The Capital Spectator

The voices worrying about inflation are all the more timely with oil prices rallying anew, perhaps to a new all-time high in the near future. The question then becomes whether the public thinks inflationary pressures are on the rise. If the answer is "yes," then the fear may become a self-fulfilling prophecy. After all, there's a lot of consumers out there paying more for food and energy who are behind the times when it comes to reading the academic literature on core.

Posted by jp at 8:50 AM | Comments (0)

July 19, 2007

HEDGING AND HAWING

Maybe, just maybe, Fed Chairman Bernanke has no better handle on inflation's future than the rest of us.

Yes, Ben's a smart guy. To be precise, he's one of the most respected monetary economists in the country, if not the world. That's a big part of why he sits atop the world's most important central bank. But as his testimony yesterday to Congress suggested, even the mighty feel inclined to bow to the vagaries of the future when it comes to setting monetary policy for the morrow by making decisions today.

We refer readers to yesterday's news that core inflation continued to fall in June. By any reasonable standard, the trend should encourage the Fed, having professed for some time now that core measures of inflation are superior to headline measures for influencing monetary policy. But listening to Bernanke's testimony, we were struck by his tendency for hedging his comments about the prospects for keeping inflation contained.

At the heart of this hedging was the Fed chief's reference to rising headline inflation (which includes food and energy) at a time when core (which excludes those two items) is slipping. "Sizable increases in food and energy prices have boosted overall inflation and eroded real incomes in recent months--both unwelcome developments," he admitted in his prepared remarks. "As measured by changes in the price index for personal consumption expenditures (PCE inflation), inflation ran at an annual rate of 4.4 percent over the first five months of this year, a rate that, if maintained, would clearly be inconsistent with the objective of price stability."

The operative phrase is "if maintained." The central bank has the power to contain inflation, or let it loose, we believe. A quarter century of Fed experience, and three Fed heads suggest no less. As a result, there are no ifs and or buts about it. If the Fed is determined to keep the inflation genie in the bottle, there's no reason to think that an enlightened hawkish monetary policy won't do the job. It may not win Bernanke and company new friends, particularly in Congress. But monetary discipline, applies in a timely manner, will serve the economy and, more importantly, the American public. A central bank can provide no greater gift than price stability. What's more, the accumulated evidence over the past generation firmly supports that rosy view.

What then is there to argue about? Good question. Listening to Bernanke, however, one could be forgiven for thinking that central banking is a dark art, subject to strange phenomena that few can decipher, much less resolve.

"Because monetary policy works with a lag," he explained, "policymakers must focus on the economic outlook," he explained. Does this imply that monetary policy proper is too tough to handle directly and so the central bank must also seek pricing stability by trying to forecast the economy? If so, who among us believes that economic predictions are easier than deciding what constitutes sound monetary policy in the here and now? Or, to put it more bluntly, didn't Volcker and Friedman teach us anything?

Yes, core inflation is behaving as the central bank prefers, Bernanke said. On the other hand, headline inflation is rising again. But long-term inflation expectations are "contained" he added. In addition, futures prices suggest that "investors expect energy and other commodity prices to flatten out, and pressures in both labor and product markets [are] likely to ease modestly [and so] core inflation should edge a bit lower, on net, over the remainder of this year and next year."

The bottom line: the Fed's official forecast for core inflation (as defined by the core rate of personal consumption expenditures) is 2.0% to 2.25% for all of 2007, slipping to 1.75% to 2.0% next year. Sounds good to us. What's more, the Fed has the power to engineer that outcome, assuming it maintains policy discipline and doesn't waver as the election cycle heats up.

Why then all the hedging and hawing? Is inflation fighting still subject to variables beyond the central bank's control? Say it ain't so, Ben.

Posted by jp at 7:23 AM | Comments (0)

July 18, 2007

BETTING ON CORE

Inflation, the government reported this morning, was running at an annual pace of 2.7% through the end of June. That's near the fastest rate posted so far this year, falling just short of the 2.8% increase in March.

Granted, 2.7% by itself is nothing to lose sleep over, as headline rates of inflation go. But it's the upward bias that concerns us. After dropping precipitously in the second half of 2006, inflation has proven itself resilient in bouncing off the low-1% range that briefly triumphed last October, as our chart below shows.

Of course, the Fed looks to core inflation as the superior measure of inflationary trends. The reasoning is that by stripping out the statistically noisy elements of headline inflation (i.e., food and energy), a core reading of pricing trends offers a superior tool for predicting where headline inflation is headed. A number of studies conclude no less. As Alan Blinder, a former Fed vice chairman and currently a Princeton economics professor, told the Wall Street Journal last week: "The Fed is pretty powerless to do something about the price of energy or the price of food. I don't want to charge the Fed with responsibility for something it can't do."

Ok, so how does core inflation look? Judging by the latest numbers out this morning, there's reason for hope. Core CPI advanced by 2.2% for the year through last month--the slowest annual pace since March 2006. The downturn is even more dramatic if you consider that as recently as last September, when the annual pace for core ran at a steamy 2.9% rate.

Perhaps the Fed should declare victory and move on. The opportunity arises today when Fed Chairman Ben Bernanke begins two days of testimony in Congress.

But while core CPI continues to cooperate, there's growing anxiety in the forex world as the dollar shows signs of sinking further. Earlier today, the U.S. Dollar Index broke through its previous low set back in 2004. In turn, the dollar's ills have inspired the gold bulls anew. "I think there has been a little bit of improvement in investor interest in gold, David Moore, a commodity strategist at the Commonwealth Bank of Australia in Sydney, told Reuters yesterday. "I certainly think the weakening in the U.S. dollar has been a factor in that."

One factor driving the greenback lower has been the Fed's steady-as-she-goes routine with interest rates while the price of money has been rising in Europe. It remains to be seen if a further deterioration of the dollar, which implies higher inflation via imports, will be enough to push Bernanke to raise rates. The political timetable, meanwhile, suggests that any rate hike will come this year in a pre-emptive move to avoid tightening in 2008, a presidential election year.

But for the moment, there's no sign of rate hikes in the futures market, where Fed funds contracts continue to anticipate no change for the foreseeable future.

That leaves Bernanke's analysis over the next 48 hours as the next great variable to dissect. The burning question for us: does core's latest trend give the chairman comfort? We're all ears....

Posted by jp at 9:46 AM | Comments (1)

July 16, 2007

ANOTHER DESPERATE SEARCH FOR CONTEXT

Analyzing the past may give us a leg up on handicapping the future. Then again, it may not. The financial gods are funny that way: they keep us guessing and make no apologies. Nonetheless, we're sufficiently naive and properly motivated to look at the historical record anyway--and take our lumps when and if they come (which invariably they always do).

With that caveat out of the way, today's effort focuses on the 10 major sectors that comprise the S&P 500. To the extent that one can assess major trends in the recnet trading of domestic equities, clues may be ripe for the picking. We can begin by observing that energy is this year's big winner...again. Through Friday's close, the energy sector's up by a cool 24.8%, as the chart below shows. That's more two-a-half-times higher than the S&P 500's 9.5% year-to-date gain, which itself is impressive as broad-market averages go over such short periods.

Contrasting energy's stellar gain in 2007 is the modest slump in financials sector, which has shed 0.4% through June 13. Let's also note that while the financials sector is last in returns so far this year, it remains first in market capitalization. As our second chart below illustrates, financials are comfortably in the lead in receiving Mr. Market's blessing as top-valued dog. On that score, not much has changed in recent years. Meanwhile, energy, for all its performance momentum this year and in the recent past, is middling by market-cap standards.

In search of context for this state of affairs, one is faced with a number of possibilities. One is that investors have grown anxious with the outlook for the likes of Citigroup and Bank of America Corp. because of fears of subprime mortgage woes and higher interest rates, to name but two of the obvious suspects. A similar fear arguably harasses the interest-rate sensitive world of REITs, which have also taken it on the chin lately.

Energy, meanwhile, is bubbling on renewed fears that future discoveries of oil are expected to disappoint. Stoking such fears is a recent report by the International Energy Agency warning that the industry faces increasing difficulty in coming up with new sources of supply, particularly as it relates to non-OPEC production. One variable driving the forecast is the expectation that the global economy will stay robust. That's bullish for oil prices as well as interest rates, which translates into higher prices for energy equities and lower prices for financials. Or so a greatly simplified theory of the recent past asserts.

No doubt there's some truth to this explanation. But shades of gray are more likely to prevail than sharp tones of black and white when it comes to extrapolating the past into the future. Whatever ails financials, the sector has been extraordinarily profitable and the notion that the game is over won't fall quickly without overwhelming, sudden evidence to the contrary. In an age of globalized finance, the business of money has been spectacularly attractive and the assumption will continue to prevail until it won't.

Consider that the Q2 median earnings growth for financials so far, based on companies that have reported, is 17%, according to Zacks. That's much slower than 2006's hefty gain, but 17% puts financials second in 2007's Q2 horse race so far.

Then again, change comes slowly, stirring disbelief at first, but convincing everyone eventually. The art of searching for turning points is all too often a dangerous business. Without dramatic turns in short periods, mere mortals suffer the thankless task of sifting through bits and pieces of news in search of strategic context. The trouble is that any given number du jour is usually irrelevant to the larger aim of finding long-term relevance.

Recognizing the challenge may not help us with forecasting, but at least we're going into the job with eyes wide open.

Posted by jp at 9:45 AM | Comments (0)

July 13, 2007

THE SLUMP DU JOUR

No matter how hard you crunch yesterday's data, the number du jour reserves the right to surprise.

The latest example comes in today's retail sales report for June, which the government unveiled this morning. The crowd was looking for a flat June; instead, the report showed that sales slumped by 0.9% last month--the largest drop since August 2005, as our chart below shows.

Lower sales at auto dealerships were the primary cause for the decline, accounting for roughly two-thirds of the overall slump in retail sales. But as one economist remarked, there's reason to stay cautious. "These big declines [in auto-related sales] followed unexpectedly large gains in May and do not necessarily imply a marked erosion of retail activity," wrote David Resler, chief economist at Nomura Securities in New York, in a note to clients today. But then he qualified the statement by noting: "Nonetheless, the data do translate into a sharp slowdown in consumer spending -- to 1.5% to 2% --- in the second quarter that could be the start of a much slower trend in consumer spending for the rest of this year."

Perhaps the critical variable going forward will be real estate. If the worst of the real estate correction is over, as some predict, future GDP reports will look encouraging next to the meager gain for this year's first quarter. Julia Coronado, senior economist at Barclays Capital, suggested as much to this reporter at a press conference in New York on Wednesday. The drag on economic activity from real estate in the recent past has been significant, she explained. But if housing stops deteriorating, which seems likely, then that fact alone will provide potent support for GDP in the second half of 2007, she said.

In a handout to journalists at the Barclays briefing, the company wrote that second quarter GDP (which will be formally dispatched by the government in its initial estimate on July 27) will rise 3.0%, up sharply from Q1's 0.7%. Looking into Q3, Barclays predicted a 3.5% advance in GDP, followed by 3.0% for Q4.

Perhaps. But while that outlook assumes that housing stops falling, it also supposes that consumers will keep spending. Yes, there's been a downturn recently in the rate of increase in consumer spending, as the latest retail numbers confirm. But Coronado advised that there's a tight relationship between headline inflation and real consumer spending. When inflation rises, spending falls, and vice versa. But Coronado predicted that headline inflation will moderate, which in turn bodes well for consumer spending, she said. Further supporting that view, wage and salary income growth is rising at a healthy clip of about 6% annualized, Barclays' analysis showed. As a result, "consumption is still benefiting from positive wealth effects," the firm counseled in the accompanying handout.

However, even if that scenario comes to pass, it nurtures risk. A buoyant U.S. economy implies that energy prices will stay high if not climb further. In fact, the notion that oil prices will stay firm in the second half is a forecast that shouldn't be dismissed lightly, suggested another speaker at the Wednesday meeting. Kevin Norrish, a commodities analyst for Barclays, argued that growth in oil production in non-OPEC crude has fallen short of estimates while OPEC's discipline has strengthened in curtailing production. That, combined with the prospect of a bubbly U.S. economy in the second half of 2007 suggests that oil prices aren't likely to materially fall and in fact may even move higher. Maybe it's time to repeat the mantra: be careful what you wish for.

Posted by jp at 10:05 AM | Comments (0)

July 11, 2007

TAXES & ASSET ALLOCATION

Asset allocation is arguably the most-important decision facing strategic-minded investors. Meanwhile, taxes are inevitable, which implies that factoring in the government's skimming when designing portfolios is both practical and essential. Traditionally, however, the twain never meet. Research on asset allocation is usually conducted as if taxes didn't exist. The idea, then, of incorporating taxes into asset allocation analysis is eminently reasonable. In fact, there's a small but growing school of researchers who advocate no less. But the devil's in the details. Inserting tax strategy into portfolio design adds more complication. Does it also yield superior results? In search of an answer, your editor interviewed an authority on this budding area of study: Stephen Horan, head of private wealth at the CFA Institute. Our conversation appears in the current issue of Wealth Manager. You can also read the article here.

Posted by jp at 11:47 AM | Comments (0)

July 10, 2007

ANOTHER CRACK IN THE WALL OF BULL MARKETS?

Today's Wall Street Journal has a story suggesting that high yield bonds' days of flying high may be numbered. Perhaps, although in the year-to-date rankings for the major asset classes, junk bonds aren't yet waving the flag of capitulation.

Surrender thus far in 2007 remains contained to REITs, which are in the red through yesterday to the tune of -3.1%, as our table below shows. High yield bonds, by contrast, are still up by 1.6% through July 9.

Then again, don't let YTD numbers fool you. As the Journal article reminded, there's a number of reasons to wonder how long the junk rally can last. Indeed, the asset class of junk bonds has posted a gain in each and every calendar year starting in 2001. But signs of pressure are building, starting with the fact that the average high yield bond trades at yield premium of around 300 basis points over comparable Treasuries--down from 1000 basis points in 2002, the paper reported.

Of course, the compression of risk premiums is nothing new. Your editor has mentioned the trend more than a few times over the past year or so, only to watch Mr. Market ignore the advice.

Clearly, we have no influence in the wider world, but the fact remains that all the major asset classes have rallied together and for several years, suggesting that something may soon give. Measured over the past month, junk seems to be doing its fair share of giving. The Vanguard High Yield Fund (which we use as proxy in the table above) has shed 1.5% in the past four weeks, according to Morningstar.com. That compares with a 2.5% loss in Vanguard REIT Index Fund over the same period.

No one knows if more selling is coming. Judging by the last few years, however, tumbles have been a prelude to even higher prices. It's been the iron law for REITs, emerging market stocks, and other asset classes. But even iron laws melt under sufficient pressure. Alas, we can't say for sure when sufficient pressure will arrive. The next best thing is recognizing the warning signs and having cash at the ready for exploiting a meltdown.

Posted by jp at 9:47 AM | Comments (0)

July 9, 2007

BUSINESS AS USUAL?

Last week's economic news gave a fresh boost to the notion that long-term interest rates should be higher.

The 10-year Treasury yield surged upward on Thursday and Friday to close at just under 5.2%--the highest closed since June 14. The immediate catalyst was a week that, on balance, suggested a moderate bias for economic growth. A brief recap of the data that re-inspired the view that the economy's still humming runs as follows:

* ISM Manufacturing and Non-Manufacturing indices each climbed in June to their highest levels since April 2006 (see chart below).

* Non-farm payrolls rose by 132,000 in June. That's below the trailing 12-month average rise of 167,000 but it was high enough to convince the bond market that economic expansion remains intact.

Pessimists can counter that last week's numbers also gave us weakness in factory orders, which posted a 0.5% contraction for May. Meanwhile, initial jobless claims for the week through June 30 edged up to 318,000 from 316,000 previously. But tempering the negative aura in those gauges is the reasoning that factory orders reflect May activity vs. the more-recent measures portrayed in the ISM indices and non-farm payrolls. In addition, the downturn in factory orders was smaller than the consensus predicted. As for jobless claims, the 318,000 number was within the range of recent activity, making it easy to dismiss as a non-event for the moment, particularly in light of the payrolls and ISM data.

The bond market's initial reaction to the news was to give the growth outlook the benefit of the doubt and elevate interest rates. But like so much of economic analysis of late, seeds of doubt can be found with a little digging. "The [June payroll] survey suggests that the job market is holding up well despite the housing downturn and the slowing" in the broad economy, Moody's Economy.com chief economist Mark Zandi told USA Today via DelawareOnline. "Hiring remains sturdy and compensation growth firm."

But (there's always a "but" these days when someone comments on the economy) the all-clear sign is far from flashing, suggests Alan Blinder, a former Fed vice chairman and currently a Princeton professor. "The market is overlooking the slowing effect" of higher borrowing costs, he told Bloomberg News.

Yet the bond market had no use for such talk, at least judging by the last week's trading on Thursday and Friday. But while traders must come to definite conclusions with each trade, clarity isn't necessarily availing itself from the macro vista. The truth is, there are competing forces pushing to and fro on the economy and it's not yet clear which side will prevail in the immediate future. Real estate, high energy costs and (for the moment) rising interest rates threaten to derail what seems to be a modest bubbling of the economy. But the forces of growth aren't giving up so easily, as last week's data suggest and so the scenario analysis remains fluid by more than a little.

But while the bulls and bear continue to battle for the hearts and minds of investors generally, some things remain unchanged in the data ocean. Fed funds futures, looking out through the February 2008 contract, remain an island of tranquility in a churning sea of economic numbers. The dominant view here remains as it has for some time: no change in the current 5.25% Fed funds rate.

It's our guess that when and if we start to see a shift in this corner of the trading universe, a major re-examination of the future may be in the offing. But by that standard, steady as she goes remains the preference du jour. Momentum, after all, doesn't give way easily and on any given day, it's statistically reasonably to expect that yesterday's truth will define what unfolds in today's session. Yes, that can't run forever, but forever never comes today.

Posted by jp at 9:32 AM | Comments (0)

July 6, 2007

THE FIRST JUNK BOND INDEX FUND

High yield bonds are now well established as a strategic component for multi-asset class portfolios, but it wasn't until earlier this year that junk was packaged in an index fund. The Barclays iBoxx $ High Yield Corporate Bond ETF (Amex: HYG) is the first attempt to offer beta in something close to its pure form from the lesser-rated realm of fixed-income in publicly traded fund. But indexing is tricky when it comes to high yield bonds, as your editor detailed in the July/August issue of Wealth Manager. For a closer look at the fund, what makes it tick and the complications that accompany the task of passively investing in junk via an ETF, read on....

Posted by jp at 9:47 AM | Comments (0)

July 5, 2007

A 5-YEAR LOOKBACK

Looking in the rearview mirror won't tell you where we're going, but it will provide absolute clarity on what's come and gone. The conceit in giving historical analysis more than passing reference is that maybe, perhaps we can glean clues about the future despite all the compelling evidence to the contrary.

Yes, the jury's forever out on the value of looking back, but it lends a veneer of credibility to an art form that's always in need of a plausibility boost. With that caveat, we're about to engage in activity that, by our own definition, is questionable.

If anyone's still reading, we refer you to the chart below, which shows that oil and gold have been in the lead over U.S. equities and the dollar, as defined by the U.S. Dollar Index. What lessons can we draw from said chart? One is that investors (or at least gold traders) are increasingly concerned with inflation.

Inflation, as officially calculated by the Department of Labor, has risen by around 3% in the past five years. By that measure, one could be forgiven for yawning at the idea that inflation's a growing threat. On the other hand, gold has paid no mind to official government numbers and instead has climbed by nearly 16% a year since 2002. The greenback, in its usual role as moving inversely to gold, has lost roughly 5% a year over the same stretch.

An op-ed in today's Wall Street Journal from the principals of Wainwright & Co. Economics warned that increased concern with inflation risk is warranted. "For several years now, as was the case in the 1970s, all the world's currencies have been depreciating relative to stable benchmarks such as gold," the essay claimed. Why, then, doesn't the CPI echo the warning? "Gold is a fast-moving leading indicator, whereas consumer-price indices are slow-moving indicators that lag far behind," the authors wrote. "We all learned in the period between 1975 and 1985 that consumer prices do eventually catch up. It is the size of the move in the gold price, rather than in the consumer price index, that is a true and timely indicator of the magnitude of the inflation problem."

For the moment, the bond market disagrees. Although the benchmark 10-year Treasury yield shot up to over 5.3% last month--the highest in five years--the surge was brief. On Tuesday, the 10-year yield at one point dipped under 5% before closing at 5.05%.

But if inflation fears raise no eyebrows in the U.S., it's percolating elsewhere on the planet. That includes Britain, where the Bank of England just raised its benchmark interest rate by 25 basis points to 5.75%, the highest in six years. It was the fifth straight increase in less than a year. And more rate hikes may be coming for England, David Brown, an economist at Bear Stearns, predicted via Reuters.

"The pace of expansion of the world economy remains robust," the BoE's statement advised. "The margin of spare capacity in businesses appears limited, and most indicators of pricing pressure remain elevated. The balance of risks to the outlook for inflation in the medium term continued to lie to the upside."

By contrast, The European Central Bank left rates unchanged, although hints of a rate hike accompanied the non action. Jean-Claude Trichet, the ECB's president, said in a prepared statement that inflation risks in the medium term are "on the upside." He explained that "as capacity utilization in the euro area economy is high and labor markets continue to improve, constraints are emerging which could lead in particular to stronger than expected wage developments."

So far, none of this has made an impression on Fed funds futures, which remain priced in anticipation that Fed funds will stay at 5.25% in the coming months. Perhaps the U.S. economy rationalizes the current state of no action by the Fed. Debate rages about whether the economy's fated to contract or grow (albeit modestly) for the rest of the year and on into 2008.

Regardless, the pressure on the dollar looks set to grow if foreign interest rates rise while U.S. rates remain unchanged. If Fed policy is intent on weakening the dollar as a means of boosting exports, the plan is riding high. The question is what a further weakening of the greenback implies for inflation, or vice versa. The gold market seems to have an answer at the ready.

Posted by jp at 10:27 AM | Comments (0)

July 4, 2007

231 YEARS AND COUNTING...

We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.

Posted by jp at 10:17 AM | Comments (0)

July 3, 2007

ANOTHER SUMMER FOR THE BULLS?

Yesterday's upbeat news on the manufacturing sector enthused the stock market. The ISM Manufacturing Index climbed to 56%, its highest reading since April 2006. Equity investors took the obvious clue and reasoned that the economy is still bubbling, which of course it is. The trend encourages growth in corporate profits. Investors were in a mood to agree and the S&P 500 gained more than 1% yesterday.

The notion that corporate profits still have more room to run on the upside is no minority vision. The bulls are still in control of the psychological tone that permeates Wall Street and investment predictions generally. Yesterday's equity rally is one source of the tone, but there are plenty of other wells of optimism to draw on.

One example: a proprietary equal-weighted index of economic and financial variables calculated by yours truly suggests that the broad trend was distinctively bullish in May. And after reading the ISM report, there's reason to think that a rebound from this year's first-quarter GDP slump is under way.

Optimism about optimism, in fact, is evident far and wide. For instance, reports that hedge fund firm Och-Ziff Capital Management Group LLC is planning an IPO remind that these are golden times for raising capital, reporting profits and otherwise basking in the financial glory.

The trend holds at the micro level and rises to the macro. Corporate profits as a percentage of GDP--at around 10%--are at their highest since just after World War II. That works out to around twice the pace that's prevailed over the last half century or so. There's no doubt that the U.S. economy has been humming by more than a little, at least when viewed through the prism of corporate America.

But we shouldn't become overly complacent about corporate profits running skyward in relative terms, warns a new essay to clients of Guerite Advisors, a boutique mutual fund in Greenville, South Carolina. Citing Warren Buffett commentary from a few years back, Guerite asserts that reversion to the mean is a risk when corporate profits are riding high:

Why does gravitating back to the average (reverting to the mean) matter? First and foremost, the current level of the U.S. equity market has received a tremendous lift from rising corporate profits. A key factor to the stock market’s sanguine demeanor is the oft-repeated line that values remain “reasonable” compared to historical price-to-earnings (PE) ratios. The current trailing PE ratio for the S&P 500 Index is 18.3. This figure is often compared to the 57 year average PE ratio of 16.7. However, what is not widely emphasized is that the average PE ratio is based on average earnings over a wide variety of economic conditions. Applying an average PE ratio to maximum earnings (as is now the case) can allow an over-valued stock market appear reasonably-valued. Therefore, an investor must adjust the average PE ratio using an “apples to apples” adjustment. Using such an approach, the appropriate average (maximum earnings) PE ratio is 12.8, not 16.7. Cast in that light, the current valuation of 18.3 (versus 12.8) doesn’t appear so “reasonable”.