February 28, 2006
The broadest measure of U.S. money supply--the so-called M3--has less than a month to live, but its swan song continues to be one of growth, and growth that's notably higher relative to that of M2, the official replacement for the doomed series.
We've written previously on the impending death of M3 (see here, here and here), and found reason to question the Fed's decision to terminate the most-expansive measure of dollars floating about in the economy as of March 23. We won't repeat ourselves, other than to reiterate our original point: M3 growth is well above M2's, as the chart below reveals. That's been true in the past, and remains true now, based on the latest update on money supply. According to the Fed, seasonally adjusted M3 rose by 7.9% for the 52 weeks through February 14, or nearly twice the rate of increase for the narrower definition of money supply labeled M2.
Why is the central bank killing the brand of money supply that's growing the fastest, which just happens to be at a rate that's well above the yield on a 10-year Treasury (4.58%), the latest estimate on the annual rise in inflation (4.0%), and the annual pace of economic growth in inflation-adjusted terms (1.6%)? The Fed is mum on the issue, other than to say that M3 is redundant, and therefore M2 should suffice. The numbers suggest otherwise.
February 27, 2006
RISK NEVER TAKES A HOLIDAY IN THE WORLD OF OIL
There are several catalysts driving oil prices higher over time. Some are economic, some are geological, and some are none of the above. In the latter category, Nigeria and Saudi Arabia figure prominently in the news of late as poster children for disturbing examples of what awaits the bigger oilfields that occur all too infrequently on the planet for satisfying the increasingly ravenous consuming crowd.
Politics reborn as war on low and stable energy prices is leverage in the global economy for those who, rightly or wrongly, think they have no other means of expression and influence. For consumers, it's a new tax on an old concept: the cost of doing business.
That cost is vulnerable to upside spikes in the short run, and a slow but steady rise in the long run. For the former, Friday's attempted but ultimately foiled attack on the Abqaiq oil facility in the Saudi Kingdom was one more wake-up call about the nature of the energy business in the modern era. The site chosen for the attack was hardly a surprise. Abqaiq processes about two-thirds of the 9.5 million barrels a day of Saudi production, home of the world's largest single source for crude exports.
Reportedly, the attack on Saudi production was hatched by Al Qaeda. It's a stark reminder that terrorism in all its virulent forms continually strives to drive up the price of oil. Destruction as a means of political statement is alive and well in the 21st century. For clarity on that point, the organization issued a statement to focus the public's expectations. In the case of Friday's assault, the failure to damage the Saudi facility is only a temporary delay rather than a permanent setback, based on the promise of more Al Qaeda attacks on oil processing complexes.
But even in failure there is success when it comes to affecting the price of the world's most valuable commodity. A barrel of crude closed at a bit more than $58 last Thursday in New York; 24 hours later, after news of the Saudi attack had made the rounds in headlines, oil was changing hands at more than $62 a barrel. The mere attempt at attack is almost as damaging as completing the act when it comes to oil prices.
Some of the recent price spike can be attributed to events in Nigeria, where the Movement for the Emancipation of the Niger Delta has launched its own brand of attack on the business of oil production and exporting. That too is a problem for the United States, for which Nigerian exports are the fifth highest.
Politically, the Nigerian assault on the oil business is distinct from Al Qaeda's, although there's a common thread of trying to take back the resource for "the people," or at least making it tougher for Western consumers to buy the oil.
In the long run, neither group will succeed in turning off the oil spigot, but they will succeed in adding a risk premium to the price of crude in the long run. The size of the risk premium is debatable, although it's a safe bet that it will fluctuate over time and remain considerable.
Risk analysis has long been central to projecting the price of oil, and the art can only become more valuable for analyzing crude. We can start by going country by country for listing the size and scope of the potential hazards that loom over oil. For December 2005, the Energy Information Administration lists the top-10 countries of origin for U.S. imports of crude run as follows, in descending order:
Canada (1.899 million barrels per day)
Mexico (1.707 million barrels per day)
Saudi Arabia (1.438 million barrels per day)
Venezuela (1.183 million barrels per day)
Nigeria (1.174 million barrels per day)
Angola (0.425 million barrels per day)
Iraq (0.390 million barrels per day)
Ecuador (0.340 million barrels per day)
Kuwait (0.268 million barrels per day)
Algeria (0.212 million barrels per day).
Canada is the long source of good news, being the single-largest foreign provider of oil to America that's at once stable and allied with the U.S. Alas, it's downhill from there. As anyone with a passing knowledge of foreign affairs understands, this top-10 list is exposed to a broad array of risks that are as entrenched and unmovable as any on the planet.
Historically, the United States has sought to manage and limit those risks by the standard approach: diversification. By developing a large and diverse portfolio of exporting sources, America has kept risk under control. But time is running out for expecting the strategy to deliver the miracle cure it's dispensed in the past.
Two stubborn trends are conspiring to render the diversification a bit less effective with each passing year. One is driven by geology. As the opportunity for finding large, new oil fields fades in politically stable nations, power and influence in pricing crude slowly but inexorably shifts to those country's with the lion's share of known supply--country's that are forever on the precipice of a revolt of one kind or another. Who are these nations? The key ones can be found in the top-ten list above. Collectively, the top-ten list presents a rainbow of ebbing and flowing dangers that threaten that most precious but too often disregarded American resource: cheap energy.
February 24, 2006
Inflation targeting (IT) is the "next logical step" for the Federal Reserve's monetary policy. So said Alan Blinder, a Princeton economics professor and former vice chairman of the Fed's Board of Governors, at a symposium yesterday in New York. A key reason: the arrival of IT supporter Ben Bernanke as Fed chairman, Blinder explained at a discussion of what comes next in monetary policy at an event sponsored by the New York Association for Business Economics. (It was fitting that the assemblage was held at the Manhattan office of the Canadian Consulate, which represents a country that adopted IT in the early 1990s.)
The Greenspan standard is gone, destined for replacement, Blinder continued. What was the Greenspan standard? The iron law that monetary policy should be exactly what Alan Greenspan wanted it to be, he quipped. "The Fed must get off the Greenspan standard, and IT seems the logical next step."
Another speaker, Laurence Meyer, an economist with Macroeconomic Advisers and a former Fed governor, also found reason to predict that IT is coming to the world's most influential central bank. His talk, titled "Coming Soon: An Inflation Target for the FOMC," expounded on the internal Fed debate that Meyer said is slowly evolving toward a policy favoring IT.
Perhaps, but for all the aura of surgical precision that surrounds the idea of a clear and exact inflation objective, the transition from the Greenspan standard promises to be messy just the same. For starters, the use of the term "inflation target" is so yesterday, and arguably carries some political baggage. For cover, IT advocates increasingly reference their favored brand of monetary policy indirectly. At the February 2005 FOMC meeting, for instance, a debate on IT was labeled a "broad-ranging discussion of the pros and cons of formulating a numerical definition of the price-stability objective of monetary policy," according to Fed minutes.
If the Fed is gradually transitioning to IT, by whatever name, there is still plenty of debate left in the formulation of monetary policy, Meyer reminded. For example, the debate over whether an inflation target should have a range v. a single number allows for more than a little variation in outcome for real-world results. Consider that if the central bank ultimately opts for the seemingly innocuous decision to go with a target range, the choice opens up a can of worms about when the Fed must act and when it's free to let things ride.
Let's assume an IT target range of 1.5% to 2.0%. Assume further that inflation is currently 1.75%. Would Fed monetary policy become more aggressive in fighting inflation if inflation subsequently rose to 1.8%? Or could the Fed wait until inflation touched 1.9% or 2.0% before acting to nip any inflationary pressure in the bud?
The alternative--a single, explicit IT--may be superior, but it raises the concern that the Fed would be handcuffed to a pre-set and restrictive monetary policy at times of financial stress, thereby removing the flexibility that's come in handy at moments in the past, such as during the immediate aftermath of the October 1987 stock market crash, when the central bank temporarily injected massive amounts of liquidity into the system. Meyer countered that by establishing a long-run IT--an average over, say, two years--would in fact allow for short-term flexibility while preserving the benefits of transparency and accountability that accompany an explicit inflation objective.
Another potentially contentious issue is choosing an index to define inflation for the purposes of an IT policy. Among policy wonks, there's broad support for using personal consumption expenditures (PCE). But wider public acceptance and knowledge of the consumer price index (CPI) may tip the scale in favor of this popular gauge, which influences various corners of finance, such as adjustments to Social Security payments.
Minds may differ over PCE vs. CPI, but the dismal science generally agrees on using core versions of those inflation measures, which is to say a PCE or CPI that's stripped of energy and food inputs. That's at once a benefit and a challenge. A benefit in that running the nation's monetary policy without the annoying volatility of energy prices makes things easier, especially since energy seems to be in a long-term uptrend. Nonetheless, there's an argument that the Fed should ignore energy prices for managing the nation's money supply. Why? Because the energy market is the mother of all exogenous events affecting inflation, and so the Fed has virtually no control over the oil variable, which can flare up at any moment unannounced. "One would like to hold the central bank accountable for something it can do something about," Blinder argued.
A reasonable view, to be sure. But it also holds open the possibility of headline inflation soaring by way of energy while the Fed congratulates itself on keeping core inflation under control. As a result, success and failure in monetary policy could in theory exist simultaneously in a world that increasingly suffers from energy insecurity.
Scoring an "A" for consistency, Blinder responded to a question about whether the Fed should be concerned about asset inflation, a thinly veiled reference to the current bull market in real estate. But whether it's stocks, property or any other asset class taking wing, the central bank has no business of trying affect prices other than in a general, macroeconomic sense, he responded. "It's not the central bank's job to say stocks or real estate are high relative to money."
What exactly is the central bank's job? For the Fed, there is the dual mandate of minimizing inflation and maximizing employment. Sometimes one conflicts with the other, and sometimes achieving success in either realm may seems hopeless, as in the 1970s. Perhaps IT, or whatever it's called, will help; perhaps not.
In any case, don't expect someone to ring a bell when the Greenspan standard ends and some form of IT formally begins. Indeed, one could argue that a degree of IT has already begun, if not in name than in process. And that process will continue to evolve. Although it's hard to figure out where the FOMC stands exactly on the issue, Meyer has helpfully compiled a scorecard of the various opinions that matter by reporting that seven FOMC members have gone on the record of embracing the idea of IT, with suggestions for a target ranging from as low as 50 basis points up to 3.0%. Meanwhile, eight governors have remained mum on the idea, and two have taken a stand against. But nothing ever stays the same in central banking, and in the wake of the anti-IT Ferguson announcing his resignation from the Fed this week, those opposed are effectively down to one, Fed Governor Kohn.
Reading the central banking tea leaves, BusinessWeek opines that the departure of Ferguson makes it easier for Bernanke to dominate the debate on inflation. The Fed's Loss Is Bernanke's Gain, runs the headline. If so, will Bernanke's gain translate into progress for the capital markets as well?
February 23, 2006
Another day, another opportunity to see whatever you want to see in the economic data. The latest example arrived yesterday within the packaging of consumer prices, which at once threatens and calms. The source for the duality comes by way of yesterday's report on January consumer prices, offering a now-familiar refrain of maybe we're in trouble, and maybe we're not, a la producer prices.
Top-line inflation advanced by a seasonally adjusted 0.7% last month, according to the Labor Department, up dramatically from December's slight decline in CPI. The jump was also above the consensus 0.5% forecast for January, and now stands as the highest monthly rate of increase since September's Katrina-induced 1.2%.
But if the news has got you down, why not keep reading to find something more encouraging to lift your spirits? As with previous bouts of CPI-defined inflation, last month's ascent is primarily a function of energy prices, a point that comes through loud and clear in the far-less bubbly core CPI, whose pace of ascent was a relatively cool 0.2% in January.
Top-line inflation, in sum, continues to raise warning flags, while the core CPI keeps telling the bond market what it wants to hear. The question is whether anyone will ring a bell when and if energy driven inflation becomes a clear and present danger as opposed to something barely worth mentioning beyond a footnote in future textbooks.
Just as consumer prices suffer a bifurcated existence, so too do the best guesses of what it all means. Speaking for the optimists, Jim Awad, chairman of Awad Asset Management, told Reuters via MSN Money, "The Fed can't justify too many rate increases with mild inflation."
Maybe. But while we're waiting to find out if that thinking is prescient of naive, let's take a bracing visit over to the dark side, if only for some perspective to see how the other half thinks. Representing the alternative view is Richard Sichel, chief investment officer at Philadelphia Trust Co., who also spoke with Reuters on Tuesday, reasoning, "We can't dismiss the 0.7 number because people actually do spend money on food and energy. That's something to be thinking about and that's something that the Fed might have to be thinking about."
Joel Naroff, president of Naroff Economic Advisers, emphasized the point, telling BusinessWeek: "Consumers continue to be battered by rising costs. It's tough out there for most households."
And then there's the Chicago Fed President Michael Moskow, who tells the Wall Street Journal today (subscription required) that "We know that increases in energy are going to pass through to the core." In fact, Moskow warns that there's a "significant risk" that higher energy prices may do just that at some point, even if the evidence to date is thin.
If there's a fissure in the explanation of January's consumer prices, it wasn't always obvious in the equity and bond markets, both of which managed to gain ground yesterday. The stock market was particularly upbeat, elevating the trusty Dow Jones Industrials to a four-year high on Tuesday. And with oil prices retreating today, the core CPI's relatively calm behavior takes on even greater significance for those who think inflation is no longer a threat. Indeed, of the ten S&P 500 sectors, financials were yesterday's big winner, rising 1.8%, or more than double the S&P's gain for the day.
"We see the light at the end of the tunnel,'' said Louis Navellier, an equity manager of $5 billion at Navellier & Associates Inc., in an interview with Bloomberg News yesterday. "There's less uncertainty now. It's like we have a road map.''
And who's to say he's wrong? Certainly not the bond market, which saw fit to celebrate as well, albeit a bit more modestly, but celebrate nonetheless. Traders in the 10-year Treasury weren't shy about buying yesterday, driving the yield on the benchmark bond down to its lowest close since February 10.
Of course, to judge by Fed funds futures, expectations of more rate hikes remain the best guess on the short end of the yield curve. Indeed, said curve remains inverted in Treasuries proper. As of yesterday, the two-year Note yields 4.66% vs. 4.53% in the 10 year or 4.84% in the newly revived 30-year Treasury. The jury's still out on whether that's also a trend worthy of celebration.
February 22, 2006
FRESH CORROBORATION FOR WHAT YOU ALREADY KNEW
It's hardly a surprise to anyone who's been following the economic news of late. But even if it's just the latest confirmation of what's already become clear in recent weeks, the soaring state of the Conference Board's index of leading indicators is a sober reminder that the economy won't easily be dragged into a slowdown anytime soon.
The Conference Board yesterday reported that its U.S. leading index jumped 1.1% last month, surprising economists by a fairly wide margin. The consensus estimate called for a rise of less than half of what was reported, according to TheStreet.com. In addition to being among the highest monthly advances in some time, it's the fifth gain in the last six months. The implication: economic growth in the future will stay robust.
Among the catalysts moving the leading indicators higher: the fading of weekly claims for unemployment insurance. It's old news in late February that the labor market has found a new head of steam. Old, but the trend still warrants attention if only because employment strength carries so much influence over the economy overall. That includes Joe Sixpack's thinking on whether he'll keep spending more within the temples of consumerism, otherwise known as malls and other retail outlets.
The bond market yesterday took notice of the strong report, retracing some of the yield dip that came on Monday. And for good reason, as it was hard not to smell the fear of additional interest-rate hikes looming in the wings.
Meanwhile, it was find economists talking up the expectation of a stronger economy in the spring, and thereby putting a spike through the heart of the first estimate of the fourth-quarter's sharply slowdown in GDP growth.
Still, some suspect that all the good news so far in 2006 is something less than sustainable. Skeptics are quick to point to the fact that last month was the warmest January on record, which was one reason why economic activity has surprised with strength. Perhaps. As always, additional data will be necessary for confirmation or denial.
Traders of Fed funds futures, however, aren't inclined at the moment to wait around for additional smoking guns. Selling of the the July '06 Fed funds contract was sufficiently brisk to translate into an expectation of 5.0% Fed funds, based on yesterday's close--50 basis points above the current rate (hint, hint).
Surprises have been everywhere in recent years, from interest rates to consumer spending to the persistent buying of dollar-based assets by foreigners. What seems logical and imminent has quite often turned out to be wrong. Even the greenback's supposed collapse has been put on hold, causing dismal scientists of a certain persuasion to scratch their heads and go back to the proverbial drawing board. The American growth machine appears to be the latest candidate to confound, mystify and bewilder the pessimists.
Anything's possible in the global economy of the 21st century, with the possible exception of figuring out what comes next.
February 21, 2006
WHICH ONE BLINKS FIRST: INCOME OR INTEREST RATES?
Fear not--the U.S. will not go bankrupt, legally or otherwise, opines James Galbraith, senior scholar at University of Texas, in a new essay published by the Levy Economics Institute. Joe Sixpack's finances, however, are another matter.
Yes, the U.S. government is running a large and growing current account deficit. And yes, that deficit portends trouble, at least in theory, in part because it could send the dollar tumbling even as the American government avoids bankruptcy in any practical sense of the word. Still, Galbraith counsels such a potential outcome wouldn't be the end of the world, at least not any time soon. "First, it is not in the interest of key players outside the United States to permit [the dollar] to collapse in the near term," he writes. "Second, there is no good and ready alternative to the dollar; that of the euro remains for now on the horizon."
Elaborating on the second point, he reminds that if, say, China started dumping dollar-denominated bonds in exchange for euro-based replacements, the limited supply would create challenges for effecting the transaction. Galbraith explains:
There are, in fact, no proper European bonds on the market, only euro-denominated bonds of individual countries, such as Italy. A major effort to buy those up would, of course, drive the euro up and drive the dollar down. This in turn would hurt the Europeans, with the likely result that they would buy dollar assets—the bonds that China, Japan, and other nations would be seeking to sell. The net result would be a redistribution of dollar asset holdings, no doubt with some decline in the dollar’s value, but that alone would not put an end to the dollar system.
When it comes to household finances, Galbraith is far more cautious. He notes that consumer debt relative to income is at record high levels. "Debt service remains manageable only because incomes have been growing, however slowly, while interest rates have remained low," he observes. Alas, "one or the other of these conditions is not likely to endure," he concludes.
Therein lies one of the great strategic questions for the future, namely, Which will falter first: Income or interest rates? Expecting incomes to continually grow or long rates to stay perennially low may be asking too much. Cycles endure, rates change, things happen.
Still, perhaps the hope that incomes will rise indefinitely enjoys favorable odds. America, after all, has a lengthy history of elevating Joe's paycheck in real (inflation adjusted) and nominal terms over time. But in an age of rising global competition, advancing Joe's real spending power arguably faces its greatest challenge in the modern era.
If there's any hope of keeping spending power buoyant, and/or interest rates low, the front line in the battle necessarily returns to inflation. Winning the war on income and/or interest rates is possible only by conquering inflation. Looking backward, there's much to celebrate. Looking forward, as every investor must, is open to debate.
As such, how is the war on inflation going these days? That depends on which market you ask. The bond market is clearly in the camp of optimism. The benchmark 10-year Treasury yield continues moving sideways, and in fact took a healthy dive yesterday below 4.55%. In fact, 4.55% is a zone that's become familiar terrain for the 10-year in recent years. As a long-term chart of the 10 year reveals, the price of money by this measure has been going nowhere fast.
Quite the opposite can be found in the price of gold, which has soared in recent years, implying in no uncertain terms that higher inflation is due for a return engagement in the economy. One could argue that the Fed is on board with that outlook, to the extent the central bank keeps raising short-term interest rates, which so far is a trend intact. Accordingly, a long-term chart of the precious metal offers a stark contrast to the relative nonchalance founds in bonds.
Rest assured, one market will be proven wrong, and will pay dearly for its mistaken outlook. Figuring out which one's which deserves more than passing attention.
Income and inflation, bonds or gold. There are choices in the global economy of the 21st century, and no shortage of opinion. It's the answers that are in short supply. Some things, at least, never change.
February 20, 2006
MONDAY'S FIVE-CHART EQUITY DIAGNOSIS
Risk continues to pay off in 2006 in the U.S. stock market. Exhibit A is slicing equities by market cap and comparing year-to-date performance through February 17. By that tactic, small cap is well ahead of mid cap, which in turn is comfortably beating large cap, as the chart below reveals. We expect no less over the long haul, and for the moment, the hierarchy is intact for 2006 thus far. (All charts below use data from StandardandPoors.com)
Further refining of equity market cap by style also shows a penchant this year for rewarding both smaller stocks and those with a value tilt. Value in fact has been on a roll for several years, trouncing growth in no uncertain terms in the 21st century. There's been talk that growth is due for a rebound, but judging by the year-to-date numbers, the evidence of growth's revival still looks premature, as the following chart details.
Moving to a sector analysis of equities, the taste for risk remains largely intact, or so one could argue. Consider that in the large cap space, as defined by the S&P 500, telecom stocks are not just leading, they're flying. Even the recently red-hot energy sector is having a tough time keeping up with telecom this year. Telecom, of course, has long since shed its aura of Ma Bell stability, and by most accounts is now a volatile sector with about as much visibility in any given company as a gray ship in heavy fog. As such, the embrace of telecom this year suggests something other than running for cover as the strategy of preference.
Over in midcaps, risk is arguably in favor as well. Telecom stocks aren't first in this slice of equities, but they're a comfortable third, and doing quite nicely in the slot. Meanwhile, information technology stocks are the midcap leaders, suggesting that risky business remains alluring in this space as well, albeit with a slightly different strategy.
Things are a bit more complicated in small caps, where the top-performing sector this year through February is materials. We'll leave it to the analysts to tell us if materials represent something safer than telecom and tech these days. In the meantime, we can say unequivocally that sector rotation in small caps marches to the beat of a different drummer relative to mid and large caps. Significant? Stay tuned….
February 17, 2006
IF YOU SEE A FORK IN PPI'S PATH, TAKE IT
What a week. After a string of economic reports in recent days suggesting that the death of growth has been greatly exaggerated (at least for the time being), today's release on the producer price index surprises with a higher-than-expected rise in wholesale prices for January. The consensus forecast called for a 0.2% rise in PPI last month, with the actual number coming in a bit higher at 0.3%, according to TheStreet.com.
No big deal, right? Maybe. Monthly numbers don't mean much. Trends over time are something else. With that in mind, consider the following chart and the conspicuously rising rolling 12-month change in PPI. You don’t need to be an economist to see that wholesale prices are on the rise, advancing at an annual pace of 5.7% last month vs. falling in 2002.
But if such a vision sends you into paroxysms of despair, we have the perfect antidote for what ails you: wholesale prices less food and energy. This is the pick-me-up you've been waiting for to chase the inflation blues away. Core PPI, after making a run for higher elevations in 2004 and early 2005, has taken a turn for lower realms lately. As the following chart illustrates, core PPI rose by 1.5% in January over the year-earlier pace. That's down from the 2.8% rate of increase posted last May, and a heck of a lot lower than the 5.7% in top-line PPI.
So, is inflation gathering a head of steam or isn't it? For one economist's perspective, we called up Mike Cosgrove of the Econoclast, a Dallas-based economic consultancy.
Mike, top-line PPI is taking wing these days while core-PPI is falling. What's going on? Should we be worried about inflation?
The concern here is that the bigger increase in the top-line growth could spill over to the core number. That is, [the fear is that the increase] in energy prices in particular could spill over into packaging, processing, transportation, delivery--all the steps in the supply chain--and then into core PPI. Even though the Federal Reserve focuses on the core, they're very concerned about the possibility of the spillover into the core and increased inflationary expectations.
What's your view of top-line vs. core PPI trends?
The core probably gives the better indicator of inflation. Unless energy prices keep going up, the overall number is going to slow dramatically. If oil prices stabilize, there won't be any additional increases [in core PPI]. So even if oil stays at high prices levels--if it stays at $60 a barrel for 12 months--you'll see the overall PPI number come down. Therefore, the core numbers are probably better in general to look at, the general direction they're moving in particular.
And that general direction in core PPI is down recently.
What's driving core PPI down?
The bigger influence of the Chinese and world trade patterns. In the U.S., products exposed to foreign competition have to remain very price competitive. In addition, productivity gains in the U.S. are very strong, which helps hold down inflation increases. The combination of productivity increases and external competition hold down core prices.
On a related note, the new Fed chairman, Ben Bernanke, is on record last year as saying that the relatively low interest rates on the long end of the curve, which has created an inverted yield curve of late, are due to a global savings glut as opposed to a looming recession. What's your view?
The global savings glut isn't anything more than the opposite of the current account deficit that the U.S. has, i.e., it's the flip side of the current account deficit. If they're saving, then we're spending. And when they spend, we'll end up saving. But right now they're saving, so we can spend. It's a long-term process. If those economies grow faster, like the Japanese economy, then the savings glut will start to disappear, because they'll be able to invest more domestically.
But doesn't the notion of a savings glut sloshing around in the global economy raise the threat of inflation down the road?
No, not really. Whether they save it or spend it, it's not new money. It's simply part of what we spend in the U.S. in terms of imports exceeding exports. That's part of the savings glut in the Far East. So it comes back and they buy U.S. bonds.
So if in fact there's excess liquidity in the world, that's unrelated to whether there's a savings glut in, say, Asia? Whether Asians are spending more or saving more is immaterial to whether there's excess liquidity in the world. Deciding whether there's excess liquidity is a separate issue from a savings glut as it relates to inflation. Is that what you're saying?
What about the inverted yield curve? What's your take on that?
The 10-year Treasury yield has to invert relative to the 3-month T-bill and stay inverted for about two months. If that happens, about a year after that we'll have a significant slowdown and/or a recession.
But an inversion of that extent hasn't happened yet. The 10-year's yield is lower than the two-year Treasury, but it's not below the 3-month T-bill, at least not yet. You have a higher standard.
Do you think we'll get a 10-year/3-month inversion?
Yes, I do.
What's your outlook for the economy in 2006?
Growth will be good in 2006. 2007 is the problem--if we get the 10-year/3-month inversion.
Is that a possibility?
February 16, 2006
STEADY AS SHE GOES…FOR NOW
The market hardly needed another piece of evidence to support the notion that the economy remains bubbling. Bonds, however, are another story, which we'll get to in a minute. Meanwhile, Fed Chairman Ben Bernanke debuted his Congressional testimony act yesterday and added to the general suspicion that growth is still the path of least resistance for the foreseeable future, accompanied by all the usual risks for monetary policy that come with such a view.
The Federal Open Market Committee's "central tendency" forecast of GDP growth in 2006 is about 3.5%, and slightly lower for 2007, according to the Monetary Policy Report Bernanke submitted to Congress yesterday. That compares with a 3.1% rise in GDP for 2005. Consistent with that outlook is FOMC's expectation that the jobless rate will decline a bit in 2006 from 2005's 5.0%. For the moment, that guess on the jobless level looks like a safe bet in light of the fact that January's unemployment rate dropped to 4.7%.
Beyond Bernanke, there's no shortage of statistical props for arguing that the economy's humming along nicely. That includes this morning's release of initial jobless claims for the week through February, which are running below 300,000 for the fifth consecutive week. Meanwhile, continuing claims for jobless benefits remain impressive too, with the fifth straight week of below-the-2.6 million level. Together, the two trends are putting labor-market pessimists on the defensive. As Nomura Securities chief economist David Resler writes from New York today, "As much as job and income growth are the key ingredients to a healthy consumer, the outlook remains relatively bright, peering into 2006."
Another bullish report on the economy comes by way of today's update on December's new residential construction. Like the labor market, new-housing development continues to impress with strength, running last month at just below 2005's best levels, or a bit over 2 million units in January.
Another upbeat report was dispensed on Tuesday via the extraordinarily strong retail sales numbers for January.
Yes, yesterday's industrial production report for January from the Fed took a bite out of some of the cheery momentum. But on closer inspection, the 0.2% drop last month in this metric isn't quite as gloomy as it appears. Indeed, the bulk of industrial production's January decline is linked to the huge 10.1% descent in utilities (the biggest monthly fall in the 34-year history of the series) due to the unseasonably warm weather. By contrast, manufacturing activity moved up again in January, continuing a trend that's been in force for some time.
If the trend you see in all of this inspires optimism, you're not in sync with current thinking among the fixed-income set. Indeed, the bond market sees fit amid all the bullish economic news to keep the yield curve inverted. As such, the 30-year Treasury this morning yields less than the 10-year, which in turn offers a current yield below that of the 2-year.
In short, back to the future. One can rationalize the state of sagging yields as a function of a global savings glut (to use Bernanke's phrase) that keeps the price of money lower than it otherwise might be. Or, if you're inclined toward pessimism, perhaps you see a looming recession that's something less than obvious in the recent economic data. But it's clear that Bernanke still favors the former explanation. As he explained yesterday, an inverted yield curve is nothing to worry about:
"Historically, there has been some association between inversion of the yield curve and subsequent slowing of the economy," the Fed chairman admitted. "However, at this point in time, the inverted yield curve is not signaling a slowdown." Presumably, that means his global-savings-glut argument, which is shorthand for an excess of liquidity looking for a home, remains the prevailing theory in the chairman's mind.
Excess liquidity, of course, raises the specter of inflation. Although Bernanke maintained the company line that inflation was more or less under control, he let on that the threat of something worse remains bubbling just below the surface. "Inflation pressures increased in 2005," he said yesterday. "Steeply rising energy prices pushed up overall inflation, raised business costs, and squeezed household budgets."
In fact, Bernanke warned that more of the same, and then some, might be coming, a point underscored by today's import/export price report that shows the U.S. is importing inflation to the tune of 1.3% in January, or 8.8% over the past 12 months--about two-and-a-half times higher than domestic inflation's overall pace. As he put it: "the risk exists that, with aggregate demand exhibiting considerable momentum, output could overshoot its sustainable path, leading ultimately--in the absence of countervailing monetary policy action--to further upward pressure on inflation." The prescription? "Some further firming of monetary policy may be necessary, an assessment with which I concur," the chairman explained.
Traders in Fed funds futures took the hint. The June 2006 contract is priced this morning at 4.875%, vs. the actual 4.5% that currently prevails.
Still, Bernanke faces no easy time in taking over the Fed. For all the talk of economic momentum, there are several ticking time bombs that may or may not explode this year or next. Calculating the odds may be the most important task for the central bank at the moment. Indeed, real estate bubbles, energy shocks, mounting red ink at the consumer and federal government levels all threaten to play havoc with monetary policy. Unless they don't. Finding the sweet spot, in short, has rarely been harder for the Fed.
Bernanke admitted as much yesterday, and he reiterated the point today in his second-day of testimony: "There are two possible mistakes. One is to go on too long and one is not to go on long enough. And, it's a very difficult balancing act."
Alas, recognizing that one has to perform a balancing act--commendable as that is--doesn't make it any easier.
February 15, 2006
IT'S JOE'S PARTY, AND HE'LL SPEND IF HE WANTS TO
Joe Sixpack is at once confounding the experts and inserting himself into every debate among economists, politicians, investors and anyone else who has a dog in the race otherwise known as the American economy.
Indeed, yesterday's blowout retail sales report revealed a sizzling 2.3% rise in January over December's admittedly weak report. Even more impressive is the 8.8% rise for last month over the year-earlier number. That's head and shoulders over general economic growth and the overall pace of inflation. Rumors of Joe's death as a spending entity, in sum, continue to look greatly exaggerated.
To be sure, by a number of metrics, Joe's spending looks set to get the better of him and his associates across the nation. Consumer debt is mounting in relative and absolute terms, in some cases to record levels, triggering anxiety attacks for some pundits. But no matter what you expect comes next in consumer spending, it's a topical subject, and arguably the only subject at the Fed, on Wall Street, and Main Street. All eyes, in other words, are keenly focused on Joe in an attempt to divine his next move when it comes to pulling out his credit card.
With that in mind, now seems a good time to take a closer look at the January retail sales report, if only to amuse ourselves as we await the next injection of data and news. As such, we present the following chart, which shows the major categories tracked in the government's retail sales survey. It's ranked by one-month percentage change, with the 12-month change for each category tacked on for added perspective.
What pops out at us first is the fact that the biggest increase by far, whether by one or 12 months, comes in visits to the local gasoline station, which in a nod to the past we like to call "fillin' stations." No surprise here, since energy prices generally have taken wing in recent years, forcing Joe to elevate his spending when filling up the SUV. If higher expenditures on energy lead to reduced spending elsewhere, the trend isn't evident. That doesn't mean energy won't take a bigger bite out of the consuming habit, but so far there's not a lot of empirical support for that notion, at least in the retail sales numbers.
How has Joe been able to stop the energy bull market from crashing his spending party? By the great American tradition of borrowing, which some party poopers like to call debt.
For the moment, Joe has been able to have his cake and eat it too, offering the American economy no less. The question is, how long can Joe keep the party going?
February 14, 2006
WAITING FOR BEN...
It's unclear how much of the game plan he'll reveal, if any, but the pressure promises to be high for spilling the beans, or at least throwing out a bone.
Talking in abstractions about monetary policy and inflation targets won't satisfy politicians this time around. It never did, and isn't about to start now. Nonetheless, that may be all they get when Ben Bernanke fields questions for his debut grilling as Fed chairman on Capitol Hill tomorrow. Among the sea of inquiries that will no doubt get tossed at him, one we'd like to see earn some lip service is exploring Bernanke's thinking (now that he's in the driver's seat) on the connection, real or perceived, between inflation and wages/employment when it comes to grinding out monetary policy decisions.
It's a topical question, considering that unemployment's fallen to 4.7% in December, the lowest since July 2001. Meanwhile, wages are growing nearly as fast as top-line inflation, measured by average hourly earnings and consumer prices, respectively. Using core CPI, which subtracts food and energy from the mix, wages are advancing at a considerably faster rate than inflation. All of which coincides with questions over the next move in the Fed's monetary policy, namely, will the central bank soon declare inflation sufficiently contained and thereby end the current round of interest-rate hikes?
There's reason to wonder, at least for those who find inflationary threats buried in wage and labor statistics. Seeing no less has a lengthy history in the dismal science, the so-called Phillips Curve being the standard example. By this model's logic, a tradeoff exists between inflation and unemployment, i.e., if the jobless rate falls, inflation rises, and vice versa.
There's precious little constancy, however, in state-of-the-art economic thinking. Accordingly, whatever empirical support the Phillips Curve enjoyed over the years began to fall apart in the 1990s, and today there's no shortage of economists who now dismiss the idea that when unemployment falls below a certain level it automatically triggers higher inflation. The question is whether Bernanke agrees, and if he does, might he say so in Congressional testimony?
For what it's worth, monetary thinking inspired by the Phillips Curve isn't necessarily dead; rather, it lurks about, dormant but ready to jump out and say "boo" at any moment. Australia's central bank, for instance, advised on Monday that it was prepared to raise interest rates is wages and labor costs elevated inflationary pressures, according to The Age.
Back in the United States, the cocktail of renewed growth in jobs creation, sharply lower claims for unemployment insurance, and rising wages has some worried that higher inflation down the road is the natural consequence.
But not everyone buys into the view that a bubbling labor market will lead to pricing momentum. In fact, there's enough conflicting data when it comes to wages to debate any which way you see fit. As BCA Research points out, the rate of change in wages and salaries per employee in the U.S. has been falling sharply for months, while the pace of change for average hourly earnings has been rising at a healthy clip. If this makes divining inflation's future tricky, it presents no puzzle to BCA, which counsels that "faster wage growth will not spur a pick up in U.S. inflation later this year." One reason for the optimism is that employment costs have been trending lower, an alternative statistic that found favor with former Fed Chairman Alan Greenspan for gauging what's afoot in labor costs. Might Bernanke continue the tradition?
David Kotok, chief investment officer of Cumberland Advisors, writes in a note to clients last week that "there are early signs of rising wage income but not enough to trigger harsh Fed policy tightening."
But what wage growth can't do, might Joe Sixpack's continued spending spree do the trick? Indeed, retail sales soared last month by 2.3%, the fastest one-month rise since 1999, according to the Census Bureau. On a 12-month basis, retail sales have climbed an impressive 8.8%.
Still, worries abound that consumer spending is due to at least slow. At a press conference this morning in New York, Barry James, manager of the James Small Cap Fund (JASCX), "We haven't had a consumer-led recession for a long, long time, so we're due." Meanwhile, Rich Cervone, portfolio manager for Putnam Investors Fund (PINVX), notes at the event that he expects consumer spending will slow as such stimuli as mortgage refinancing fade.
Everyone has an outlook on 2006. Ben Bernanke no doubt has one too. Ah, but will he share his thoughts in any meaningful way? Stay tuned. The post-Greenspan era will begin shortly. Whether it proves to be an improvement, or something less, is the operative question.
February 13, 2006
BONDING IN A BULL MARKET
Merrill Lynch is reportedly in talks to acquire a 50% slice of BlackRock, well known for its bond funds although it manages equity too. Merrill's coup is said to come at the expense of Morgan Stanley, which also tried but failed to get a piece of this rock.
If there's any confusion as to what makes BlackRock so attractive, a quick look at the fixed-income manager's stock price will alleviate any stupefaction. Indeed, soaring share prices usually explain any frenzy over asset buying.
As it happens, there's been no shortage of ascending performance in fixed-income land of late. Just ask the managers of Loomis Sayles Strategic Income, a mutual fund that searches the globe for alluring bonds, a strategy that's fueled the mutual fund with a three-year annualized total return of more than 16% through the end of last year, according to Morningstar. That beats the Lehman Brothers Global Aggregate bond index's 5.5% over that span, as well as the S&P 500's 14.4% run. Everyone loves a winner, and some want to own it when it's hot. Long live momentum.
BlackRock's no slouch in cashing in on the bull market in bonds. As a business, the times could hardly be more flush for the firm. That said, the cat's long been out of the bag on this score. The company's shares are up more than 60% over the past year, more than ten fold higher than the stock market's return over that span, based on the S&P 500, reports Yahoo Finance. BlackRock's stock is no recent arrival to its bull market, having soared some ten-fold over the past six years as well.
It's also no great mystery what's behind BlackRock's success. Bond yields remain relatively low of late, after having fallen for the better part of a generation. What's not to like? Falling followed by relatively stable low yields is a bond manager's claim to fame in the 21st century. Accordingly, net income for the fixed-income manager has climbed more than 290% in 2005 from 1999, mirroring the fortunes that accompany life among the fixed-income set when yields fall and don't get up.
But if it's a great time to buy bond managers, along with bonds, using rear-view mirrors, how will the purchase square with the years ahead? If the BlackRock acquisition is deemed a savvy move today, with the yield on then 10-year Treasury under 4.6%, how might the transaction be described several years hence if yields are materially higher?
The answer depends on your expectations for the price of money. To wit, do you expect inflation, deflation, or something in between, and how much? We can surmise Merrill's forecast.
February 10, 2006
THE 30-YEAR QUESTION
We know why they're selling it. The question is, why are they buying it?
The "it" here is the 30-year Treasury bond, which returned to the capital markets after a four-and-a-half year respite. By all accounts, the security's return was a rousing success, at least for the government. Buyers were crawling over each other to grab a slice of government debt whose principal won't be returned until 2036. Bloomberg News reports that yesterday's bidding was such that the yield fell to 4.53%, the lowest on record for a 30-year Treasury.
The government could hardly wish for something better. Perhaps the feds could advise GM and Ford on how to better market their wares. Indeed, federal deficits may be mounting, but the public is only too happy to help Uncle Sam bridge the red-ink gap. Now that's what we call effective marketing.
In fact, the return of the 30-year Treasury is only the latest government triumph in managing its debt load. Readers may recall that the Treasury announced last April that it would stop paying variable rates on U.S. savings bonds and instead offer a fixed yield. Now, the Treasury has started selling 30-year bonds again. Who says the private sector has a lock on savvy traders?
All in all, the folks at Treasury are batting a thousand when it comes to strategic thinking on debt management. Financing the government's projected fiscal year deficit of $337 billion, or 2.6% of GDP at historically low rates for 30 years is nothing short of brilliant.
The clarity on the sell side gives way to a raging debate about the wisdom of the buy side. If the government deserves kudos for selling 30-year bonds at ~4.53%, how then should we label the action of the buyers?
Like everything else in fixed-income land, the answer depends on where you think rates are headed in the coming years. Clearly, those who think long rates are destined to rise are in the minority, to judge by yesterday's embrace of the 30 year as if it was a long lost uncle returning from the wilderness. No less a respected force of analytical thinking than BCA Research predicts that bond yields around the world are headed lower, mostly on the belief that economic growth will continue to slow. If true, buying a 30-year Treasury may prove to be a winning trade.
Nonetheless, over at that other institution in Washington, efforts are underway to keep short rates rising, arguably with an eye on raising long rates. This, one could say, represents a threat to the assumption that buying a 30-year bond at a 4.53% is a good deal. On the other hand, perhaps it's an aid, in that higher rates will eventually slow the economy. Even if we agree on what's coming, we can still argue about the effects.
Speaking of arguing, how should an informed investor assess the future of economic growth, interest rates and inflation with the news of a robust labor market of late? The two-week average of initial jobless claims through last week fell to its lowest since April 2001, notes David Resler, chief economist at Nomura Securities in New York, in a note to clients yesterday. "The downtrend in claims reveals a healthy job market that is likely to generate the sort of employment and income growth necessary to generate the growth in consumer spending necessary to sustain a 'virtuous cycle' of growth," he advises.
Still, there are no absolutes in fixed-income trading, although relative value springs eternal. On that note, here are some of the alternatives to the 30-year's 4.53%, as of yesterday's close:
10-year Treasury: 4.54%
2-year Treasury: 4.66%
10-year inflation-protected Treasury: 2.05%
5-year CD (national average): 4.47%
Inflation-protected savings bond: 6.73%
One could argue that locking in a yield of 4.53% for the next three decades makes sense if it satisfies one's liabilities. Pension funds tend to think in such terms, and so any instrument that dispatches liabilities to the dust bin of history in a timely manner is a step forward on the road to financial salvation.
But not everyone, whether institutional or individual, can reasonably hope that future financial burdens will advance at a relatively meager rate of 4.53%. The challenge gets worse after adjusting for inflation. Based on the latest measure of annualized consumer prices, and assuming that inflation is at least as high going forward, a nominal 4.53% yield on the 30-year Treasury evaporates into a real yield of around 1.1%, or about half the rate on the current real yield of a 10-year inflation-protected Treasury.
Some may have the brainpower to know what's coming. For the rest of us, hedging one's bets looks like a safer bet. Diversification has rarely looked so enticing.
February 9, 2006
The world is awash in liquidity, and that includes central bank coffers. Using IMF's numbers, the monthly tally of international reserves at central banks around the world shows liquidity rising by 2.5% to a record high in the 12 months through December 2005.
Where is all this central bank liquidity going? Presumably, a fair chunk of it winds up in dollars. In fact, the buck has been climbing once again, giving support to the notion that central banks continue to park reserves in the world's lone reserve currency. The gloom that hung over the greenback in January has since lifted, with the U.S. Dollar Index rising 2.6% since the selloff on January 23.
The growing consensus that the Federal Reserve will keep raising interest rates is no doubt a factor in the renewed embrace of the dollar. The source for that prediction includes none other than Alan Greenspan, the recently retired Fed chief who's now jumped onto the lecture circuit. According to various press reports, including the Financial Times, the maestro spoke on Tuesday at a Lehman Brothers confab, observing that the U.S. economic growth surprised the former Fed head. The implication: interest rates are headed higher.
"Apparently [Greenspan] spoke very hawkishly and suggested the market isn't pricing in as much as they should as far as future interest-rate hikes,'' John Cholakis, a currency trader at Natexis Banques Populaires in New York, told Bloomberg News yesterday.
The combination of a surfeit of liquidity looking for a home, and the prospect of higher rates in the world's reserve currency has set the dollar bulls running again. Traders of Fed funds futures seem to agree with the thesis. The CBOT's April 2006 Fed funds contract lends support to this view as it's priced in anticipation of another 25-basis-point rate hike.
The Fed is increasingly worried that so much cash sloshing around raises inflationary fears. Perhaps the bond market is boarding this worry train too. The 10-year Treasury yield continues inching higher, closing yesterday at just under 4.6%, the highest since November 15. Might the bond vigilantes of yore be planning a comeback?
February 8, 2006
DIRTY DATA DANCING
The yield curve has inverted again, raising fears anew that a recession may be in the cards after all (or is that just another reverberation from the global savings glut that Fed Chariman Bernanke likes to talk about?) In any case, the 10-year Treasury's yield of 4.56% in mid-morning was trading below the 2-year's 4.61%. The inversion is all the more striking coming after last week's batch of economic releases that suggested that the economy was still growing at a healthy clip in spite of the surprisingly low rate of growth posted in the first estimate of fourth-quarter GDP.
But if the bond market is now convinced that the economy will slow, or worse, there's still a dose of mixed messages rolling about from yesterday's and today's statistical updates to keep the pundits guessing.
Let's start with the International Council of Shopping Centers (ICSG) retail sales index for the week through February 4. Advancing 2% over the previous week, the measure posts its strongest growth in more than a month. Granted, one week a trend doesn't make, but for what it's worth the rebound found some bullish sympathy with the 3.3% rise in the Johnson Redbook Retail Sales Index for the week ended February 4.
Whatever optimism springs from those weekly reports is muted by the news released yesterday from the Federal Reserve that consumer borrowing rose by a relatively light 3% in 2005. That's the slowest pace since 1992.
Of course, that doesn't necessarily mean that consumers are turning away from their beloved passion for borrowing. Joe Sixpack and his friends have been increasingly tapping home-equity loans to find the cash they need at prices they can afford. In theory, however, Joe's willingness to supplement his borrowing from his house will fade as rates on home equity loans rise, a state of money pricing that the Fed is intent on pursuing until consumers cry a collective shout of "uncle."
Assuming the Fed's strategy to make Joe think twice about borrowing, the trend is expected to reduce consumer spending, and thereby slow economic growth. Of course, home equity borrowing could slow by way of falling real estate prices, a slide that would reduce the amount of equity available for tapping at any price. In either instance, the effect on the economy would presumably remain the same, namely, less consumer spending.
If fact, yesterday's release of U.S. mortgage applications posted a decline for the week through February 3, according to the Mortgage Bankers Association. That's the second week of decline. Perhaps that's no surprise, considering that borrowing costs for 30-year fixed-rate mortgages has been rising, the yield curve inversion notwithstanding.
You can find whatever you're looking for in the 21st century economy, and some of it might actually be enlightening.
February 7, 2006
Earnings estimates are suffering from a bout of weakness these days, writes Michael Krause of AltaVista Independent Research, a New York consultancy that specializes in fundamental analysis of exchange traded funds, or ETFs. In a newly minted report, Krause observes that for 2006 forecasts "we are seeing sustained and accelerating revisions to the downside. Over the past month, 2006 estimates for seven out of nine sectors declined…." He adds that the slide is "the fastest rate of decline since we began monitoring 2006 estimates back in July 2005."
Krause's report comes at an anxious moment, given all the debate about whether the economy is, or isn't poised for a stumble. Indeed, the mixed signals emanating from recent economic releases has Wall Street abuzz about what comes next for the stock market. In search of clues, we interviewed Krause via email....
In your latest research report, you write that "we are seeing sustained and accelerating revisions to the downside." Give us an overview of what's going on. Is the earnings cycle finally turning?
We still expect that S&P 500 earnings will increase this year. What’s different is that expectations are now on the decline, whereas for the past two years estimate revisions were almost universally positive, even excluding the effect of Energy earnings on the S&P, which everyone recognizes played a big part.
The accompanying graph (see below) illustrates the trend in 2006 earnings estimates since July of last year. Estimates for the S&P 500 as a whole rose through November and then started to decline. But excluding Energy, estimates that had remained stable through last summer began to weaken in the fall and have started to decline at a faster rate more recently.
Historically, trends in estimates revisions tend to persist for some time. That is, they don’t haphazardly move up/down from month to month, so the downward trend, now established, could well continue. After two years of being behind the ball on the strength of corporate earnings, Wall Street analysts might now be too optimistic at a time when earnings growth is quite naturally slowing in this, the fifth year of a profit recovery.
However, the fact that Wall Street gets its numbers wrong need not spell doom for the market. Even if negative estimates revisions were to continue apace, S&P 500 earnings would likely end the year up around 6%. That’s not as high as the 11.4% suggested by current consensus estimates, but still in-line with the post-WWII average of 6.2%.
Is the downshift in earnings estimates for 2006 limited to any one or two sectors for the S&P 500, or is the trend more broadly based?
It appears to be fairly broad based. Over the past month, estimates for seven out of nine sectors declined; only Energy and Industrials were up. And since July 2005, when we began monitoring estimates for 2006, only Energy and Utilities were up significantly. Particularly weak were Consumer Discretionary estimates, down 3.4% since July, and Consumer Staples, down 4.5%, which is disturbing for a supposedly defensive sector.
Again, overall the problem appears to be one of expectations and not necessarily fundamental weakness in earnings. For example, if consensus expectations are to be believed, the Consumer Discretionary sector--home not only to retailers but autos and homebuilders--will show a 17.4% increase in earnings this year. That's faster than all other sectors--driven by a huge increase in margins from already high levels. Earnings for the sector may in fact increase this year, but the 17.4% figure seems particularly optimistic.
How important was the energy sector for S&P 500 earnings in 2005, and how does that compare with the outlook for 2006?
Last year Energy accounted for about 40% of the S&P’s 14% earnings growth, and was the biggest contributor. Although oil prices are an obvious wild card, current estimates suggest Financials will replace Energy as the biggest contributor to S&P earnings growth in 2006, accounting for about 28% of the total, while Energy will fall to second or third place, accounting for around 17%.
How does the outlook for 2006 earnings translate when it comes to breaking the S&P 500 into value and growth slices? Does one look better than the other?
S&P, in concert with Citigroup, recently changed from a single-factor methodology (based on price-to-book value) to a multi-factor methodology to divide the world into Growth and Value. For the S&P 500, it has introduced Pure Growth and Pure Value indices, as well as plain (or ‘not pure’) Growth and Value indices. The pure indices include only stocks with strong characteristics one way or the other; the plain indices divide the market cap of stocks without strong growth or value characteristics and place half in each index, thus blurring the distinction.
Unfortunately, the only readily tradable vehicles, the iShares S&P/Citigroup Growth and Value exchange traded funds (NYSE: IVW and IVE, respectively) track the plain indices. One of the criticisms we have of the prior single factor methodology was that price-to-book value had almost no relationship to earnings growth. And in fact over the past five years companies in the Value index grew earnings faster than those in the Growth index! Oddly enough, even under the new methodology that problem appears to persist, with Growth companies expected to grow aggregate earnings by 10.6% in 2006, and Value companies expect to grow earnings by 12.1%.
In all fairness, according to consensus expectations for long-term earnings growth going forward, firms in the Growth index are expected to post slightly faster earnings growth than those in the Value index. That said, Growth (IVW) is currently trading at a P/E of 16.3x estimates for 2006, while Value (IVE) is trading at 13.7x. Also worrisome for Growth is the fact that two of the weakest sectors mentioned above, Consumer Discretionary and Consumer Staples, together account for 27% of the Growth index, but are limited to 13% of Value.
Does the 2006 outlook for small cap earnings generally also raise some warning flags?
As a whole, earnings for the S&P Small Cap 600 index are on the decline, though not as fast as for the blue-chip S&P 500. The almost universal refrain that after six years of outperformance by small and mid caps, its blue chip’s turn to shine is overdone in our opinion.
While it is true that small and mid caps are now slightly more expensive than large caps, trading at a P/E of 17.3x and 16.9x this year’s estimates, respectively, versus 14.9x for the S&P 500, they also offer much faster earnings growth that leaves more room for analyst error. Current expectations are for small and mid cap earnings growth of 19.6% and 21.7% in 2006, respectively, compared with 11.4% for the S&P 500. Even if those estimates prove to be optimistic to the tune of five or six percentage points, you still end up with a small and mid cap earnings growth rate of more than double that for the S&P 500.
February 6, 2006
NEW BUT NOT NECESSARILY IMPROVED
Thirty years is a long time, but is it too long for comfort these days? The folks at Treasury think not, or at least that's the implied message that will come packaged in the revived 30-year bond, which debuts anew on Thursday.
In August 2001, when we last glimpsed the government issuing new debt with a life span of three decades, the world looked a bit different. For starters, the tragedy of 9.11 was still a concept in a few twisted minds, and so a bit of innocence (or gullibility?) still defined the investment psyche on conjuring the risk factors that could arise on a moment's notice. Meanwhile, inflation in August 2001 was running at a relatively mild 2.7% annual rate, based on the government's consumer price index.
In February 2006, fewer investors harbor illusions about the risks that potentially lurk in the foreseeable future. Those risks can cut either for or against the fortunes of bond values, which is to say that winds of inflation or perhaps disinflation could blow harder at a moemnt's notice. The former, however, seems to have the upper hand at the moment.
Indeed, inflation (the only potential threat to an otherwise "safe" government bond) is a bit higher now than when the 30-year bond last made an appearance. Consumer prices are rising by 3.4%, according to the annualized rate posted in December. Inflation's pace, in other words, is roughly one-quarter more than it was when the Treasury last sold its paper embedded with 30-year maturities.
Inflation may be inching higher, but current yields on Treasuries, by contrast, have gone the other way. The long-term composite yield of Treasury maturities of 10-years-plus was 4.68% on Friday, the government reports. That's down from 5.44% at the close of the month that last witnessed the sale of new 30-year Treasuries.
The trend may be puzzling, but a trend it surely is, namely, rising inflation and falling current yields. Par for the course these days. It's unclear if any of this casts doubts across the bow of the new 30-year sale scheduled for Thursday, but if trading in the 10 year is any indication investors will snap up the longer maturities with nary a complaint. Indeed, Bloomberg News today reports that in pre-auction trading the new 30-year yielded a mere 4.49% on February 3, well below the 5.52% that prevailed at the August 9, 2001 sale of the bonds. For perspective, the 10-year Treasury traded at a 4.53% yield at Friday's close.
Yield-curve inversion, it seems, looks likely to remain alive and kicking.
February 3, 2006
THE PLOT THICKENS (AGAIN)
Today's employment report for January strikes yet another blow at the forces of pessimism emboldened by last week's surprisingly weak fourth quarter economic news. Indeed, this week's news on the economy has been generally upbeat, offering a sharp counterpoint to last Friday's disappointing GDP release. But there's a catch: the encouraging update on the employment front comes at an anxious time for inflation expectations, which are on the rise, or so the ongoing bull market in gold suggests.
Sticking with jobs for the moment, it's a bit easier to be cheery about growth this morning. The Labor Department advises that the jobless rate last month fell to 4.7%, the lowest since July 2001. The economy created 193,000 new jobs in January, up from December's relatively sluggish pace of 140,000. Although November's revised sizzling pace of a 354,000 gain seems a world away, it's nonetheless clear that the American economy's ability to mint new employment opportunities is far from dead in 2006. Indeed, last month marks the 29th straight month of growth in new jobs. The previous stretch of unbroken gains was the 33 months through May 2000 (the run would have been 52 months had it not been for August 1997's mild stumble, but we digress).
Adding to potency of January's employment momentum is the fact that the rise was broadly dispersed. Even the perennially job-challenged manufacturing sector managed to eke out a gain of 7,000 new jobs last month. Only retail trade and government posted losses, albeit relatively slight ones at that.
For those who are inclined to point out that January's monthly job growth pales next to the best months of recent years, Ian Shepherdson, chief U.S. economist for High Frequency Economics, suggests it's time to rethink such pessimism. A mini boom, in other words, seems to define the labor market of late. The January jobs report
"is much stronger than it first appears," he tells MarketWatch.com today. "Despite the 'disappointing' headline, this is a strong report, with the theme again one of upward revisions." The statistical point being: the average for payroll growth has been 229,000 in the past three months, well above the 160,000 average for all of 2005.
But if there's a flip side to the continued momentum of the payroll train, yesterday's report on labor productivity is in the running as the statistical bad boy that threatens to throw an egg on an otherwise jolly party. Productivity (a measure of per-person output) declined 0.2 percent in the business sector and 0.6 percent in the nonfarm business sector, the Labor Department reported on Thursday. Those are the first quarterly declines since 2001. In the same report comes news that non-farm labor costs rose 3.5% in the fourth quarter.
The combination of falling worker productivity and rising labor costs has sparked worries anew that inflation, however docile at the moment, may be gearing up for a return engagement in the near future.
"The glory days of surging productivity that kept labor costs down look to be behind us," opines Joel L. Naroff, chief economist at Naroff Economic Advisors, in today's Washington Post. "The expected slowdown in productivity has arrived, and that is putting pressure on costs and the Fed."
You don't have to say that twice to gold bugs. The precious metal this morning was trading just a hair under 25-year highs.
Even the bond market seems to be taking the hint. The yield on the benchmark 10-year Treasury jumped to 4.6% this morning, the highest since November 15. Over in the pits of Fed funds futures trading, expectations are on the march that the Fed will keep raising interest rates. The CBOT's July 2006 Fed funds contract, for instance, is priced in anticipation of a 5.0% rate, or 50 basis points above current Fed funds.
Meanwhile, sellers have the upper hand in the stock market this morning as well, building on yesterday's drop in the major market averages.
Distinguishing between good news and bad news is seemingly easy in the grand scheme of the dismal science, but it's getting tougher for investors trying to make informed decisions in 2006. Maybe the answer is simply to wait once again for a revision that better suits your expectations. The good news: there's always a fresh update coming.
February 2, 2006
It's too early to say what trend will define the Bernanke era of central banking, but the bull market in gold may get a footnote or two once the final history is written. Indeed, the precious metal is soaring, suggesting that something less than unwavering faith prevails when assessing the odds of success among mortal beings charged with defending the integrity of paper currencies.
As of yesterday's close, gold has climbed 10% so far in 2006. Catalysts driving the metal higher come in two basic flavors: geopolitical and economic. The obvious suspects in the former include rising anxiety over any number of Middle East tensions (Iran's nuclear program, Hamas' election in Palestine, the ongoing terrorism in Iraq, etc.) The economic worries start with the red ink that defines America's budget and trade ledgers, and move on to the ongoing elevation in the price of oil, which some say portends higher inflation.
"Rising oil prices will continue to keep gold prices buoyant this year as it's likely to lead to inflation,'' Ross Norman, an analyst at TheBullionDesk.com, tells Bloomberg News today.
A degree of sympathy for Norman's view can be found in Fed funds futures trading, where the CBOT's April 2006 contract is priced in anticipation of another 25-basis-point rate hike when the Fed convenes again on such matters next month.
It's worth noting too that gold's ascent in 2006 comes amid fresh weakness in the greenback, which has shed 1.8% this year through yesterday's close, based on the U.S. Dollar Index.
All of which raises a burning question for investors these days, namely, can the Fed keep inflation contained while staving off a weaker dollar and without derailing the economy? Finding the sweet spot for success on this front will prove tricky, if not elusive. Indeed, clear and concise signals on the economic front are lacking at the moment. For example, last week's surprisingly weak GDP report for the fourth quarter has been followed this week with a number of new releases that paint a profile of ongoing economic strength.
Consider, for instance, this morning's update on jobless claims reveals that new fillings for unemployment insurance were a relatively mild 273,000 for the week ending January 28. That's the third week in a row for claims below 290,000, a trend that economists say reflects rising demand for workers.
Meanwhile, yesterday's release of the ISM index of manufacturing activity for January documents the continued expansion of the sector. Additional support for making the case that economic growth will roll on comes from the update on December's construction spending, which rose 1% over November--the fastest pace of increase since September.
It's easy to be optimistic, or pessimistic. It just depends on whether you're willing to keep the blinders on and stay focused on the data releases that confirm your particular worldview.
February 1, 2006
WILL THE REAL ECONOMY PLEASE STAND UP?
On the first day of the newly minted Bernanke era, the pressing question is whether the economy's slowing, and if so, is it slowing more than a little?
The topic returned to the limelight last week when the first estimate of the nation's gross domestic product surprised with a sharply lower rate of growth than the dismal science was expecting. Optimists quickly responded that something was rotten in the data, and that future revisions of GDP would return the official measure of the economy's pace to form, namely, robust growth.
Judging by consumer spending of late, the optimists have reason to cheer. As the government reported on Monday, Joe Sixpack and his friends are in no mood to reign in their spendthrift ways. Personal consumption rose a strong 0.9% in December, as it did in November, based on revised numbers. Back-to-back strength, in no uncertain terms. Take that, you pessimists. Underscoring the trend is the fact that durable goods purchases were in the driver's seat for pushing overall consumption higher in the final two months of 2005.
If a sharp slowdown, or worse, is coming, Joe seems cheerfully oblivious to the threat. As such, one might wonder if a slowdown is probable, or even possible if Joe and his buddies aren't on board with the idea. Personal consumption spending, after all, represents around 70% of GDP. As goes consumers' willingness to use the heralded credit card, so goes the economy.
By that crude measure, it's hard to accept last week's warning sign dispensed in the fourth-quarter GDP numbers. Consider that the sharply lower annualized pace of economic growth during October through December of last year (1.1% v. 4.1% for the third quarter) came in large part due to the reported drop in durable goods-related personal spending. To be precise, consumer spending on durable goods dropped a staggering 17.5% in last year's fourth quarter v. the previous period, according to the GDP numbers. But wait, there's more: the GDP stats don't square with ongoing party in personal consumption as profiled by the personal income and outlays data series for November and December.
One set of numbers is wrong. But which set?
We can only imagine what Ben Bernanke, the new Fed chief, thinks of all this, or if he thinks of it at all. But whether he remains quiet or speaks, the relevance for clarifying the statistical discrepancy can't be denied, even if it must be delayed. To state the obvious, if the economy lives up to the portrait of weakness painted by the fourth-quarter GDP report, the central bank may be inclined to end its current round of interest rate hikes, which has been ongoing since June 2004. Indeed, yesterday's 25-basis-point hike brings Fed funds to 4.5%.
Alternatively, if the personal consumption reports of November and December prevail as constituting the real world, Ben may be inclined to keep tightening monetary policy.
Alas, Ben's not talking as to which view of the world he prefers, nor is he likely to reveal himself before the next Federal Open Market Committee meeting, scheduled for March 28. Much can happen between now and then, leaving investors with the uninviting task of guessing what comes next.
Among those who are paid to do no less is Charles Dumas of Lombard Street Research, who ventured out on that slim forecasting limb on Monday by writing in a note to clients that "rapid [personal] spending growth should support profits, helping stock prices." As for anyone who thinks that the "illusory softness" displayed in the fourth-quarter GDP report will bring an end to the Fed's rate hikes, think again, Dumas advises. The strong blast of consumer spending in November and December "makes it likely that Q1 GDP will rebound to at least a 5% rate, probably 6% or more...." But here's the kicker: the rebound will be short lived, he predicts. "After that the crumbling housing picture could take over...."
Perhaps. But the devil's in the details these days, and the details aren't necessarily clear of late.
The bond market's current bet, for what it's worth, seems disposed toward anticipating continued Fed hikes and economic growth. The 10-year Treasury yield has been north of 4.5% this week, up from as low as roughly 4.3% in early January.
Of course, with nearly two months to go before the Fed makes an official statement on the price of money, the data as we know it could yet change, and dramatically so. But if transparency about the future is in a state of unusually short supply, bond investors are being asked to swallow hard and worry not when it comes to any fear that rates could rise further. And investors are more than willing to comply.
Bloomberg News reported yesterday that the appetite for 30-year corporate bonds is alive and kicking. The folks over at Treasury no doubt take that as a good sign for market sentiment regarding the relaunch of the 30-year government bond, scheduled for February 9.
The Treasury Department is nothing if not bold in rolling out its formerly mothballed 30-year bond at a time when the government's red ink has jumped considerably since the security last made an appearance in 2001. We'll leave it to Mr. Market to decide if this is progress. The first hint of a definition comes on February 9.