August 31, 2006
WAITING, WATCHING & WONDERING
Is the recent pullback in commodities a sign of things to come?
As you can see from the chart below, commodities are the only major asset class that's in the red over the past month, through August 29. Although commodities are still up on the year, they trail most of the other asset classes. Only inflation-indexed Treasuries and U.S. bonds have delivered lower year-to-date gains than commodities.
Asset class proxies: Vanguard REIT ETF, iShares Russell 2000, iShares MSCI Emerging Markets, iShares MSCI EAFE, S&P 500 SPDR, Vanguard High-Yield Corporate, PIMCO EM Bond, Morningstar Ultra-Short Gov't Bond Category, PIMCO Foreign Bond, iShares Lehman Aggregate Bond, Vanguard Inflation Protected Securities Fund, Credit Suisse Commodity Return Strategy Fund.
Predicting turning points in investment cycles is difficult, if not impossible, and quite often dangerous if investors go to extremes based on their expectations about the future. The risk of bailing out of an asset class completely has been on display recently by way of REITs. Some pundits (including yours truly) have worried that the REIT bull market is long in the tooth, and so a correction of some duration and magnitude looked probable. But as the record shows, REITs haven't suffered much of a correction, at least nothing that comes close to looking like a sustained bear market.
If fact, REITs have continued to make new highs. So much for predictions.
Deciding if commodities will continue to deliver stellar gains, or something less isn't any easier than forecasting when (or if) REITs will hit the wall. Such is life in the prediction game.
But while we hold no illusions about our (or anybody else's) ability to discern what's coming, that doesn't stop us from making calculated bets in adjusting our asset allocation from time to time. And that includes paring back on asset classes that have run up while adding to those that have fallen on hard times.
To be sure, an enlightened approach to diversification is a bit more complicated. Valuation and macroeconomic factors should play role in rebalancing decisions too. But the analysis starts with comparing performance over a variety of time frames. By that standard, we're inclined to pare back on REITs and emerging market stocks. Alas, the game gets tougher for deciding where to redeploy the capital. Having no good choices (i.e., compelling valuations are in short supply at the moment) at our disposal, we're forced to make the least worst decision, which for us has been one of taking some money out of cash and putting it into short- and medium-term bonds and equivalent funds.
No, we're not smitten with bonds. In fact, we're not smitten with any of the major asset classes. That doesn't stop us from owning some of each. But better days surely lay ahead for asset allocation opportunities. One or more of the asset classes, we expect, will emerge as convincing buys. We're not sure when that will happen, or which asset classes will make the grade. But the opportunities may come sooner than many expect. And it is that rationale that continues to convince us to hold an overweight in cash.
August 30, 2006
MIXED DATA AND CLEAR FORECASTS
As messages from the bond market go, yesterday's trading session was fairly distinctive. It may even be accurate.
For much of the trading yesterday, sellers were in control, based on transactions in the benchmark 10-year Treasury Note. The yield climbed steadily as the hours passed, reaching upward to nearly 4.84% just after 1 p.m., New York time, the highest since last Wednesday. For the next hour, all was calm, and the yield level more or less held. Then at 2 p.m., the buyers rushed in and the yield on the 10-year dropped like a rock, as the chart below shows. The result: the yield tumbled back to 4.78% by the close--roughly the lowest since March and virtually unchanged from Tuesday.
What happened at 2 p.m.? The release of the minutes from the Fed's August 8 FOMC meeting, of course. The perception-altering news of the minutes, or so traders decided, was that the central bank wasn't quite as hawkish on interest rates as had been assumed earlier in the day. Thus, the repricing of risk, namely, the nominal yield on the 10-year Treasury, which, of course, is susceptible to future inflation (and the next story to hit the wires).
But inflation, the fixed-income set resolved, isn't going to be much of a threat. That, at least, was the message of yesterday's bond-market action. But the casual observer can be forgiven for confessing confusion. Indeed, yesterday's FOMC minutes made it clear that the debate on August 8 (which marked the Fed's first pause in hiking rates after 17 previous elevations) was hardly decisive one way or the other. As the minutes advised, "In view of the elevated readings on costs and prices, many members thought that the decision to keep policy unchanged at this meeting was a close call and noted that additional firming could well be needed."
Nonetheless, most voting members of the FOMC voted to pause on August 8, apparently concluding that inflation is fading as a material threat. Of course, it's also true that while there was but one dissenting vote at the last meeting, the minutes reveal that several members who voted to cease and desist were less than 100% confident in the accuracy of their decision. Again quoting the minutes: "In view of the elevated readings on costs and prices, many members thought that the decision to keep policy unchanged at this meeting was a close call and noted that additional firming could well be needed."
Holy data confusion, Batman! Is the outlook really that muddled?
Fed Chairman Bernanke has said that the Fed's forecast of a slowing economy will pare inflation's upward momentum of late. And in fact, the economy has been slowing, although it remains to be seen if that will translate into a sustained fall in the core rate of inflation. A minor setback, if we can call it that, on that front comes in this morning's latest estimate on second-quarter GDP. As it turns out, the economy grew slightly faster than previously calculated, according to the Bureau of Economic Analysis. GDP advanced at an annual rate of 2.9% during April through June, which is moderately faster than the 2.5% estimate previously disclosed. By itself, that doesn't change much. Then again, we'll have to wait and see what Friday's employment report for August says before coming to any fast and furious conclusions.
Meanwhile, BEA reported that the higher GDP estimate reflects "upward revisions to exports of goods, to nonresidential structures, to private inventory investment, and to state and local government spending that were partly offset by a downward revision to residential fixed investment."
It's anyone's guess how the bond market will react in the days ahead, although based on yesterday's trading, it's clear that the path of least resistance for interpretation seems to be one of optimism, i.e., inflation's fading and the risk of slowdown, or perhaps even recession, is rising.
Indeed, a 10-year Treasury yield just below 4.8% as we write is one that's materially below the current Fed funds rate of 5.25%. There are many unknowns in the world of economic forecasting, but the bond market is crystal clear about what it thinks is coming. An inverted yield curve and its implications of recession may not be fate, but as a measure of expectations it's a precision instrument.
August 29, 2006
WATCH THOSE SPREADS
For the second day running, the yield on the 10-year Treasury yesterday closed under 4.8%. That hasn't happened since March.
Traders of government bonds have become increasingly optimistic that inflation isn't half the threat it was perceived to be in weeks past. In concert with that forecast, the 10-year's yield has dropped roughly 20 basis points from the 5.0% level of August 14. Although many disagree with the trend and instead fear that inflation will continue to harass the economy, for now the fixed-income set is convinced that it knows what's coming, and the world can either follow or get out of the way.
No matter what you think of the decline in yield, the trend is being felt elsewhere in the capital markets. That includes the market for high-yield debt securities, otherwise known as junk bonds.
Among the byproducts of the falling bond yields is a rise in the spread of junk yields over the 10-year's. The KDP High Yield Index currently carries an 8.0% yield, which translates into a spread of roughly 3.2% over the 10-year Treasury. The spread is highest since the second half of 2005, and up about 70 basis points from earlier this year, according to KDP Advisor.
The rise in the junk spread is encouraging for those looking at high yield bonds. But encouraging does not yet convince us to buy, even if we're finding more incentive to look. Indeed, a 320-basis-point spread is the richest so far this year. Alas, it still pales next to levels from recent history. In the first half of 2005, for instance, the spread touched ~400 basis points, based on the KDP High Yield Index, as the chart below shows (courtesy of KDPAdvisor.com) And back in 2002, an astonishing spread of nearly 900 basis points could be had, albeit for a brief and fleeting moment.
KDP High Yield Index Spread over 10-Yr Treasury
Source: KDP Advisor
Of course, no one should expect a 900-basis-point spread to return any time soon. The monetary and economic climate has changed drastically since then, all but insuring that far-more modest spreads are likely to prevail for the foreseeable future.
Nonetheless, for those smart enough to dive in junk bonds in mid-2002, the subsequent returns have been remarkable, as the trailing returns remind. For the past five years through yesterday, for instance, the Merrill Lynch U.S. High Yield Master II Index has earned an annualized total return of 8.3%, or more than double the S&P 500's rise over that span, according to Morningstar.com. Bonds overall, as measured by the Lehman Bros. Aggregate, have also trailed, posting an annualized total return of 4.85% for the five years through yesterday.
But if there's worry that junk bonds still aren't offering an enticing spread over Treasuries, the anxiety isn't obvious in 2006. The Merrill Lynch U.S. High Yield Master II Index so far this year is up 5.6% on a total-return basis--virtually identical to the S&P 500's year-to-date performance and well ahead of the Lehman Aggregate Bond's 1.8% advance through yesterday.
The recent rise in the junk-Treasury spread is due primarily to the fall in the 10-year's yield. As a result, the trailing 7.43% yield currently offered in Vanguard's High Yield Corp. Fund, for instance, is looking more attractive by the day. Just how attractive such yields will ultimately become appears to be a function of sentiment among Treasury traders. And for the moment, those traders are intent on giving investors ever-more alluring spread opportunities.
If the trend keeps up, it may be time to consider a fresh deployment of capital into junk bond funds. We're not there yet; then again, the boys in the Treasury pits aren't quite done chasing government bonds. All of which is inspiring us to keep a close eye on spreads.
August 28, 2006
IS THERE ANY LOW-HANGING FRUIT LEFT TO PICK?
Is this as good as it gets? Has perfection in corporate profits come and gone? Anxious investors with above-average allocations to domestic equities can be forgiven for asking such questions these days. Perfection, after all, has nowhere to go but down.
As The New York Times observed in a front-page story today, corporate profits as a share of the economy, at 10.3% in this year's first quarter, are the highest since the mid-1960s. The story quoted UBS research, which termed the recent level of corporate profits as "the golden era of profitability."
Can a golden era remain golden indefinitely? Or is the natural course one that will turn gold into lead? These are the questions that weigh on equity investors, who are sitting on tidy gains generated since the stock market collapse of 2000-2002. For those who were lucky enough to time the subsequent rebound in stocks just right, the ensuing gains have been sweet. The S&P 500 boasts a torrid 15% annualized total return from March 1, 2003 through July 31, 2006. That's about 50% higher than the stock market's long-term average performance. Small-cap stocks have enjoyed even stronger performance. The Russell 2000's total return over the same stretch is nearly 23% a year.
Bull markets for stocks, in other words, don't get much better than the previous three years or so. But with clarity on economic and political issues receding by the day, a bit more caution on the future may be just the thing to calm one's nerves.
Don't misunderstand. We like stocks. We like them a lot. Some of our favorite portfolio holdings are equities. In fact, we're committed to holding equities as a long-term proposition, come hell or high water. But we're also inclined to think that the last three years may be anomalous compared to what's coming for U.S. stocks overall, i.e., a stretch of mediocrity. In turn, our expectations (flawed though they may be) inform our thoughts on equity allocations, which for the moment we prefer to ratchet down.
Trimming back on equities for some may look premature. The rear-view mirror is nothing if not impressive, casting a bullish aura for those who like to extrapolate the past into the future, no questions asked. Earnings, after all, have been the great power that's elevated stock prices in recent years, and on that measure there's much to celebrate by looking back. The Federal Reserve saw fit for several years prior to June 2004 to lower interest rates to levels that, with the benefit of hindsight, were excessively low. And even once the Fed started raising rates, it did so slowly, allowing cheap money to endure. Corporate America, being a for-profit group, took advantage of the situation and proceeded to repair balance sheets to a degree that was as dramatic as it was quick.
Consider that in 2001, income before taxes for nonfinancial businesses fell more than 5% from the previous year to $1.15 trillion, according to date from the Fed's current Flow of Funds Accounts of the United States. However, as the chart below shows, corporate income has been climbing ever since. In fact, last year, income advanced nearly 23% over 2004, making the year one of the more remarkable 12-month stretches in corporate history.
Curiously, the stock market reacted rather sheepishly, with the S&P 500 climbing only 4.9% last year. Perhaps it's not so curious after all. The stock market is widely credited with looking ahead. Sometimes it sees things that don't materialize, but in 2003 and 2004 its powers of prognostication were prescient, or so the S&P's 29% and 11% total return for each of those years, respectively, suggests.
Indeed, earnings continue to impress relative to the past. But the fuel that powers those earnings--rising corporate income--is showing signs of slowing. For this year's first quarter, corporate income slowed considerably relative to the year-earlier quarter, rising by 13%, as the chart above reveals.
Granted, there's a big difference between slower rates of growth and outright declines. But for those who think strategically, the signs of income growth turning sluggish are a warning.
No, it's not time to write off equities and go to cash. Far from it. But pulling back, taking some profits seems eminently reasonable at the moment. Asset classes never go bankrupt, but they do fluctuate. Exploiting those fluctuations and redeploying profits is the only way to fly.
August 25, 2006
Inflation fears are on the rise lately, courtesy of the upward momentum in the pace of the core consumer price index, which extracts food and energy from the mix. But judging by the market's outlook on inflation, derived from inflation-indexed Treasuries (or TIPS, as they're known), not much has changed this year. Mr. Market, it seems, isn't worried about inflation. And perhaps that's as it should be. The Fed tells us that a slowing economy will do the dirty work of cutting any inflation surprise off at the knee, and it's becoming clearer that the economy is in fact slowing.
Nonetheless, core CPI advanced by 2.7% for the year through July--that's up from 2.2% in 2005 and the fastest annual pace since 2001. A sign of things to come? Maybe, but the market-based outlook for inflation has been calm, cool and largely inert this year. Consider that at the close of 2005, the TIPS-based inflation projection (calculated by difference in yield between the nominal 10-year Treasury and the 10-year TIPS) was 2.33%, which inched up to just 2.53% as of yesterday, as our chart below illustrates.
As warning signs of future inflation go, the one emanating from TIPS is a fairly tepid animal. Indeed, the current 2.53% forecast is well below both the latest reading on the annual change in core inflation (2.7%) and top-line inflation (4.1%).
Some may take comfort in the fact that the market thinks there's no bull market in inflation, but a number of skeptics say that TIPS are less than a reliable forecasting mechanism when it comes to pricing trends. In fact, the subject of inflation and TIPS became a topical, if hotly debated subject yesterday after commentary from Arthur Laffer. Writing in The Wall Street Journal in a piece called "The Flawless Fed", he invoked the securities and announced that a reading of the yield spread between nominal Treasuries and TIPS indicates that "over the past three years there has been no upswing in the market's expectations of inflation."
The blogosphere reacted, warning that reading the tea leaves from TIPS offers no special insight into the future, and perhaps a whole lot less than some assume. Bret Swanson at the Discovery Institute was speaking for some, including Don Luskin, when he wrote "Dr. Laffer says expected inflation gleaned from TIPS bonds is the best predictor of inflation, but in fact TIPS have not been very good at all at predicting inflation." Macroblog weighed in as well, sparking a debate on Laffer's assumptions.
For others, Laffer's op-ed was swallowed hook, line and sinker. This blogger, for instance, cited Laffer's commentary on low inflation expectations by way of TIPS to gush,
This spread tells you the market, which is the most efficient and effective entity when it comes to valuation and prediction, expects 10 year inflation rates around 2.5% a year, a very acceptable rate. This is just one more example that the US economy is in the best shape it has been for some time now. Mr. Laffer points out how good of a job managing monetary policy the Federal Reserve has done in a very difficult environment, and I would agree….
Consensus is a rare commodity in the marketplace, and getting rarer by the day when it comes to economic assumptions. Even Mr. Market's conclusions are increasingly suspect. All of which raises the question: why should we believe that 12 men and women voting in a room tucked away in Washington have any more insight into what the price of money should be than the collective judgment of the bond market? We're always skeptical when people say, "The market's wrong." Of course, that's true, albeit at selective points in time. But as a general proposition in the long run, one incurs more than a little risk when betting against Mr. Market.
At least J.P. Morgan was right when he famously advised that prices will continue to fluctuate. There's one forecast we'll take to the bank. Otherwise, it's every man, women and bond trader for him- or herself.
August 24, 2006
MORE DATA, MORE QUESTIONS
News of the economy's slowdown continues to roll in, with this morning's report on durable goods orders delivering the latest excuse to embrace gloom.
New orders for manufactured durable goods fell 2.4 percent last month, the U.S. Census Bureau announced. Coming along with yesterday's report that existing home sales continued to slide, it's getting easier to assume that something more than a pause that refreshes has arrived.
Durable goods are a volatile series, of course, and its relevance is one that's limited to long-term trends. On that note, it's worth noting that durable goods orders were still higher last month compared with 12 months previous. Nonetheless, Wall Street now seems inclined to see the glass half empty, and any explanation to the contrary is apt to be dismissed.
The aura that trouble lies ahead for the economy is starting to take root in the stock market. The S&P 500 shed nearly a half-percent yesterday, and it's likely that yesterday's news of falling home sales in July had more than a little influence. Equity investors previously had been inclined to buy in the wake of the Fed's hold-'em-steady decision on interest rates on August 8. But the market is coming to realize that if the Fed's not hiking the price of money, that implies that economic growth may be waning.
Waning, perhaps, but earnings growth remains intact...so far. According to Zacks, S&P 500 median earnings per share growth for the second quarter is a strong 13.2%, based on reporting by nearly 94% of companies in the index, noted Dirk Van Dijk on Monday. What's more, the positive surprises on earnings far outweighed the negative ones.
Ah-ha, you say, the second quarter is gone; on to the third. Indeed, although for the moment the consensus outlook on earnings calls for a slowdown of only marginal proportions amounting to a 9.4% rise, Van Dijk reported. That's slower than the third quarter's pace, but not exactly the end of the world. In fact, 9.4% looks pretty good by historical standards, assuming it proves accurate. And while we're indulging in prophesy, the median analyst prediction calls for an 11.5% rise in earnings for all of 2006.
Elsewhere at Zacks, Charles Rotblut today advised that analysts overall aren't forecasting a recession. "I analyzed the projected earnings growth rates for more than 2,300 companies for the next four quarters and numbers were bullish," he wrote. "Profits are projected to rise by an average of 18.6% in the third-quarter and 22.4% in the fourth quarter. Next year, earnings growth is expected to average 21.8% and 20.6% in the first and second quarter, respectively. By means of comparison, these companies averaged 17.4% growth last quarter."
The notion of a "soft landing" it seems is alive and well. And it's hardly just Zacks. The odds of a recession in 2007 are a mere 15%, opined Richard Hoey, Dreyfus chief economist and chief investment strategist in a research note earlier this week.
Donald Luskin, chief investment officer at Macrolytics tends to agree. In a research note today, Luskin explained that "we expect continued robust earnings growth, a view affirmed by the bottom-up Wall Street forward earnings consensus....This forward-looking view on the macroeconomy sees no sign of a slowdown whatsoever."
But not everyone takes confidence that the past will continue to be prologue for earnings, and by extension, the economy. Although optimism reigns supreme this month for predicting corporate earnings growth, the bloom is set to come off the proverbial rose, warned a report from BCA Research published yesterday. "The recent uptick in global earnings revisions is unsustainable given the developing slowdown in world economic growth," the consultancy wrote. The smoking gun is the "continuing weakness in our 23-country Leading Economic Indicator."
So it goes in the land of predicting. But the devil's in the details, and with a turning point in the cycle upon us, it's wise to err on the side of prudence for crafting portfolios. The future is always unknown, and when cycles shift, surprises can pop up like weeds.
For now, a big and risk-laden assumption for many is that a slowdown is coming, and that it will, to paraphrase Fed Chairman Bernanke's recent commentary, take the edge off the inflationary momentum of late. Both equity and fixed-income investors are hoping for no less, and many are investing as if that's a done deal.
If such hopes find confirmation in the data, the consecration of Bernanke into church of central banking will proceed apace. We too would like to believe that the economy can slow and reduce the core rate of inflation along with it. Perfection is always preferable to the alternative. Unfortunately, perfection is all too rare in the world of economics, and so alternative outcomes must be considered, if only to pass the time.
That notion was on our minds when we read an op-ed piece in today's Wall Street Journal (subscription required) by Arthur Laffer, who wrote, "You'd have to dig pretty far down in the duffle bag of economists to find one who actually believes in the Philips Curve -- the idea that rapid growth causes inflation. In truth, rapid growth in conjunction with restrained monetary base growth is a surefire prescription for stable low inflation."
In other words, it's all about money supply (still).
August 23, 2006
LOOKING FOR A U-TURN
Stocks are leading bonds by a comfortable margin this year, but Mr. Market may be plotting for a reversal of fortunes.
The motivation for considering such an apostasy in a world that holds equities near and dear comes by way of recent action in the 10-year Treasury Note's yield, which dipped below 4.80% yesterday for the first time since March 29. Since June 28, the recent top in the price of money on the benchmark Treasury, the 10-year's yield has dropped more than 40 basis points.
The trend in yield is down, which means demand for bonds is up. Nonetheless, the surge of buying fixed-income securities of late still hasn't reversed the edge that stocks hold over bonds this year, but the odds for a turnaround are looking better, or so we're told. For the moment, however, the S&P 500 is still up by 5.3% this year on a total return basis through yesterday, while the Lehman Brothers Aggregate Bond Index has climbed only 1.7%.
The catalyst behind the notion that bonds may wind up the winner in the two-legged asset-class performance race for 2006 is the expectation that the economy's slowing. Some are even going so far as to predict that a recession is coming. Nouriel Roubini, an economics professor at New York University, on Sunday wrote on his blog that the "U.S. economy will fall into a recession by early 2007." Such talk is inspiring the bond market because it implies that interest rates will fall, delivering big gains to fixed-income securities along the way. If so, stocks would take a hit, or so the history from past recessions suggests.
Recent data has provided a degree of support for the economy-is-slowing view, and as a result the bond bulls have become emboldened for their cause by backing up their predictions with cash. Indeed, the only trend that impresses Wall Street is one backed by money, and so the rush to Treasuries of late has more than a few financial types sitting up and paying attention.
But despite the gush of bond buying in recent weeks, the road to relative outperformance is still booby trapped with anti-clarity cluster bombs. Chicago Fed President Michael Moskow yesterday tried to throw some cold water on the bubbling expectations in the bond market by warning that the Federal Reserve may still have more rate hikes up its sleeve. Yes, the Fed ended its two-year campaign of tightening at its last meeting on August 8, but Moskow (who's not a voting member of the FOMC) said yesterday that higher rates may yet be required for slowing inflation's upward momentum of late.
"My assessment is that the risk of inflation remaining too high is greater than the risk of growth being too low,'' Moskow said yesterday via Bloomberg News. "Thus some additional firming of policy may yet be necessary to bring inflation back into the comfort zone within a reasonable period of time."
Perhaps, but the bond market doesn't seem inclined to agree, if the ongoing fall in the 10-year's yield is any indication, and it is. Perhaps that's because there's a range of opinion on inflation's outlook among the Fed heads. If you don't like what you're hearing from Moskow, you can shop around for a more comfortable bout of opining.
For those disposed to consider the alternatives, Atlanta Fed President Jack Guynn offered a fresh dose of soothing words yesterday. After a farewell talk warning of the need for vigilance in combating inflation, Guynn then told reporters that "I am comfortable that policy seems to be, at the time of the last meeting, properly calibrated for my best forecast," Bloomberg reported. Inflation, Guynn predicted, will slow in the "medium term."
Anything's possible in the short term, of course, which makes betting the ranch on either stocks or bonds for the foreseeable future so precarious in the here and now. Much depends on whether Moskow or Guynn's forecast prevails. No matter, traders are making their bets and accepting the associated risks.
For everyone else, there's still a little invention known as diversification. And by that measure, a simple 50/50 split of stocks and bonds has fared well over time, a trend we expect we deliver no less comfort going forward. Consider that for the past five years, an even mix of the S&P 500 and the Lehman Aggregate Bond indices (both of which are available in mutual fund and ETF proxies these days) generated an annualized total return of 4.45% for the five years through yesterday. That, by the way, is ahead of the S&P 500's annualized 4.0% performance over that span and below the Lehman Aggregate's 4.9%. One side or the other is always up, and the other is down. Diversification is many things, but extreme isn't one of them.
As such, taking a performance slice born of some mix of the two looks eminently reasonable as a long term proposition. Alas, the world is focused on what's on tap for tomorrow.
And with that, we conclude our lecture and return you to your regularly scheduled horse race....
August 22, 2006
RUMINATING OVER REAL ESTATE RUMBLINGS
In the prediction game of deciding if the economy's downshift will be soft or hard, real estate figures prominently as a clue of substance. We say that based on the knowledge that the bull market in housing in the 21st century has been spectacularly robust in elevating consumer spending. If the real estate boom turns from boom to bust, the ensuing fallout will have no less an impact on the economy, albeit in reverse.
It may be too early to forecast what the housing slowdown will bring, or extract, but there's no doubt that a slowdown is underway and the change is conspicuous. As evidence, one need look only at a graph of the percentage change in revolving home equity loans to realize that the tide has turned in a material way. Take a look at the chart below, which comes courtesy of yesterday's research report from Northern Trust's Asha Bangalore. Notice anything dramatic in the chart?
Revolving home equity loans are, of course, just one piece of a very large and complex real estate puzzle. As such, the massive industry of residential real estate turns on more than just home equity loans. That said, it's hard to imagine that the collapse in home equity loans of late, relative to its year-earlier level, doesn't reflect a wider trend underway in housing, namely, a correction. In fact, as Bill Conerly's Businomics Blog pointed out last week, the evidence is mounting that the pullback in housing is something more than a minor hiccup.
Meanwhile, the connection of home equity loans to the broader economy is clear, as Bangalore reminds in yesterday's research: "Households tapped into home equity to the tune of about $600 billion in 2005 to support their expenditures." And those expenditures have been instrumental in raising GDP in recent years. Indeed, consumer spending overall comprised 70% of GDP in this year's second quarter, according to numbers from the Bureau of Economic Analysis.
To be sure, $600 billion of home equity loans is just 6.5% of the seasonally adjusted annualized $9.23 trillion in personal consumption expenditures (PCE) in the second quarter. But when you consider that PCE in this year's second quarter rose by just $149 billion over the first quarter, it's clear that that marginal impact of $600 billion in home equity loans on economic growth is potentially huge.
The trouble arises from the realization that last year's $600 billion of home equity loans will be something less this year. The growth rate of home equity loans this year is decidedly negative, Bangalore reports. "For the tenth straight week, home equity loans dropped from a year ago," the Northern Trust economist writes, an observation illustrated in the chart above.
It's no surprise to the home building industry that a correction is underway in the housing business. Looking at Morningstar's 129 equity industry benchmarks, home building's performance this year is ranked 128, which translates into 32% loss in 2006 through yesterday. For some stocks in the industry, the damage is far worse. Shares of Comstock Homebuilding Companies (Nasdaq: CHCI), for instance, have shed nearly 70% so far this year.
Although shareholders of home building stocks are all too aware of what's unfolding in their marketplace, equity investors overall are unmoved by the bear market in residential real estate companies. The S&P 500 is comfortably in the black thus far in 2006, posting a tidy total return of 5.3% through August 21.
Considering the contrast between equities generally and real estate particularly, one has to ask if one side has underestimated the threat, or if the other has simply overreacted. Everyone has their own theory, and an axe to grind. But the definitive answer will arrive soon. In the meantime, we can only wait for the statistical evidence that will inform us if Joe Sixpack can maintain his penchant for spending while a key pillar of the boom in conspicuous consumption crumbles. We're all data dependent now.
August 21, 2006
SOFT LANDINGS & HARD RAIN
It's all about the soft landing now. Ergo, will he or won't he engineer one?
Fed Chairman Ben Bernanke is now engaged in what may prove to be the defining act, for good or ill, of his central-banking career. Having bet more than a little of his reputation (nascent though it is as the Fed's leader) on the arrival of a soft landing, the world will be monitoring the associated economic data as it rolls in for confirmation or denial. The smallest deviation from the expectations that Ben has fomented could deliver more than a little volatility in stock and bond markets, which have recently become accustomed to believing that the Fed can deliver on its promises.
But the challenges on the road to economic perdition (or salvation) are many. For starters, recent converts to the faith in bull markets might ask themselves what exactly constitutes a soft landing? In general terms, the answer is obvious: an economic slowdown that avoids recession. But even a downshift in GDP's pace that manages to stay north of zero isn't problem free.
Consider that the U.S. economy advanced at an annual rate of 2.5% in this year's second quarter. That's sharply slower than the 5.6% logged in the first quarter. One might argue that the change represents a soft landing. But the concept of supple economic set downs must be housed in proper context with inflation. The main reason the Fed seeks a soft landing is because it wants a lesser inflation.
A noble ideal, and one that's notoriously tricky to deliver. Although the pace of GDP has slowed considerably, inflation has yet to show a commensurate pullback. Yes, the core rate of consumer prices in July decelerated from its trend in March through June. But it's not yet clear if the drop to 0.2% for core CPI last month from 0.3% for each of the previous four months is sustainable, or just a temporary pause.
The truth will out, of course, one economic release at a time. For this week, the highlights (or low points, depending on your perspective and the numbers dispensed) will come on Wednesday, with the July update on existing home sales, and then on Thursday, with last month's durable goods orders and new home sales.
The price of oil will also doubt cast a heavy influence over investor perceptions as to what comes next in the economy. The September contract for crude oil dipped below $70 in New York last week for the first time since June, but if oil's headed for sharply lower territory, the outcome remains the stuff of speculation.
Nonetheless, fundamentals suggest a sharp and extended selloff is coming, according to the energy group at Bernstein Research. In a report sent to clients this morning, Bernstein's Neil McMahon advises that "crude prices are currently divorced from underlying supply and demand fundamentals." Several trends (rising storage supplies of oil and new production sources coming on line, for instance) are afoot that may bring the price of oil sharply lower in the foreseeable future. Timing is unclear, however, in part due to the complex array of geopolitical and economic factors that drive the price of crude. Yet McMahon is undeterred from dispensing his warning:
"High prices are causing supply to grow faster than demand, increasing spare capacity," McMahon writes. "As a result, the longer the pricing bubble lasts, the larger spare capacity will grow, and thus the more prices are likely to fall when the correction finally comes and prices re-link to the fundamentals."
Oil's price is always a critical component for influencing economic growth. As such, Bernanke's fate to a degree lies with futures traders in the oil pits. Even so, a material change in oil prices, either or up or down, has several implications for the U.S. economy. If oil prices fell sharply, and for a sustained period, top-line inflation would likely slow, and so the potential for the same in core CPI would be considerable. In turn, that would help raise the odds of a soft landing. But how much of that trend would be offset by the economic stimulus that might come from dramatically lower energy prices?
Meanwhile, assume that oil prices keep rising due to, say, continued turmoil in the Middle East. In that case, the slowdown in economic growth could be more than Mr. Bernanke bargained for. Lower inflation won't due much for Bernanke's legacy if it arrives by way of a nasty recession.
Deciding what's lurking around the corner is never easy, and in fact it's getting harder all the time. Risk, in short, is in a bull market. Investors should recognize this, along with the fact that betting the house on a soft landing may be asking too much of fate and Mr. Bernanke's capacity for engineering economic perfection. Anything can happen in the global economy, which is another way of saying that the odds of any one thing occurring is slim. If nothing else, your editor has an incredibly lucid grasp of the obvious.
August 18, 2006
In a perfect world, the writing on the economic wall would be clear and concise. But as any student of the dismal science knows, we instead live in an alternative universe where trends are fuzzy, data is suspect, and stuff happens that degrades the value of otherwise reasonable analysis. Welcome, in short, to reality.
Reality, it seems to us, continues to be on display in all its exasperating shades of gray this year, and yesterday's batch of economic releases continued in that vein. Let's begin with the Conference Board's leading economic indicators for July, which fell 0.1% last month. "The leading index has decreased in four of the last six months and the leading index has fallen below its most recent high reached in January," the Conference Board explained in a press release. For the year through July, the leading indicator is down by 0.7%. "At the same time, real GDP grew at a 2.5 percent annual rate in the second quarter, following a 5.6 percent gain in the first quarter," the press release observed. "The behavior of the leading index so far suggests that slow to moderate economic growth should continue in the second half of the year."
That will cheer the Fed, which is currently staking its prestige on an economy that will moderate enough to take the edge off inflation but without creating a recession.
In fact, there's an even split in trend among the ten factors that comprise the Conference Board's leading indicator. By this metric, the economy is teetering, but which way it falls remains to be seen. Five of the factors rose last month, and five fell, allowing optimists and pessimists more than a little fodder for battling over what it all means. Consider the positive contributors, starting with the largest gainer, followed by those in descending order of import:
1. average weekly manufacturing hours
2. vendor performance
3. stock prices
4. index of consumer expectations
5. manufacturers' new orders for consumer goods and materials.
In contrast, the negative contributors to the leading index, beginning with the largest negative contributor:
1. building permits
2. average weekly initial claims for unemployment insurance
3. interest rate spread
4. manufacturers' new orders for nondefense capital goods
5. and real money supply
Deciding if one trumps the other, or if one side cancels the impact from the other, is the debate du jour. But for those who see the potential for more than a mild slowdown, yesterday's update on weekly claims for jobless benefits suggests that there may be more strength in the economy than the leading index suggests.
Seasonally adjusted initial claims for unemployment insurance totaled 312,000 for the week through August 12, the Labor Department reported. That's down slightly from both the previous week and a year ago. In other words, jobless claims are holding steady these days, belying worries that the economy's about to take a tumble. Granted, jobless claims are but one number, and one should be careful about reading too much into its predictive power. But if the leading indicator trend is correct, the associated slowdown will begin revealing itself in jobless claims. So far, however, there's scant evidence.
In fact, some contrarian thinking types continue to predict that there's more inflation in the pipeline than some expect. One analyst who embraces this line of thinking says Mr. Market is destined for disappointment. David Gitlitz, chief economist at TrendMacrolytics, advised in a note to clients on Wednesday that growth is stronger than the consensus believes. "Financial markets, especially fixed income, have taken wing on the idea that growth is slowing enough and inflation appears tame enough to keep the Fed out of the picture," he wrote. The markets, he continued,
want to believe that the Fed's Phillips Curve/output-gap paradigm, in which inflation is a function of economic growth, will prevail -- and with the pace of expansion apparently cooling, the Fed will have no reason to return to action. In the fullness of time, this is likely to go down as a serious misjudgment. As an inflation forecasting tool, the Phillips Curve has gotten it wrong time after time, while the market price model we use has repeatedly proven its validity. Besides, while the markets are counting on an economic slowing to continue providing the Fed with the cushion it needs to stay sidelined, from our perspective the growth outlook appears strong. At some point in the not too distant future, the Fed will unavoidably be forced to take more action to raise rates than either it or the markets are now anticipating.
In fact, we know that the economy's pace isn't what it used to be. The rate of expansion in GDP has declined, and there's a widely publicized downshift in the residential real estate market. But the jury's still out on the extent and duration of the slowdown. That is, unless you're a central bank.
For the moment, the Federal Reserve expects that the downshift in the economy has legs, a reading on the future that increasingly extends to those in the world of bond trading. At one point yesterday, the yield on the benchmark 10-year Treasury dipped to 4.84%--the lowest since April 5.
The stock market too is becoming emboldened by the prospect of lower interest rates, as forecast by the renewed bullishness in the bond market. Just as the 10-year's yield has made a clear downside breakout, the S&P 500 has done the same on the upside in recent sessions following the Fed's decision last week to put rate hikes on hold. The S&P touched the 1300 mark yesterday for the first time since May. As a result, the S&P 500 is up 5.2% on the year through yesterday.
The renewed fondness for embracing risk is even popping up in emerging market equities. The dramatic selloff of the spring is currently in the process of being reversed. The MSCI Emerging Markets Index, measured in dollars, is up more than 10% for the past four weeks, according to Morningstar.com.
Ours is a time of questions about the path of least resistance for the economy, but for those charged with trading bonds and equities the dismal science moves too slowly. In the age of immediate gratification, the morrow must be dissected in definitive terms in the here and now, leading to definitive conclusions as to what comes next. Back in the real world, however, there's more than a little confusion, but no trader worth his bonus is going to let that get in the way of his day job.
August 17, 2006
A FRESH TAKE ON STRATEGIC GUESSWORK
The tactical is vastly more interesting than the strategic when it comes to investing, but the latter is vastly more important for determining results. Unfortunately, coming up with reliable numbers is a challenge, and even in the best of circumstances the estimates are only guesses. Ideally, they're informed guesses, but guesses nonetheless.
No matter, as guesses are all we've got for strategic portfolio design. The three building blocks in the endeavor of building efficient portfolios (i.e., portfolios that maximize return for a given level of risk) are expected returns, volatility (standard deviation) and correlations for the major asset classes. The latter two tend to be relatively easy to project based on a careful sampling of history. Expected returns, however, are another animal, and this is where the challenge lies. Simply put, projecting returns far into the future is at once immensely critical for long-term portfolio design, and immensely difficult. The reason: history is of limited value in determining performance in the years ahead.
That said, we're more than a little interested when a respected research team brings fresh numbers to the genre of strategic projections. On that score, we refer you to EnnisKnupp. The Chicago-based institutional investment consultant last month updated its Capital Markets Modeling Assumptions, with an eye on assessing the outlook for returns, correlations and volatility among the major asset classes. Strategically minded investors would do well to give the research paper a read and consider the implications for portfolio design. Granted, the paper dispenses estimates, but robust ones nonetheless. As a result, the numbers offer a starting point for deciding how to structure a portfolio. As a preview, here's a sampling from the paper's statistical offerings:
Asset Class Expected Long-Term Compound Return
US Equity 7.5%
Non-US Equity 7.2
US Bonds 5.6
Real Estate 6.5
Historical Asset Class Standard Deviation (1978-2005)
US Equity 16.7
Non-US Equity 18.7
US Bonds 6.6
Real Estate 11.3
Historical Asset Class Correlations (1978-2005)*
Relative to US Equity:
US Equity 1.00
Non-US Equity 0.71
US Bonds 0.20
Real Estate 0.59
Relative to Non-US Equity:
US Equity 0.71
Non-US Equity 1.00
US Bonds 0.20
Real Estate 0.63
Relative to US Bonds:
US Equity 0.20
Non-US Equity 0.20
US Bonds 1.00
Real Estate 0.58
* 1.0 is perfect positive correlation; 0.0 is no correlation
We're fairly confident that the standard deviations and the correlations will prove reliable, if not perfect benchmarks for the future for the simple reason that history is a fairly good guide for such measures. Expected returns, of course, are another matter, requiring more than a little suspicion as to their accuracy relative to what the future brings.
That said, one thing stands out in the numbers: the low correlation of bonds relative to equities. In fact, that's consistent with history. The no-brainer diversification decision has long been one of adding bonds to a stock portfolio. If nothing else, the EnnisKnupp numbers reaffirm that the strategic does in fact trump the tactical as a vital issue for investing success. We can debate what the Fed will do next, and whether inflation is rising, falling or standing still. Exciting as all this is, it pales in importance next the recognition that bonds are likely to remain excellent diversification tools for equities. This, at least, is one paradigm that looks set in stone.
August 16, 2006
A MURKY CPI REPORT INSPIRES THE BOND MARKET
After yesterday's surprisingly encouraging news on producer prices, investors were looking for a clear and unambiguous repeat performance with this morning's report on consumer prices for July. But the financial gods delivered something else. Something else, but it will suffice, or so early signs from the bond market reveal.
Today's CPI release is a poster child for mixed messages. Top-line CPI advanced by a seasonally adjusted 0.4% last month, the Labor Department reported. That's twice as high as June's 0.2% pace, and near the highest levels on a 12-month rolling basis for recent history. As a result, consumer prices jumped by 4.2% for the year through last month--a rate that lends no comfort for thinking that inflation is a receding force.
But investors are focused elsewhere, namely, the core rate of inflation (which ignores food and energy prices), and this gauge offers a more promising trend. Core CPI rose by 0.2% in July, down from the 0.3% in the previous month. But any optimism that springs from this good news is tempered by the fact that core inflation on a 12-month basis remains at the June level of 2.7%, which is the fastest 12-month change since 2001, as the chart below shows.
12-month rolling % change in core CPI, through July 2006
It all boils down to a consumer price report for July that's less encouraging than yesterday's producer price report. The bond market was no doubt expecting something more clarifying, or so yesterday's buying spree in the trading pits of the 10-year Treasury suggest. Indeed, the bulls aggressively snapped up the benchmark 10-year on Tuesday,
pushing the yield down to 4.93% by the session's end--or seven points lower than the previous close on Monday. As votes of confidence go, Tuesday's trading spoke loud and clear on expecting the PPI's-inspired cheer to continue today.
Cheering, however, is a fragile state of mind these days when dissecting the future path of inflation. Or is it? As we write this morning, the 10-year's yield has continued to inch lower, dipping to 4.87% more than one hour after the CPI data hit the streets.
The message on inflation may be still be a bit murky, but Mr. Market's prediction couldn't be clearer: the Fed's pause will continue. The interest-rate-setting FOMC convenes next on September 20. But while a lot can happen between now and then, bond traders are growing more convinced that the future of monetary policy is no longer a mystery.
August 15, 2006
A FLOWER OF OPTIMISM BLOOMS ANEW IN A DESERT OF WORRY
This morning's update on producer prices for July was surprisingly low, which bodes well for tomorrow's release of consumer prices. The producer price index (PPI) rose just 0.1% for last month, the least threatening report for wholesale prices since February's anomalous 1.2% decline. The consensus forecast anticipated a 0.3% rise, according to TheStreet.com. Core PPI (less food and energy) was even more benevolent, posting a 0.3% fall in July, vs. a consensus prediction of 0.2%.
If tomorrow's dispatch on consumer prices for July echoes today's PPI news, Fed Chairman Ben Bernanke's big gamble, as we recently labeled his monetary policy inclinations, will enjoy a resurgence of respect. One month a trend does not make, but the hawks may be forced to snack on a little crow come the end of the week.
Indeed, the 12-month core PPI certainly appears on its way to being tamed. Having advanced by 1.3% for the year through July, the pace has now fallen dramatically from the pace of recent history, as the chart below illustrates.
12-month rolling % change in core PPI, through July 2006
For investors looking for another excuse to turn optimistic, there's also the news that oil prices are again on the retreat, which if it continues has the power to take more than a little of the inflationary pressures out of the system. The immediate trigger for the selloff is the tentative ceasefire announced in the Israel-Lebanon conflict. Such things are tenuous in that corner of the world, but for the moment there's reason to at least be somewhat less pessimistic for the remainder of the summer.
As we noted a few weeks back, the fundamentals of crude suggest that prices should be lower, at least for the foreseeable future. The complicating factor has been fear, which has kept oil prices higher than economics alone imply. If fear takes a respite, if only briefly, and the latest warm and fuzzy aura on prices holds steady with tomorrow's CPI report, the bulls may regain control of the stock and bond markets this week and perhaps this month.
Hope in August...it's the new new thing.
August 14, 2006
A DROUGHT IN CLARITY
Former New York Mayor Ed Koch loved to ask his constituents "How am I doing?" One can only speculate as to an answer if Federal Reserve Chairman Ben Bernanke posed a comparable question on matters of monetary policy to his constituency of dollar holders.
A clue as to our thinking on a provisional answer can be found in the following analysis. The first displays the yield curve at two points in time: Friday's close, and a previous manifestation from a year earlier, August 11, 2005. As the chart illustrates, the arc of money's price has become slightly inverted relative to the upward-sloping curve of 12 months previous. On Friday, the yield in a 30-day Treasury bill (a proxy for "cash") was 10 basis points higher than a 10-year Treasury Note. That's in sharp contrast to a year ago, when a 10-year Treasury commanded a 100-basis-point premium over a 30-day T-bill. Progress may be elusive, but change is incessant.
Now consider the trend in the core rate of inflation, which is computed by excluding the prices of energy and food. A year ago, for the 12 months through June 2005, core CPI rose by 2.0%. A year on, core CPI advanced by 2.6% during the past year through June 2006. That may not mean much to the man in the street, but in central banking terms the upward shift is dramatic and signals that pricing pressures are mounting.
In other words, the central bank has been raising interest rates, but without a material impact on slowing inflation's rise. Bernanke and company realize that their attempts at prevailing has proved insufficient on altering core CPI's course, and have admitted as much in FOMC statements this year. Plan B is telling the world that while the rate hikes haven't put a ceiling on core CPI, elevating the price of money will still prevail because it will slow the economy, which in turn will do what rate hikes have not yet accomplished: end if not reverse core CPI's upward momentum.
The slightly negative yield curve does in fact suggest that economic growth will slow. The question is whether slower growth will produce the proverbial rabbit from the Fed's hat in the form of core CPI that no longer rises or declines? Getting from here to there remains an open debate, and history provides at best a mixed message.
The next clue in this all-important sage comes on Wednesday, when the Labor Department publishes July's consumer price indices. The consensus forecast, according to TheStreet.com, is that core CPI will remain elevated by unchanged from June at 0.3%. If accurate, that would be better than 0.4%, although it will hardly reduce the pressure on the Fed to convince an increasingly skeptical Wall Street that it's still in control of inflation trends. The best-case scenario would be a fall in core CPI, in which case Bernanke's credibility goes up a notch, if only until the next monthly inflation update.
Alas, the Fed's power (which is primarily one of managing expectations) now hinges on each new data point. This is a setback for the central bank, and for investors generally. To be sure, the markets are far more concerned these days with geopolitical events, which dominate the daily news. Watching the evolution of monetary policy is comparatively a sleepy sport that's comparable to watching glaciers melt.
Nonetheless, keeping an eye on a small drip can pay off in the long run. Another drop comes tomorrow. And so, our glass is out, although we're still not sure if it's half full or half empty. Clarity invariably quenches our thirst, but the slaking takes time.
August 11, 2006
THE STOCKS OF AUGUST
Confusion, terrorism and risk in general hang heavy over the global economy, but Mr. Market is getting used to the noise.
Measured by year-to-date returns, the broad stock market continues to post returns firmly in the black. The Russell 3000 Index, for instance, has climbed 2.6% so far this year, through August 10, as the table below shows.
But lest we get too excited, it's worth mentioning that 2.6% is less than spectacular in a world where a low-cost money market fund offers a yield nearly twice as high. Risk, in short, just isn't paying off like it used to.
In addition, much of the rise in the stock market this year comes on the back of value stocks. The Russell 3000 Value has risen nearly 8.8% year to date. By contrast, the Russell 3000 Growth is down more than 3%.
In fact, all measures of growth are in the red so far this year across the large-, mid- and small-cap equity spectrum for U.S. stocks, as you can see from the graph below.
Equity investors are in a defensive mood this year, a notion supported by looking at the ten major sectors in the S&P 500, where cyclically sensitive stocks have tumbled so far in 2006. Info tech stocks have suffered the most, falling by more than 9% this year. Meanwhile, consumer staples, utilities and energy continue to shine.
Then again, if the predictions of a slowdown prove true, it's odd that the stock market generally doesn't look all that concerned. One reason: earnings continue to hold up. As Michael Krause of AltaVista Independent Research notes in a recent report, second-quarter earnings continue to surprise on the upside. "Overall earnings look set to come in about 12.8% higher compared with the same period last year, and slightly better than the 11.9% growth recorded in Q1 of this year," he writes.
But if the recent past still impresses, the immediate future is another story. "The good earnings picture," Krause continues, "is clouded by the fact that full-year estimates have only risen about half as much as the upside surprise in Q2 results would dictate, suggesting that on the whole guidance and other comments made during the conference calls in which analysts discuss the fundamental outlook with company management teams were negative enough to prompt analysts to cut Q3 and Q4 estimates."
With all the talk of an approaching economic slowdown, equity investors may be wondering if the positive returns posted in broad and value equity indices are set to join the losses that dominate the world of growth stocks. Perhaps, although Krause suggests it's still not time to throw in the towel on hope. Earnings are once again the reason:
Expectations would have to decline a long way before earnings could be described as average; despite this recovery’s age, earnings growth of 12.6% this year and 10.2% next year are still well above the post World War II average of 6.3%. Meanwhile, forward P/E is just 14.1x, a tad below its long-term average of 14.5x. This suggests that the reflexive defensiveness of the past month may be overdone.
In any case, it's a safe bet that whatever awaits Mr. Market, the outcome lies heavily in the hands of Ben Bernanke and company. So while equity investors can count their profits today, prudence suggests that one should keep a close eye on the boys and girls in the Fed.
August 10, 2006
MR. BERNANKE'S BIG GAMBLE
The Federal Reserve's decision on Tuesday to stop raising interest rates marks the start of a new phase for monetary policy. Only time will tell if this new phase is enlightened or something less. But no matter what comes next, ending the two-year campaign of rate hikes harbors a fair amount of risk at a time when inflationary momentum is picking up.
Bernanke is betting that an economic slowdown will cool inflation. The underlying assumption is that inflationary threats are self correcting. Unfortunately, history is less than clear when it comes to finding hard data to back up the assumption. In fact, recent history suggests the opposite. As we noted back on August 1, rate of increase in core inflation (as measured by personal consumption expenditures) has picked up recently just as the pace of personal consumption expenditures has turned lower. In other words, the primary engine of the economy (consumer spending) is softening at a time of rising inflation.
The Fed's effectively arguing that it can now take a hands-off approach to managing inflation because economic growth will do the job. The issue is whether the Fed's monetary policy in the recent past is partly or wholly responsible for the rise in core inflation in the here and now. If the central bank's actions are accountable to a degree for the higher core inflation now, then it follows that the Fed must be proactive in bringing that inflation down (or preventing it from rising further).
Adding to the Fed's burden is the fact that productivity in the American labor force slowed sharply in the second quarter while labor costs jumped, according to yesterday's update from the Labor Department on productivity and costs. Labor costs increased at an annual rate of 4.2% during March through June, the fastest rate since 2004's fourth quarter, and sharply higher than the 2.5% pace in this year's first three months.
The rise in labor costs is "a warning shot across the Fed's bow," Joel Naroff, president of Naroff Economic Advisors in Holland, Pa., told U.S. News & World Report. "The Fed is facing a very difficult situation" between containing inflation and spurring growth, Naroff said. "It may not change the decision [to halt rising rates], but it puts pressure on them to make comments about how they are monitoring inflation."
To be sure, the future course of inflation is open to debate. And to the Fed's credit, it's announced to the world that it reserves the right to resume rate hikes. But there's a risk that letting time elapse will only give inflation more time to take root, forcing the central bank to be that much more severe with future increases in the price of money.
For those who are optimistic, there are potent disinflationary, and even deflationary forces to consider in the global economy, as evidenced in a range of markets. From prices paid for DVD players to the going rate for day laborers picking lettuce, there's hard evidence showing that that path of least resistance for inflation is down.
So, why is core inflation rising? More importantly, what does the Fed intend to do about it?
Ours is an age of questions without comforting answers--a sharp contrast to the past 20 years. Navigating this new world order of monetary policy is an untested Fed head, charged with managing the world's most important central bank at a time of potent cross currents and change in the global economy.
Risk, in other words, is alive and well. The challenge is figuring out how to price it. The bond market seems inclined to reassess the Fed's decision to halt rate hikes. After the yield on the 10-year Treasury touched 4.88% on Tuesday--near the lowest level since April--traders have sold, raising the yield to around 4.93% as we write this morning.
The burden of proof is firmly on the Fed going forward. With that in mind, the history of inflation and central banks is clear: inflation usually wins in the long run, tempered by occasional but temporary wins on behalf central banks in the short run. Inflation, like unkempt rooms, weeds in the front lawn, and authoritarian governments, is part of the natural order. To the extent that central banks have engineered brief respites from inflation's domination is a testament to innovative thinking and disciplined monetary management. But let's be clear: eternal vigilance is necessary for battling inflation. That battle's been relatively easy during the past generation, but it's getting tougher in the 21st century.
Mr. Bernanke is betting that an economic slowdown will do the heavy lifting in the next stage of this battle. In effect, he's betting that stagflation (rising inflation and declining economic growth) isn't a threat. Let's hope he's right. But let's also recognize that Mr. Bernanke's wager has multiple outcomes.
August 7, 2006
CS TAKES A HOLIDAY
It promises to be a hot week for financial news, but The Capital Spectator is taking a cool vacation in the North. We're on ice through Wednesday, August 9, returning to the heat on Thursday, August 10, with another hot essay. Till then, stay cool, and thanks for reading!
August 4, 2006
BUY NOW...PAY LATER?
This morning's employment report for July gives the bond bulls one more reason to buy.
The unemployment rate rose to 4.8% last month, the highest since February, the Bureau of Labor Statistics announced. Meanwhile, the economy added only 113,000 new jobs, based on the nonfarm employment survey--the smallest increase since April's 112,000 rise.
"The uniformity of the evidence of softer labor market conditions should make the FOMC decision next week easy," writes David Resler, chief economist at Nomura Securities in New York, this morning in a note to clients. "With virtually all the recent reports confirming the FOMC's [view] that the economy is now on track for the forecasted 'moderating growth,' and with market interest rates possibly suggesting that the slowdown is more severe than desired, the prudent course for policymakers is to maintain current policy until a clearer picture of the outlook develops."
But while the payroll trend continues to show continued weakness, the related inflation tied to wages continues to inspire caution on matters related to turning the handle on the monetary-sausage machine. The widely monitored average hourly earnings for the private sector rose by 0.4% last month, unchanged from June's pace but still in the upper range of monthly advances for the past several years. On a 12-month rolling basis, July's jump in hourly earnings was 3.8% higher compared to July 2005, which is also in the upper range posted in recent years, as the chart below illustrates. To the extent that wage pressures are helping elevate inflationary momentum, today's report won't do much to assuage such fears.
But if the Fed must make a choice between juicing the economy so as to avoid a recession vs. nipping any mounting inflationary pressure in the bud, the former is getting the bond market's vote of late. The yield on the 10-year Treasury fell again yesterday, settling at 4.951%--the lowest since mid-April. Meanwhile, in the wake of the July employment report comes a burst of buying in the August Fed funds futures contract in early trading today, which reflects the strengthening sentiment that the central bank will take a pass on another rate hike at next Tuesday's FOMC. If so, that would be the first pause in two years of elevating the price of money.
But while the consensus is now predicting the Fed will take a breather, it's worth remembering that there's a complicating factor overhanging Treasury pricing and the associated signals on inflation expectations that spring from current yields. Fear, it seems, is no trivial force driving money into government bonds, and thereby lower yields. That decline in the price of money, in other words, isn't wholly a reflection that inflation's a waning threat. With the Middle East ravaged by war in more than a few locales, anxious deployers of capital the world over are finding fresh incentives to park money in what is still regarded as the safest paper obligations on the planet.
Of course, even the mighty Treasuries have competition when it comes to stores of value. Perhaps that's why gold is again moving higher, having jumped by around $100 an ounce over the last two months.
The Fed has a very simple and one-dimensional tool for addressing a very complicated world with a myriad of economic and geopolitical cross currents. Up, down or hold are the choices for monetary policy. If only the real world were that simple.
August 3, 2006
NAIL BITING & NUMBER CRUNCHING
The Federal Reserve may be set to put its rate hikes on hold, but the European Central Bank's tightening phase is in full swing.
The ECB today raised its key interest rate by 25 basis points to 3.0%--the fourth rise in eight months. The Bank of England also elevated the price of money today, bumping up its key rate by a quarter of a point to 4.75%. The BoE's decision was unexpected, and is the first rate hike for the bank in two years.
In both cases, the common denominators were economic growth and rising inflation. Although neither looks poised for a radical break out on the upside any time soon, the upward momentum of late is worrisome for the central bankers.
Back in America, the buzz (again) is that the Fed is set to pause in its two-year-old campaign to raise interest rates. Anticipating as much, bond traders chased the benchmark 10-year Treasury to the extent that its current yield fell to 4.96% by the close of yesterday's session, the lowest since June 13.
The official word from the Fed on interest rates comes next Tuesday. Between now and then, precious little new data will be released, excepting for tomorrow's update from the Labor Department on July's employment status. Judging by the consensus outlook, as per Briefing.com, not much will change. June's jobless rate of 4.6% is forecast to remain the same for July, while the widely monitored nonfarm payrolls number for last month is expected to rise only marginally.
But in the spirit of the times, there's still reason to keep an open mind about what comes next. Case in point: yesterday's July update of the controversial ADP National Employment gave traders an excuse to wonder if tomorrow's government employment update for July will be weaker than expected, in which case the bond bulls will be beside themselves with celebration. The ADP report showed a sharp decline last month in the growth of private employment in the U.S. July added only 99,000 new jobs to the economy, according to ADP, down from 368,000 in June.
By ADP's standard, the Fed will find more than enough statistical ammunition to call off the rate-tightening dogs next week. But there's a debate about how accurate the ADP numbers are relative to the government's survey of payroll trends. David Resler, chief economist at Nomura Securities in New York, advised in a note to clients today that in the brief three month history of the ADP employment report, "it has not proven to be a very reliable indicator of the change in nonfarm payrolls as estimated by the BLS, so I suspect few forecasters will change their estimate of nonfarm payrolls."
Ed Yardeni, chief investment strategist for Oak Associates, also notes that ADP's numbers may be suspect. In an email to clients this morning, Yardeni summarized some of the issues at stake in the dispute:
Yesterday's ADP employment report, which is based on actual paychecks, showed an increase of only 99,000 in private sector jobs in July, following a gain of 368,000 in June. The official June headcount conducted by the Bureau of Labor Statistics showed nonfarm payrolls rose 121,000 and 90,000 with and without government employment. June's household employment survey showed a very impressive gain of 387,000. The ADP series starts in December 2000 and has tracked the official numbers closely. That's why [I'm] sticking with 180,000 to 200,000 for Friday's payroll number, well above the consensus of 140,000. We figure the divergence with the ADP report should be narrowed, and that the economy is still creating plenty of jobs. In any event, the payroll numbers will most likely determine whether the Fed raises the federal funds rate one more time next week and then pauses, or pauses next week.
It's all about the numbers now. May the statistical gods have mercy.
August 2, 2006
THE PERFORMANCE STANDARD DU JOUR
Can you beat 5.65% over the next five years?
It's an innocent question, but perhaps a timely one. The FOMC meets next Tuesday to decide what comes next for interest rates. Some are predicting that that what comes next is nothing, which is to say, no rate hike. If so, the 5.65% currently offered by Raymond James Bank looks enticing.
We have mixed feelings when it comes to locking up money in fixed-income instruments these days, as our various posts over the past weeks and months suggest. But we're also an adherent to the school of thought that the future's uncertain, even if the end isn't near. As such, we're predisposed to take a good deal when we see one.
Granted, there's been a devaluation in good deals of late, and so we're reduced to looking for the next best thing. By that diminished standard, 5.65% on a five-year certificate of deposit looks pretty good. As we write, 5.65% from Raymond James Bank is within a few basis points of the highest-yielding CDs in the nation, according to Bankrate.com.
Context, of course, is everything when shopping for fixed-rate securities. On that score, 5.65% still looks pretty good, considering that that a 5-year Treasury yields 4.89% this morning, and a 10-year's 4.97% isn't much higher. Taking some marginal extra risk to bump up the expected return to 5.65% looks like an eminently logical tradeoff at the moment.
Let's be clear: we're not saying that it pays to put an entire portfolio in one 5-year CD. On the other hand, moving some money out of a money market fund is starting to look like a mildly intelligent move.
Regular readers of CS know that we've been sweet on holding an above-average allocation to cash, primarily in a money market fund, for strategically designed portfolios. The reason has been that with short rates moving higher, owning a money market mutual fund has been an efficient means of tapping into that higher yielding trend. The Vanguard Prime Money Market Fund, for instance, now yields 5.07%--more than double its annual average total return of 2.11% for the past five years.
Keeping an above-average allocation in a low-cost money market fund still strikes us as sensible. At the same time, it's time to start redeploying some of the cash to lock in the higher yields of the moment. The Fed may keep raising rates, but the outlook is becoming fuzzier by the day. If we really knew what was coming, there'd be no need for asset allocation or rebalancing. Unfortunately, we live in this world; thus, our dilemma and response.
In any case, we'll conclude by reminding that while 5.65% over the next five years--each and every year--won't make you rich, but it will deliver a tidy return that, if nothing, else, looks good by the standard of the rear view mirror, based on the trailing five-year annualized total returns for the major asset classes, as listed below. Ongoing diversification across all the major asset classes is standard operating philosophy here, but that assumes a bit of tweaking is in order from time to time.
August 1, 2006
FRESH DATA, THE SAME OLD COMPLICATIONS
The consumer has been resilient. The consumer has been extraordinary. The consumer has been spending. In the folklore of modern America, to spend is to live, and one lives to spend. But while Joe Sixpack has done everything but sell a kidney to keep on shopping in recent years, even Joe has limits. Or, to be more accurate, his wallet has limits, even if his heart is inclined to think otherwise.
The inspiration for the above observation comes by way of this morning's Personal Income and Outlays report for June, which details that Joe and his counterparts across the country raised their consumption last month at the slowest pace since December 2005.
Yes, consumer-spending increases have been lower in recent history, as our chart below illustrates. But the latest slowdown comes at a time when the real estate market is showing signs of a downshift, suggesting that the economy may be winding down in earnest as well. Consumer spending after all represents more than two-thirds of GDP, and so the prevailing winds by this gauge carry more than a trivial impact on the economy as a whole.
But if you thought that today's report gives the Fed a clear and unambiguous justification for halting future rate hikes so as to renew Joe's spirits (and spending), think again. The core personal consumption expenditure inflation rate rose 2.4% last month vs. June 2005, today's report advised. That the highest rate since April 1995. Since this is reported to be the Fed's preferred measure of inflation, we take it that the numbers didn't go over well this morning at the world's most important central bank.
The FOMC meets next on August 8 to weigh in on monetary policy. To say that today's report on spending and inflation complicates next Tuesday's Fed confab is an understatement. But at the moment, if the central bank must choose between juicing the economy by pausing with rate hikes or fighting inflation by keeping up the monetary squeezing, the latter seems the preferred course.
In fact, the Fed funds futures contract for August has slipped a bit this morning, giving a bit of support for the idea that another rate hike may yet arrive. Even so, the contract's price reflects a trading community that's still unsure of what comes next. That seems eminently reasonable if only because the Fed probably doesn't have a clue about the future either. Such is life when the Fed's held hostage to the data.