June 29, 2007
SEPARATE BUT UNEQUAL
The time has come to once and for all put to rest the notion that crude oil and gasoline are joined at the hip as commodities in solidarity.
Yes, there's a thin veil of truth to the myth, born of the fact that the latter is refined from the former. But for all practical purposes, it's prudent to consider each separately from the other. The reason: each is driven by a separate, and at times dissimilar set of supply and demand factors.
Still, the two appear to share a commonality in pricing trend at times, promoting the illusion of equality. But as the news from Iran reminds, the danger in the conceit carries more than a little risk for clear thinking on energy matters.
The casual observer may wonder why Iran, home to 10% of the world's proven oil reserves and second in global crude production, has started rationing gasoline, which has sparked riots and unrest in the country. In fact, there's no great mystery here.
Iran produces far more crude oil than it consumes domestically, thus its high level of exports. But its domestic gasoline production falls well short of internal demand. The reason should be familiar to Americans, namely, a lack of investment in refineries to slake rising consumption.
Iran in 2005 imported roughly one-third of its domestic gasoline consumption of 400,000 barrels a day, according to the Energy Information Agency. In an odd twist of fate, reliance on foreign gasoline makes Iran the world's second-largest importer of the fuel after the United States.
Adding to Iran's challenge in solving its gasoline shortage is the fact that the state imposes price caps on the fuel, thereby insulating the population from the market price for a commodity that's set globally by supply and demand forces. As a result, Tehran buys foreign gasoline for $2 a gallon and sells it domestically for 34 cents, The New York Times reported via The Houston Chronicle. In addition to the ill-advised policy of promoting consumption while domestic production is, at best, static, state subsidized gasoline plants the seeds for social strife for the day when market forces inevitably shatter the myth that energy's inexpensive.
The moral of the story: access to large quantities of crude oil doesn't necessarily translate into energy security for the man on the street. That truism doesn't stop some, if not most Iranians from letting expectations run away from the reality on the ground.
"There is no reason why we should pay the same price as people outside Iran do," Amir Aram, a carpenter in Tehran, told the Times. "We have all this oil beneath our feet and have to wait for hours in line to get our ration."
Politicians in Washington would do well to study the current Iranian energy crisis and recognize the distinction between the markets for crude oil and gasoline and the separate but independent challenges looming in each for the United States. Yes, each commodity requires sober analysis and planning. But however that unfolds, accepting that the two aren't interchangeable for policy making is essential.
The U.S. could have all the inexpensive oil in the world, but that alone doesn't put gasoline in Joe Sixpack's SUV tank. We can and should have an intelligent national debate about the country's long-term energy strategy. (Hey, there's a first time for everything.) But no matter the path we take, the choice must flow from a firm grasp of the facts. That begins with understanding the supply/demand dynamic that is the U.S. gasoline market.
* Fact number 1: There were 149 operating refineries in these United States in 2006--down 50% from 1982, according to EIA.
* Fact number 2: the capacity of the operating U.S. refineries has fallen by 3.7% during 1982-2006.
* Fact number 3: motor gasoline consumption in the U.S. increased by 40% in 2006 vs. 1982.
* Fact number 4: gasoline imports to the U.S. have climbed by 140% during 1982-2006.
On the surface, the above stats don't look all that different from the dynamic of crude oil, i.e., rising consumption, falling domestic production, increasing reliance on imports. The difference is that geology has imposed its reality on the U.S. when it comes to oil. In sharp contrast, whatever awaits for gasoline in this country will come solely as a self-inflicted scenario, a fact that Iran understands all too well these days.
June 28, 2007
IS SOMETHING AMISS?
Core CPI may be under control, but the Federal Reserve isn't convinced that the war on inflation is over just yet.
The central bank's "predominant policy concern remains the risk that inflation will fail to moderate as expected," today's FOMC statement advised. That's a verbatim repeat of what the Fed said after the last FOMC meeting in May. But this time it added a proviso: "Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures."
The warning is all the more striking coming just 13 days after the encouraging report on May's reading of core inflation, the Fed's preferred prism for viewing monetary-policy-relevant pricing trends. More than a few analysts reasoned that after that heartening report on core, the central bank was home free. But now we're told that any cheering was premature.
"The Fed is signaling it wants it proven first that inflation is down and will stay down,'' Gerald Lucas, senior investment strategist in New York at Deutsche Bank, told Bloomberg News after the FOMC release.
Marc Chandler, senior currency strategist at Brown Brothers Harriman in New York, looked at the news this way, via Reuters: "The take-away point from the Fed statement is that the easing of price pressures thus far has not been sufficient to change the Fed's risk assessment."
From our perspective, we can only wonder why the central bank chose this moment to elevate its rhetorical anxiety over future inflation. Was it the fact that while core inflation looks like a lamb, top-line inflation is still roaring like a lion? If so, the rise today of oil prices above the $70-a-barrel mark will only raise anxiety levels. Energy, after all, is the inflation-laced fly in top-CPI's ointment. Ignoring the top-line trend, as we suggested on June 15, won't be easy in a universe populated with politicians and price-sensitive consumers at the start of a presidential election cycle.
Meanwhile, some corners of the Federal Reserve system are warning that focusing solely on core for monetary policy is still an experiment. It may prove successful, but the jury's still out.
While the capital markets sort it all out, this much is clear. One, we can rest easy that the odds of a rate cut just went down by more than a little. Two, the economic reports from here on out will receive even closer scrutiny (if such a thing is possible) for clues about inflation's future path.
As Comerica Bank chief economist Dana Johnson told USA Today this afternoon, "They are going to watch it until the data tells them something is amiss."
June 27, 2007
STILL WAITING, WATCHING & WONDERING WHAT COMES NEXT
The government updates the first-quarter GDP tomorrow, but till then we're told that the economy expanded by a scant 0.6% in the first three months of this year, based on a real, annualized calculation. Meanwhile, the real yield on the 10-year TIPS closed yesterday at 2.70%, which is to say that inflation-indexed Treasuries offer a considerable yield premium over the pace of economic expansion.
By that standard, U.S. interest rates are tight by more than a little relative to recent economic growth. Of course, the relationship between the price of money and GDP's pace evolves, sometimes dramatically. GDP rose by a strong 5.6% in real, annualized terms in Q1 2006, a quarter that witnessed real yields on the 10-year TIPS in the low-2% range. In other words, the price of money in early 2006 appeared loose, but has since given way to looking tight.
The challenge to that theory comes by surveying the price of money internationally. BCA Research yesterday published a provocative chart showing that globally defined bond yields generally are low relative to the world economy's rate of growth. Interest rates, the research shop opined, "are not yet restrictive." From that analysis comes the counsel that global equities looked poised to rise. "It will take a much sharper rise in the cost of debt to curtail the bull market in global equities. Until then, our outlook for higher stock prices remains intact," BCA counseled.
So far, so good. But the human mind is subject to what's only just passed, and on that score there's the issue of red ink to assess. A look at MSCI's suite of benchmarks for various slices of developed foreign markets shows a trend of unmistakable consistency: down. For the past month, virtually all MSCI indices in the developed world are in varying states of loss. Representative of the trend is MSCI EAFE, which is off by 1% for the past month, in dollar terms.
But even here, selectivity in how one reviews the world's equity markets offers alternative results. Emerging markets continue to bubble. MSCI Emerging Markets is up 3.6% for the past month, in dollar terms. Regions within EM are doing even better over the same period, with MSCI EM Asia rising 5.6% for the past month and MSCI EM Eastern Europe adding 7.2%.
Into this mix comes tomorrow's Federal Reserve announcement on its latest thinking for monetary policy. The ongoing belief that the current 5.25% Fed funds will remain the standard finds wide appeal, as reflected in Fed funds futures prices.
But nothing is written in stone. The incoming economic data continues to challenge the belief that the future is transparent as defined by the bulls. Yesterday's news on new home sales gave fresh support to the view that the housing market is still correcting, which in turn adds potency to the fear that the subprime mortgage turmoil may yet bring bigger headaches to the economy overall. Meanwhile, this morning's news of a robust decline in durable goods orders for May only heightens worry that economic weakness is the path of least resistance for the United States.
Ours remains a period of transition. There's a case to be made for both bullish and bearish predictions as to the final outcome of the current climate. But a broader, objective analysis suggests that there are still too many variables, both pro and con, weighing on the future to say with any confidence what's coming. The potential for surprise and shock from isolated events looks uncomfortably high to your editor's eyes--all the more so after several years of virtually non-stop bull markets in nearly everything. We could cite any number of examples that lead us to caution, but we'll close with just one reminder of how precarious the morrow appears to this reporter.
The news that Exxon Mobil and Conoco Phillips are prepared to abandon their energy investments in Venezuela in the face of an increasingly hostile business climate imposed by the Chavez regime reminds that formidable threats to stability and calm that prop up bullish visions continue to lurk in the shadows. Energy prices are currently high, and there's little reason to think that they couldn't suddenly and unexpectedly go much, much higher tomorrow.
Yes, there's a persuasive case to be made that the outlook is modestly encouraging for the U.S. economy. On balance, momentum retains the upper hand across the mix of variables that collectively define and drive U.S. and world GDPs. The problem is that the outlook is largely dependent on looking backward. With so much change unfolding in formerly trending variables, the future presents, in our humble opinion, a higher-than-normal risk to forecasting confidence.
As a result, the current climate only strengthens our view that broad diversification across asset classes, combined with a slow but sure rise in the allocation to cash, remains the best game in town. We're avoiding heavy bets on any one asset class or tactic. Better opportunities are coming, we believe. Another boring analysis, perhaps, but that's our story and we're sticking to it. Sometimes the best strategy is one of waiting. Patience is famously said to be a virtue. It may also be the secret to future performance success.
Yes, we may be wrong. It wouldn't be the first time. That said, we prefer to be wrong in a defensive posture and watch the markets rally further rather than find ourselves mistaken while loaded up on aggressive portfolio bets. Every investment climate sends a different signal, and the current one is no different. As such, we're reading the tea leaves and making a value judgment, replete with all the usual caveats and limitations that go with the job.
June 25, 2007
ANXIOUS BULLS & CONFIDENT BEARS
The Federal Reserve's FOMC meets again this week to decide what's next for the price of money. Judging by Fed funds futures, more of the same is what's next, which is to say more of letting it ride.
The July contract is priced in anticipation that Fed funds will stay at the current 5.25%. Looking at longer-dated contracts doesn't materially change the outlook. But no matter what the central bank decides on Thursday when it makes a formal announcement of its monetary policy, someone will be grumbling.
Ours is a moment of anxious bulls and confident bears. There's plenty to worry about, and yet encouraging news can still be found with minimal effort. As such, the casual observer of the American economic scene can be forgiven for feeling confused. On the one hand he's reading stories laced with references to hedge fund woes and subprime mortgages, real estate corrections, higher interest rates and warnings by some that the economy is headed for rougher waters. Adding to the worries is yet another rise in oil and gas prices, which is an equal-opportunity offender in reducing that all-important variable for economic momentum: disposable personal income.
At the same time, unemployment is a relatively slim 4.5% and weekly jobless claims, while not exactly low, have for some time remained in a holding pattern that can optimistically be called slightly elevated. Meanwhile, last month's report on retail sales suggests there's still plenty of get-up-and-go in the consumer sector.
"Seventy percent of Americans now say the economy is getting worse," observed Donald Lambro, a columnist at the conservative-minded Townhall.com. But he added that the sour outlook is "contradicted by a growing workforce, increased wages and household wealth, and a stock-market rally that has boosted worker-retirement investments."
Optimism, however, wasn't exactly dominating the thinking of one Paul Kasriel when he wrote earlier this month that the longer the Fed defers a cut in interest rates, the bigger his forecast of a drop in U.S. gross domestic product. The central bank, advised the director of economic research for Northern Trust, sees a rebound for economic growth in this year's second half, a prediction that informs its decision to keep rates steady. Kasriel isn't so sure, and so he counseled that a failure to lower the price of money will take a toll on the economy. Accordingly, he reduced his GDP forecast in early June for this year's second half to a meager 1.7% annualized real rate from his previous prediction of 2.25%.
Meanwhile, on Friday, an IMF executive said that whenever U.S. economic growth fell to around 2%, recessions have shown a nasty habit of following. That would seem to offer an iron-clad indictment of the future if one accepts the government's report that GDP in this first quarter rose a scant 0.6%. Last we checked, that's more than slightly below 2.0%.
But this time is different, added the IMF official: "We expect something of a soft landing, and the reason is because some of the other factors that you associated with recessions are not in place. Real interest rates, in particular, are actually quite low and unemployment, most importantly, is also very low. So we have, I think, the fundamentals that are needed, that we see as supporting the economy."
In other words, the IMF expects the U.S. economy will grow by 2% for all of 2007, and accelerate next year with a 2.75% rise. What's more, the Fed's current policy of keeping rates at 5.25% is just what the economy needs to deliver this modest but otherwise hopeful scenario, the IMF said.
More than a few investors apparently agree with the Fed's reading of the economic future, which we're told is one of better times ahead, if only modestly. Dissent hasn't been banished, but it's looking more defensive these days. Yesterday, The New York Times reported that Fed Chairman Ben Bernanke's star has risen sharply on Wall Street of late. "The real news," the paper of record informed, "is that financial markets now accept the Fed’s view of the economy and are no longer betting against it."
You can see whatever you want to see when it comes to the economy in 2007. There's room for all views. But in some respects, a few of the old rules still apply. That starts with the basic fact that even in a sea of competing predictions, dispatched continuously in the digital age, the future still has room for only one truth.
June 22, 2007
CONNECTING THE DOTS
The debate over inflation's future path is for many a question of focus. For those who look to top-line inflation, as measured by the consumer price index or its cousin, the personal consumption expenditures index, the trend is clear: prices are rising.
But the response to the contrary comes by those who say that core measures of CPI and PCE are more relevant. By that standard, the trend of late reflects control and containment.
The disparity between the two measures of inflation is no great mystery. The rising price of energy is captured in top-line CPI and PCE, and this measure of inflation has been climbing. Energy and food are excluded from the core measures, which explain why core CPI and PCE look calm and their top-line counterparts are rising.
But as a recent research note from the St. Louis Fed reminds, the jury is still out on what a widening disparity between top-line and core measures of inflation means for monetary policy. "A disconnect between measures of headline and core inflation could be a concern for policymakers," Riccardo DiCecio, an economist at the bank advised. "It may not be reasonable to conclude that monetary policy has been effective in maintaining price stability by looking solely at a core measure of inflation that excludes sustained oil price increases."
DiCecio goes on to suggest that "an increase in energy prices could present monetary policymakers with a tradeoff between controlling inflation and stabilizing the output gap (i.e., the difference between actual and potential output) if these price increases affect actual output more than potential." Clarity, however, is still missing. "The optimal resolution of this trade-off is an active area of research," he notes, adding that readers can survey an outline of the debate in a recent research paper by Lutz Kilian (an economics professor at the University of Michigan) that's slated for publication in The Journal of Economic Literature.
As Kilian pointed out in The Economic Effects of Energy Price Shocks, the challenge is one of understanding in greater detail how energy price shocks are relayed through the economy and how central bankers should react. Much of what was once thought known about energy-price shocks is now considered only partially true, if not completely misleading. A more granular analysis of what causes oil prices to rise, for instance, is critical for weighing the implications for the economy overall. Demand shocks and supply shocks, to cite two of the more commonly noted distinctions of late, shouldn't be considered one and the same when it comes to energy bull markets.
That said, "The Economic Effects of Energy Price Shocks" states that "while no two oil price shocks are alike, most oil price shocks have been driven by a combination of strong global demand for industrial commodities (including crude oil) and expectations shifts," or assumptions about the potential for future supply-related ills.
While no one should mindlessly assume that higher oil prices automatically lead to higher inflation per se, neither can one occupy the opposite philosophical extreme and relate energy as just one more commodity. At least not yet. The fact that inflation measures already recognize energy as something worthy of separate consideration suggests as much.
Nonetheless, ours is a moment of transition for deciding what higher energy prices mean for inflation. It's tempting to conclude that the bull market in oil and gasoline (each driven by different factors) will have limited relevance for monetary policy, i.e., that there's salvation embedded in core price trends. Perhaps, but it's too early to make definitive judgments.
As DiCecio explained,
...price indices provide a snapshot of the dynamics of prices of a basket of goods and services. However, because each core index suppresses a different source of information, they each provide a different measure of inflation. Especially in times of substantial relative price movements, all price indices should be considered by policymakers and analysts.
June 20, 2007
REITS & RED INK
Change may come slowly, almost imperceptibly to the capital markets. Or it may come as a thunderbolt from the blue. But invariably it comes, raising questions and sidetracking long-running expectations in the process.
What's unfolding presently in one corner of the marketplace appears to be change in its more subtle hue. That leaves room for debate, although it spurs questions too. Reading the trail left by the major asset classes shows that REITs are at the head of the shifting financial winds. Posting the only loss so far this year among our list of broadly defined markets, real estate securities are testing a concept that has long eluded the sector: loss.
As our table below shows, red ink distinguishes the asset class so far this year:
To find a calendar year in which REITs generally suffered a loss one has to return to 1999, when Wilshire REIT's total return was a negative 2.6%. Since then, REITs have been on a bull market run that's extraordinary for its duration and magnitude. If you had the prescience to buy the Wilshire REIT at the close of 1999, the resulting annualized total return from that point through this past May was a stellar 22.3% vs. a paltry 2.2% for the S&P 500, according to Morningstar Principia software.
The question is whether the REIT train has finally run its course? No one knows, but there are several reasons to consider the possibility. We can start with the observation that nothing goes up forever. REITs have taken flight now for seven years straight through the end of 2006. We don't know if fate will make that eight in a row, but after such a long bull run, the odds of extending a rally with ancient origins looks decidedly lower the longer the party goes on.
Another reason to consider taking at least some modest profits from REITs comes by looking at interest rates. The yield on the 10-year Treasury has for some time exceeded what's available in REITs generally. Vanguard REIT Index Fund, for instance, had a 3.65% yield on May 31--or 124 basis points below the 10-year Treasury at the time. For those who look to REITs for yield--and many do--why give up yield in return for higher risk? Presumably one could answer that the growth prospects of REITs are still high enough to overcome the yield deficit. Many subscribe to this forecast, but it rings a bit hollow to our ears after hearing for so many years that REITs are attractive because the yield offered a premium over Treasuries.
And while the 10-year's yield has pulled back from its spike of last week, there is a growing expectation that interest rates may be headed higher still in the second half of this year. If so, that's hardly good news for bonds or REITs.
REITs have long been thought of as interest-rate sensitive securities. As such, it came as no shock to see REITs in a bull market in years past amid a climate of falling interest rates overall. If rates move higher, REITs may be fated to suffer.
Meanwhile, there are reports of late that lenders are becoming increasingly anxious when it comes to commercial property. Does that imply a peak for buyout deals, which could have repercussions for REIT sentiment? A Reuters article today suggests as much.
Full disclosure: your editor has become increasingly cautious on the prospects for REITs in recent years. For as long as he's embraced the view, he's been wrong. Eventually we'll get it right, although there's no guarantee as to when. Meanwhile, even a broken clock offers an accurate reading twice a day.
Nonetheless, ours is a strategy of evolution, informed by the past with an eye on the future. Paring back REIT allocations, gradually but consistently, in search of greener pastures elsewhere appeals to our sense of prudence at this point in the cycle. Defense over offense is increasingly our motto when it comes to portfolio strategy. Having ridden the wave up since 2002, we have no intention of getting pulled out to sea when the tide shifts.
June 19, 2007
STUCK ON A PIN
Former Fed Chairman Alan Greenspan, speaking last November, predicted that the worst of the housing market's correction had passed. But judging that commentary by housing starts suggests otherwise.
The government this morning advised that the seasonally adjusted annual rate of housing starts for May dropped 2% from April. Compared to last November, starts are off nearly 6%. Looking at the data on an annual basis reveals that housing starts are almost one-quarter lower compared to a year earlier.
One might point out that the low point for starts arrived this past January, as our chart below shows. But the trend since, although technically improved since that trough, has yet to inspire confidence that a genuine recovery has arrived.
It should also be noted that while housing's future trend remains a question, the larger economy has yet to suffer an associated shock of any great magnitude. Although no one will confuse June 2007 with June 2006, optimism is still the easier sell. But make no mistake: there's still reason to worry that housing's ills aren't over and that the virus may grow bigger as a negative for the larger economy.
"I see [the fall in housing starts in May] as further confirmation that the housing sector is going to be a drag on the U.S. economy for the rest of this year," Carl Riccadonna said today via Reuters. "There was some doubt about that a few months back, but this data show continued declines in activity."
The question is how much the drag will press on economic growth generally. The answer is forthcoming but presently unknown. Economic growth continues until it stops. The transition from expansion to contraction is clear in hindsight and mysterious as it unfolds in real time.
No one knows which variable might turn the trend. Meantime, we can amuse ourselves by looking at the past and consider that housing may yet tip the cycle from up to down--or not. For those who think the latter's the favored outcome, the statistic to embrace is housing permits, which the government also dutifully reported today.
Permits are considered a superior measure of what's coming for housing, vs. the rear-view-mirror status that starts are said to suffer. As such, last month's 3% rise in single-family housing permits (at a seasonally adjusted annual pace) is encouraging. Alas, we'll need many more upticks to resolve the fact that permits in May 2007 are still 22% below the tally of the previous May.
For mere mortals, the only reaction is wait, wait for more data. Yes, we've been waiting now for months and still we've no clarity. Grin and bear it. As Iggy once sang, "I feel stuck, stuck on a pin."
June 18, 2007
Mr. Market is full of surprises. Some are good, others less so. For the moment, the fomer seems to be in control when it comes to equities, and arguably the main reason is the fact that consumers continue to surprise as well with a seemingly non-stop bout of spending.
More than a few analysts have been surprised by the trend. Indeed, bears remain flabbergasted that the median firm in the S&P 500 reported a 10.1% rise in earnings in the first quarter, according to Zacks. That marks the 19th consecutive quarter of double-digit gains. Perhaps even more encouraging for the here and now is the fact that two cyclical sectors of the S&P reported the strongest earnings gains in Q1: a 14.5% jump for materials (which was the earnings leader among the 10 sectors); and a 13.5% rise for industrials.
One is inclined to connect the dots and note that Joe Sixpack's affinity for spending shows no sign of slowing in recent history. The latest evidence came in last week's retail sales report for May, which registered a 1.4% jump over the previous month--the strongest monthly advance since January 2006. Reports of the death of consumer spending, in other words, have been greatly exaggerated.
The future, of course, is up for grabs, as always. But for now, there's no denying the basic American urge to spend, to keep on spending, and spend a little more. If Joe wills it, channeling triumph by way of his wallet, a financial reckoning of any great magnitude will be postponed. No one can say for how long, but skeptics of the Joe's capacity for consumption, conspicuous or otherwise, have taken it on the chin so far.
To the extent that one can draw conclusions about earnings predictions, the odds are low to mixed that a material change in trend is imminent. Again using Zacks numbers, the Q2 estimate for earnings in the median S&P 500 company calls for an 8.9% rise. That's down from Q1, and perhaps indicative of the great slowdown that many say is lurking. Perhaps, although an 8.9% rise is hardly suggestive that the apocalypse is just around the corner. Indeed, the projected growth of earnings for 2007 for the median S&P firm is robust 10.9%. If anything like that holds fast, a recession worthy the name this year seems as likely as the renunciation of violence in the Middle East.
The bears aren't giving up, however. The persistence of high gasoline prices, rising interest rates and an ongoing slump in housing stoke fear in some that today's rosy pace of consumer spending will soon turn lower. We're living on borrowed time, in other words. But the fact is, economic momentum generally has been strong. April was particularly impressive on a number of fronts, and some of that has spilled over to May.
It's possible that the bottom could fall out of the economy in coming weeks, but such a reversal isn't obvious to our eyes yet, at least as we look backward from mid-June. That said, there's no dearth of things to worry about, starting with the fact that bull markets are in bloom nearly everywhere and expectations for more of the same appear baked into the cellular structure of every trader and dealmaker on Wall Street. That by itself worries your editor and makes a case for methodically if undramatically moving money from risk-laden asset classes sitting on tidy gains to risk-free ones.
Like baseball and war, anything's possible in the immediate future, but eventually the stats determine the outcome. We're not sure if momentum's in the 7th inning or the 9th, but we're looking ever closer for clues. At some point, a climate of value will retake the throne from momentum, reinforcing the ancient tradeoff of pendulum swinging between the two. The longer one rolls on, the more intensely we prepare for the other's arrival.
Admittedly, ours is a strategy born of ignorance for what's coming and when. In the absence of knowing the future, we're reduced to reading the past and defending against surprises, albeit in moderation and gradually.
June 15, 2007
A TALE OF TWO INFLATIONS
Thank goodness for core!
For those intent on staying positive on the future path of inflation, focusing like a laser beam on the so-called core rate of the consumer price index is essential to one's mental health.
This morning's report on CPI offers a potent example. On the surface, there's bad news: top-line CPI rose 0.7% last month, the highest since September 2005's anomalous 1.2% surge. As a result, CPI's annual pace as of May is a worrisome 2.7%. More troubling than the absolute level is the trend. Since late last year, CPI's annual rate of change has been climbing. As recently as last October, annual CPI was a mere 1.3%--lower by more than half compared with the current inflation.
But optimism has a savior in the core CPI reading, which extracts the troublesome energy and food prices from the mix. By that standard, all's well. In a bubble universe where no one buys energy and food, inflation is barely worth a mention. The 0.1% rise in core CPI last month was lower than April's 0.2%. In fact, the annual change in core CPI through May is notable mainly for its descent over time. For the fourth month running, the 12-month change in core CPI has fallen, posting just 2.3% for May, down from 2.9% in September 2006.
The question then becomes: which one speaks the truth? The answer depends on one's perspective. Indeed, the central bank has a fondness for the core reading because it conveniently strips out the biggest pricing variable over which the Fed has no control: energy. True, of course, and so there's a case to be made for central banks focusing on core. The hope, and it's not entirely unjustified, is that the Fed can excute a prudent monetary policy by ignoring food and energy prices. If so, the benefits will eventually flow to the economy overall. By that standard, we can all rest easy.
But will reality eventually intrude and spoil that conceptual package? OPEC may be the mother of all exogenous pricing shocks that the Fed ignores in its appointed rounds. But the masses can't afford such a cavalier view on energy prices.
It remains to be seen how long a divergence between top-line and core CPI will run with no material impact on monetary or political policies. But this much is clear: if top-line CPI moves higher for long enough, there will be a political price to pay, in which case an economic impact, intended or not, may soon follow.
It's hard to imagine that Federal Reserve Chairman Bernanke won't find himself on the losing side of the debate in Congressional testimony if top-line CPI runs at 3%-plus in the near future even as core CPI remains contained. The econometric logic that rationalizes a focus on core as a monetary signpost is lost on the man at the pump paying $60 to refuel his car. Members of Congress will spontaneously sympathize with their constituents on such issues, which in turn will foster calls to do something, anything to relieve the financial suffering.
Invariably, the political pressure to bring relief to consumers paying more for energy runs the risk of stoking inflation. The connective tissue that binds the political to the economic isn't always obvious, but history suggests that the former will invariably affect the latter. In theory, the Fed could abet such pressures by refraining from an interest rate hike or even lowering rates when monetary prudence suggests otherwise. Barring that, Congress may see fit to engage in an ambitious new program to redistribute wealth to the stricken masses paying more for gasoline. The opportunities for reactionary populist notions are endless in an energy bull market.
Don't let the serene core CPI fool you. The rise in top-line inflation, if it continues, will have consequences for the economy. Ideally, the top-line number will turn down or at least stabilize, in concert with the top-line number. Until and if that state of correlation arrives, there's reason to wonder what's coming.
June 14, 2007
HOT & COLD, UP & DOWN, ROUND & ROUND
Yesterday's news on the strong jump in retail sales cheered equity investors. And for good reason: the 1.4% gain in consumer spending in May is the highest in 16 months. But in keeping with the spirit of the times, for every bit of good news, there lurks a new reason to worry.
Yesterday's news on import prices, for instance, surprised on the upside, coming in at 0.9% last month, which was much higher than the consensus forecast.
Meanwhile, this morning's producer price report for May offers another indication that pricing pressure may be staging a comeback in the wholesale world. Seasonally adjusted PPI advanced by 0.9% last month, up from 0.7% in April. On an annual basis, PPI rose by 3.9%. As our chart below shows, it's clear that there's inflationary pressures, while not necessarily fatal, remain a concern.
The optimistic view is that after stripping out food and energy, PPI still looks tame. Yes and no. It's true that core PPI rose just 1.6% for the 12 months through May--less than half the pace for the top-line number. But the annual rate of 1.6% is unchanged from April. In fact, the annual rate of change in core PPI has been holding fairly steady in a range of 1.6% to 1.8% this year. The question: will the core rate be pulled up if the top-line pace continues to take flight? Looking beyond PPI one may wonder what's in store for consumer prices, which have been showing signs of trending higher too. Tune in tomorrow for the May CPI report.
Meanwhile, supporting evidence for thinking that inflation remains an issue comes from the bond market, which has been signaling its displeasure with the matter of prices. Although the
yield on the benchmark 10-year Treasury turned down yesterday, it's too early to declare that the month-long surge in interest rates has run its course.
But if all the inflation talk has convinced the fixed-income set to reconsider the future, there's still no sign of fear in the trading of Fed funds futures. In this corner of financial forecasting, calm prevails in second guessing the central bank's next move on interest rates. Contracts through next March remain priced in expectation that there's no change in store for the current 5.25% Fed funds rate.
Perhaps. But while we ponder the embedded message in futures pricing, it's getting harder to ignore the opportunity bubbling in the market for inflation-indexed Treasuries. The surge in long yields has spilled over into the TIPS market, with the 10-year inflation-indexed Treasury yield closing at 2.75% yesterday. Tuesday's close of 2.83% is the highest since at least 2003 (the Treasury site's data doesn't go back any further). It's not yet a no-brainer for locking in a real yield just below 3%, but it's getting close.
Ours is still an economy of conflicting signals and data that burns hot and cold, depending on when and where you look. But while the jury's still out and the market's lie in perpetual fear that the other shoe may drop, the prospect of locking in real yields north of 3% for the next decade strikes us as eminently reasonable for a portion of assets. As such, mark us as officially on a TIPS watch. We don't know if we'll be able to buy above 3%, but we're prepared to open the door when and if Mr. Market knocks.
June 13, 2007
The rise in the 10-year Treasury yield to its highest level since 2002 may or may not signal a secular change in the future supply of liquidity. But when it comes to interpreting the signal, strategic-minded investors should think strongly about erring on the side of caution. The advice is all the more relevant for those who've profited from the liquidity driven bull market of the past five years that's dispensed gains in all the major asset classes.
For all we know, the current spike in interest rates may end tomorrow--or not. But when the bond market sends a message this crisp, we're reluctant to dismiss it out of hand.
Then again, the rise in the 10-year yield isn't all that astonishing, given the recent evidence that the economy's still bubbling. For those who assume the economy's not headed for recession any time soon, the case for an inverted yield curve (long rates below short rates) has been on shaky ground.
"We've been through a three- or four-year period where yield curves have been a weird shape," said Tim Bond, head of asset allocation at Barclays Capital, told Reuters. "I think you've got further to go [with rising interest rates]; yield curves are just normalizing."
No matter your view on where the economy's going, the bond market has some very definite ideas. To be sure, the ideas of the moment stand in sharp contrast to the ideas of the recent past, as our chart below reminds. In fact, those ideas may change again.
The future, of course, is debatable; the past is set in stone. Looking at the carvings left by fixed-income trading reveals that something approaching a normal state may be coming in the relationship between yields and maturities. Using last night's close as a guide, there now exists a 60-basis point spread in favor of the 10-year over the 1-month T-bill. At the close of last year, the 10-year's yield was 10 basis points under the 1-month T-bill. On its face, the change implies that the economy will stay stronger than previously assumed. Now all we need is fresh data to support the bond market's forecast.
But don't hurt yourself looking. Long yields may be rising for any number of reasons, some of which don't necessarily lend themselves to bullish notions about the economy. One example comes via Bloomberg News, which reported Federal Reserve Bank of Cleveland President Sandra Pianalto as saying that inflation is "uncomfortably high."
Just to keep things interesting, however, there's a wrench in the analytical machinery in the form of commentary from former Fed Chairman Alan Greenspan. The maestro of old, speaking yesterday at a conference in New York, warned that the low yield premiums on emerging market debt wasn't long for this world. Again citing Bloomberg News, Greenspan advised that "all the spreads you are looking at, including your spreads relative to the 10-year, are going to start to open up and the 10-year is going to be moving as well." The comment, we read, inspired the selling in the 10 year. If so, one might wonder if the rate jump is artificially induced by one Alan G.
No matter, as fundamentals will ultimately dictate prices. The truth, in short, will out. Maybe not today, but eventually and, we think, soon. Clarity is coming, albeit in small doses released irregularly and over time. Patience, more than ever, is a necessity as well as a virtue in these ambiguous financial times.
June 11, 2007
A TIMELY REVIEW OF REBALANCING
Fear got the upper hand on greed last week, offering a rare change of pace in the five-year-old running of the bulls. Deciding if the turnaround in sentiment foreshadows more of the same, or was just a temporary detour in an otherwise intact bull market, remains to be seen.
Without the benefit of the answer, now seems like a good time for a refresher course on the all-weather strategy that's fitting for market trends driven by bulls and bears alike. Rebalancing is no get-rich-quick scheme, nor can it guarantee triumph in one's voyage through the capital markets. What it does offer is a prudent approach to managing a multi-asset class portfolio with an eye on balancing reward with risk over time.
Finding the right balance between gain and loss in portfolio management is an evolving and always challenging pursuit. But if there's a promised land, the path to that nirvana arguably rolls through the province known as rebalancing. But even assuming as much offers no shortcuts.
There are as many ways to rebalance as there are brokers on Wall Street. In an effort to bring order to what is in theory a black hole of potential is one Gobind Daryanani, a CFP who's researched the subject of rebalancing in search of strategic enlightenment. Your editor interviewed Daryanani in the June issue of Wealth Manager. If you're inclined to share in the finer points of his analysis, read on....
June 8, 2007
As signals in the bond market go, yesterday's was fairly lucid. Translating bondspeak to street language, the trading in the 10-year Treasury on Thursday might be interpreted thus: Ahhhhhhhhhhh!
As the chart below shows, the 10-year yield jumped more than a little, closing at roughly 5.1%. That's the first time the benchmark Treasury has been swimming in those statistical waters since last July.
What caused the revaluation in the price of money? In broad terms, it's clear that risk is being repriced. What's triggered this repricing? Liquidity invariably turns up as a suspect. Mr. Liquidity is innocent till proven guilty, of course. But for the moment, he's been arrested and awaits arraignment.
Meantime, the court of public opinion will survey the evidence until a formal decision arrives. Exhibit A is the supply of liquidity in the global economy. But most standards, it's in amply supply, and then some. But for every action there's a reaction, which may or may not arrive in a timely fashion. Eventually, however, liquidity will have an impact and the debate about what comes next will be done.
In fact, we've already witnessed some of the impact in recent years in the form of price inflation across the spectrum of asset classes. Bull markets, in other words, have reigned supreme.
The Federal Reserve has, of course, been a co-conspirator in the liquidity boom. In fact, the central bank continues to keep M2 money supply bubbling to the tune of more than 6%, based on a year-over-year basis using weekly data. Through May 28, money supply increased by 6.4% over the past year. In contrast, the rate of growth in the summer of '06 was comfortably under 5%.
There are other measures of liquidity, and perhaps more relevant ones. But no matter which gauge you employ, the result is the same: the world is awash in capital. We know where the cash has gone; the question is where it's going in the coming weeks, months and years. Indeed, finding capital a home that offers an expected return that will beat the risk-free rate available is looking more challenging by the day. No doubt there's still opportunity left. But comparing that opportunity against the sea of cash-laden investors looking for financial salvation, frustration looks set to rise a notch or two.
June 6, 2007
IT'S ALL ABOUT INTEREST RATES--AGAIN
The yield on the benchmark Treasury is climbing--again.
Yesterday, the 10 year closed at just under 4.98%, the highest since last August. The immediate cause of the renaissance in the price of money is the growing suspicion that the recession has been postponed--again.
Almost no one's arguing that economic growth's about to explode on the upside, but the latest batch of data suggests that a contraction in GDP isn't imminent either. The most persuasive evidence came in yesterday's update on the ISM index of non-manufacturing activity, otherwise known as the service sector. The gauge rose last month to its highest since April 2006, reversing March's tumble and suggesting that growth still has some momentum.
But along with the upward momentum in business activity comes news that prices are following suit. As David Resler, chief economist with Nomura Securities in New York, wrote in a note to clients yesterday, "Non-manufacturing businesses continue to face rising prices as the prices paid index rose to 66.4 in May, the highest since last August (71.9)."
The bubbling of pricing pressure hasn't been lost on the bond market, which now sees fit to err on the side of caution as to what comes next. Adding to the anxiety in pricing money is yesterday's counsel from Fed Chairman Ben Bernanke on the always delicate matter of inflation. "Although core inflation seems likely to moderate gradually over time," the chairman said in prepared remarks for the International Monetary conference in South Africa, "the risks to this forecast remain to the upside."
The potential for future inflation trouble, in short, isn't quite dead, he warned--again.
Meanwhile, today brings news that the European Central Bank has raised interest rates--again. The Continent's benchmark refinancing rate was elevated to 4.0%, the highest in six years. "This decision was taken," said ECB President Jean-Claude Trichet, "in view of the prevailing upside risks to price stability over the medium term that we have identified through both our economic and monetary analyses."
The ECB, in other words, is worried about inflation--again.
"The ECB, like many others, may have underestimated the economic growth dynamic in the euro area," Thorsten Polleit, chief Germany economist at Barclays Capital in Frankfurt, told Bloomberg News today. "They will leave the door open for further rate increases by highlighting upside risks to inflation...."
There is a certain economic logic to the rising anxiety about pricing pressures generally, as per today's Wall Street Journal. "For the past decade, low-priced labor from China, India and Eastern Europe has helped much of the world enjoy economic growth without the sting of inflation," the paper reported. "Now that damper on prices is beginning to reverse -- and global inflation pressure is starting to build."
Chief among the smoking guns cited by the Journal is the fact that "many countries are operating at close to full capacity, facing shortages of everything from land to equipment. Western workers and their low-cost rivals both are winning higher pay, thanks to rising demand. In some cases, the global links of the economy are increasing costs rather than lowering them, as far-flung businesses compete for the same resources."
Dallas Fed President Richard Fisher agrees, according to another report in the Journal. "I sense that global capacity has moved from being a tailwind to a headwind in terms of inflation control," he told the paper's Greg Ip.
It's anyone's guess as to when, or if, the Federal Reserve will opt to hop on the rising-rate wagon. But it's clear that the odds of a rate cut in these United States looks somewhat dimmer today compared to last week. Yet the Fed fund futures market isn't convinced, at least not yet, that higher rates are coming. Looking at those futures prices early this morning, the outlook for keeping Fed funds at the current 5.25% remains the dominant view for the next several months.
But don't let the calm fool you. Indeed, this is no time to take long naps on the beach. Volatility may frighten Mr. Market, but a material shift in sentiment has been known to bring opportunity for strategic-minded investors who keep their cool and have cash at the ready to capitalize on a sudden spike in fear.
June 5, 2007
RISK IS STILL A FOUR-LETTER WORD
Rarely have so many earned so much for so long.
That sums up the performance record for the broad asset classes. By almost any measure, the past five years have been extraordinary. Rarely has everything run higher, year after year, and posted robust gains in the process.
One might think that the party would be showing signs of age after such an astonishing track record. But as our table below suggests, momentum in its upward form remains the dominant force in the markets this year--again. Indeed, red ink has been banished from the list.
Debating how long red will continue to be conspicuous in its absence from the performance tally should be topic number one for strategic-minded investors. By extension, one can reasonably question how long the mother's milk of this bull era will last, namely, liquidity, which has been exploding globally for some time now.
Of course, such topics have proven to be losers in recent history for the simple reason that taking on more risk has proven to be the winning concoction. Staying the course and committing more money to markets around the globe promises to remain the winning strategy, we're told by more than a few bulls. Perhaps they're right. We certainly continue to own a diversified portfolio, albeit one that's continually biased toward less rather than more risk as time goes by.
Nonetheless, full-blown discussions of risk are rare. Such is the power of bull markets, especially those that have been around for a while. Risk, by contrast, couldn't get arrested if it tried.
But as students of market history know, there is no return without risk, no bull without bear. The great unknown, as always, is the timing. On that we can offer no insight other than to opine that the cycle will one day turn and that the peak is closer today than it was yesterday, and will be closer tomorrow than it was today.
With that in mind, there are two basic paths one could choose. The first, which we wholeheartedly renounce, is declaring that a new era has dawned and that corrections of any magnitude or length are the stuff of history. The alternative is assuming that cycles remain intact, however much the past few years appear to contradict such thinking.
We offer no proof in defense of the latter except to point to the repeated rise and fall of markets over the course of time. That, of course, opens us to the charge of using history as a guide to the future. As such, we confess our guilt on that score. Our only explanation is that we are otherwise blind. Flawed though the past is for reading the future, it's all we have.
For those who agree, and are inclined to act accordingly, we point you to recent research by one Mebane Faber, currently managing director and portfolio manager at Cambria Investment Management in Los Angeles. Mr. Faber has crunched a considerable amount of market history for a paper titled "A Quantitative Approach to Tactical Asset Allocation," which can be read here and also in the Spring issue of The Journal of Wealth Management.
Among the paper's insights is the familiar counsel that diversifying across asset classes, selling in bull markets and buying in bear markets enhances risk-adjusted returns. The result comes primarily by reducing risk rather than elevating return, the research finds, echoing what others have said over the years.
If nothing else, the paper adds to the growing body of literature that argues for owning a mix of assets and rebalancing when the respective weights of those assets move to extremes. Alas, everything now seems engulfed in one of those extreme moments. History offers precious little context for navigating in these waters. Perhaps then it's time to reconsider the original zero-correlation asset class: cash. No, it won't make you rich, but its prospects for risk reduction are looking more alluring with each passing day.
June 4, 2007
Inflation, we're told, isn't a problem, and won't be any time soon. But we worry about the threat just the same. Maybe we're a victim of irrational pessimism.
Whatever afflicts our powers of analysis, there's no question that inflation's had a pretty good run since the Federal Reserve's founding in 1913. Yes, recent history offers reason to argue that the central bank has finally figured out how to tame the beast. Maybe, although we'll continue to reserve judgment, thank you very much. It's our money, after all, and we're reluctant to watch it slip away, in either relative-purchasing-power terms or through outright capital losses.
That said, we're not obsessed with inflation, or so we believe. Our allocation to gold, TIPS and other hedges against upward pricing pressures is still modest, bordering on insignificant if inflation were to come roaring back tomorrow. And by rank-and-file goldbug standards, our investment strategy could be confused with thinking that inflation has forever been banished.
Still, your editor recognizes that, in the long run, the political and economic pressures to inflate are potent, as a careful study of the past reminds.
Even at today's reportedly modest rate of inflation, the damage adds up as the years pass. Consider that what cost $100 in 2000 now, on average, sets one back to the tune of $120, according to the inflation calculator on the Bureau of Labor Statistic's website. In other words, a dollar's worth 20% less today than it was just seven years previous. That disturbing state of affairs has unfolded during what officially hailed as a triumphant suppression of inflationary forces!
The above calculations come by way of the government's definition of inflation, as per the consumer price index (CPI). By some accounts, the definition underestimates the true extent of pricing pressures. But for most investors, the opportunities are limited for hedging away inflation's corrosive effects. Gold, of course, is a traditional strategy, although few are willing to will hold more than a token amount of the metal. There's also the vast world of collectibles and commodities, but any number of issues plague this realm as practical tools for inflation-fighting inflation, ranging from illiquidity to volatility to lack of pricing transparency.
For most investors, that leaves inflation-protected Treasuries, or TIPS, as the more practical choice. But since the bonds are tied to CPI, buying them requires a certain amount of faith in the underlying benchmark. For some, that's asking too much, as we reported in the June issue of Wealth Manager magazine. Nonetheless, as the article reminds, most investors are stuck with CPI. For an exploration of the implications, read on....
June 1, 2007
WHAT HAVE WE LEARNED FROM THE MAY JOBS REPORT?
This morning's update on job growth for May offered a dose of encouragement for the stock market bulls.
The consensus forecast called for a net gain of 135,000 nonfarm jobs last month, according to TheStreet.com. The actual number exceeded the collective guess by a comfortable margin: a rise of 157,000 new jobs in the nation in May, the Bureau of Labor Statistics advised. Adding to the tally's shine is the fact that last month's gain nearly doubled April's lethargic advance of 80,000--the lowest in more than two years.
By recent standards, then, all looks well. The economy's ability to mint 157,000 jobs will be hailed as evidence that the gods of growth continue to hold the upper hand. Perhaps, although without knowing what the future will bring we can only look to the past for definitive clarity. On that score, there's reason to stay modestly cautious on the always precarious business of forecasting.
For those who're interested in a broader historical context, last month's 157,000 rise in nonfarm payrolls is hardly stellar, welcome though it is after April's stumble. Crunching the monthly percentage change in nonfarm payrolls for the past four years reminds that last month's rise is no more than middling, and that's by a standard that's been steadily slipping for more than a year.
Indeed, the trailing 12-month average percentage change in monthly nonfarm payrolls has been declining virtually nonstop since early 2006, as our chart below shows. Last month's 0.11% rise in new jobs exactly matches the average change for the past 12 monthly reports. Each and every investor must decide if such facts inspire confidence, despair or something in between.
That said, there's a case to be made for embracing the in-between theory, which runs like this: if the economy can maintain 150,000 new jobs a month, something approaching a sweet spot in balancing growth and inflation containment may be at hand for the foreseeable future. The jury's wide open on which outlook will prevail, but at least we can agree about the road that's brought us this far.