative to exports. As new Fed chairman observed last spring, "for the developing world to be lending large sums on net to the mature industrial economies is quite undesirable as a long-run proposition."
Undesirable or not, the phenomenon is no trivial factor in American finance these days. The availability of cheap credit, despite the Fed's best-laid plans to raise short interest rates, continues to make itself known in the U.S. economy. In turn, the trend diminishes the efficacy of central banking's traditional levers of monetary influence while unleashing speculative bubbles in various asset classes. All the while, traditional gauges of inflation remain calm. Residential real estate, for instance, have been soaring in recent years while consumer prices generally have stayed fairly steady.
The question of whether central banks should consider narrow definitions of asset price inflation, whether it's in stocks, real estate or somewhere else, draws no consensus in the world of central banking. Greenspan's Fed refused to prick bubbles as a pre-emptive strategy for heading off the pain of a speculative crash or a wider inflationary trend. In contrast, the Bank of England and its counterparts in New Zealand and Australia are proactive when it comes to fighting contained asset bubbles that don't otherwise reveal themselves in the general inflation statistics.
But even Alan seemed to be rethinking his reluctance to fight irrational exuberance. Greenspan recently said the housing market looks "frothy" and he took the unusual step of putting his name to a Fed research paper last September that raises concerns that a drop in housing prices might negatively impact consumer spending.
No one knows how Bernanke will respond, or if he'll be successful in battling these and other issues that threaten to undermine central banking's power and influence. This much, at least, is clear: we won't have Alan Greenspan to kick around any more.
January 30, 2006
The federal government is a large and sprawling beast, spitting out economic reports as routinely as politicians call press conferences. The only difference in the 21st century being that official statistical releases now come a la carte, and in a variety of flavors. Search for a perspective that suits you, and consume only what you want.
Case in point: If you're feeling gloomy about Friday's surprisingly weak report on the economy for the fourth quarter, the ever helpful Treasury Secretary John Snow has a few encouraging words to counter the gloom emanating from that other government agency. "The advanced estimate of fourth quarter 2005 GDP released this morning is inconsistent with the underlying strength of the U.S. economy," he opined in a press release dispatched after the Bureau of Economic Analysis released the advance estimate of GDP for last year's October-through-December period.
Not only does Secretary Snow find reason to question BEA's fourth-quarter analysis, he suggests that an informed observer might do well by looking elsewhere for economic enlightenment. "I would not read too much into today's numbers," he counsels. "They are somewhat anomalous, reflecting some special factors." (Is that Treasury-speak for the BEA goofed?)
To be sure, Snow's not alone in putting a different spin on the numbers. More than a few dismal scientists have made similarly optimistic observations since the latest GDP report was released, as we noted Friday. The question is whether the bond market agrees. Venturing a guess, Charles Dumas, watching the action from London at Lombard Street Research, writes that there are "excellent buying opportunities for long bonds ahead." He reasons that "it will take a miracle…to prevent a sharp U.S. slowdown in the second half 2006, possibly to nil growth by Q4," a scenario that implies lower interest rates and thereby fueling a new bull-market leg for bonds.
The Treasury Secretary begs to differ. "The American economy is on a good course and I am very confident," he enthuses. "I am optimistic about the first quarter and the year ahead and am confident that we will see strong growth for the year."
It's not often that one government agency disparages the data releases of another. Coming on the eve of Alan Greenspan's retirement, the arise of an inter-government dispute over numbers and methodology does little to promote confidence in official statistics. To be sure, it may very well turn out that the fourth-quarter GDP number will be revised upward, an expectation that more than a few pundits espouse. Secretary Snow, meanwhile, isn't compelled to wait for a revision, upward or otherwise.
As it happens, the benchmark 10-year Treasury closed over 4.5% for the last two trading sessions, an elevation not seen in over a month. The fixed-income set, as any market observer can tell you, has had a mind of its own in recent years, and the trend shows no sign of ending.
The economy may or may not be slowing, the Fed may or may not continue easing, and government agencies may or may not agree with one another's statistical releases on any given day. Other than that, all's clear as glass in Washington as the world awaits the first pronouncements from Ben Bernanke, assuming the Senate tomorrow confirms him as Greenspan's successor.
January 27, 2006
NOW WHAT? WAIT FOR A REVISION, OF COURSE
No matter how you spin it, a drop to 1% from 4% is something more than trivial.
The big question now is whether the advance estimate of 1.1% growth for the economy in the fourth quarter portends a recession or merely a slowdown in 2006. Some pundits continue to think that neither is coming. Then again, weren't we warned recently of darker days ahead via the inverted yield curves?
In any case, there are the numbers to digest; taken at face value, they paint a troubling profile. GDP rose at the slowest pace in three years in the last three months of 2005, the Bureau of Economic Analysis reports. Digging deeper, the stats only get worse, starting with the massive 17.5% fall in durable goods purchases in the fourth quarter--the biggest decline in 18 years. And while consumer purchases kept rising during October through December, they did so at a slim 1.1% pace, or the slowest rate of ascent since the last recession in the second quarter of 2001.
To say that economists were surprised by the GDP report is something of an understatement. The consensus forecast called for a 2.8% rise. The fact that the actual number came in at only 1.1% tells of the vast disconnect between expectations and reality.
The question is whether the advance GDP report constitutes reality, a line of inquiry that's found much attention today in the wake of the economic news. Knowing full well that each and every GDP report is revised, some are holding out the hope that today's 1.1% fourth-quarter rise will evolve into something more encouraging when the government dispenses the so-called preliminary report and then the final one.
Indeed, some dismal scientists are scratching their heads. "It's hard to recall a more puzzling 'advance' estimate of real GDP," writes David Resler, chief economist at Nomura Securities in New York, in a letter to clients after the report's release. "While it is not unusual for forecasters to miscalculate the high frequency (monthly) indicators, it is rare indeed for EVERYONE to be so far off a quarterly GDP number because nearly 2/3 of the inputs to the advance estimate are already 'known.' It's hard to escape the inference that "everything we knew (or thought we knew) is wrong."
Yet all's not lost, Resler continues. Separately reported numbers for consumer purchases suggest that consumer spending is stronger than the GDP lets on. "Previously reported monthly numbers showed that real consumer spending in November was just 0.1% above its third quarter average," he writes, adding…
Even allowing for the December surge in vehicle sales and the likely increase in spending for home-heating, the December retail sales report seemed to make it quite unlikely that consumer spending growth could grow enough in December to generate even 0.5% quarterly growth much less the 1.1% gain reported by the BEA. The BEA won't make the monthly details known until Monday, but its quarterly estimates imply that, without revisions to the two previous months, real consumer spending jumped by 1.2% in December. That would put consumer spending on a very strong first quarter trajectory of 4.3% growth BEFORE Q1 even starts.
Ian Shepherdson, chief U.S. economist for High Frequency Economics, cuts to the chase, stating, "We expect big upward revisions [in the fourth-quarter GDP report," he tells MarketWatch.com.
Ken Mayland, president of ClearView Economics, virtually dismisses the fourth-quarter slowdown,
noting in a Bloomberg News article today: "I fully expect the economy to bounce back strongly in the first quarter.''
Mark Zandi, chief economist at Moody's Economy.com today says flat out: "I'm not at all worried about the health of the economy," according to AP via ABC News. He predicts the economy will return to form in this year's first quarter by expanding at a robust 4% annualized pace.
Hope, in sum, continues to spring eternal, warning signs or not.
January 26, 2006
HOUSING'S FALLING BLOOMS
The general assumption regarding the current Fed policy is that the central bank's intent on cooling the housing boom. Until and if the real estate market cries "uncle," the central bank will continue raising interest rates. At least that's the theory, and as theories go it's as good as any, which is to say it's in play until proven irrelevant.
As for facts, the housing market in particular has been on a tear in the 21st century, the fuel being the easy credit that became standard of recent years. Meanwhile, the Fed's Alan Greenspan has been stung by criticism that the world's most powerful central bank has been asleep at the switch while two of the greatest speculative booms in history have unfurled beneath its monetary nose.
The first, an extraordinary stock market run in the late-1990s, ended with a bursting of the bubble that for a time looked like it might drag the economy down with it. The Fed barely lifted a finger to slow the rise of excess in the latter half of the nineties, despite the maestro's infamous recognition of the clear and present danger brewing a la his "irrational exuberance" speech of 1996.
Arguably, there is now another bubble in our presence, this time in residential real estate. But compared to its predecessor, the signs of irrational exuberance are fuzzier, the implications for the economy less distinct. History is clear on what the stock market crashes can do. The deflating of national housing bubbles isn't nearly as common, nor as deeply studied.
That said, there are signs of late that the housing bubble, if in fact that's what we're in, is losing air. Whether the future will bring a slow leak or a crash remains to be seen. For the Fed's part, it seems fixed on encouraging the former. Yet central banking is a blunt tool, as we're so often told, and so the best laid plans may yet produce surprises.
In any case, it's clear that the next five years aren't likely to look like the past five years when it comes to housing trends. Yesterday's report on December's existing home sales is the latest bit of evidence suggesting that cooling is now the operative trend in residential real estate. Last month's sales fell to the lowest rate since March 2004, dropping a sharp 5.7% in December from the previous month.
Adding to the anxiety is the news that the normally booming housing market in the South suffered its first dramatic monthly setback in some time, with existing sales falling more than 7% last month.
In addition, sales prices of existing homes nationally fell for the second month in a row in December, dropping 1.9% after a 1.4% setback in November.
Perhaps we're getting overly concerned over nothing. It's winter, after all, and real estate tends toward the sluggish when the air turns cold. What's more, any bullish run invariably corrects at some point, thought not necessarily leading to a crash.
Nonetheless, some dismal scientists warn that economic growth of late has been overly dependent on rising home values, which in turn drives consumer spending. To that extent there's a reversal in the real estate boom, the fallout threatens the economy, or so this line of thinking goes.
BCA Research subscribes to that line. In a note published January 20, the venerable consultancy advises that a "cooling in U.S. housing activity is underway and should coincide with a consumer spending slowdown." Among the data points that BCA cites:
* Failure in the January U.S. home builders’ survey to rebound after steep losses in late 2005.
* Sharp declines in both housing starts and new permits in December
"Housing affordability has eroded significantly due to sky-high house prices and, to a lesser extent, higher mortgage rates," BCA concludes. "Real consumption growth tends to weaken after affordability has significantly declined."
So far, talk of an expected housing slowdown as a catalyst for something dramatically negative in the economy has remained just that--talk. But if the Fed's intent on cooling the housing market, there's reason to sleep with one eye open.
"The bloom is definitely off the housing rose," Mark Zandi, chief economist at Economy.com, tells AP via The Mercury News. If so, what does that imply for the economy and the stock market?
January 25, 2006
HOW FAR WILL COMMODITIES RUN?
Optimists like to say that there's always a bull market somewhere. The challenge is deciding where the aphorism applies, and where it doesn't. As always, there are doubts for each and every asset class. Inevitably, there is hope as well. Beauty and bull markets, in sum, remain in the eye of the beholder. Time is the final arbiter of who's right and who's wrong, but waiting ten years is about as practical letting your cat baby-sit the parrot.
Now that we've dispensed with the usual caveats, we're free to point out that commodities, broadly defined, appear to be caught up in a phenomenon that some might label a bull market. In fact, more than a few pundits are applying the term these days, and forecasting that more of the same is on tap. One of the early adopters of this theme has been the celebrated globe trotter/investor Jim Rogers, who jumped on the band wagon early by launching the Rogers Commodity Index in 1998, a contrarian move at the time, given the soaring equity market back then.
In 2006, commodities as an investment look decidedly less contrarian. Indeed, most broad-based commodity indices have done quite nicely in recent years. The Dow Jones-AIG Commodity Index, for instance, gained an annualized 18% a year for the three years through the end of 2005, comfortably above the S&P 500's 14.4%, for instance. And last year's performance showed that commodities' momentum was in particularly strong form, as the chart below reveals.
That strong run may be enough to turn some investors away. But that could be a mistake. In addition to being a hot tactical play at the moment, many studies note the strategic appeal as a permanent holding, albeit one deserving of a weighting adjustment from time to time depending on the outlook du jour. An academic study from last year, for instance, strongly suggests that commodities are no fair-weather friend for the enlightened asset allocation plan. “Facts and Fantasies About Commodity Futures" crunches data on more than 40 years of futures prices through December 2004 and concludes that raw materials are a potent agent for diversification over the long haul. “While the risk premium on commodity futures is essentially the same as equities, commodity futures’ returns are negatively correlated with equity returns and bond returns,” write finance professors Gary Gorton of the Wharton School at the University of Pennsylvania and K. Geert Rouwenhorst of Yale School of Management.
The inherent cycles that define commodities help explain why the asset class delivers so much value as a diversifying agent in an otherwise paper-laden portfolio of stocks and bonds. Commodities futures “perform well in the early stages of a recession, a time when stock returns generally disappoint,” Gorton and Rouwenhorst write in their study. “In later stages of recessions, commodity returns fall off, but this is generally a very good time for equities.”
Exposing a traditional investment portfolio to the price volatility of raw materials for the long haul, in other words, pays off. “Facts and Fantasies” notes that commodities’ negative correlation with equities and fixed-income tends to increase as the holding period lengthens. Meanwhile, the risk-return profile of commodities is comparable to equities for the 43 years through March 2004, the paper reports. Commodity futures returned about 11 percent annualized over that span, or roughly the same as equity returns, as measured by the S&P 500. As for risk, defined as the standard
deviation of returns, commodities scored slightly lower numbers: 12.1 percent versus 14.9 percent for the S&P 500.
There are a growing number of proxies for commodities beyond trying to assemble a mix of individual futures contracts. Reportedly, that includes soon-to-be-launched ETFs. Meanwhile, there are futures and options contracts on broad commodity indices, various limited partnerships, and a handful of mutual funds, such as the Oppenheimer Real Asset fund (QRAAX). It doesn't take a Ph.D. to figure out why investors have poured money into this and similar commodity-oriented funds in recent years. QRAAX is an index fund that tracks the Goldman Sachs Commodity Index, which, like its competing benchmarks, has run rings around most other asset classes of late. Indeed, Morningstar reports that QRAAX sports a 22.8% annualized total return for the three years through 2005's close, far above the 8.5% posted by the S&P 500.
But the past is gone, and the future is unclear, which brings us back to the question: What might commodities do as an asset class going forward? As you might expect, there is no shortage of opinion, a fair chunk of tending toward bullish. That includes the latest musings from Mr. Commodity, a.k.a. Jim Rogers, who tells BusinessWeek in a fresh interview dated today that the bull market for commodities still has long legs.
"If history is any guide, this bull market [in commodities] will last until sometime between 2014 and 2022," Rogers tells BW's Alex Halperin. The reason? Supply and demand remain "out of whack," Rogers explains. "There's been no major oil discovery anywhere in the world in over 35 years. All the oil fields in the world are in decline. All the mines in the world are in decline. There's been one lead mine opened in the last 25 years."
In fact, Rogers' prediction for a bull market extends beyond energy, which tends to be the dominant force in commodities indices. "I expect all commodities to do well. The supply-and-demand situation for nearly all of them is out of balance, and it takes a long time for those forces to change. That's why bull markets have lasted so long and likewise, why bear markets have lasted so long."
Rogers isn't alone in his bullish outlook. For example, Philip Richards, chief executive at RAB Capital, told Reuters yesterday that commodities will provide a handsome return for the next decade.
But lest anyone think commodities are sure thing, they might do well to remember that greed and fear remain the only perennial factors in the marketplace. Making the indelicate point with a touch more diplomacy, Richards cautions that "it would be a mistake to expect everything to go up in a straight line." The price of crude oil, to take the obvious example, has been strong lately, "but there is evidence of new supply coming to the market, which could quiet things down for a couple of years."
This might be a good point to remind that nothing is guaranteed, which is why the financial gods invented diversification. That said, perhaps the best argument for owning a strategic allocation in commodities is the fact that relatively few investors do so. Indeed, one only has to look at the world of mutual funds to gain some quick perspective. The overwhelming majority of funds target paper investments. By contrast, portfolios focused on commodities are but a tiny fraction of the mutual fund realm. By that measure, commodities are still a contrarian play. Nonetheless, even contrarians can get burned from time to time.
January 24, 2006
HANDSHAKES ACROSS THE WATER
It was King Abdullah's first trip away from home since assuming the throne that oversees the world's largest reserves of crude oil. It was telling that his first outing beyond the desert kingdom of Saudi Arabia brought him to the Middle Kingdom, widely expected to remain the world's primary engine of demand growth for petroleum in the foreseeable future. In purely economic terms, it's a marriage made in heaven: supplier and buyer holding hands, sharing tributes, and otherwise embracing each other's press releases.
"Your excellency is the first Saudi King to visit China," intoned Chinese President Hu Jintao on Monday in talks with the Saudi king, via CRI Online. "This is also your excellency's first visit to another country since coming to the throne. And China is the first stop of your excellency's tour. These three 'firsts' themselves demonstrate the importance you attach to Sino-Saudi relations."
Supplier meets consumer...
Indeed, it would hard to underestimate the nascent but growing relationship. China is the world's second-largest consumer of oil, having reached that position by displacing Japan, the former runner-up to the U.S. in crude consumption, in 2003, according to the Energy Information Administration (EIA). The primary challenge that comes with the elevation to second place is figuring out how to fill the gap between consumption and domestic production, the former having left the latter in the dust.
Energy salvation, as the United States has learned, invariably comes through imports. China pumped an estimated 3.49 million barrels a day of crude oil in 2004, according to EIA data. That was more than 3 million b/d below China's consumption that year. Ten years ago, domestic production and consumption were roughly equal in China. Therein lies a bull market trend that's present in more than few large energy consuming nations around the globe.
But the real challenge is yet to come. Again quoting EIA: China's oil demand is projected to rise to 14.2 million b/d by 2025, with imports of 10.9 million b/d.
Let's stop and do the math here. Chinese oil imports of 10.9 million b/d a day would represent a 275% jump over 2004 imports, which totaled 2.9 million b/d. Where might China find an additional 8 million b/d? Saudi Arabia, of course, or so wishful thinking counsels. But while the Saudi and Chinese leaders shake hands and toast one another's plans for increased energy trade, the technicians are left to see that the happy talk turns into reality. Easier said than done, if only because chit-chat never lifted a drop of oil out of the ground.
"The global petroleum industry is facing unprecedented challenges given its responsibility to supply a worldwide market," Salim S. Al-Aydh, senior vice president, engineering and operations services at Saudi Aramco, said yesterday via Emirates News Agency. He forecast that global oil demand will rise by more than 40% over the next 25 years. The main catalyst: growth in developing nations.
China, in short, is hardly alone in its growing thirst for oil that can't be quenched at home. Who might be these other nations in search of higher crude imports? For an answer, just look at Abdullah's current touring schedule.
The intrepid Saudi king visits New Delhi today, the first head of state from the desert kingdom to arrive on the subcontinent in 50 years. The talk is sure to begin and end with oil, which India imports to the tune of 70% of consumption. "Energy constitutes the core of [the India-Saudi] bilateral relationship," Talmiz Ahmed, a senior Indian government official told AFP via The Financial Express. "It is the number one supplier of oil, meeting 26 per cent of our requirements, and is likely to remain so for several years to come." Abdullah is only too happy to comply, explaining on an Indian newscast: "With regards to the export of crude oil to India, we would like to provide India's requirement of energy in the future," the monarch said in the interview broadcast yesterday.
India, like China, is growing, and that requires energy. Oil consumption in India continues rising, roughly doubling in the last 20 years to a recent 2.5 million b/d, according to the EIA. Since the country produces less than one million b/d, imports constitute the primary source of crude for India. And with overall consumption projected to rise to more than 3 million b/d, it's no wonder why Abdullah has come to shake hands and break parantha in New Delhi.
The bigger question that overhangs Abdullah's consumer-grooming excursion is whether Riyadh can deliver the goods in the years ahead. More than a little ink has been spilled in recent years questioning whether Saudi supply is up to the challenge in the years ahead. Indeed, it soon will be time to put up or shut up when it comes to issues of promising higher crude oil exports from the aging Saudi fields.
In the meantime, we can only wonder how the political scene in Washington will react, if at all, to Abdullah's trip. The U.S. could hardly forge closer ties with Saudi Arabia, even if that comes as a shock to some (most?) Americans. Might King Abdullah be coming to the U.S. for another hand-holding event with President Bush? The imagery doesn't do the White House any political favors. But the man in the SUV is happy for such couplings, whether or not he realizes the source of his fuel-induced contentment.
Nonetheless, the Saudis can fly around the world all they want. In the end, it's the oil that China, India, and the U.S. want. If a little hand-holding does the job, so be it. But only Saudi Aramco technicians know for sure if a hearty handclasp on various continents will be in vain or not in the years ahead.
Alas, the Aramco boys aren't talking details, at least not while they're actively employed. But a few retirees drop a clue or two from time to time, albeit from a remote perch and by indirect reference. On that note, we reprise a CS piece from last August that quotes Sadad al-Husseini, the recently retired head of Saudi Aramco's exploration and production division, courtesy of an article in the New York Times Magazine. The topic of discussion: the ever-rising global oil demand and the problem of quenching that thirst on a global scale, a challenge that inevitably puts Saudi oil fields front and center:
"The problem is that you go from [average worldwide oil consumption of] 79 million barrels a day in 2002 to 82.5 in 2003 to 84.5 in 2004. You're leaping by two million to three million a year, and if you have to cover declines, that's another four to five million." In other words, if demand and depletion patterns continue, every year the world will need to open enough fields or wells to pump an additional six to eight million barrels a day--at least two million new barrels a day to meet the rising demand and at least four million to compensate for the declining production of existing fields. "That's like a whole new Saudi Arabia every couple of years," Husseini said. "It can't be done indefinitely. It's not sustainable."
January 23, 2006
BUBBLE, BUBBLE, TOIL AND TROUBLE?
With the Iran crisis continuing to bubble, oil prices mounting another run at $70 a barrel, and renewed anxiety on Wall Street about corporate earnings, you might think that the odds were fading for another round of Fed-induced interest-rate hikes. But the members of the National Association for Business Economics (NABE) think otherwise. The January NABE Industry Survey, released today, reflects expectations of "solid growth in the economy," said Gene Huang, NABE member who in his day job is chief economist, FedEx Corporation, in a
Reviewing a copy of the entire survey obtained by CS reveals that the 142 NABE-member economists polled generally observe that industry demand for goods and services is rising. In fact, NABE's net rising index--which measures the percent of respondents reporting rising demand minus the percent reporting falling demand-- increased to 54 percent, the highest reading since the second quarter of 1997. No wonder then that the NABE survey finds that three out of five respondents predict inflation-adjusted gross domestic product will grow at an annual rate of three to four percent in the first half of 2006.
The question is whether the Fed is drinking from the same batch of dismal science Kool-Aid? Judging by current trading in Fed funds futures, the answer comes back a clear "yes." The April '06 Fed funds contract is priced for a yield of roughly 4.6%, a sizable premium over the 4.25% that now prevails as official policy at the central bank.
In simpler times, when there was just one telecom stock and state-of-the-art money management was run with a pencil and a legal pad, such a positive outlook for continued economic growth would cheer Wall Street. Alas, nothing's quite so simple in 2006. Equity traders are as nervous as a cat in a room of rocking chairs, as witnessed by the S&P 500's sharp fall of nearly 2% on Friday, a pullback that nearly wiped out the January rally that formerly graced the venerable stock-market index. Still, some are scratching their heads over what's weighing on stocks at a time when economic growth is thought by many to be in no danger of evaporating any time soon. But worry not: as usual, there are plenty of gremlins lurking in the shadows to explain what ails confidence.
As noted above, the Iranian situation extends no shortage of potential for anxiety, largely as a geopolitical event that, in the worst-case scenario pushes oil prices into stratosphere, thereby taking the expected toll on corporate earnings. But a reading of the insular world of studying bull and bear markets also offers some excuses for staying cautious as well, according to analysis published on Friday by the money management shop of Comstock Partners:
A study of past bull and bear cycles indicates that cyclical peaks and troughs exhibit repetitive and consistent behavior that helps determine whether the stock market is closer to a top or a bottom. Market bottoms typically are accompanied by low valuations, highly negative investor sentiment and an easing monetary policy. By way of contrast, market peaks usually exhibit high valuations, positive investor sentiment and tightening monetary policy. In addition, by definition market peaks occur following substantial gains while bottoms occur after significant declines. In our view the current status of these factors strongly indicate that current market conditions are much more typical of a top than a bottom. Valuations are high, investor sentiment is positive, the Fed is tightening, and the market has risen significantly over the last three years.
Donald Luskin of TrendMacrolytics is also "uncomfortable" with the rally that formerly defined January trading before Friday's selloff. Writing on January 20 in a note to clients, Luskin invoked a contrarian strain of thought by lamenting the fact that investor sentiment was recently quite strong. "In 77 years, there have been only a dozen in which the first four days of January performed better than this year -- a fact that animated much non-fact in the media about the "January Indicator," he observes.
Luskin's "most disturbed," however, by "the fact that more than all the gains year-to-date were made during those celebrated first four trading sessions. Those days coincided with a surge of confidence that the Fed would conclude its rate-hiking cycle with the January 31 FOMC meeting." Yet in Luskin's opinion, which seems to be gaining ground on the Street, the Fed's tightening won't conclude at the end of the month, a prediction supported by the renewed rise in oil prices, to name one smoking gun altering perceptions on monetary affairs at the moment.
If you're looking for consistency, the best locale remains the worldview of bonds, where the 10-year Treasury yield continues to provide a counterpoint to predictions of higher rates on the short end of the yield curve. The 10-year's 4.38%, as we write, is about the same level from late-December--or October, or the summer of 2004, for that matter. The message here is unchanged: economic slowdown and/or deflationary winds are coming.
The equity market may be swirling, the geopolitical scene reeling, and oil prices running. But at least you can still find consistency in the 10 year.
January 20, 2006
ASSET CLASSES--ONE YEAR AT A TIME
How do asset class returns stack up on a calendar-year basis for the past 10 years? Funny you should ask--we just compiled the answer, in graphical form. It's too wide for our front page, but you can click here to behold the horse race for each of the 10 years through the end of 2005.
Once again, it's clear that the variation of returns is far and wide, even on a year-by-year basis. For instance, last year witnessed emerging markets stocks soar by more than 30%, while foreign government bonds in developed markets shed 9% (both in $ terms). The big-picture playing field, in sum, delivers plenty of action, even for an active trader.
Meanwhile, for the more strategic minded, more than a few trends stand out when considering asset classes in calendarial terms. That includes the realization that cash isn't always trash, and sometimes it's one of the better games in the house. In 1998, 2000 and 2001, in particular, 3-month T-bills posted impressive returns in both relative and absolute terms by besting half of the asset classes listed in each of those years.
Of course, the only enduring truth for the restless rotation of asset classes is, well, the restless rotation of asset classes. Something's always winning, and something's always losing. Beyond that, you're on your own, other than this bit of counsel: stay diversified, keep an eye on tactical rebalancing, and sleep with one eye open.
And now, step right up and place your bets for 2006....
January 19, 2006
RECESSION? INFLATION? GROWTH? DEFLATION? ALL OF THE ABOVE?
The casual investor can be forgiven for claiming ignorance on the topical subject of inflation's future path. In fact, enlightenment probably eludes the financial sophisticates as well.
Yesterday's update on consumer prices in December exemplifies the muddle that prevails. Top-line inflation, measured by the consumer price index, pulled back last month by 0.1%, the Bureau of Labor Statistics reports. December's 2.2% decline in energy prices was the big reason for CPI's drop, which follows November's even-larger descent.
But then there's the core rate of inflation, which excludes the volatile food and energy variables. By this measure, inflation advanced by 0.2% in December. In fact, core inflation has been advancing on a monthly basis for some time, as opposed to the up-one-month, down-another standard that reigns in top-line CPI.
It all adds up to a mixed bag. If you want to see inflation creeping into the system, you'll find it. But you can also make a case that inflation's no threat. Whatever you choose, here's how 2005 stacked up:
|Dec 2005 CPI:||-0.1%|
|Dec 2005 CPI-ex Food & Energy||0.2%|
|2005 CPI-ex Food & Energy||2.2%|
More than a few observers have concluded that inflation, whether top line or core, is a toothless beast, at least for now. Ed Yardeni, chief investment strategist at Oak Associates, writes in a missive to clients this morning:
Despite widespread fears that soaring energy costs might boost core CPI inflation in 2005, it was only 2.2%, the same as in 2004. We expect it will stay this low again in 2006. The core CPI goods inflation rate is near zero, and could turn negative. The CPI services rate ex energy finished 2005 at 3%, reflecting a surge in hotel costs. These costs tend to be volatile, and will likely move lower again.
David Resler, chief economist at Nomura Securities in New York, agrees. "Overall...the core rate shows little meaningful movement and seems to be 'well-anchored' in the 2% to 2.3% range it has been in for most of the last decade," he writes yesterday in a research note. He adds that the core CPI has risen by less than 2% in only two (2003 and 2004) since 1965.
The notion that pricing pressures may stay contained for the foreseeable future was given another shot of adrenaline this morning with news of a sharp 8.9% drop in housing starts, and single-family starts off by more than 12% for December relative to the previous month, according to the Census Bureau. Perhaps that's simply a reaction to the arrival of colder weather. Whatever the reason, a sign of cooling in housing suggests that the primary suspect in driving exuberance of late is under control, giving new life to optimism that inflation will stay contained.
But if you're a skeptical type who thinks pricing pressure is only dormant, you'll find reason to worry anew in another data point dispensed today. Initial claims for jobless benefits fell dramatically to 271,000 last week, according to the Labor Department. As a result, the 40-week moving average for jobless claims is now under 300,000 for the first time since October 2000, Resler notes. It was a burst of vigor that few expected. This too may be a reflection of technical issues, including the volatility of hiring after the holidays. But coming after yesterday's Beige Book review from the Fed, which advised that economic activity generally remained robust across the nation, there's reason to wonder if inflation may yet mount another run later in the year.
Not necessarily, the bond market effectively announced yesterday, courtesy of another sighting of an inverted yield curve. This time it was the yield on the lowly three-month T-bill inching above the 10-year Treasury. The inversion follows another instance last month, when the 2-year Treasury briefly topped the 10-year.
The traditional interpretation of such a lopsided state of money-pricing affairs is that it presages recession. But this time around there's much debate as to the value of an inversion's forecasting power. No less than Richmond Federal Reserve President Jeffrey Lacker yesterday dismissed the idea that an inverted yield curve predicts recession, or anything else. "Some of the reaction, some of the discussion, reminds me of Medieval times when the arrival of a comet would spark a sort of apocalyptic hysteria," he opined, according to Reuters. "Concerns about inverted yield curves are somewhat overblown."
You can see whatever you want to see (or not see) in the global economy of the 21st century. Rather than drawing hard and fast conclusions from any analysis perhaps we should think of it as a dismal science Rorschach test. Maybe someone can study the correlations between personality types and economic prognostications. No matter, the future will probably surprise the hell out of everyone, as it usually does.
Meanwhile, we can all deconstruct the data to pass the time.
January 18, 2006
REPRICING RISK FOR 2006
It doesn't take much to set the oil market running skyward these days. A bit of anxiety here, talk of trouble there, and--wham! Crude's takes flight.
Anyone who's surprised by the trigger-finger mentality that defines oil trading of late hasn't been paying attention. It may be easier to sleep by turning a blind eye to unfolding events in far-off locales, but for those who crack a newspaper or Google the world of oil news it's deja vu all over again.
Indeed, there's little wonder why a barrel of crude has shot up to nearly $67 in early New York trading this morning--that's up by around 4.5% since Monday's close, and the highest in around three months.
THE FLY IN MR. MARKET'S OINTMENT...
Oil prices, Feb '06 contract
The current mix of supply-side catalysts include the international brouhaha over Iran's stated intention of proceeding with the development of its nuclear program, and the ongoing crisis in Opec-member Nigeria over oil worker hostages. In the latter case, there's no mystery that it's all about shutting off oil shipments from one of the world's largest exporters. "We have decided not to limit our attacks to Shell Oil as our ultimate aim is to prevent Nigeria from exporting oil," the militant group responsible for the current turmoil announced in an email statement, according to Reuters.
In both cases, worries of a spillover effect on crude exports has contributed to anxieties anew that the supply of oil is sufficiently vulnerable to warrant higher prices.
To be sure, the Iran situation so far is only talk, although the implied threat is hardly any different from the Nigerian crisis. In fact, talking can have real-world impacts too when it comes to energy. "The oil weapon is more talked about than used, but it rattles the markets" David Hobbs, managing director of Cambridge, Massachusetts-based CERA, told ISN Security Watch. "And they get more money for their oil."
Turning to the demand side, not much has changed, which is to say that the consuming nations of the world still require incrementally bigger fixes as time goes by. Underscoring the trend (again) is the latest monthly oil report from the International Energy Agency, which predicts that the U.S. and China will be front in center in pushing worldwide demand higher by 2.2% this year, up from a 1.3% advance in 2005, reports Reuters.
Jim Rogers--famed Wall Street investor turned commodities bull--spoke earlier this week at the International Oil & Gas Investor Forum in Aspen, Colorado, urging the audience to recognize the obvious. “Most Chinese don’t have electricity; they’re going to get electricity,” he said, advising that oil and gas will deliver satisfaction, via ResourceInvestor.com. “Unless someone discovers a substantial amount of oil soon, the price is going to keep going up," he continued. On that note, he observed: “Since 1988, Saudi Arabia has said it has 260 billion barrels of oil--that’s 18 years of the same number!”
No wonder, then, that of the S&P 500's ten sectors, energy remains far and away the best performer this year, rising 10.4% so far in 2006 as of yesterday's close, or nearly four times more than the S&P 500's 2.78% year-to-date climb.
Global risk, in short, is alive and well. That risk is re-emerging in oil prices and share prices of energy companies, emphasizing a trend that's ever more firmly in place as something secular rather than short-term. Whether that risk is reflected in prices elsewhere in the capital markets--such as bonds and stocks generally--promises to be a topical subject of debate in the days and weeks ahead. Rest assured, the people on the ground in Nigeria and Iran understand as much. Does Wall Street?
January 17, 2006
RUNNING WITH THE WIND
Wall Street resumes trading today after a long holiday respite, and at the opening bell it's clear that differentiating stocks by market cap by style remains every bit as potent thus far in 2006 as it was last year.
Slicing the stock market by capitalization reveals that smaller is still better. The Russell Microcap Index in January has easily outdistanced its larger-cap brethren, posting a 5.36% total return through Friday. Large-caps, represented by the Russell 1000, looks sluggish by comparison, rising by a relatively sluggish 3.3%.
The year has only just started, of course, so reading too much into year-to-returns carries risk. That said, it's instructive to note that Mr. Market is rewarding higher-risk stocks with higher returns. That's not surprising as a long-run proposition, but for the weeks and months ahead some may find reason to wonder if smaller stocks are deserving of accelerated performance.
Small-caps have been on a roll for several years now relative to large caps. Will rising anxiety over predictions of an economic slowdown, as reported by today's Wall Street Journal (subscription required), derail the small-cap train? In theory, small-cap stocks are more vulnerable to an economic stumble relative to larger firms.
Slicing the market by style and capitalization is messier, although small-caps remain the favorites. As for large caps, value still has the edge so far in 2006.
Although some strategists have been predicting that large-cap value would finally turn this year, and reverse the leadership that large-cap value has held for several years, there's scant evidence for the turnaround so far.
January 16, 2006
THE HIGH PRICE OF SANCTIONS
The West (a.k.a. energy consumers) has a choice. An ugly choice, but a choice nonetheless: Iran without nuclear weapons, or cheap oil--cheap here defined as something approximating ~$60 (if you can call that cheap).
Rest assured, the label will fit if oil's at, say, $100 a barrel. In any case, the West (along with China, Japan and other dependents on imported oil) can't eat their energy cake laced with geopolitically friendly frosting and have it too. Or so it seems, as news of Tehran's tenacity on its nuclear program continues to invade, harass and otherwise threaten the outlook on matters of war and peace, energy and security.
The five permanent members of the United Nations Security Council--the U.S., Britain, France, China and Russia--are discussing the matter as we write. Whether they will vote to impose sanctions on Iran is still up in the air. But the fact that we've come this far suggests how precarious the new Iranian crisis has become.
For those who've managed to stay clueless on the pressing geopolitical crisis du jour, here's the update: Iran insists on developing nuclear power plants, which it insists is all about peaceful energy development. The U.S., Europe and the powers that be in Asia are skeptical, in varying degrees, thinking that ulterior motives may be applicable too. There's even more variation in current thinking on what, if anything, to do about it. But we digress.
Officially, the glitch arises by way of the Nuclear Non-Proliferation Treaty. Iran is effectively dismissing the document these days, despite the fact that the theocracy in 2003 signed the protocol with the U.N.'s International Atomic Energy Agency. Part and parcel of the agreement was the suspension of Iran's nuclear energy research and development. All of which apparently has been resumed after Iran removed IAEA seals on enrichment-related equipment and material.
Mohamed ElBaradei, director-general of the U.N.'s International Atomic Energy Agency (IAEA), tells Newsweek in the January 23rd issue that "if [Iran has] the nuclear material and they have a parallel weaponization program along the way, they are really not very far—a few months—from a weapon. We need to revisit the treaty, because that margin of security is unacceptable."
How's that for stakes? And just to keep things interesting, let's throw in a hefty supply chunk of the world's most valuable commodity as potentially at risk for an extra twist.
Fears that Iran is moving ahead with nuclear research intended for more than peaceful energy development has brought the world closer to yet another energy crisis. Indeed, the U.N. Security Council may vote to impose sanctions on Iran as a penalty for breaching the Nuclear Non-Proliferation Treaty. In which case, Tehran seems intent on responding, perhaps in increments, perhaps in one fell swoop. In any case, rest assured that if pressed Iran will ultimately react by wielding the biggest stick at its disposal in any argument with the West: oil.
How do we know that? Because Iran's economy minister, Davoud Danesh-Jafari, announced as much to the world yesterday. "Any possible sanctions from the West could possibly, by disturbing Iran's political and economic situation, raise oil prices beyond levels the West expects," he told Iranian state radio, via The Mail & Guardian.
Lest anyone underestimate the potential for trouble, Sen. John McCain laid out the stakes yesterday on CBS' "Face the Nation" program, via CNN.com: "This is the most grave situation that we have faced since the end of the Cold War, absent the whole war on terror." The Republican senator also advised: "If we're going to put an economic stranglehold on Iran, which we should be doing -- it's preferable to military, any military option, and maybe more effective -- we need the Russians and Chinese....If the price of oil has to go up, then that's a consequence we would have to suffer."
What's the risk that the tangled affair with Iran will deteriorate into a decline, if not a collapse in oil exports from the land of the mullahs? Something higher than zero. Only time will decipher the outcome, of course. In the meantime, there are intervening steps, at which points a unique and new set of risk dynamics must be assessed. The first approaching challenge resides with Security Council, and therefore the question: Will they vote to impose sanctions? If so, Iran will undoubtedly be provoked.
Iran, for its part, seems unyielding. As reported by the country's government-run news organization, the Islamic Republic News Agency, there's precious little room for debate if only because Tehran speaks in tones that sound less than encouraging for compromise. "Iran has the inalienable and legal right to access nuclear technology and produce nuclear energy under the nuclear Non-Proliferation Treaty (NPT) and with the supervision of International Atomic Energy Agency (IAEA) inspectors," Ahmad Moussavi, Iran's vice president for legal and parliamentary affairs, said yesterday.
The U.N., via the IAEA, begs to differ. The question before the global economy: Does the U.N. Security Council beg to differ too? To press the point, will the Security Council vote to impose sanctions on Iran?
There's reason to wonder, if only because China, a U.N. Security Council member, has signed major energy deals with Iran in recent years and so the Middle Kingdom may find reason to pull back from imposing sanctions on its new energy sugar daddy, and thereby vetoing any effort to teach Iran a lesson.
In fact, the U.S. knows all too well the energy-related incentives for playing softball. Iran holds some 10% of the world's proven oil reserves, and is second only to Saudi Arabia within Opec in pumping crude oil, according to the Energy Information Administration. Most of Iran's production is exported; its primary customers are Japan, China, South Korea, Taiwan, and Europe. That's not to say that the import-dependent U.S. would be off the hook if an Iranian-induced oil spike arrives. Oil is a fungible commodity, and so higher prices there invariably result in here prices here.
For the moment, however, this is all an academic exercise, to be debated in the Security Council. Mr. Market, of course, may or may not be inclined to wait for a definitive answer from the geopolitical high ground for assessing a reasonable price going forward, adjusted for any and all glitches. All eyes will be on oil traders (again) when trading resumes tomorrow.
January 13, 2006
STRATEGIC THINKING--AVAILABLE IN A CONVENIENT 5-YEAR BITE SIZE
Five years is a long time. Long enough to shatter old myths, forge new ones, and remind investors that luck is no trivial factor. A little skill couldn't hurt either. In any case, we submit for your consideration the trailing five-year annualized returns for the major asset classes through yesterday, followed by some observations.
What jumps out at us is the performance dispersion, which is to say the robust variety of returns--ranging from more than 20% a year for REITs down to just over 1% a year for the S&P 500, a.k.a. large cap domestic stocks. The point being that there's been no shortage of opportunity and pitfall in the global capital markets in the last five years. There never is. The winners and losers keep changing, but you can always count on a broad assortment of returns over time for the major asset classes. The not-so-subtle implication: asset allocation still matters, and more than a little.
The mother of all strategic issues in money management all too often becomes subsumed in the chase for the next hot stock. But anyone interested in investment success as a durable notion beyond the end of the month should ignore the widespread obsession with short-term tactical.
The fact that asset allocation is no less relevant in the 21st century than in the preceding generations comes as no shock. Indeed, 2006 is the 20th anniversary of the seminal research from "Determinants of Portfolio Performance," the 1986 paper in the Financial Analysts Journal that first proclaimed the overwhelming influence of asset allocation on portfolios. Market timing and security selection, by comparison, were found to be relatively inconsequential factors regarding diversified portfolios over time.
The eternal question, of course, is what's an enlightened asset allocation going forward? A difficult query to answer, even for an enlightened student of money management. In turn, that suggests investors should spare no effort in coming up with an informed guess, or otherwise hiring someone to do the dirty work.
With that in mind, it's worth remembering that nothing goes up or down forever, at least when it comes to asset classes. Individual securities come and go, but asset classes are forever. That may be small comfort, but it's more than you can say for any particular company or bond. The Acme Computer Co. may hit the skids tomorrow, but equities overall will be here long after we've become fertilizer. Accordingly, paying attention to reversion to the mean (otherwise known as portfolio rebalancing) is one of the few worthwhile pursuits in the study of market history.
Timing, alas, is a crucial part of the equation, at least in the relatively short run. So while we can all congratulate ourselves in recognizing that the REIT group has been one of the globe's hottest asset classes in the last five years, or that the large-cap U.S. equity sector has been a dog, deciding what to do about it for the next five years is another matter.
Inching toward an answer starts with deciding what your "normal" weight in each of these assets should be. "Normal" here is defined as a long-term weighting a la a pension fund's infinite time horizon. For some, that means something approximating the current weight of the asset class as calculated by its relative market cap within the global capital markets. However you calculate it, coming up with a normal weight is fundamental. Why? Because if REITs, for instance, are deserving of a 10% normal weight, then the challenge at any given moment is deciding how much to deviate, if at all, from the normal weight, either with an overweight or underweight.
Coming up with intelligent answers takes time, a bit of number crunching, and in the long run some luck. But for the moment, we can start with step one: knowing where we've been, which hopefully can shed a tiny bit of light on where we're going.
January 12, 2006
IN SEARCH OF CLARITY (AGAIN)
Does he or doesn't he think asset prices are crucial for setting monetary policy? One could be excused for having a less-than-clear grasp of the answer after digesting the talk dispatched by New York Fed President Timothy Geithner yesterday at the New York Association for Business Economics in Manhattan. Throughout his speech he alternatively endorsed and distanced himself from the value of asset prices as practical tool in the setting of interest rates.
Yet even though the man on the street would recognize Geithner's commentary as an instance of flip-flopping, it's also true that relative to the Fed establishment he's taken a relatively clear course in elevating asset pricing as something more than intellectual garbage in monetary theory. Such is the state of central banking these days in America where any and all viewpoints are at once embraced and discarded.
At the start, at least, he set a tone that seemed intent on drawing hard and fast rules. Alas, it proved a fleeting moment. "As financial markets continue to broaden and deepen," Geithner advised, "the behavior of asset prices will play an important role in the formulation of monetary policy going forward, perhaps a more important role than in the past."
Just what "important" means has yet to be determined, although one could assume it would translate into asset prices casting a greater influence on the direction and level of interest rates going forward compared with the past. But presumptions may be dangerous, based on the subsequent qualifications Geithner laid out in his talk.
Indeed, there are many assets to consider in the global economy, and gold is one of them, though not necessarily a favored one in central banking courtesy of the precious metal's tendency to take flight these days. Gold closed just below the $550 level yesterday, up around 6% so far this year, and after a stellar performance in 2005. The buying continued this morning, with gold barreling above that round number.
Perhaps goldbugs are simply underscoring another of Geithner's comments from yesterday's chat, when he observed a "relatively low compensation for risk priced into asset markets today…." Might he be referring to the 10-year Treasury yield, which remains under 4.5%, or roughly a spare 100 basis points over the government's estimate of annualized consumer inflation as of November?
Lest any one think Geithner is about to start advising Ben Bernanke (the Fed chairman in waiting) on the merits of gold, or any other asset as a foundation for a new era of monetary pricing, think again. "There is a well established, and I believe fundamentally correct, case against directing monetary policy at specific objectives for asset values or the future path of those values," he explained. "In other words, asset values should be neither a target nor a goal of monetary policy. The rate of increase in asset values alone seems to tell us very little about underlying and future inflation."
Really? Gold is of no value in assessing inflationary pressures? How about real estate, or oil, or a broad basket of commodities, stocks and bonds? Alas, no, in the mind of Geithner. "Because we know so little about how to assess the appropriateness of asset values against fundamentals," he continued, "because we have so little capacity to both forecast and predictably affect the future path of asset prices, and because we know relatively little about how changes in wealth affect the real economy and inflation, we cannot use monetary policy responsibly or effectively to achieve specific objectives for asset values."
If asset prices are destined to have an uncertain authority in monetary policy, might the process work any difference in reverse? That is, does Geithner think the Fed can influence asset prices through the lever of fiat money? Not a chance, he opined, thereby reaffirming the company line in the legendary debate from a few years back as to whether Greenspan's Fed could have/should have pricked the stock market bubble in the late-1990s before it reached epic levels and then crashed. Setting out his thinking in no uncertain terms in this case, Geithner lowered the rhetorical boom: "Monetary policy does not today and is unlikely in the future to offer us an effective tool for directly reducing the incidence of large or sustained deviations of asset values from what might turn out to be their fundamental values, what some call bubbles."
But just when you thought the asset price topic was inured against change in central banking, Geithner reversed course again, reasoning that "monetary policy still has to take into account the impact of significant movements in asset values on output and inflation. Financial asset prices, by their nature, allocate resources between the present and the future and thereby affect consumption, investment and future growth. History provides us with numerous examples in which significant movements in asset prices have had sizable effects on the path of output relative to potential and on price stability."
In fact, no matter whether you love or hate the link between asset prices and monetary policy, it's there and it's not going away. Geithner said as much, noting that "experience suggests that asset values can be very sensitive to movements in monetary policy or to the perceptions of future policy moves."
So, what should an enlightened Fed do? "The challenge for central banks, Geithner outlined, "is to determine how movements in asset values and expected asset values affect the evolution of the economy. There is little to suggest that the task has gotten easier with the increasing complexity of financial markets, and it has more likely gotten harder."
That sounds like an entry to declaring that the Fed should incorporate asset prices, tough as it is, into the monetary policy mix. But it wasn't, as his concluding remarks attest. The future, in short, remains unclear as to how the Fed will pursue monetary policy in the new era set to launch with the assumption of the throne by Ben Bernanke at the end of the month.
So, what else is new? Nothing, really. That is, unless your time horizon is measured in years as opposed to days. Don Luskin, chief investment officer of TrendMacrolytics, laments the fact that in the good old days the central bank would be responsive to the raging bull market in gold of late. "Gold, now at new recovery highs and 60% above its 10-year moving average, is expressing inflationary expectations in relation to the existing price level that have historically been associated with a 5.5% core CPI, based on robust regression analysis," Luskin writes in a note to clients sent yesterday. "There was a time more than a decade ago when Alan Greenspan, as well as Fed governors Wayne Angell and Manuel Johnson, would have been very responsive to such an alert -- but those days are gone."
Geithner seems inclined to agree. In his concluding remarks yesterday, the New York Fed chief offered something less than complete clarity on what the central bank might do in regards to incorporating asset prices into the policy mix: "Asset prices probably matter more than they once did, but what that means for monetary policy necessarily depends on the circumstances."
Perhaps the incoming Fed chairman will have a different perspective. As such, Mr. Bernanke, the proverbial ball is now in your court.
January 11, 2006
The stock market has charged out of the gate in 2006 with a head of steam. The S&P 500, every institution's favorite benchmark for large cap stocks, is ahead on a price basis by 3.3% through yesterday, January 10. But wait, there's more: small caps are still hot, as they have been in recent years. The S&P 600's significantly higher year-to-date rise of 5.3% easily tops the gain for its large-cap brethren a la the S&P 500.
What's driving equity returns thus far in 2006? The answer rings familiar, to judge by recent history in the performance of the ten sectors that comprise the S&P 500 and S&P 600. In a word, energy is again leading the charge, as it has been for several years now. Indeed, as the two graphs below illustrate, energy stocks are at the head of the performance rankings for both large- and small-cap categories.
But before you dismiss the S&P 500 and S&P 600's advances as solely energy-induced booms, consider that technology stocks are a close second in the large-cap rankings, rising 6% year-to-date--just below energy's 7% jump. Meanwhile, tech's in third place so far this year in the small-cap race, posting a 6.1% rise vs. 8.6% for energy in the S&P 600.
A number of analysts have been predicting that 2006 will witness a rebound in earnest for tech shares, and so far that forecast looks alive and well. In fact, as the New York Times noted last week via News.com, the potential for relatively strong performance in tech is attracting value managers, who think the sector's relatively undervalued. Barbara Walchli, manager of Aquila Rocky Mountain Equity fund, was quoted as saying she's "looking for ways to play corporate technology spending," adding, "that's where the opportunities are strongest." Semiconductors are a bright spot, she continues: "People haven't focused on the fact that the platform change from 32-bit to 64-bit computing" is set to launch, Walchli notes. "There will be a bigger effect than people realize."
Big-cap tech may do well too, based on earnings estimates for the sector in this year's first quarter. According to a new report penned by Michael Krause of AltaVista Research, the tech sector of the S&P is expected to post the second-highest pace of earnings increase in this year's first quarter over the year-earlier period. Tech earnings are forecast to rise by 17.5% in the first three months of this year. Although that pales next to energy's anticipated 44.4% rise over 2005's first quarter, the forecast for tech earnings is still well above that of the 11.9% climb for S&P 500 earnings in this year's first quarter, according to AltaVista.
Overall, Cumberland Advisors' ETF strategist Matt Forester thinks the sectors may offer some surprises in 2006, and for him that translates into looking at some of the lesser celebrated big-cap performers of late:
Given that we expect to start seeing some economic concern, we’re playing the sectors with a defensive tilt. Medical sector stocks (mostly drugs) are as inexpensive as ever. We favor the large caps via XLV, the health care sector SPDR. Also on the defensive theme, we think the consumer staples might end up being a winner over the year. It provides pretty good growth and attractive fundamentals, especially if we get some concerns over future GDP later in the year. We’re picking XLP, the consumer staples SPDR.
Of course, when it comes to sector bets, few are willing to discount energy completely as an ongoing investment theme. That includes Forester, although he advises emphasizing the small-cap energy theme. "Contrary to our large-cap theme, high energy prices mean that small-cap energy names outperform as mergers and acquisitions activity continues unabated. We prefer VDE, the Vanguard Energy VIPER, for this large and small cap blend for energy stock exposure."
January 10, 2006
CONSUMER CREDIT STUMBLES TWICE
Like the proverbial canary's demise in the coal mine, the initial rumblings of things to come can be subtle, and therefore easily misinterpreted. With that caveat, we're cautious of reading too much into yesterday's news from the Fed that consumer credit dropped for the second consecutive month in November, as the chart below reveals. The October/November stumble is the first back-to-back monthly decline since 1992.
.....DOES THE STUMBLE HAVE LEGS?
We can't help but wonder (again) if this is an early sign of an approaching secular pullback in borrowing, and by association an indication that Joe Sixpack will start saving more and spending less in the malls and online in 2006. More than a few economists have been waiting for no less for several years now, only to be surprised by Joe's momentum to keep on truckin'. The economy, as a result, has powered on. But the debate on weighing the odds of more of the same returns anew with November's consumer credit update.
"This downturn in consumer credit mirrors the sharpest quarterly pullback in consumer spending in the fourth quarter since the 2001 recession," Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi Ltd. in New York, observed yesterday via BaltimoreSun.com. But don't throw in the towel just yet, he suggests, noting that "with the economy creating over 2 million new jobs per year, we expect consumer spending and credit to recover in the first quarter this year."
Whatever the outcome that awaits for the great consumer boom is of interest to the global economy as well as investors in the U.S. Just ask China if its likes exporting consumer goods to American shores at valuations that greatly exceed what China buys from the U.S. We all know the answer, largely because we know that countries like to have trade surpluses, the U.S. being an obvious exception. But what if those Chinese exports materially slow? What might be the impact on China, and by extension, the Treasury market, over which China's trade surplus casts no small influence these days?
Nonetheless, waiting for Joe Sixpack to crack has been a mug's game. But Joe's stamina on matters of consumption can't last forever (or can it?).
No, comes the answer from some of the more dismal dismal scientists. As such, yesterday's consumer credit update caught our attention, in part because the news is still fresh in our mind of last month's brief encounter with an inverted yield curve in 2- and 10-year Treasuries, a state that's historically foreshadowed recession or economic slowdown.
There are a million smoking guns in the global economy. Consumer credit is but one. That said, monitoring the various measures of retail sales and related trends promises to be one of the more insightful hobbies in 2006.
January 9, 2006
DOLLAR DOUBTS RETURN WITH A VENGEANCE
Baptism by fire looks like the operative phrase for describing the first order of business when Ben Bernanke succeeds Alan Greenspan at the Fed at the end of the month.
The central bank's principal ward, otherwise known as the dollar, is looking increasingly ill as 2006 rolls on. As of Friday's close, the U.S. Dollar Index shed 3.9% from the recent highs set back in November, with more than half of that loss coming last week. Adding insult to injury, gold is rallying again, pushing again to highs not seen in 25 years.
A leading explanation for the greenback's stumble is the prediction that the Fed's interest-rate hikes will soon end, thereby taking away one of the currency's key means of support. One man's forecast calls for Fed funds to rise to 4.75% in the near term from the current 4.25%. The man here is George Soros, famed hedge fund trader, as quoted by the Financial Times today.
Soros, who's no stranger to currency trading, is hardly alone in expecting a conclusion to the Fed's current round of monetary tightening. Whether he and like-minded speculators are right is another matter. If the dollar continues to weaken, Bernanke may feel the pressure to keep the rate hikes rolling for longer than previously expected.
In any case, the stakes are high for doing the right thing, and avoiding the opposite. Anticipating what exactly is right and wrong for Fed policy going forward will be difficult--more so than usual, courtesy of an approaching regime change at the central bank.
This much, at least, is clear: It's no small advantage for the buck when its chief debt instrument, a 10-year Treasury, offers a yield premium of more than 100 basis points over its German equivalent (a euro proxy) or nearly a 300-basis-point edge over the yen-denominated 10-year from the Japanese government, according to Bloomberg data.
Even if the premium remains intact, there are other potential hazards to weigh when it comes to forex: Among the other suspects thought to be driving the recent selloff in the dollar:
* The demise of 2005's special tax break for U.S. firms as per the Homeland Investment Act. As a result, the motivation for American multinationals to repatriate overseas profits and bring the money home, and thereby create demand for dollars, went the way of the Edsel on December 31.
* New reports circulating that China is finally getting serious about diversifying its vast holdings of dollar reserves (second in the world only to Japan's portfolio of greenbacks) into other currencies.
* Renewed fears that the petrodollars building up in the coffers of the oil exporters are burning a hole in their collective pocket for seeking diversification into other currencies.
In second-guessing such events, real or imagined, yield clearly matters in the global market for assets. To the extent the dollar's yield advantage wanes, it's reasonable to expect some repercussions.
Rest assured, the Treasury's yield edge isn't going away any time soon. Short of a massive selloff in German or Japanese bonds, a new buying frenzy in Treasuries, or both, the spread won't soon close in any great measure. But it will narrow; perhaps slowly, but narrow nonetheless. The relevant questions necessarily become: How fast will the spread narrow, and how will the markets react?
Anticipating said narrowing, the forex gods have deemed the dollar to be worth less today than in the recent past. What's more, the revaluing of the buck is more than rank speculation. "The yen is finally trading in line with the strong Japanese growth and balance of payments fundamentals,'' London-based Goldman, Sachs strategist Thomas Stolper wrote on Friday in a research note, according to Bloomberg News.
Meanwhile, optimism is on the march that Europe's economic growth will advance at a higher pace than previously expected. Germany, the Continent's largest economy, is said to be at the forefront of this upward reassessment. The government in Berlin was previously forecasting a 1.2% rise in the country's 2006 GDP; that was raised last week to as high as 1.8%, according to German economy minister, Michael Glos via Deutsche Welle. "We're sensing an upturn in the economy," he opined.
Apparently, so too are forex traders, who increasingly are focusing on Japan and Europe's growth prospects and America's fiscal and trade deficits. It didn't help that U.S. employment growth in December was weak, advancing a relatively shabby 108,000 for the month, down sharply from November's more-impressive 305,000 gain.
To be sure, in the grand scheme of the dismal science, nothing has really changed today vs., say, last week or last quarter. America, for all its troubles, is still growing faster than its developed-nation counterparts while offering higher yields. It was a winning combination in 2005. But the potential ills that hover over the U.S. economy are no less potent today than they've been in the recent past. But that didn't stop the greenback from delivering a sharp rally from 2005's September through November.
Suddenly, that's a distant memory. The danger in a fresh dollar selloff is that the momentum sparks something more than a quick selloff. Forex traders are by nature an anxious lot. Equity and bond traders the world over should now be wondering if a grand reversal of the buck is possible.
January 6, 2006
M3--THE FINALS DAYS
It's nearly curtains for M3, the broadest measure of money supply currently published by the Federal Reserve. "Currently" being the operative word here, since the Fed will cease M3 updates in March.
Dying, but not yet dead. Indeed, in the limited time left for M3 the series is showing some spirit for one final run skyward. In the latest weekly money-supply data published yesterday, M3 advanced by 8.1% for the week of December 26, 2005 v. its year-earlier level. The somewhat narrower gauge of money supply known as M2 grew by roughly half as fast, rising 4.1% over the same span. In fact, that's no surprise. The spread between the two rates of increase has been growing ever wider as 2005 unfolded (as the chart below reveals), suggesting that there may be more difference between M2 and M3 than the central bank likes to admit.
Officially, the Fed argues that M2 and M3 are virtually identical, and so M3 is a statistical redundancy of no material value, and therefore scheduled for the numerical scrapheap. As funerals go, this one promises to be as quiet as a bond conference in 1999.
As CS readers know, we've written previously on the impending demise of M3--first here, and then again here. And now we dive in for a third time, in part because the gap between the two measures shows every indication of widening, perhaps to the bitter end at M3's scheduled death in March.
As long the spread grows, we'll keep updating it, no doubt to the consternation of the Fed and others. Perhaps we're unnecessarily anxious, but when the most powerful central bank on the planet says it's discarding its broadest measure of money supply, and the only one that's growing at more than twice as fast as the officially stated rate of inflation, we're intrigued, to say the least.
What, you ask, is M3 made of? Sugar and spice, along with everything that comprises M2, plus these extras, as per the Fed's definition:
1) balances in institutional money market mutual funds
2) large-denomination time deposits in amounts of $100,000 or more
3) repurchase agreement liabilities of depository institutions, in denominations of $100,000 or more, on U.S. government and federal agency securities
4) Eurodollars held by U.S. addressees at foreign branches of U.S. banks worldwide and at all banking offices in the United Kingdom and Canada.
Does the distinction matter? The Fed doesn't think so. And the market's accepting the company line, or so one can argue in a world where a 10-year Treasury yields around 4.38%, as we write--materially less than the 8.1% climbing pace set by M3.
Are we a bit paranoid and obsessive over what some might term an arcane bit of monetary statistics? Perhaps. It's a dirty job, but someone's got to do it.
January 5, 2006
WATCHING THE WHEELS GO 'ROUND
Maybe you call it a bubble; maybe you don't. But whatever descriptive label you prefer, the real estate market looks set to figure prominently in economy in 2006, one way or the other.
Indeed, some pundits think Joe Sixpack's relationship with housing will reach a critical juncture this year. With that in mind, the Levy Economics Institute of Bard College has penned a fresh analysis of real estate, provocatively titled: Are Housing Prices, Household Debt, and Growth Sustainable?
The answer is necessarily unclear, as are all peeks into the future. Nonetheless, more than a few dismal scientists have been warning that the economy's zing of late is due in no small measure to the buoyancy of the housing market. As such, all eyes are firmly locked on real estate trends in search of any early signs of what lies around the corner for the American economy.
On that score, there's reason to worry, or at least wonder, the new Levy paper suggests. In fact, the report cuts to the chase in the first paragraph, laying out the challenge and the presumed end game, as the authors see it:
Rising home prices and low interest rates have fueled the recent surge in mortgage borrowing and enabled consumers to spend at high rates relative to their income. Low interest rates have counterbalanced the growth in debt and acted to dampen the growth in household debt-service burdens. As past Levy Institute strategic analyses have pointed out, these trends are not sustainable: Household spending relative to income cannot grow indefinitely.
Everyone knows that, of course. Only the timing is in question. And for the moment, it's easier to maintain a sunny disposition and point out that the economy continues to sail along nicely, thank you very much--especially considering the hodgepodge of threats it's faced and largely overcome in 2005. From trade deficits to budget deficits, from terrorism to oil-price spikes, Joe Sixpack has kept on spending, and trading up to newer and bigger houses, assuming ever larger mortgages, both in absolute dollars and as a percentage of household wealth. If that was the best shot at derailing the American dream machine, then it looks like Uncle Sam passed the audition. In short, the pessimists have been told to bug off, and get a life.
Point taken. But at the risk of being shouted off the digital stage, we can't help but notice that there's a small but growing list of cracks in the housing armor. So far, it hasn't added up to much as far as the wider economy is concerned. And yet…
Consider, for instance, that Manhattan real estate is showing signs of tiring. To be more precise, the soaring prices that prevailed in the first half of 2005 turned into something dramatically less in last year's second half, according to two recently published reports from New York City brokers via MoneyCNN.com. The median sale price for co-ops and condos in Manhattan advanced a scant 1.3% in the final three months of 2005 to $760,000, according to one survey. Another advised that the median sales price shed 4% in 2005's fourth quarter.
Granted, Manhattan real estate is in a world by itself. Yes, it may be destined for a slowdown, if not correction, but that doesn't necessarily mean prices in Peoria will collapse. In fact, there's quite a bit of evidence out there suggesting that to the extent there's a real estate bubble in the U.S., much of it's found on the East and West coasts, in cities like New York and San Francisco. So what else is new?
The question is whether a crack in the high-end markets could spill over into lesser property realms? Stay tuned.
In any case, the fact remains that a robust real estate market has been instrumental in recent years to the broad economy's top-line growth, which is a cute way of saying that low interest rates have made buying--and speculating on houses attractive in recent years. But as we all know, interest rates have been going up. Not dramatically, but going up just the same. Even the Fed's baby-step hikes are starting to add up, considering that they began in June 2004. Is this the year Joe takes note?
Ah, but there's the rub, you say. Short rates have been going up, but long rates have been less than eager to follow. Thus, the brief encounter with the inverted yield curve last month, in which short rates exceeded long ones.
Perhaps, then, the key to keeping the economy humming is praying for an inverted yield curve to prevail, and at the same time hope that its traditional message--recession--doesn't follow this time. Alternatively, one can dismiss the seemingly persuasive list of smoking guns in the Levy paper that suggest that the margin for error from here on out is tiny when it comes to the link between real estate and the economy. In which case, we submit the following points highlighted in the report for your dismissal:
* The price-to-rent ratio (housing prices divided by rent) has soared to more than 20 at the end of 2004 from around 15 in the early 1990s. In order for it to fall, either house prices must fall or rents must rise.
* The debt burden on households has also soared in recent years. The household debt to disposable income ratio, still below 95% at the end of the 1990s, has recently jumped above 120%--a record high.
* Recent borrowing by the household sector has also taken flight into record elevations. Borrowing, as a percent of household disposable income, has recently leaped to nearly 14% from around 3% in the early 1990s.
And the list of potentially troubling statistics rolls on. If you're in the mood for an ominous read, cuddle up with this paper.
The stock market, however, pays no attention to any of this, or so one could argue. Today is the third trading day of 2006 and, as we write, the third day of gain for the S&P 500. Meanwhile, the yield on the benchmark 10-year Treasury continues to trade below its 2005 close.
The market, of course, is always right…until and if it's wrong.
January 4, 2006
OLD QUESTIONS IN A NEW YEAR
The new year on Wall Street kicked off with a bang. The S&P 500 yesterday jumped 1.6%, with all 10 sectors in the venerable index gaining ground as well. The S&P 500, as a result, is again within shouting distance of the highs set last month, which were the loftiest since 2001.
Hope, in short, is alive and well thus far in 2006. But for all the initial celebration, debate about what comes next rages like never before, and with the stakes arguably higher this year than last it's getting harder for investors to take a wait-and-see attitude.
.....THE BAROMETER OF HOPE
The fun starts with economic prognostications, which were stoked yesterday with the release of the December 13 Fed minutes. For some, the message embedded here was that the central bank would soon stop raising interest rates, a habit in force since June 2004. Old habits are said to die hard, and this one's proving to be no exception.
But if there's an end in sight of monetary tightening, it won't be immediate, or so 29 economists surveyed by Bloomberg News forecast. Rather, another 25-basis-point hike will arrive on January 31, when the FOMC meets next, or so predicted this group of dismal scientists. Richard DeKaser, chief economist at National City Corp. in Cleveland, summed up the sentiment for Bloomberg by advancing the theory that "we're awfully close to the end of the game. They've got another quarter point in them. We'll see it later this month.''
A belief in the end of the current tightening cycle, whenever it comes, cheered stock investors yesterday, but there are other implications as well, and not all of them are cheery. In particular, what does a cessation of rate hikes mean when the interest-rate yield curve still threatens inversion? One could argue that the Fed is becoming more sensitive to squeezing the economy at a time when anxiety's once again on the rise about growth. We've been there, and done that, of course. But even a broken clock's right twice a day.
As such, does the traditional message of an impending slowdown or recession still hold in these strange times? Yes, is the short answer from Paul Kasriel, director of economic research at Northern Trust, in a research note yesterday. Although some have said the inversion isn't meaningful this time around, Kasriel begs to differ, arguing,
In Q3:2005, the annualized growth in real final sales to domestic purchasers was 4.5%. Now, because growth in real consumer expenditures in the fourth quarter will be lucky to be positive, I expect that growth in real finals sales to domestic purchasers in Q4:2005 will be considerably slower than in Q3. Moreover, I expect that a fundamental slowing in final domestic demand is in the offing for 2006.
In short, "the shape of the yield curve is a leading indicator," Kasriel warns.
But consensus is hardly in abundance with the birth of a new year. David Gitlitz, chief economist for TrendMacrolytics, to cite one name, thinks the brief yield-curve inversion of late all light and no heat. His reasoning boils down to the fact that the real (inflation-adjusted) Fed funds is significantly lower at the moment than when the yield curve inverted in the past. As a result, the recent, and so far fleeting inversion of the yield curve is less than definitive in signaling the approach of economic stumbling. "When inversions have presaged recessions, such as in '81 and '00, they have accompanied exceptionally tight monetary policy, with a real Fed funds rate exceeding 4%," Gitlitz writes in a note to clients yesterday. Yet the real Fed funds rate is just slightly above 2%, he observes. As such, Gitlitz concludes:
Given the ample signs that this economy remains in vigorous health amid solid expectations for sustained growth -- including tight credit spreads, rapid growth in household wealth and a highly positive outlook for capital spending -- we view the chances as minimal that the curve is signaling that recession or even a significant slowdown is in the offing.
Nonetheless, there's always a few smoking guns out there to keep pessimism bubbling, and yesterday's ISM index of manufacturing activity for December is among the more topical ones to arrive, courtesy of its larger-than-expected decline last month to a four-month low. Some economists say that manufacturing, although a shrinking piece of the economy, still harbors clues about what's coming. As a result, the December slump in this gauge is once again raising a warning flag.
To be sure, the ISM manufacturing index is still comfortably in the black, which is to say above 50 and thereby indicative of growth in the sector. As students of the measure will recall, there was a previous scare last year with this index, when it appeared set to drop below 50, thereby ushering in a recession. But the economy found a second wind and manufacturing activity rebounded.
.....ANOTHER FALSE SIGNAL?
Is another dramatic turnaround in store for 2006? Will consumer spending continue to surprise on the upside? Will Jack Abramoff name more names? Will Ben Bernanke continue lifting rates after he succeeds Alan Greenspan at the end of the month?
January 3, 2006
FROM RUSSIA, WITH SPITE
The first energy crisis of 2006 was brief, but it may be telling.
Russia, flexing its muscles as the biggest source of energy exports outside of the Middle East, put the kibosh on New Year's celebrations in Ukraine by shutting off the tap for natural gas to this former province of the Soviet Union. After a bit of stop-and-go negotiations, Moscow has relented, turning the gas back on, but not without casting aspersions on any good will that's accrued in recent years regarding Mother Russia's reliability as an exporter of crude and natural gas.
On both counts, Russia is a heavyweight, regardless of how it exercises that power in the years ahead. A close rival to Saudi Arabia as the world's leading exporter of crude, Russia enjoys the status of harboring the most reserves of natural gas. The combination insures that the land of Tolstoy and Pushkin will be central in the global economy's energy strategy in the 21st century. If the latest news of Russia's heavy-handed tactics is any indication of things to come, energy consumers should postpone any expectations of export bliss in the Russia-connected strategy for a while longer. Indeed, it was only a few short years ago that Americans were touting Russia's emergence as an oil-rich democracy of late, suggesting a solution to Opec was just over the horizon. That may yet prove accurate, but for the moment caution is the new watchword.
The trouble du jour centers on the Kremlin-controlled Gazprom, and its decision to effectively abandon the 2004 deal to sell Ukraine natural gas at greatly reduced prices. Suddenly, Gazprom wants Ukraine to pay market prices. Nothing wrong with that, although the details are a bit messy when it comes to the Gazprom-Ukraine energy soap opera.
For starters, the 2004 gas deal was originally scheduled to run through 2009. And while Russia has decided to get tough with Ukraine, the sweetheart deals of deeply discounted gas are still in force with other former slices of the Soviet Union, including Georgia and Azerbaijan. Although Russia is intent on eventually charging market rates for all its customers, it's given some a grace period of transition, as opposed to the cold-turkey deal imposed on Ukraine. So much for consistency.
Perhaps we can simply say that Moscow suffered a momentary lapse of judgment, if that's what it turns out to be. There is precedent, after all, for temporary stumbles when it comes to the history of energy exports. The general consistency of the Saudi export machine has been known to stagger at times, the episode of cutting off oil exports to the West in October 1973 being the shining ignominious example. The political catalyst all those years ago was the October War, when Egypt and Syria attacked Israel in an effort to retake territory lost in the 1967 conflict. Politics, in short, was lurking just below the surface in the oil business of 1973, thereby suggesting a rephrasing of Clausewitz's famous dictum to: oil is a continuation of politics by means. Is it time to brush off that revised dictum for fresh duty in the booming natural gas trade of the 21st century?
Not so fast, at least not yet. Compared with the Saudis' 1973 goals for its oil embargo, Russia's reported political ambitions may be somewhat less spectacular when it comes to the Ukraine. Still, the global economy may not be in a mood to parse such distinctions, given the recent bull market in energy of late. In any case, politics is thick and heavy in the latest Russia-Ukraine flare-up.
The offending event was the election of Victor Yushchenko as Ukraine's president last year, which reportedly irritated his Russian counterpart, Vladimir Putin to no end. Yuschenko, you'll recall, talks of democracy, free markets, and all the trimmings that accompany such a state of liberal political affairs. All of which clashes with the autocratic inclinations of the former KGB man, otherwise known as the Russian president presiding over an alleged democracy.
Alas, Putin has been no slouch when it comes to reseeding the government's influence in such industries as media and energy. It pales by the standards of the old Soviet Union, although the trend in recent years has somewhat sullied the former bright expectations for Russia's alleged return to the fold of democracy. To wit, Gazprom, to cite the operative company of the moment, produces more than 90% of Russia's natural gas and the government just happens to own a majority share of the firm, according to Hoover's.
Is it any wonder that Ukraine, which is trying to reinvent itself in a manner that evokes if not mimics Western democracy, has fallen out of favor with Russian political bent of late?
It remains to be seen if turning off the natural-gas spigot will work for or against Moscow and its grander schemes. For the moment, the Continent should worry, since Germany and others in Europe currently rely on Russian natural gas exports to a degree, and one that seems fated to only rise.
Lest anyone think the lessons dispensed a generation ago in wielding the oil weapon will keep comparable intentions from infecting the coming boom in natural gas exports, we're not so sure. Consider that a certain South American president who goes by the name of Hugo Chavez (the self-proclaimed leader of the so-called Bolivarian Revolution in Venezuela) has been nothing if not ambitious in forging a new template for brandishing the oil weapon in a political context in recent years. From offering deeply discounted fuel oil supplies to New Yorkers last year to buying influence via buying Argentine bonds with Venezuelan petrodollars, Chavez has arguably been successful in creating an oil-soaked regime that's anti-American, among other things. Of course, one could simply chalk it all up to generosity. Then again, maybe not.
In any case, the stakes are larger for Russia regarding its role on the world stage compared to Venezuela, and presumably that's why Putin, who's clearly calling the shots for Gazprom, reversed course and turned the gas back on. Germany, it seems, was more than a little upset that the Russia-Ukraine spat was reportedly affecting gas flows to the Fatherland, which is at once one of Russia's key political allies and a major fuel customer.
Economics still has the upper hand when it comes to the fast-growing natural gas market, which is in the early stages of evolving into a global exporting business on par with crude. But economics, as the lessons of 1973 suggest, can give way to politics in the blink of an eye. Yes, the blink may be brief, but as we learned in the 1970s, brevity can also be brutal.
January 2, 2006
WHAT A YEAR IT WAS--NOW WHAT?
It's still a holiday here in the States, so we'll be brief. But as the new year dawns, we look back on the old, and once again ponder what was hot and what was not--all in a hopeless search for clues about the future. To wit, we present total returns for last year, courtesy of data from Vestek Systems via Aronson+Johnson+Ortiz. Forecasts may be cloudy, but the past is always crystal.
On that score, mid-cap stocks were hot again last year in the U.S., as were REITs--the latter once again defying the common wisdom that real estate equities are due for a correction. But it all pales next to the absolute sizzling year that just unfolded for stocks in emerging markets. Fixed-income performance, meanwhile, is looking ever-more plodding, although even 90-day T-bills beat the great-great grandfather of indices, the Dow Jones Industrials.
Enough of the past. On to the future. Happy New Year!
S&P 500 CAP WEIGHTED 4.92%
S&P MIDCAP CAP WEIGHTED 12.54
S&P SMALLCAP CAP WEIGHTED 7.67
S&P 500/CITIGROUP GROWTH 1.14
S&P 500/CITIGROUP VALUE 8.74
S&P REIT INDEX 11.30
RUSSELL 1000 INDEX (large cap) 6.27
RUSSELL MIDCAP INDEX 12.65
RUSSELL 2000 INDEX (small cap) 4.52
RUSSELL MICROCAP INDEX 2.56
RUSSELL 1000 GROWTH INDEX 5.26
RUSSELL 1000 VALUE INDEX 7.05
RUSSELL MIDCAP GROWTH INDEX 12.10
RUSSELL MIDCAP VALUE INDEX 12.64
RUSSELL 2000 GROWTH INDEX 4.12
RUSSELL 2000 VALUE INDEX 4.68
DOW JONES INDUSTRIALS 1.72
NASDAQ COMPOSITE (PRC CHG) 1.37
MSCI WORLD EX US 14.89
MSCI WORLD EX US GROWTH 14.55
MSCI WORLD EX US VALUE 15.11
MSCI EAFE 13.97
MSCI EMERGING MARKETS 34.07
VESTEK 90-DAY T-BILL INDEX 3.04
VESTEK LONG TREASURY INDEX 5.70
VESTEK BROAD BOND INDEX 2.61