December 25, 2006
A SHORT WINTER'S NAP...
For the remainder of 2006, CS will be on holiday. We'll return on January 2, 2007. Meanwhile, to all our readers, your editor sends best wishes for a prosperous New Year! Out with the old, in with the new, and let's hope it's a good one. Cheers!
December 22, 2006
THE BOUNCE THAT REFRESHES
Yes, you've got to hand it to our hero Joe Sixpack. He always comes through in a pinch.
The pessimists thought he'd materially slow his spending and throw the economy into a tailspin. But Joe confounds the experts time and time again, and last month was no exception.
Personal income increased by 0.3% last month, the Bureau of Economic Analysis reported today. But Joe and his counterparts across the nation, true to form, saw fit to raise spending by 0.5% in November. Even more impressive is the fact that consumer purchases accelerated for durable goods, the most volatile and, for reasons we discussed yesterday, the most cyclically sensitive slice of the public's spending habits.
The volatility of late seems to favor higher spending for durable goods. As the chart below illustrates, personal consumption expenditures (PCEs) have rebounded handsomely from August's steep decline.
August's 1.5% drop in durable-goods spending appeared to foreshadow trouble ahead for the economy, all the more so as worries mounted over the unfolding correction in the housing market. Several months later, however, fears that a correction in the real estate market would convince Joe to hoard his income look unfounded. Or was the summer fear just premature?
ANOTHER KREMLIN VICTORY IN ENERGY
If you're looking for one more reason to worry about the future of global oil production, take a gander at the news on Royal Dutch Shell's coerced sale of a majority stake in its Sakhalin-2 oil and gas project in Russia to the state-controlled Gazprom.
On the surface, it all looks quite innocent. Shell sells 50 percent plus one share of the project to Gazprom. The deal comes after a 12-month effort by the Kremlin of running interference on the project, reportedly because of environmental concerns. Shell and its partners read the writing on the wall and threw in the towel. The result: another victory for the Russian government's not-so-subtle strategy of nationalizing the lion's share of its energy business.
"You are never going to have majority control under this regime in Russia,'' Tim Harris, chief investment strategist for Europe, the Middle East and Africa at J.P. Morgan Private Bank in London, told Bloomberg News. "That's a fact of life. The resource opportunity in Russia is vast. The risk is political.''
This is more than of passing interest to the West. Russia, after all, pumps as much if not more oil than Saudi Arabia. With the Kremlin slowly but surely taking control of its vast energy reserves, there's reason to wonder about what comes next for Russia's oil game, which is increasingly under Putin's thumb.
The larger message from Russia concerns developing nations, which collectively harbor the only real potential for new energy discoveries. Unfortunately, the lesson seems to be that it's okay to nationalize energy projects. That is, nationalize after private oil companies spend billions locating and developing the opportunities, as Shell did in Russia. Then, when it's clear that there's gas and oil to be had, the state will take over.
The example in Russia for private, for-profit oil companies isn't encouraging when it comes to making fresh capital committments for investing in new energy projects. What's true for Russia will be true for other regions of the world where the rule of law resides on even shakier ground.
The problem all of this carries for the West is that the main opportunities for increasing oil production reside in Russia and other nations where political risk is high--and rising. After reading the news today, it's hard to imagine the major oil firms will find new inspiration for sinking billions of dollars into projects in faraway lands that run the risk of being snatched away at the 11th hour.
December 21, 2006
REASON TO BE WARY, PART III
The government dispensed the third and final update on third-quarter GDP this morning, and no one who routinely reads such things will be shocked by the numbers. The annualized quarterly real 2% pace of economic growth for July through September was a bit slower than previously estimated, although it's in line with the latest consensus guess from the dismal scientists.
The government's former estimate for GDP was a tad higher at 2.2%. More importantly, the final 2.0% rate in the third quarter is below the 2.6% rise logged in the second quarter. The economy, in sum, is still slowing. Everyone knew that, of course. So, now what?
Divining the future based on looking at the past is like trying to cut your lawn while watching your neighbor wash his car. Yes, it can be done, but you may miss a few spots and cut off your foot in the process. Nonetheless, we cautiously reviewed the data and came to the not-terribly insightful conclusion that there's still reason to worry about 2007. No, we're not consumed with fear, but we're sleeping with one eye open. For those who want a bit more detail, read on, and we'll try not to cut off our foot as we explain.
Let's start by observing that personal consumption expenditures form the engine that keeps the economy humming. PCEs represent about 70% of GDP, which reminds once again that Joe Sixpack and his colleagues are collectively running the show. Within the PCEs column, services spending is the largest chunk, running at roughly 56% of total PCEs in the third quarter, followed by nonndurable goods purchases (29%) and nondurable goods purchases (15%), based on chained 2000 dollars measured at seasonally adjusted rates.
In other words, keeping an eye on Joe Sixpack's spending notions starts with looking at services. As such, alarmists will note that services spending advanced by 2.8% in the third quarter at a seasonally adjusted annual rate. That's down from 3.7% in the second quarter. But before we read too much into that, remember that the third-quarter pace of services spending was also higher than in this year's first quarter. Let's sum it up by saying that services spending was middling during July through September compared to what came earlier in the year. What's more, since much of services spending is tied to recurring household items such as electricity and medical care, Joe doesn't have a lot of choice here.
Ditto for nondurable goods spending, the second-largest component of PCEs. Nondurables include such items food, gasoline and clothes purchases. While we're on the subject, nondurables spending increased at a slightly faster pace than in the second quarter, although the rate of change was notably slower than in the first and second quarter. Something to watch, but the trend at least is slightly encouraging of late.
That leaves us with durable goods purchases, the last of the three major components of PCEs. Although it's the smallest of the three in terms of dollars spent, it's the most volatile because Joe has what economists call discretion here. Durable goods includes purchases of cars, computers, furniture and other items that can easily be delayed or increased when and if consumers are so inclined. Access to credit is the reason. No one need postpone instant gratification in the 21st century. Accordingly, an early warning of things to come may be found in trends in durable goods spending. With that intro, let's go to the numbers:
Durable goods spending jumped 6.4% in the third quarter at a seasonally adjusted annual rate. That reverses the slight decline (-0.1%) posted in the second quarter but is still far below the first quarter's 19.8% surge. What can we make of this? One thing that leaps out is the fact that the back-and-forth trend in durable goods spending this year is uncommon based on recent history. From the first quarter of 2003 through the third quarter of 2005, durable goods spending was continually positive, albeit in varying degrees. The persistently upward trend was broken starting in 2005's fourth quarter.
All of which implies that consumers are becoming wary and are now willing to curtail spending. That's something we haven't seen until recently. We suspect that we'll see more of it in 2007. Joe's confidence isn't what it used to be when it comes to pulling out the credit card. That doesn't mean he's about to give up going to the mall, although the durable goods spending numbers are telling us to be wary.
December 20, 2006
FOLLOW THE MONEY
With bull markets blooming around the world in recent years, the news of yesterday's self-inflicted financial wounds in Thailand has delivered an unscheduled reminder that prices also go down.
The calamity started when the Thai Finance Ministry yesterday announced a "lock-up" program to restrict capital flows into the economy. Investors reacted by selling…and selling and selling some more. The Thai stock market crumbled by 15% by Tuesday's close, although as we write this morning (New York time) prices have retraced the lion's share of the decline.
Students of market history will recall that Thailand was the source of the emerging markets crisis of 1997 that crushed equity prices around the world and unleashed an international banking debacle. But while crises are still around, and always will be, the underlying forces that cause them are different this time--and those differences matter.
In 1997, the ills that dispensed financial calamity were born of financial weakness. Thailand in 1997 suffered a large current account deficit and a currency that was vulnerable to bearish speculators. Ditto for many other emerging markets. The opposite is true today. Sitting on a tidy account surplus and an estimate $65 billion in currency reserves, Thailand in 2006 fears that its currency, the baht, will rise too far too fast. Many other emerging markets can also boast of sound finances this time around.
Nonetheless, too much of a good thing convinced the Thai government to slow the surge of capital coming into the country. Officials in Bangkok have since rescinded their ill-advised restriction, albeit on the unmitigated advice of one infinitely savvy force in the financial universe.
Mr. Market has once again had the last word. He always does. The only difference these days is that his verdict and the associated penalties come faster than in the past. The forces of supply and demand can't be suppressed, at least not indefinitely and sometimes not even for 24 hours.
The tragic experiment of communism is testament to that reality. Yes, it took decades for Mr. Market to reassert his authority in Moscow and elsewhere, but things move quicker in the 21st century.
Speaking of which, one of the many lessons that arise from the latest upheaval in Thailand is that capital is in a desperate search for currencies tied to growth, which in turn opens the doors to superior investing opportunities. Logic and economics 101 demand no less. The flip side of this law is that currencies associated with ailing economies are vulnerable.
Of course, reality's a bit more complicated when we speak of the world's reserve currency, otherwise known as the American dollar. Rebalancing takes longer when you're the top dog in the currency realm, in part because old habits die hard and there's debate over the contenders to the throne. But eventually, Mr. Market will have his way with this and all paper assets, including fiat currencies masquerading as intrinsic stores of value.
It's worth noting that while Thailand was taking its lumps yesterday, forex traders found cause to sell the greenback. The U.S. Dollar Index tumbled yesterday even as the world was focused on another Asian crisis. Why? Well, here's a news flash: Asia and the dollar are more than passing ships in the night. The story can be summed up by noting the growing current account surpluses in China and other Asian nations, and the deepening red ink on the same ledger for the United States. The fact that Thailand is trying to restrict capital from coming into its economy reminds that the same capital necessarily is trying to escape from somewhere else.
Mr. Market is certainly paying attention to the broader events unfolding over time as well as the news du jour, or so one could reason. The U.S. Dollar Index has fallen by nearly one-third since the end of 2001. The bear market in the buck enjoyed a respite for much of the last two years. But the clock is ticking, Mr. Market is reasserting his influence and investors are again receiving reminders that economics still matter in the long run for valuing assets and even nations.
December 19, 2006
AND NOW FOR SOMETHING COMPLETELY DIFFERENT
The folks at TrendMacrolytics have been advising for some time now that the economy will "reaccelerate" and inflation isn't as tame as some think. This morning's updates on housing starts and producer prices lend support to this contrarian view of things to come. Does that mean it's no longer a contrarian view?
In any case, housing starts climbed 6.7% last month, the Census Bureau reported today, reversing some of the pain from October's 13.7% collapse. Even so, November's housing starts are still off more than 25% from a year ago. And there's no getting around the fact that last month's annualized 1.588 million starts, along with October's 1.488 million, are the lowest in one-two punch in several years. If nothing else, today's report proves once again that dead cats do indeed bounce. The question is whether the kitty has any more jumps up his paw?
While you're chewing on the implications, add this to today's menu of economic consumables: producer prices in November rose 2.0%--the highest monthly gain since 1974. The core rate of change in PPI last month wasn't quite the record that top line PPI was, but it was close. Indeed, the 1.3% surge in core producer prices in November is a height that's rarely attained.
The change in the prevailing price winds last month comes as stark contrast to the back-to-back declines in PPI. What caused November's turnaround? We can start with the usual suspect: energy. As the Commerce Department advised in its press release on PPI today:
The upturn in the finished goods index was broad-based and led by prices for energy goods, which climbed 6.1% in November after declining 5.0% in October. The index for finished consumer goods excluding foods and energy rose 1.1% following a 0.8% decline in the previous month.
If any of this comes as a shock, the flabbergasted don't reside at the offices of TrendMacrolytics. Back in October, the firm's chief economist, David Gitlitz, warned on these digital pages that inflation would get worse before it gets better. At the time, some took issue with his outlook. Presumably, those willing to argue with Gitlitz are slightly fewer in number today.
Meanwhile, Don Luskin, chief investment officer at TrendMacrolytics, yesterday wrote in a note to clients:
We have steadfastly maintained that the economy would reaccelerate in the fourth quarter, and that all growth surprises would be on the upside. Now, with a stream of surprisingly robust data over the last two weeks, it seems that we've been right, with retail sales and net import data pointing toward real GDP in the fourth quarter coming in above 3%.
Then again, the trend may reverse course yet again depending on the number du jour. Ours is a moment of transition, which wreaks havoc with smooth trend lines and calming economic reports. The past is gone and the future's unknown; everything else is a guess. Getting from there to here and beyond, in short, is never easy. Amid the thankless task of finding the future by reading last month's government release, the potential for stumbling is more than casual. Today's oracle may be tomorrow's jam-faced analyst. There's only one truth and it will eventually out. In the meantime, the predictions are flying, and some look better than others. The trick is looking better in the long run.
December 18, 2006
NEW ERAS & OLD WORRIES
In search of reasons for why all the major asset classes have been on an extended bull run, Justin Lahart in today's Wall Street Journal (subscription required) raises the possibility that smoother, kinder and increasingly gentler economic cycles are the source of the good times.
"The economy doesn't rock 'n' roll the way it used to," he wrote. And indeed it doesn't. Recessions are less frequent intrusions, and when they do arrive they tend to be less severe compared with the contractions of generations past.
A forthcoming paper in The Review of Financial Studies explains that declining macroeconomic risk, or the volatility of the economy, may account for a lower equity risk premium. In other words, stock prices are higher than they otherwise would be if recessions were more common and took a bigger bite out of the economy.
The idea that things have fundamentally changed is hardly new, especially when it comes to finding cause for predicting that bull markets will run longer. Unfortunately, the advice is often tainted with failure. One of the more infamous examples came on the eve of the 1929 stock market crash, when Professor Irving Fisher of Yale counseled that equities had reached a "permanently high plateau."
Fisher's new era turned out to be a crock, and most (all?) theories for why bull markets don't have to end have suffered similar fates. The enduring constant, so far, is that markets rise and fall.
That doesn't mean that the economy of late isn't smoother and gentler. Nonetheless, there are some who question if there's such a thing as a free lunch paid for with the so-called repeal of the business cycle. In the late-1990s, financial journalist James Grant gave a thorough and informed airing to this strain of skepticism in his book The Trouble With Prosperity: A Contrarian's Tale of Boom, Bust, and Speculation.
As to the question of whether the current progress in managing economic cycles affects investing cycles, we regret to inform readers that we don't have a definitive answer. But we've got plenty of reasons to wonder if a new new era has truly dawned. The Federal Reserve and its counterparts around the world may be wiser than before, but investors are still investors.
Fear and greed, in other words, still haunt the canyons of Wall Street, infecting otherwise lucid minds with visions of grandeur and, when the time comes, worries that the unsightly gains will be forever lost and that prices will never again rise. Bernanke and company are an intelligent lot, to be sure. But investors in the aggregate aren't necessarily any wiser when it comes to exploiting peaks and troughs in asset prices.
Yes, we can argue about whether the various asset classes are now overvalued, fairly priced or even underpriced given the smooth economic sailing that presumably awaits for as far as the eye can see. The latter view has plenty of support, according to Lahart's article, which cites research from a Hong Kong research outfit, GaveKal, which observed that reduced economic volatility has boosted the demand for financial risk. The question before the house: is the higher demand warranted?
There are many views about fundamental drivers at work in the 21st century economy, although as Lahart notes, a source for the smoother cycles may be plain old luck.
This much, however, is clear: the major asset classes are enjoying a multi-year bull run, as we noted a few weeks back. It's rare to see so many asset classes emitting optimism, at the same time, and for so long. Perhaps it's warranted, perhaps not. We'll take what comes and rebalance accordingly. Timing, of course, is the great unknown.
With everything rallying, raising cash is easy: throw a dart at an investment and sell. Odds are, you're bound to have a profit. Rather, deciding where to redeploy the cash with a modicum of prudence is the conundrum du jour. Usually, there's always something hurting on the asset class level. But based on trailing returns of recent vintage, there are no obvious candidates wallowing in pessimism, which tends to make for attractive pricing for strategic buyers.
Alas, the only thing to do is sit tight, wear a pair of flame-retardant pants to keep the cash from burning a hole in your pocket, and wait for clearer opportunities.
December 15, 2006
Today's inflation report is a gift, and it arrives just in time for the holidays. But after we've unwrapped it, ogled its components and dispensed a few "oohs" and "aahs," it'll be time to ask: Is it a gift that keeps on giving?
There's reason to think that the gift may in fact be around a while, as suggested by reading today's update on November's consumer prices, which were unchanged last month. Ditto for core inflation, which excludes food and energy. In fact, one could say with more than a little pleasure that a whole lot of 'nuttin was going on with inflation last month.
If true, the trend (or non trend, if you will) frees up the Federal Reserve to focus on growth. Once it's clear that inflation is no longer accelerating, the central bank can, if necessary, begin cutting interest rates to offset any additional weakness in the economy, which some dismal scientists predict for 2007.
Taking inflation out of the picture, in sum, simplifies the Fed's job enormously. Promoting growth and fighting inflation is a thankless task, by contrast. In fact, it may well be impossible to pull off both with any success, at least simultaneously. Then again, it depends on the magnitude of the challenge. Mild and fading inflation combined with modest job growth and low unemployment is one thing. Rising inflation and rising unemployment are something altogether different. For the moment, it appears that we have the former.
That's no small advantage for Bernanke and friends. Generally speaking, fighting inflation isn't often a growth-promoting, jobs-producing endeavor. Turning that notion around, it's also true that pumping the economy with greater doses of liquidity for encouraging growth and convincing businesses to hire more workers may not impress inflation hawks.
Sure, a deft central bank can split the difference and manage some success in both arenas. But it helps if there's a beneficial tailwind. In the 1990s, inflation generally was coming down for a variety of reasons, leaving Greenspan's Fed with a relatively wide margin of error. By contrast, Volcker's Fed in the early 1980s wisely sought to fight the lofty inflation of the era, which left little opportunity for stirring the growth pot until after the pricing beast was returned to his cage.
Today's Fed faces milder inflation threats and milder growth opportunities. Indeed, a reading of the numbers du jour suggests there's not much to fear. Unemployment is still quite low, the economy is still bubbling, and inflation appears to be receding or at least treading water. But it's the future, as always, that raise questions. We don't know what's coming, but we can extrapolate from the past, a risky game but one that offers a slice of context nonetheless.
While some may have already decided that inflation's a dead issue, we'll continue to sleep with one eye open. It's not yet clear that core inflation has died as a material threat. Consider the chart below, which shows core inflation on a rolling 12-month basis. The recent slide is encouraging, but it's not yet obvious that it represents something more than a temporary blip. Maybe, perhaps, possibly. But we refer you to the spring of 2005, when a similar decline arrived, only to prove fleeting. Higher levels of core inflation soon followed.
But let's not spoil the moment. Optimists want to celebrate, and so they shall. Inflation is dead is the toast. We'll drink to that, while confessing to ourselves that we're still not quire sure.
December 14, 2006
RETAILING'S BIG SURPRISE
In theory, one economic release has marginal relevance. But as yesterday's news on retail sales for November reminds, sometimes theory gets trampled under the rush to embrace the number du jour, particularly when there's a big upside surprise making the rounds.
The consensus outlook for retail sales last month was a meager rise of 0.1%. The actual number was a startling 1.0% surge, the Census Bureau reported. Such a hefty surprise comes at just the right time for anxious investors who are told by some that the economy will slow considerably next year. But after yesterday's news, is the notion of a slowing economy now officially dead?
One is tempted to answer a tentative "yes" after considering the latest retail numbers. As the chart below shows, consumers continue to spend across the board (gasoline station sales being the lone and not particularly relevant exception).
Do economic slowdowns really begin with robust consumer spending? Before we answer, it's instructive to consider the broader context for the latest retail numbers. Yes, a 1% jump in retail sales is impressive, particularly at this point in the economic cycle. What's more, retail sales have advanced 5.3% through last month from the year-earlier month.
But before we conclude that all's well, now's a good time to point out that retail sales, by last count, are growing faster than the economy--and by more than a little. Third-quarter GDP rose at an annualized real pace of 2.2%. Even the current-dollar GDP is only growing at 4.0%. Retail sales, meanwhile, are chugging ahead at an annual pace of 5.3%. How long can that last?
In the short term, we wouldn't venture a guess. That said, the spread noted above implies that either the economy's about to perk up or retail sales will continue to soften. Soften? Yes, that's right: soften. As the chart below illustrates, the trend of late in retail sales is down.
How much retail sales soften is the question. And that will depend on a variety of other factors, ranging from interest rates to what additional fallout from real estate, if any, arrives next year.
Anything's possible in the 21st century, but that doesn't mean momentum's irrelevant.
December 13, 2006
The Federal Reserve yesterday kept Fed funds at 5.25%. Treading water, in other words, continues to remain the bias of choice for monetary policy. But while the central bank must pronounce a decision whenever the FOMC meets, the matter of what constitutes an enlightened and accurate price for money given the context du jour and an informed outlook is far from settled in the capital markets. The great questions of the moment center on whether or not a recession looms, and if the future will bring higher or lower core inflation. The answers are coming, but just not today. While waiting for the financial gods to speak, investors may want to review the primary forces that shape trends in the capital markets. On that score, a recent paper considers the interactions of monetary policy, economic cycles and stock market booms and busts. Your editor interviewed one of the authors, David Wheelock, an economist at the St. Louis Fed, for the December issue of Wealth Manager. For the associated observations, read on….
December 12, 2006
THE CASH MACHINE
The Federal Open Market Committee meets again today to dispatch the latest wisdom on matters monetary. By and large, the market thinks that Fed funds will remain unchanged at 5.25%.
Doing nothing may seem to be the wisest choice at the moment, but no one should underestimate the complexity of the current global economic climate. One factor that's skewing perceptions and modifying valuations is the mountain of cash looking for a home. There is an enormous amount of liquidity sloshing around, both domestically and in foreign economies. The magnitude of the liquidity is unprecedented, and so its impact on the capital markets and economic conditions are yet fully understood.
In light of the bull market in liquidity, the main questions for strategic-minded investors are: Is it really different this time? and if so, How's it different?
As we wrote last week, 2006 is shaping up to be the fourth year running that all the major asset classes post gains. That hasn't happened since 1996, and the record of multi-year bull markets across the board is even more infrequent and probably unique (although we don't have all the data to confirm the latter). But no matter how you slice it, these are extraordinary times and we're confident that it's due partly to extraordinary liquidity.
The Economist this week wrote that the combination of the petrodollars born of crude oil sales and China's export machine is enormous. What's more, the petrodollars dwarf even China's export-driven cash stash. "At the global level, the biggest counterpart to America's deficit is the combined surpluses of the oil-exporting emerging economies," The Economist advised. "They are expected to run a total current-account surplus of some $500 billion this year, dwarfing China's likely surplus of $200 billion."
When America pays oil exporters and China dollars in exchange for energy, electronics and other goodies, where do those dollars go? A fair chunk is reinvested back into America by purchasing Treasuries, stocks, and an assortment of other assets. This liquidity is sufficiently large so as to alter the capital markets. How's it altered? That's a matter of some debate, but we have our suspicions, starting with the strange state of affairs that's delivered bull markets across the board in all the major asset classes. Would such an astonishing run of bull markets survive without the degree of global liquidity?
Investors must decide if the mass of global liquidity will keep bubbling and flowing into all the asset classes, regardless of valuation. As challenging as that question is, it's all the more prickly if, as some predict, the economy will materially slow in 2007.
The last several years have been extraordinary, but even strange days evolve and eventually end. Timing, as always, is the big unknown. But that doesn't stop us from guessing. And by our watch, the hour is late.
December 11, 2006
A FREE TRADER'S GUIDE TO THE TRADE DEFICIT
The U.S. trade deficit has grown sharply over the years, and now routinely exceeds $60 billion a month, according to the government. By some accounts, red ink's rise on the trade ledger portends trouble, if not calamity for the United States and perhaps the global economy when the trend reverses.
But while the trade deficit must eventually shrink, or at least stop growing, are the effects sure to be painful? Or could a reversal be relatively smooth and orderly?
Arguably, a disciplined descent in the red ink is not only possible but is now underway. The U.S. trade deficit in September, for instance, tumbled by $4.7 billion, which was the biggest monthly decline in five years. The primary driver of the fall: lower prices for imported oil.
Nonetheless, one dismal scientist warned against expecting too much from the trend. "There is little in this report to tell me that once we get past the petroleum effect, [that] there are any basic changes in the trade situation," Joel Naroff, chief economist at Naroff Economic Advisers, told CBC News last month after the September trade figures were released. "With the Congress changing hands, the political pressure on the administration to do something about China is likely to build."
Indeed, U.S. Treasury Secretary Henry Paulson warned a few days back that protectionism may be on the rise. "There's a growing protectionist sentiment,'' he said in an interview with CNBC television via Bloomberg News. "It's a paradox because the lesson of the last 25 years has been that those economies that have opened themselves to competition, reform, integration into the global economy have benefited, and the rest have been left behind."
The menacing history of the Smoot-Hawley Tariff Act of 1930 invariably hangs over any talk of protectionism. By sharply raising tariffs on thousands of imported products at the start of the thirties, the law is widely thought as one of the contributing factors that deepened the Great Depression.
Meanwhile, the high level global trade in the 21st is unprecedented, suggesting that the stakes are also high for what comes next. Is the trade deficit therefore something to worry about? For some thoughts, last week we talked with Daniel Griswold, director of the center for trade policy studies at the Cato Institute, a Washington, D.C. think tank that promotes free trade.
Clearly, there's a variety of thinking on what the trade deficit means and what should be done about it, if anything. Griswold, of course, brings a free trader's perspective to the debate, and so those who favor mercantilism or some other type of heavy handed government intervention may want to avert their eyes before the conversation below begins in earnest.
Q: Does the trade deficit matter?
A: The trade deficit's an important trade number, more for what it tells us about the rest of the economy than for any effect it's having on the economy. It's the result of the underlying factors than any kind of driver in the overall economic health. The trade deficit fundamentally reflects underlying levels of savings and investments in the United States. We run a big trade deficit because we don't save enough to finance all the investment opportunities. Foreign capital comes into the United States to fund those investments, and therefore we run a chronic trade deficit.
Q:. Is America's profligacy a concern? If so, how should the country deal with it?
A: If policy makers were determined to do something about the trade deficit, the only constructive option available would be to encourage more domestic U.S. savings. Politicians can do that directly by reducing the federal government's budget deficit, which eats into domestic savings and creates demand for foreign capital inflows. They could also reform the U.S. tax code to eliminate biases against savings and investment. If we were to move toward a consumption-based tax system, it would in theory encourage more companies and households to save more, which would increase the pool of domestic savings to finance our investment opportunities and reduce the inflow of foreign capital, and ultimately lower the trade deficit.
Q: How should an investor react to the trade deficit?
A: Economic and investment analysts have been crying wolf over the trade deficit for 20 years. If someone had taken their [bearish] advice back in the 1980s, when we had relatively large trade deficits, I think they would have lost a lot of money betting against the dollar, betting against the U.S. economy. The trade deficit is not a very meaningful figure in terms of determining investment decisions.
What the trade deficit does tell us is that foreign savings are important to the U.S. economy. Up until now anyway, the U.S. has been successful in attracting foreign investment. When the trade deficit starts shrinking precipitously, that's a warning sign that the economy's in a recession.
Q: Your point has some empirical support. Hasn't Japan's slump in past years been associated with a trade surplus?
A: Yes. Over the last 15 years, as the Japanese stock market was losing half to two-thirds of its value, as its economic growth ground to a halt, Japan was running trade surpluses. Ditto with Germany. As its growth was slowing and the unemployment rate was hitting double digits, Germany too was running a large trade surplus. So there's no connection between a healthy economy and a trade surplus.
Q: Nonetheless, a number of economists continue to forecast trouble for the United States as the red ink in trade keeps rising. Is the trade deficit something to worry about as it grows bigger?
A: Not in and of itself. The biggest worry I have is that it brings a negative direction in U.S. policy with rising protectionism and hostility to foreign investment. If that happens, it'll not only hurt domestic investors, but it will discourage foreign investors, which would drive away foreign capital to other markets, causing a weakening of the dollar. That typically leads to a smaller trade deficit.
Investors should keep their eyes on the fundamentals, the same fundamentals that determine the trade deficit. That is, the overall investment climate, economic growth, and the vitality of the U.S. market overall.
Q: So, in your view, a shrinking trade deficit wouldn't be inherently be positive for America. Trade deficits and surpluses can rise and fall for different reasons. Ergo, context is everything.
A: Yes. I've looked at the ebbs and flows of the trade deficit over the last 30 years and some startling patterns jump out. Our smallest trade deficits--in fact, our rare surpluses--have occurred in the middle of recessions. That's because the ability of consumers to buy imports declines; the appetite of foreign investors to put their money into the U.S. declines. This all contributes to smaller trade deficits.
Conversely, the trade deficit tends to grow when the U.S. economy is experiencing its strongest growth. That's when we're attracting savings from around the world and U.S. consumers and businesses are hungry for imports. Meanwhile, the dollar's typically stronger, and that tends to drive up the trade deficit. So, investors should be looking at 20 other indicators before considering the trade deficit to be some kind of indicator of where they should be investing their money.
Q: Why do you think there's so much worry about the trade deficit?
A: The expanding trade deficit does reflect the growing integration of the U.S. capital market in the global economy. We could not run such a large trade deficit--or a large surplus, for that matter--if there wasn't significant freedom to flow in and out of the United States. That freedom has some inherent risks--capital that flows in can also flow out.
But of course the benefits of that far outweigh any risk. For example, we can tap into foreign capital markets, and foreign direct investment brings technology and management expertise and opens up trade opportunities. The bottom line: we just don't save enough in the United States to finance all our investment.
If we wanted to reduce the trade deficit to zero, we'd basically have to close our economy to significant capital flows and that would deprive our economy of investment dollars. A recent study by the National Bureau of Economic Research determined that foreign capital coming into the United States was holding down long-term interest rates [in the U.S.] by about 100 basis points.
Q: But the trade deficit can't keep growing indefinitely.
A: It's a truism that the trade deficit can't go on growing at the pace it has indefinitely. Everybody recognizes that, from Alan Greenspan on down the line. The question is, How's the unwinding going to occur? Is it going to be sharp and disruptive--the so-called hard landing that's been predicted for 20 years? Or is it going to be incremental?
Q: And your forecast….
A: I think the odds are that it will be incremental, and I'm not the only one who expects that. Our capital markets and foreign currency markets are extremely flexible. The dollar floats every day on global markets. The most likely scenario: foreign investors will say, "I have enough American investments in my portfolio; I'm not going to accumulate so many." Demand for the dollar will slack off, and that will eventually turn into a moderated trade deficit. A weaker dollar means imports cost somewhat more and imports are somewhat more competitive on global markets.
The Chinese, as they develop social safety nets and as they're able to afford more consumer items, will save less. There'll be less of their savings out there in the global capital markets looking for a home. That too would contribute to a weaker dollar and a moderated U.S. trade deficit.
Another way to look at it: every year the world saves something like $5 or $6 trillion. If $800 billion of that is finding its way to the United States, is that a fundamentally unsustainable scenario? We're 25% of global GDP; we're 50% of global stock capitalization. The United States is going to attract large amounts of foreign capital and there's nothing wrong with that.
Q: Is there any precedent for a country building up a large deficit that eventually unwinds relatively smoothly? Or are we in uncharted territory with a large U.S. trade deficit?
A: We're certainly in uncharted territory in terms of the size of the U.S. trade deficit. But of course we're the biggest economy the world's ever seen. Australia's run current account deficits of a magnitude comparable to U.S. deficits in terms of the size of its economy for 20 years or more. And Australia's been one of the better-performing economies with no sign of a hard landing. The U.S. economy itself ran trade deficits for most of our history up until World War One, and those deficits unwound without a hard landing. There have been studies of developed countries around the world that have witnessed their trade deficits fall and many have done it without a hard landing. In that sense, we're not in uncharted territory.
The key to a softer, more incremental adjustment is to have flexible institutions. A flexible exchange rate, flexible labor and capital markets so that the economy can make the internal adjustments. Those are the key issues.
A: A free market approach as opposed to trade barriers and other interventions in the marketplace.
A: Yes, trade barriers bring the perverse effect of chasing away foreign investment. My biggest worry about the trade deficit is not the deficit is itself, but what politicians may do in the name of curing it. It's a bit like falling sick in the hands of medieval physicians who believe in bloodletting.
Q: Of course, one could argue that in the generation after World War Two, trade was managed and everything seemed to work out fine. At least for a while.
A: Up until the mid-1970s, capital wasn't free to flow; no country had a very big deficit or surplus. That was the Bretton Woods arrangement, that included fixed-exchange rates and pretty severe capital controls. Large trade deficits or surpluses are only possible if you have capital mobility, which we have. And that's strengthened the global economy. So, [the rise of free trade] has been a positive development.
December 8, 2006
THE BIG SQUEEZE
The European Central Bank raised its main rate by 25 basis points yesterday, bringing the price of money on the Continent to 3.5%. Meanwhile, Fed funds continue to tread water at 5.25%.
The spread between the primary interest rates for the planet's leading currencies is now just 175 basis points, and a further narrowing is expected in 2007. The ongoing tapering appears set to come from both sides of the Atlantic: hikes from the ECB and holding steady at the Fed. In fact, the trend may be accelerated if Bernanke and company decide to cut rates next year, as some strategists are predicting.
The implications of a narrowing spread between U.S. and European rates are many, including increased pressure on the dollar. If euro-denominated debt continues to offer increasingly higher yields while dollar-based bonds remain more or less unchanged, forex traders and other overseers of capital will presumably adjust their decisions accordingly. The current choice stacks up as follows: a 10-year Treasury yields 4.63% vs. 3.75% for the equivalent in Germany. There's still a premium in the U.S., but if it fades further, the realignment currently underway in the greenback could accelerate.
If the only variable in the world was interest-rate spreads, the Federal Reserve might very well decide to raise rates if only to defend the dollar. But the global economy's more than a one-factor model. Among the additional complications: domestic inflation. On that note, The New York Times noted today, wage pressures are building. "After four years in which pay failed to keep pace with price increases, wages for most American workers have begun rising significantly faster than inflation," the Times reported.
If the trend has legs, as the article suggested, might it complicate the Fed's monetary policy in 2007? It might if the ECB continues raising rates, the U.S. economy continues slowing and core inflation continues rising, as it has in 2006. The scenario just described, if it remains intact, promises to bedevil the Fed, and everyone else who holds dollar-denominated assets.
December 7, 2006
WILL MR. MARKET MAKE IT FOUR IN A ROW?
Labeling a particular stretch of time ordinary, extraordinary or just plain weird is one of those tasks that fall under the heading of subjective analysis. But we'll risk it and proclaim that ours is an extraordinary moment in time, perhaps even weird.
We speak from a strategic perspective on the subject of asset allocation. As we've noted before, bull markets are in blossom everywhere, in virtually every asset class. While that's good news for calculating the profits on former investments, it raises doubts about what's coming.
Before we go any further, let's admit that timing the markets isn't our forte. In fact, we're skeptical that any one harbors such a talent, at least when measured over a business cycle or two. Our preference is one of rebalancing based on the signals Mr. Market dispenses. If asset A is up 10% over the past year and asset B is down 10%, we're inclined to take profits from A to feed B. Yes, that's a dangerous game with individual securities, but it carries an impressive pedigree when dealing exclusively in asset classes. The reason: asset classes don't go bust, which is more than we say for individual securities.
But there's always a glitch, even in the best-laid plans. The last few years have provided strategic-minded investors with a conundrum. Indeed, if everything is up, then it stands to reason that nothing is down. As a result, the prudent course for rebalancing is less than obvious and fraught with more than the usual dosage or risk.
Consider that all of the following indices posted gains in each of the three calendar years for 2003-2005.
* Russell 3000 (U.S. stocks)
* MSCI EAFE $ (Foreign developed-market stocks)
* MSCI EM $ (Emerging market stocks)
* Lehman Bros. Aggregate (U.S. bonds)
* Credit Suisse High Yield (U.S. junk bonds)
* DJ-AIG Commodity (commodities)
* DJ Wilshire REIT (REITs)
Previous to 2003-2005, the last year that all seven asset classes were winners was 1996, which followed a less-than-perfect 1995. So, yes, sometimes the bulls are running the show across the board, but it's a rare event and it almost never lasts for very long, unlike the current run.
Suffice to say, across-the-board bull markets should be seen for what they are: a gift from the financial gods, but one that comes with a price tag at the end of the rainbow. After 1996's perfection, 1997 dispensed losses to emerging markets and commodities, with MSCI EM $ shedding 13.5% that year and DJ-AIG losing 3.4%. In fact, in 1998, both of those indices continued retreating at an accelerating pace and the selling spilled over to DJ Wilshire REIT, which tumbled 17% that year.
So where does that leave us in 2006? Worried...and prepared to take advantage of any attutide adjustment in the capital markets.
No, we don't know what's in store for the asset classes in 2007, but we have our suspicions. Those suspicions are informed by the fact that all of the seven asset classes listed above are firmly in the black for 2006 through the end of November. For the moment, one could reasonable expect that all seven asset classes could again post gains this year when the final tallies are written in stone on December 31.
If so, that will make the fourth year in a row that the major asset classes all show calendar-year advances. Now that's extraordinary and arguably weird and, if history can be trusted, more than a little risky. Then again, from the current vantage, some might say it's the norm. Recent history has an overly large influence on investment thinking. But for our money, the trend of recent vintage lives on borrowed time, which is why we continue to favor the eighth asset class, and the only one that's supposed to show gains (however slight) in each and every calendar year: cash.
December 6, 2006
THE ENERGY OUTLOOK DU JOUR
Forecasting next year, never mind events in 2030, is a tough job, but somebody's got to do it.
Prognosticating America's future for oil and related energy trends falls on the statistical shoulders of the Energy Information Administration. Predictions must be taken with a grain of salt, of course. But since the government has gone to so much trouble to crunch the data, the least we could do is take a look.
That said, the EIA yesterday dispensed its latest prophecy on the long term on the various energies consumed, produced and imported from the vantage of the 50 states. Officially, the numbers are an advance release of the agency's 2007 Annual Energy Outlook, scheduled for publication early next year. Unofficially, the data offer another warning of what may coming.
Availing ourselves of the advance release, we went immediately to the oil numbers. Alas, we found no reason to think that all is well on the long-term energy front, as the chart below advises. Consider that the EIA predicts that over the 25 years through 2030, domestic crude oil production will advance by a paltry 0.2% a year. Consumption, by contrast, will rise by 1.0% a year over that stretch. To underscore the obvious: a large gap between production and consumption will bedevil these United States for the next generation, much as it has for the past generation. How might the future gap be sated? Imports, of course. Once again, more of the same. To wit, the EIA projects that imports will rise 1.0% a year through 2030.
For anyone who routinely follows the news in the oil market, such forecasts will come as no shock. Then again, that doesn't make the prediction any less humbling.
Yes, so-called alternative fuels will play a larger role in the years ahead, the EIA counsels. But in order for new energy sources to have a relatively meaningful impact, their role must grow at a rate that's faster than the economy's overall increase in energy consumption. That will prove difficult, perhaps impossible, the EIA suggests.
Consider that the biggest projected relative change in energy consumption in the next 25 years will be in coal, the EIA predicts. As the chart below notes, coal's usage will rise by more than 3% by 2025, measured as a share of total U.S. energy consumption. Yes, oil and natural gas are expected to decline in relative terms, but it will be replaced primarily by another fossil fuel, or so we're told.
To quote the EIA directly,
Despite the rapid growth projected for biofuels and other nonhydroelectric renewable energy sources and the expectation that orders will be placed for new nuclear power plants for the first time in more than 25 years, oil, coal, and natural gas still are projected to provide roughly the same 86-percent share of the total U.S. primary energy supply in 2030 that they did in 2005 (assuming no changes in existing laws and regulations). The expected rapid growth in the use of biofuels and other nonhydropower renewable energy sources begins from a very low current share of total energy use; hydroelectric power production, which accounts for the bulk of current renewable electricity supply, is nearly stagnant; and the share of total electricity supplied from nuclear power falls despite the projected new plant builds, which more than offset retirements, because the overall market for electricity continues to expand rapidly in the projection.
The more things change....
December 5, 2006
These are stressful times for investors wondering what the economy will bring next year. The stress level jumped another notch for those who read this morning's news on October's factory orders.
New orders for manufactured goods dropped by 4.7% in October, the Commerce Department reported today. Not only does that look bad after September's 1.7% gain, it looks downright awful based on the fact that one has to go back to 2000 to find a bigger monthly descent in the series.
To say that something's amiss in factory orders is to reiterate a theme that's been bubbling for some time in the economic data. To review: the economy's slowing. How much it's slowing is the question, although when it comes to October's new orders for manufactured goods, there's not a lot of room for debate.
Deciding if October will carry over into November, December and beyond is the great question that increasingly consumes investors. Of course, to judge by equity trading of late, Mr. Market looks less than stressed. Let's rephrase that: some investors are consumed with worry, but it may take a while to find them on Wall Street these days.
The S&P 500 as we write is trading within shouting distance of its post-2000 high. It's arguable if this is the ideal time to be an incautious bull, but buyers seem disinclined to embrace the idea that they might be ever so slightly overoptimistic. Banish the thought.
Of course, optimism isn't without merit today. The services sector (which is by far the bigger slice of the economy relative to manufacturing) unexpectedly accelerated in November. The Institute for Supply Management's services index advanced to 58.9 in November from 57.1 in the previous month. Any reading above 50 reflects growth.
For those who think that the Fed remains behind the curve in fighting inflation, the ISM Services news is the only game in town today. The slowdown in housing and autos, which is apparently having some spillover effect in factory orders, is more than offset by the rest of the economy, runs this line of thinking. "The service sector is really what is holding the whole economy together and providing the impetus for growth," Michael Metz, chief investment strategist at Oppenheimer & Co. in New York, told Reuters.
Adding to the optimism is the government's upward revision in productivity for the third quarter. The U.S. Department of Labor reported that productivity in the manufacturing sector of the economy grew at a seasonally adjusted annual rate of 6.7% during July through September--nearly a percentage point higher than the 5.9% previously reported. Since higher productivity is said to ease inflationary pressures, it's a tad easier to think that inflation may not be quite the beast that some say it is.
There are signs that such thinking is starting to affect trading in Fed funds futures. The May contract, for instance, is predicting that the current 5.25% Fed funds will drop to 5.0% at some point in the spring, if not earlier. What might compel the Fed to cut rates? Easing inflation pressure is one factor. Another? An easing economy, which brings us back to the lower factory orders. And that's where we came in....
December 4, 2006
ASSET ALLOCATION FUNDS FOR THE 21st CENTURY
So-called asset allocation mutual funds are enjoying a renaissance in investment flows. Along the way, the group's undergoing an image upgrade. In the old days, the notion of owning multiple asset classes in a mutual fund that owned other mutual funds was widely dismissed as an excuse for layering fees on top of fees. A new generation of asset allocation mutual funds is attempting to reform that image. In the December issue of Wealth Manager, your editor took a closer look at the new-fangled multi-asset class mutual funds. For the details, read on....
December 1, 2006
One out of 41 isn't a bad record, but it's not what the optimists wanted to hear right now.
After 41 consecutive months of growth, the widely monitored ISM Manufacturing Index showed that the sector contracted in November for the first time since April 2003, the Institute for Supply Management reported this morning. New orders and production both ended growth cycles at 42 months during November, ISM added. "On the positive side, growth in new export orders continued as the weaker dollar continues to fuel that segment," the accompanying press release advised.
But no matter how much you try to spin the numbers, there's no getting around the fact that another minor milestone has arrived that suggests the path of least resistance is further economic slowing. Indeed, the index has slipped to 49.5 for the first time in more than three years. Any reading below 50 in the ISM index reflects a contracting manufacturing sector, which is usually accompanied at some point by a weakening economy if not recession.
There was a moment back in early 2005 when the ISM Manufacturing Index looked set to stumble below 50. More than a few analysts warned that an economic slowdown or worse would soon follow. But such forecasts turned out to be premature. Indeed, the danger passed, and the index took flight, as did the economy. But the jump was only temporary, and now it's completed the below-50 stumble that looked imminent previously. In short, the stimulus of 2004-05 is ancient history now. The question: what, if anything, will give the economy a fresh jolt higher now?
Clearly, no one will be surprised by the news that manufacturing activity's slowed. A number of other gauges have been telling the same story in recent weeks and months. The ISM index merely offers confirmation of what was already obvious.
The good news is that manufacturing's fate has long been dethroned as a determining factor in what comes next for the economy overall. Ours is a service economy by far. Alas, that metric has also been showing signs of downward bias recently. But let's not get ahead of ourselves: the ISM Services Index is still above 50, implying that the economy may remain stronger than the manufacturing sector suggests.
In any case, next Tuesday's update on the ISM Services Index will reveal if the manufacturing slowdown is spilling over into services. Meantime, the pessimists have another data point to cite.