September 28, 2007
Let's get right to the point: the American consumer isn't easily distracted. A recession may be looming, the housing market may be swooning, but Joe Sixpack isn't easily discouraged from indulging in the great American pastime otherwise known as shopping.
As he has so many times in the past, Joe's keeping the economy bubbling in 2007, as this morning's update on personal income and spending reminds. In fact, the extraordinary staying power of the American consumer is that much more amazing as it comes in the face of lesser personal income last month. In theory, income and spending are joined at the hip. If you earn less, you spend less; earn more, spend more. No explanation needed. But that seemingly iron law only applies in the long run, and even then there's room for debate in a world of easy loans and a myriad of innovations to keep shopping habits alive and kicking. And once you turn to the short term, well, let's just say that logic and mathematical certainty are as ephemeral as the wind.
Consider the latest reading on consumer spending, which accounts for the lion's share of GDP. The government today reported that personal consumption expenditures (PCE) rose 0.56% in August vs. July. As our chart below illustrates, that's the highest monthly pace since April. Last month's rise is all the more impressive considering that it was accompanied by a lesser rate of increase in disposable income.
The notion that the economy may be bubbling more than some think also finds support in yesterday's initial jobless claims report. Last week's new filings for unemployment benefits fell to a four-month low, which implies that the outlook for economic momentum still looks healthy. Then again, this encouraging news was tempered by Thursday's report on new home sales for August, which confirmed what was already obvious: the housing market remains mired in a slump. Indeed, sales of new homes fell in August to the lowest annualized rate in seven years.
But for the moment, there's no obvious sign that the housing problems are spilling over into the labor market. That may soon change, and more than a few analysts are warning of no less. Perhaps, although Joe's still spending as we write. Even so, before we break out the champagne, it's worth taking a look at the broader context for consumer spending trends. As our second chart below indicates, there's reason to stay cautious about the coming months based on the fact that changes in PCE on a rolling 3- and 12-month basis is slowing.
This is a good time to point out that consumer spending can still grow in the midst of tough times for the economy overall. Take another look at the chart above and recall that during 2000-2002 the financial markets suffered their worst stretch in 30 years. Yet consumer spending at the time kept growing for the most part. Of course, the growth was relatively meager.
Is the growth of consumer spending fated to become meager once again? If so, what are the implications for the overall economy and the capital markets? Stay tuned.
September 26, 2007
THE GATHERING FORCES OF WEAKNESS
In search of economic signs confirming or denying the gathering weakness, this morning's durable goods report for August extends fresh support for the fear that the forces of darkness are indeed approaching. As our chart below shows, August witnessed the biggest monthly drop in percentage terms since January. It's also the first decline since May. If you ignore defense orders, new orders dropped by an even steeper 5.9% last month.
It's hard to put a positive spin on the latest durable goods report. The aura is that much gloomier when you couple today's news with yesterday's update on existing home sales, which tumbled more than 4% last month to the slowest annualized rate in five years.
It would be folly to dismiss the signs that the economy's weakening. On the other hand, all's not lost, at least not yet. Consider our second chart below, which puts today's weak durable goods report into broader historical context. As you can see, the latest dip, while troubling, is hardly definitive proof that recession is imminent. We're still within the range of volatility that's prevailed in recent years.
But let's be clear: the pressures are building and from the evidence in recent weeks it's only prudent to expect that the news will get worse before it gets better. That, at least, is our guess. But the economy is still standing and, despite all the hits continues to hold up, as far as we can tell at this point. If there's a deciding factor that will tip the balance one way or the other, that will probably be consumer spending, which accounts for more than 70% of GDP.
The next update on Joe Sixpack's spending habits comes on Friday, when the government releases personal income and spending numbers for August. The consensus outlook calls for a 0.4% rise in spending, according to Briefing.com. That would match July's 0.4% rise, suggesting that stability still dominates.
Yet even a 0.4% rise in spending would not dispel the notion that Joe's affinity for buying is weakening. The year-over-year trend has clearly been down in 2007. Consumer spending, while still rising, has been advancing on a 12-month basis by less than 5% recently, down from the 5-6% rate in 2006 and nearly 7% at times in 2005.
Momentum, down or up, isn't easily reversed when it comes to macro trends. That said, the anticipated slowdown is now widely anticipated. A change of course that brings a surprise burst of growth would likely trigger a large relief rally in equities.
Ultimately, the data will tell the story and by that standard the optimists are now in need of some statistical assistance--soon. The hour is late. Hope that growth can win one more time is still alive, but it's fading.
September 25, 2007
OPTIMIZING COMMODITY INDICES
Commodities have enjoyed a renaissance in recent years as a strategic tool in portfolio design. The allure boils down to the low correlation between the prices of raw materials and stocks and bonds. Adding commodities to a conventional investment portfolio enhances the overall expected risk-adjusted returns. But what looks good in an optimizer can get messy in the real world. Yes, there are a number of mutual funds and exchange-listed securities that offer investors one-fund solutions to owning commodities broadly defined. But when you buy one of these funds you're buying commodities futures rather than raw materials proper. There's nothing wrong with futures, and in fact they're a reasonable proxy for commodities. Then again, futures contracts are quirky animals and they introduce an additional layer of risk as well as opportunity over and above those dispensed by the underlying commodities.
A recently launched ETN seeks to exploit those risks and opportunities while still providing broad, passive exposure to the asset class. On the surface, the S&P GSCI Enhanced Commodity Total Return Strategy Index (NYSE: GSC) looks like one more fund tracking the Goldman Sachs Commodity Index. And to an extent, it's just that, considering that GSC stays true to its benchmark by weighting the various components as per the underlying index. Where GSC differs is in its management of the futures contracts. The idea is that GSC will outperform GSCI by taking a more proactive approach to exploiting opportunities and minimizing risk inherent in futures. Will it work? Kochis Fitz, a San Francisco wealth management shop, thinks so. In fact, the firm, which partnered with Goldman Sachs in GSC's design, initially invested $70 million in the new fund as a vote of confidence. Is the bet likely to pay off? In search of an answer, your editor recently interviewed Jason Thomas, chief investment officer at Kochis Fitz. To learn more, read on….
September 21, 2007
It's probably just coincidence but it's a striking one just the same.
Frederic Mishkin, a voting member of the Federal Open Market Committee, has a new research paper that considers the evidence that monetary policy has become more science than art over the past generation. By Mishkin's reckoning, nine "key principles" form "a set of basic scientific principles, derived from theory and empirical evidence, that now guide thinking at almost all central banks and explain much of the success in the conduct of monetary policy." First among the nine he cites: Milton Friedman's widely repeated observation that inflation is always and everywhere a monetary phenomenon.
Against that backdrop we turn to the latest money supply numbers from the Fed, which brings us through September 10. Considering the 50-basis-point cut in Fed funds earlier this week it comes as no surprise to learn that a bull market prevails in M2 money supply, the broadest measure published. In fact, in late August, the 52-week percentage change in M2 topped 7% for the first time in nearly four years, as our chart below shows. Although the surge pulled back in the last two weeks, the ascent remains intact. Until and if the Fed gives reason to think otherwise, a prudent observer of monetary trends would do well to assume M2's pace will go higher still.
No one should be shocked. M2's flight skyward has had a long and steady takeoff over the past several years and the Fed's now operating on the assumption that the economy's slowing. Trying to juice growth, as a result, is priority one and the weapon of choice is pumping up liquidity.
The question is what a strategic-minded investor should do? Some are opting for a hedge by voting with their wallets and converting paper into gold, the traditional store of wealth and insurance policy against the inherent risks of fiat money. Indeed, the precious metal yesterday had another big day, rising nearly $14 to almost $736 an ounce. That's the highest price for gold since the early 1980s.
In a related move, the dollar plumbed new lows. The historic inverse relationship between gold and the buck is alive and kicking, feeding off one another like gasoline and fire.
Ironically, the clear inflation warning emanating from the gold and currency markets finds no sympathy in the official inflation statistics published by the United States government. On Wednesday, the Bureau of Labor Statistics reported that consumer prices fell in August by 0.1%. Rarely has gold run up so quickly and sharply in the face of officially stated deflation. For the moment, at least, this divergence is in the running for the mother of all statistical disconnects in the field of economics and finance.
It requires no great insight to realize that someone's wrong about future inflation. CPI and gold can't both be right. One side or the other's headed for a massive dose of attitude adjustment. No one can be sure who's going to get stuck, or when, but we have our suspicions.
September 20, 2007
DOES THE DIP HAVE LEGS?
The August employment report, which posted the first monthly job loss in four years, is considered the leading smoking gun that convinced the Federal Reserve to cut interest rates on Tuesday. The worry, of course, is that a recession's coming. Why, then, is there no confirmation in the initial jobless claims so far this month?
This morning's update on new filings for unemployment benefits through September 15 shows that the trend through September's first half has been unmistakably down. As our chart below illustrates, new filings fell to 311,000 last week. That's the lowest since late July and slightly below the year-earlier level of 322,000.
It's too soon to declare that the risk of recession has passed, but today's jobless claims report raises another clue suggesting that maybe, just maybe, the Fed acted a bit too hastily. Indeed, you don't have to look too far to find a dismal scientist to argue that jobless claims in the low 300,000 level is considered normal in the context of an expanding American economy in 2007.
Of course, it would be foolish to read too much into this one number. Next week's report could deliver a stinging reversal of fortunes. Jobless claims are volatile, which is why the smoother four-week moving average offers a somewhat better picture of the larger trend. But as you can see from the above chart, the four-week average is trending down as well.
Ultimately, the true state of the economy can only be known ex post, which is to say after the data's published, scrubbed and confirmed. As such, the definitive word on the economy today will arrive some months down the road. For those who can't wait, the alternative is to look at every number as it comes off the statistical assembly line while trying to keep the big picture in mind. Good luck.
In sum, observers of the economic scene must choose either timeliness or accuracy, but you can't have both simultaneously. Yes, the choice is a thankless task for mere mortals-- and perhaps central banks too.
September 19, 2007
BULL MARKET WORRIES
Maybe the cut was justified, maybe not. But now that it's a done deal, investors are left with the job of deciphering the implications.
The immediate reaction on Wall Street: yee-hah! Stocks across the board surged in the wake of the Fed's bold 50-basis-point cut yesterday. The S&P 500 jumped 3% by Tuesday's close.
But there's more than one bull market unfolding, and therein lies the potential for trouble down the road. Indeed, it's hardly irrelevant that crude oil closed at a new high yesterday. Ditto for the ascent of gold prices, which climbed to over $720 on Tuesday.
But not every market's celebrating. The beleaguered buck took another hit on the news that the Federal Reserve lowered the price of money. The U.S. Dollar Index slumped half a percentage point yesterday, leaving it at a record low.
The falling dollar's not-so-subtle implication: higher inflation. One only has to look at the bull market in oil to understand the risk. The United States is the world's biggest importer of crude. It's safe to assume that foreign exporters of oil aren't insensitive to receiving payment in a currency that's falling in value. One way to offset the forex risk is to charge more for oil in dollar terms.
Yes, oil's a global commodity and its price is set internationally and so price-fixing is difficult if not impossible. But the next best thing is limiting production. OPEC will no doubt give that prospect serious consideration if the dollar keeps dropping.
Part of that consideration includes the issue of investing today to lift oil production tomorrow. Most if not all OPEC members are in need of technological upgrades to boost production to keep pace with rising global demand for the years ahead. But that takes money, and lots of it. Suffice to say, it's a hard choice. Will a sinking dollar make the choice easier to delay such investment? If so, how will that affect the price of oil?
Then again, the man who heads the Federal Reserve has a paper trail arguing that a bull market in oil doesn't necessarily bring higher inflation. The rationale is that oil prices are largely statistical noise and so they should be ignored when making monetary policy choices. Our guess is that notion will be put to the test big time in the coming months and years. The Fed, in short, will be proven right or wrong on the issue of whether higher oil prices can bring higher inflation. The question for strategic-minded investors then becomes: Is the potential risk worthy of hedging? That's another way of ask: How much confidence do you have in the central bank? Judging by the dollar's descent of late, there's no doubt where forex traders stand.
September 17, 2007
THE THANKLESS BUSINESS OF FORECASTING
On the eve of what may be the launch of the next big thing in monetary policy, we humbly ask: What have we learned this year?
One lesson is that while the future's always unclear, clues about what's coming are occasionally dispatched. Alas, those clues are often far more compelling in hindsight than they are in real time.
A case in point: Mr. Market snookered us back on June 13 of this year, when the 10-year Treasury yield briefly traded at 5.3%. Yes, that now looks pretty good when it's lined up next to the 4.46% yield at Friday's close. Back in June, your editor had an idea that something was bubbling in the credit markets, but we were less than convinced that buying 10-year Treasuries at a 5.3% was a no-brainer.
Three months later, it's clear that we should have been leveraging ourselves to the hilt to snap up the now-obvious rich payouts guaranteed by our friends in Washington. Indeed, bonds have outperformed stocks handily in the last three months by a robust margin. The iShares Lehman Aggregate Bond ETF is up around 4% on a total return basis through Friday's close from June 13 vs. a 1.5% loss for the S&P 500 Spider ETF.
So, what were we thinking in June? Or drinking? We were inclined to see the economic data as biased toward strength and so we thought rates might go higher, thereby raising questions about bonds. As it turned out, rates went lower, fueling a fixed-income rally.
Perhaps rates will go lower still. The Federal Reserve tomorrow is widely expected to lower Fed funds for the first time in four years. If so, might that trigger a fresh round of lower rates across the board?
While we ponder that one, consider what might happen if the Fed doesn't cut. "It's the most forecasted rate cut in history," Gary Kaltbaum, president of Kaltbaum & Associates, told USA Today. "If they don't cut, expect a 500-point drop [in the Dow Industrials] in minutes."
Surely, Fed Chairman Bernanke's aware of the market's expectations and will act accordingly. Yes, but the debate is now over defining "accordingly." The Fed head himself warned a few weeks ago that "It is not the responsibility of the Federal Reserve to protect lenders and investors from the consequences of their financial decisions."
Into this mix comes the reality that while the U.S. economy appears to be slowing, global growth is still bubbling. The net result, according to BusinessWeek, is "Bernanke's Dilemma." One dismal scientist distills the dilemma this way: "We've been revising the growth forecast for the U.S. down, and up for the rest of the world," Tim Condon, an ING in Singapore, told BW.
Risk is guaranteed for investors. Return is not. Over time, the only way to improve the latter is by mitigating the former and the tool of choice is diversifying across asset classes. Nothing reminds us of that more than a humbling experience at trying to second guessing the future. To which we might add: reminders are a constant presence in the investment universe.
September 14, 2007
ANOTHER LOOK AT TIMING
Asset allocation is widely accepted as one of the most important, if not the most important decision for strategic-minded investors. But even if you accept the premise--and there are many reasons why you should--there's still the question of how to manage the asset allocation strategy. The default choice is letting Mr. Market run the show, which follows a strict interpretation of modern portfolio theory. That is, own the world's stocks and bonds in their market-weight proportions and let the market rebalance the weights from there. Deviating from that approach embraces active-management risk, which of course comes in a rainbow of choices. One that caught our eye recently is a momentum-based tactical asset allocation (TAA) strategy designed by Mebane Faber of Cambria Investment Management in Los Angeles. His paper on the strategy appears in this year's Spring issue of The Journal of Wealth Management. No, we're not necessarily recommending the strategy, nor are we dismissing it. Readers will have to make up their own minds on its merits. That said, a closer look at Faber's strategy provokes worthwhile debate about how portfolios work and what investors can expect when it comes to second-guessing Mr. Market's global asset allocation. We recently interviewed Faber in the September issue of WM. You can read the conversation here....
September 13, 2007
THE TROUBLE WITH TOMORROW
With all eyes increasingly focused on employment trends, this morning's update on new filings for jobless benefits was a disappointment--a disappointment in the sense that it didn't tell us anything new that wasn't already apparent.
Initial jobless claims rose a slight 4,000 to 319,000 (see chart below) for the week through September 8, the Labor Department reported today. Yes, that's not the direction the optimists are looking for. But as smoking guns go, it's mostly a dud.
Further complicating the search for clarity, the four-week moving average of jobless claims declined slightly through September 8, as the second chart below illustrates.
What can we distill from the latest numbers? Not much. Yes, the reported trend in jobless claims gives no compelling reason to think that a stealth boom is about to explode. On the other hand, the pessimism that reverberates from last Friday's August employment report isn't yet confirmed in the initial jobless claims. That doesn't mean that confirmation isn't coming. But for the moment, there's no obvious statistical sign in this morning's report that the labor market's poised for an imminent and dramatic turn for the worse. The future, it seems, may take its own sweet time in arriving, frustrating those of us in need of instant satisfaction.
Economic growth, in short, continues until it stops. Clear and obvious warning signs may or may not arrive in a timely manner. That leaves mortal observers to sift through the data as it comes, looking for crumbs of insight when (and if) they're dispatched. One might be tempted to equate the task of standing guard for signs of economic danger with watching grass grow.
All of which reminds that a fair amount of subjectivity still hangs over next Tuesday's FOMC meeting, when the Fed will decide if the economy requires a change in the price of money, or not. The current target Fed funds rate is 5.25%, as it's been for more than a year. Common wisdom suggests that the Fed will cut rates by 25 basis points, perhaps 50 basis points to offset the anticipated economic slowdown.
For those looking exclusively at the housing market and the trend in monthly employment, the case for a rate cut looks persuasive. But a broader view of the world still raises questions--and risks. The sinking dollar, for instance, lends no encouragement for dropping rates. The battered buck hit a new low against the euro yesterday, and the prospect of lower U.S. interest rates implies that even lower lows may be coming.
No, the dollar isn't the only factor under consideration when it comes to the Fed's monetary policy. It may not even be a leading factor. Then again, no central bank worth its name can completely dismiss the news that its currency is sinking like a stone in the foreign exchange market. With that in mind, if there's any argument at all for keeping the dollar stable then there's also a case for minimizing any rate cut if not delaying it completely.
Alas, your editor's at a loss as to what is the ideal decision is at this moment. That, in turn, is directly related to our inability at seeing the future. Perhaps there are others who are also struggling with the interpretation of the broad array of economic and financial data. Fortunately, strategic-minded investors have a solution in the form of diversification across the major asset classes and the opportunity to add a currency-diversification overlay. Yes, the outlook is uncertain, and arguably getting more so by the day. The good news: diversification's still as valuable as ever, perhaps more so.
Meantime, there are three business mornings of economic updates left till the FOMC announces its new and hopefully enlightened monetary notions. If the data gods are in a generous mood, maybe they'll bring some much-needed clarity between now and 2:15 p.m. next Tuesday, Washington time. Maybe, but don't hold your breath.
September 12, 2007
WILL HIGHER OIL PRICES FORCE A REASSESSMENT OF CORE INFLATION?
The only thing worse than a slowing economy is a slowing economy harassed by rising oil prices.
That unpleasant combination seems to threaten at the moment. The U.S. economy shed jobs on a monthly basis in August for the first time in four years while a barrel of crude oil has made a fresh run upward to just under its all time high of $78-plus.
The powers that be at the latest OPEC meeting have just agreed to raise production quotas in a bid to keep crude prices stable, but the effort is expected to be a marginal solution, if that, for containing the ongoing bull market in oil. "The outlook is for the oil market to continue to tighten all the way through the fourth quarter and that's exactly what you are seeing reflected in the price," Kevin Norrish of Barclays Capital told Reuters today. "What happened at the OPEC meeting doesn't alter that perception one bit. The [production] increase was relatively modest."
The implications of a slowing U.S. economy and oil prices that remain high are many, and not necessarily encouraging. One issue that arises is the prospect of the energy market exacerbating the economic slowdown. The odds of this risk may be rising to the extent that the U.S. economy is decoupling from the global economy.
Exhibit A in the decoupling argument is China's economy, which continued roaring higher by a real annualized 11.9% in the second quarter vs. 1.9% for the U.S. If China and other "emerging markets" are increasingly driving the price of oil, a bull market in energy may prevail for longer than a U.S.-centric view suggests.
The possibility of oil prices staying high while U.S. growth weakens raises a number of challenges. We'll focus on one: the expected impact on inflation. The prevailing view at the Fed is that core measures of inflation (i.e., excluding food and energy) are superior for estimating future headline inflation. The basic idea is that rates of change in core and headline inflation eventually converge even though in the interim one index can deviate sharply from the other. But as a forecasting tool, core is said to be superior because it delivers a lower amount of statistical "noise" compared to headline. For those who accept this line of thinking, core measures of inflation of late offer support for the view that inflation's contained.
The main reason for rethinking the wisdom of core comes from the idea that the energy market's cyclical dynamic has changed. For much of the oil industry's history, energy prices have generally followed a boom-bust cycle with prices rising sharply followed by dramatic price declines. But in the 21st century, one school of thought argues that the boom-bust profile of energy markets has ended, or at least diminished substantially. If so, that raises doubts about using core inflation as a superior predictor of headline inflation over time. In other words, ignoring energy if it's now in a long-term uptrend suggests that headline inflation may now be superior over core for gauging the general direction of prices.
In fact, there's some evidence suggesting just that. In the past, core and headline inflation (measured by the relevant personal consumption expenditures indices) have deviated in the short term but eventually converged in recent five-year time frames. But the trend toward convergence seems to have faded lately. Simply put, higher headline inflation doesn't appear to be coming back in line with lower core. If this continues--which it will if energy's in a long-term bull market--setting monetary policy by watching core inflation will underestimate inflation's trend by more than a little.
One can only wonder if Bernanke and company recognize the risk. Presumably, they do. The Fed, after all, draws on one of the largest economic research teams on the planet. If there's a trend in economics, someone at the central bank is documenting it. That said, the Fed's room to maneuver on monetary policy may be narrower than Wall Street realizes. Much depends on how energy reacts to a slowing U.S. economy.
September 11, 2007
SIX YEARS LATER...
Sad memory wakes anew at morning's touch
And, as some muscles move without our will,
She seizes, with involuntary clutch,
The sorrow that we hate, our bosom ill;
But we are formed with such fine wisdom, such
A Providence our moral need supplies,
That we can seldom overrate our sighs
Nor prize our organs of regret too much;
Then welcome still these ever-new returns
Of anguish! Who escapes or can escape
The burthen, while the great world sins and mourns?
Grief comes to all, whatever be her shape
To each, but we are framed with pain to cope;
And, when we bow, we help our climbing hope.
Charles Turner, Morning Sorrows
September 10, 2007
BERNANKE'S BIG TEST IS ABOUT TO BEGIN
The Federal Reserve is virtually certain to cut Fed funds rate in the wake of Friday's news that the economy is shedding jobs for the first time in four years. But the anticipated easing still comes with risks.
It's not obvious that more liquidity is the solution for what ails the economy. The return of job losses after four years of gains may simply be the natural ebb and flow of the business cycle. There's a general sense that such cycles have been banished to the dustbin of economic history, but that's a premature conclusion. Yes, the Fed has learned how to smooth the business cycle with tactical injections of liquidity. But there's no free lunch and it's possible that keeping deep recessions at bay all these years has been a temporary triumph that's had the unintended effect of letting excesses build up to the point that they're now set to burst forth.
If the cycle is poised to reassert itself on the downside, the Fed will no doubt intervene in an effort to keep the economy bubbling. The past 20 years have shown that the central bank is inclined to do just that. But at what cost? Has the smoothing of the business cycle in past years dispatched the fallout or simply rolled it into the future?
The economy may be weakening but the cause doesn't fit neatly into the classic boom-bust story. In the old days, the Fed would choke off rising economic growth by raising interest rates, sometimes by too much. The tightening brought recession, which in turn spurred the Fed to ease to induce growth once more.
This time, however, it's debatable if the economic slowdown that appears to be in progress is directly caused by excessive monetary tightening in the traditional sense. The Fed funds rate has been at 5.25% since June 2006, but the charge that the price of money's been too high is exaggerated. Only in recent weeks has the cry for lower rates gained critical mass.
Judging by the 10-year Treasury yield, for instance, interest rates have been fairly low by historical standards. One reason the 10-year yield's been relatively low is the surge of liquidity in the global economy, a large chunk of which has been routinely flowing into the U.S. The Fed controls the domestic money supply in theory; in practice, central banks around the world have a growing sway on U.S. liquidity levels. As you may recall, it was Fed Chairman Bernanke who promoted the notion a few years back that a savings glut was evident in foreign economies, notably in Asia. Last we checked, the glut's still intact overseas.
Nonetheless, the Fed will probably lower interest rates. But for an economy that's been swimming in liquidity for several years, arguably to excess, it remains to be seen if more of the same will induce the old magic one more time.
Simply put, there are risks to doing nothing and there are risks to cutting. The conventional wisdom now is that the risks of the holding rates steady outweigh cutting, and so lowering Fed funds is now a forgone conclusion when the FOMC meets on September 18. In fact, the futures market expects that Fed funds will fall to 4.50% by the end of this year, 75 basis points below the current 5.25%.
The cause, at least will be clear: the economy seems to be weakening, or so the August employment report advised. But that doesn't automatically mean that the excess liquidity that's built up in recent years has evaporated. Indeed, the inherent conflict between the central bank's dual mandate of containing inflation and maximizing employment is especially perilous at this juncture.
That, at least, is one interpretation after witnessing the renewed rise in the price of gold. An ounce of the precious metal changes hands at a spot price of $700, the highest in more than a year and up 7% from a month ago. Some of the surge is directly tied to worries over future inflation, which may rise if the Fed overshoots on its new adventures in liquidity injections. M2 money supply is already rising at a healthy clip--up by 6.3% at an annual rate for the 13 weeks through August 28. That's up sharply from a 3.7% pace in M2 growth from a year earlier.
In a related concern, the gold market notices that the dollar's getting weaker, a trend that will accelerate if the Fed drops interest rates. Gold and the buck historically have shared an inverse relationship, with each moving in the opposite direction relative to the other.
The U.S. Dollar Index on Friday slipped below 80. Save for a brief time in 1992, the U.S. Dollar Index has never traded that low in 35 years. The dollar, in short, is probing new and uncharted depths in the modern era of free-floating currencies. The Fed can't ignore the fact that lowering rates will almost surely hasten accelerate the pace of the dollar's descent, which in turn will embolden the gold bulls. At the same time, the Fed's under enormous pressure to lower rates to head off what may be a recession.
This, dear readers, is the monetary rock and the hard place. It's been a long time coming. Mr. Bernanke, as a result, is facing what seems likely to be the test that defines him, for good or ill, as a central banker.
September 7, 2007
A DARK CLUE?
Is the bond market finally right? It's starting to look that way.
Yesterday we discussed the latest slide in the 10-year yield and presumed that it reflects rising pessimism in the fixed-income set that future economic growth will disappoint if not evaporate completely. This morning, the argument for that pessimism received another piece of supporting evidence in the August jobs report.
Nonfarm payroll employment slipped by 4,000 in August from July, the Labor Department reported. Statistically, that works out to a wash in a labor force numbering upwards of 138 million. Nonetheless, there are still several reasons to embrace the warning signal embedded in the report.
First, consider the chart below, which graphs the monthly percentage change in nonfarm payrolls. It's clear that the trend has changed this year and for the worse. Only the financial gods know for sure what comes next, but mortal observers will have no trouble drawing rather dark conclusions from the trend. An economy that had been creating jobs fairly steadily is now an economy that's treading water in minting employment opportunities. Is the next phase an economy that destroys jobs?
The trend looks better if you look at the pace of job growth on a year-over-year basis, as per our second chart below. By that definition, nonfarm employment rose 1.2% in August compared to a year ago. But the trend still doesn't inspire. An annual rise in jobs of 1.2% is the slowest in over three years and the downward momentum looks like it has a head of steam.
Then again, it's worth noting that last month's slippage in private-sector employment generally was exclusively due to job losses in construction and manufacturing/goods producing. By contrast, the other major areas of private employment posted gains, including the single biggest source of private jobs: services employment, which rose by 0.5% in August.
The great debate now is whether the pain in the goods-producing area spills over into the broader employment picture. Optimists think the answer is no, an outlook that jibes with the forecast that the real estate correction will remain an isolated problem without triggering a recession.
Hope isn't dead, although it took another blow this morning. Meanwhile, the case for dropping interest rates just got another bit of statistical support. This much, at least, is clear: each and every economic number dispatched will take on more import than the one that preceded it for swaying Mr. Market's sentiment.
September 6, 2007
BACK TO THE (GHOULISH) FUTURE
When the 10-year Treasury yield briefly dipped under 3.10% on an intraday basis one day in June 2003, some thought a milestone had been set that would last for years, even decades. But suddenly there's reason to wonder if the era of low rates is poised for renaissance.
The immediate cause for such thinking comes from looking at yesterday's action in the bond market. The 10-year yield closed at 4.47%. That's the lowest close this year, as our chart below shows.
That may come as a surprise for some, although in the broader context of history it doesn't look out of place. As our second chart below illustrates, the longer history has been one of falling interest rates, interrupted only by temporary jumps higher. The latest jump upward has been unusually long. But is it temporary? Or is the longer trend of falling rates reasserting itself once more?
It's been popular to look at the trend since the low of June 2003 and conclude that the era of cheap money has ended and that rates will slowly but inexorably rise from here on out. The prediction has more or less held true in the last four years or so. But after yesterday's dip, one might take a minute to reassess the implications for portfolio strategy if rates take a turn south in a big way.
The questions are all the more relevant given the economic climate of late. Many on Wall Street expect that the Federal Reserve will soon lower its key Fed funds rate by 25 basis points to 5.0%. In fact, Fed fund futures are priced in anticipation of Fed funds falling to 4.50% by January.
Much of the support for forecasting lower rates rests on the belief that the economy is weakening, perhaps by more than a little. So far, however, there's not much statistical support for the darker predictions. This morning's update on weekly jobless claims, for instance, continue to hover in a range that's prevailed for months. In fact, new applications for unemployment benefits dipped for the week through September 1 to 318,000--down from the prior week and roughly unchanged from a year ago.
The primary catalyst for thinking that the economy still faces serious headwinds is real estate. On a range of measures, the residential property market in particular continues to suffer, suggesting to some analysts that it's only a matter of time till the pain spills over into the general economy. The thinking here is that consumer spending will take a hit once the sobering trend in housing (i.e., lower prices, fewer buyers) takes a negative toll on Joe Sixpack's buying habits.
That, at least, is the theory. The jury's still out, although the bond market seems close to coming to its own private verdict, namely, the economy's headed for rougher waters. The bond ghouls have been wrong before, of course. What's more, it wasn't that long ago that many economists were predicting that the worst of the real estate bust was behind us. Nonetheless, pessimism seems to have the upper hand--again.
September 5, 2007
PONDERING MULTI-ASSET CLASS PORTFOLIOS
Asset allocation is built on the premise that some asset classes zig when others zag. Recent history has put this notion to the test as virtually everything has run up in price. Yes, there's been a correction of sorts in July and August, but red ink still remains scarce so far in 2007 among the major asset classes. The notable exception is REITs, although considering that the asset class soared 35% last year leaves more than a little room for correction in 2007 without materially impacting the general uptrend. The question of what the flowering of bull markets across the board implies for asset allocation strategies was a topic for this reporter in the current issue of Wealth Manager. Easy and obvious conclusions are elusive, but pondering what it all means nonetheless offers some healthy food for thought for strategic-minded investors. If you're inclined to take a bite, here's today's blue plate special.
September 4, 2007
IT'S STILL A GOOD YEAR…SO FAR
The capital markets greet September with many questions. But whatever perils or opportunities await, the year-to-date tally doesn't look all that bad.
August was a rocky month, but the bulls remain the dominant species on Wall Street. That may change, of course, but for the moment the numbers speak for themselves. Everyone's favorite benchmark--the S&P 500--is up 5.2% on a total return basis in 2007 through August 31. Not bad, if you consider that on an annual basis that represents above-average performance.
In fact, the major asset classes are still bubbling in 2007. Some may be battered a bit after August's slings and arrows. But the upward bias appears intact on a collective basis. That's not to say that smooth sailing's assured for the remainder of the year. But one can at least look at the trailing numbers and dream.
Consider that a standard 60/40 portfolio mix (60% U.S. stocks/40% U.S. bonds) is up by 4.2% on a total return basis this year through August 31, as our chart below shows. That's in line with the gain from a portfolio that equal weighted the major asset classes at the end of each month. Equal weighting isn't necessarily a superior strategy, but it's a useful benchmark for suggesting what's possible for diversification-minded investing.
The equal weighted portfolio is comprised of the following:
* Cash (3-month T-bill)
* U.S. stocks (Russell 3000)
* U.S. REITs (DJ Wilshire REIT)
* U.S. Bonds (LB U.S. Aggregate)
* Inflation-indexed Treasuries (LB U.S. TIPS)
* U.S. high yield bonds (iBoxx HY)
* Foreign developed mkt stocks (MSCI EAFE)
* Emerging mkt stocks (MSCI EM)
* Commodities (DJ-AIG Commodity)
The question, of course, is can the upward momentum continue? Much will depend on how the economy fares. There's a fair amount of debate as to whether the mortgage troubles will spill over into the general economy. We don't have a better guess than anyone else, but we can look backward with clarity and observe that the growth machine is looking weary.
Consider our proprietary index of economic indicators, which we call the Capital Spectator Economic Index, which you can see below. It's an equal weighted mix of 13 leading, coincident and lagging indicators (see list at bottom) that, we believe, offer a broad measure of economic activity. The calculation is such that a rise in the index reflects growth. But as you can see, the CS Economic Index (updated through the end of July) is looking sluggish. It managed to eke out a small gain in July, but the upside action of late pales to the good old days of past years.
Yes, the Fed may be able to pull a monetary rabbit out of the hat, but the trick doesn't impress as it used to. Adjusting interest rates is a potent tool, but it's one prescription and it doesn't cure every ailment under the sun. Still, don't underestimate Bernanke and company. And as Mr. Market's action so far this year suggests, hope of one more home run (or at least a single or double) can't be dismissed yet. Nonetheless, it may be later than it appears if you're looking exclusively at trailing data.
CS Economic Index components:
Avg weekly hours of prod workers
Total nonfarm payrolls
Interest rate spread (10yr Treas - Fed funds)
Mfg's new orders (advance)
Disposable personal income
Personal Consumption Expenditures
New home sales
University of Mich Consumer Sentiment