February 29, 2008
WHAT'S UP (OR DOWN) WITH CONSUMER SPENDING?
On the surface, consumer spending appears to be holding up, and surprisingly well, considering the barrage of discouraging economic and financial trends harassing the waking hours of our hero, Joe Sixpack, of late.
This morning's update on personal income and spending in January reveals that personal consumption expendtires rose 0.4% last month, up slightly from December's 0.3%. That's about average if we look at the past two years of monthly PCE spending patterns. If we leave it there, we can say that Joe's spending habits haven't changed much, at least in nominal terms. Extending the thought, perhaps worries of recession are excessive. Consumer spending, after all, represents 70% or so of GDP; if Joe's still pulling out his wallet as always, the odds of a deep and/or lasting economic stumble may be overbaked.
But as regular readers of this site are all too aware, we're never willing to "leave it there." Obsessed with the idea that there may be a more granular truth lurking in the numbers, we push on, wondering if we've missed something in the 30,000-foot survey.
On that note, let's dive a bit deeper into today's spending update by noting that the 0.4% rise in PCE last month all but evaporates when we adjust for inflation. Real PCE spending was unchanged (based on rounding to one decimal point) in January. In fact, that's the second month running that real PCE was flat, and it was the third instance in the last four months. Stepping back and looking at the broader trend in real personal consumption spending only reaffirms the message in the last few months, namely, a slowdown in Joe's willingness and/or ability to spend after stripping out inflation, as our chart below illustrates.
If the trend raises questions about the future, breaking out real spending by the major categories provides even more incentive for staying cautious on the question of, What's next? Durable goods spending last month fell by 1.3% last month from December, measured in real terms at a seasonably adjusted rate--the fourth monthly decline in a row. Nondurable goods spending slipped too, albeit at a comparatively modest -0.2%. Only services-related spending managed to rise in real terms last month, advancing by 0.4%.
The implication: consumer spending, after cutting away the distorting cloud of inflation, is generally falling, and arguably looks set for more of the same in the foreseeable future. The hope is that the Fed and Congress can arrest the trend via rate cuts and fiscal stimulus, respectively. Perhaps, although there's a cost to everything, starting with the risk of trading a cyclical downturn for higher inflation. In addition, there's the added worry that even if Washington is able to engineer a bounce in consumer spending, the effect will be temporary and so a "W" recovery may be coming. That is, we'll see a modest bounce down the road, but it'll give way to another dip before the real upturn takes root.
This is all speculation, of course, and so this essay may end up being one more hockey puck added the junk yard of discredited analytics. So it goes in attempting the impossible: forecasting tomorrow with yesterday's data. To which the only antidote is watching, waiting and looking at the new numbers as they come in, which is the worst possible solution except when compared to the alternatives (our apologies to Churchill). Stay tuned.
February 28, 2008
THE REAL TEST
CNNMoney calls it a "high wire act." BusinessWeek says Bernanke "faces stiff headwinds." And Allan Meltzer in today's Wall Street Journal asks if the Fed has "reverted to its mistaken behavior in the 1970s?"
The immediate source of the sobering commentary is yesterday's chit chat between the House financial services committee and Fed Chairman Bernanke, who emphasized that the central bank is focused on the softening economy, by which he means that inflation fighting is of secondary import, at least for now. Suffice to say, that's a provocative idea with inflation on the rise. In any case, it's clear that more interest rates cuts are coming, a prospect that helped the dollar sink to new lows against the euro and raise questions anew about the future of inflation in these United States.
"The continued focus on the weak growth outlook supports our view that the Fed will cut rates by 50 basis points - when it meets on March 18 - and will continue to cut rates beyond that in order to limit the downside growth risks," Drew Matus, economist at Lehman Brothers, told the Financial Times today.
Hardly anyone disagrees, although not everyone's celebrating. "Bernanke has really overweighted the economic risks relative to inflation,'' John Silvia, chief economist at Wachovia Corp. explained in a Bloomberg News story. In fact, "he may get some disagreement'' among colleagues on the Federal Open Market Committee, Silvia speculated.
The disagreement, of course, is whether the Fed's planting the seeds for higher inflation. That's a debate that will be ongoing for some time because a definitive answer one way or the other won't arrive for months, perhaps years.
But for the moment the Fed is likely to keep cutting for two reasons. One, the economic reports continue to reflect weakness, and so the perception that the country needs more economic stimulus is now widespread. Two, the bond market is still on board with the Fed's game plan. When one or both of these factors reverse, the proverbial jig may be up and the central bank may be forced to hike rates, perhaps sharply and quickly.
For now, Bernanke can keep pushing rates lower without fear that inflation expectations are soaring. One measure of the market's outlook for inflation is measured by the breakeven rate, defined as the spread in the nominal 10-year Treasury yield over its real yield in its inflation-indexed counterpart, a.k.a. the 10-year TIPS. By that standard, inflation expectations haven't changed all that much from the perspective of recent history. Then again, those expectations have recently turned up.
Note that the last data point in the above chart is through yesterday, February 27, which closed with an inflation expectation of 2.4%. That's middling by the standard of the last four years, and so the Fed may still have room to lower interest rates without sparking worries that it's letting inflation momentum build. And as a number of studies over the years remind, managing inflation expectations is crucial to keeping a lid of prices generally.
Still, no one should assume that inflation expectations can't rise quickly. Recall that in mid-2003, inflation expectations were running at 1.6%, according to the nominal/TIPS yield spread; by early 2004, the market was anticipating inflation at over 2%, a prediction that rose as the year rolled on, hitting 2.6% by May 2004.
For good or ill, the Fed watches this measure of inflation expectations closely, said Larry Kantor, head of research at Barclays Capital in New York. He spoke yesterday at a press briefing attended by this reporter and other journalists. As a former economist with the Federal Reserve Board, Kantor knows a thing or two about how the central bank operates. As such, we were all ears when Kantor advised that "the real test is if the breakeven [rate] moves up."
February 26, 2008
WHOLESALE PRICES KEEP RISING
This morning's update on wholesale prices brings more bad news on the inflation front. Producer prices jumped a seasonally adjusted 1.0% last month, elevating the 12-month pace to an eye-popping 7.7%--the highest since September 1981.
Higher energy prices are partially responsible for PPI's ascent, but this is no longer solely about oil and gas prices, as today's report reminds. A few examples from the Labor Department's press release:
* The index for finished goods excluding foods and energy accelerated to 0.4 percent in January from 0.2 percent in December.
* The index for pharmaceutical preparations advanced 1.5 percent after increasing 0.4 percent in the prior month.
* Prices for light motor trucks and passenger cars turned up after falling in December.
* The Producer Price Index for Intermediate Materials, Supplies, and Components rose 1.4 percent in January following a 0.2-percent decrease in December. This upturn was broad based.
Clearly, wholesale and consumer prices are now rising at uncomfortable levels. Maybe they'll cool down, maybe not. Meantime, the prevailing wisdom at the Fed has been that the slowing economy will take the wind out of inflation's sails, leaving Bernanke and company with freedom to continue dropping interest rates. That future may be coming, but so far there's little sign that the pricing trend is cooperating.
It remains to be seen if the Fed will continue to sit on its monetary hands while inflation continues showing signs of life. If the current scenario continues, the central bank risks losing control of the pricing momentum and 20 years of hard monetary work hang in the balance. Indeed, some hawks already complain that the Fed's already lost control. We're not quite so pessimistic and so we still believe that Bernanke can nip the pricing troubles in the bud before inflation takes on a life of its own. But the opportunity won't last forever if the prices keep running higher.
Time's running out. If the inflationary momentum doesn't show a sustainable downturn soon, or at least tread water, the Fed will have to act—either that or risk even higher inflation in the years ahead.
February 25, 2008
RULES OF THE GAME
Inflation seems to be bubbling again in the U.S., but not enough to convince everyone that the pricing cat's out of the bag. But if it's still easy to dismiss America's uptick in pricing pressures, the task becomes tougher when considered globally.
As inflationary sightings around the world rise, the probability also increases that the general trend reflects something more than a statistical anomaly of limited relevance. The reasoning unfolds as follows: Inflation is primarily if not wholly a byproduct of monetary mismanagement. Meanwhile, there are many central banks operating on the planet, and many operate independently of their counterparts. The evidence is found in the fact that rates of inflation and money supply growth and interest rates vary. No one would confuse the state of monetary affairs in Japan, for instance, with that of the U.S. Japan has a number of economic challenges, but rising inflation isn't one of them. The U.S., by contrast, seems to be looking at a more challenging inflationary scenario. To the extent that such differences apply, the source of the praise or disapproval frequently lies with the local central bank.
Of course, globalization has dimmed the power of central banks compared to the past. But the loss of sway over prices is far from absolute. Central banks still matter, which is to say they continue to wield enormous influence over prices in the long run. Accordingly, central banks, if they're so inclined, can unleash the forces of higher or lower inflation.
A quick digression: we're defining inflation as price increases due to something other than shifts in supply and demand. If the price of widgets rises because several widget factories burn down, that's not inflation as we're defining it here. Similarly, if widget prices fall because some clever company devises a more-efficient process for manufacturing widgets, that's not deflation, at least not a deflation engineered by a central bank. On the surface, the average consumer may not recognize the difference, but in macroeconomic and monetary terms the distinction matters a great deal.
With that in mind, we note that inflationary flare-ups, albeit still mild, are popping up around the globe lately. Among some recent examples:
* Australia's core inflation is running at "16-year highs." --Wall Street Journal, February 25, 2008
* "In Saudi Arabia, where inflation had been virtually zero for a decade, it recently reached an official level of 6.5 percent, though unofficial estimates put it much higher. Public protests and boycotts have followed, and 19 prominent clerics posted an unusual statement on the Internet in December warning of a crisis that would cause “theft, cheating, armed robbery and resentment between rich and poor." -- New York Times, February 25, 2008
* "Euro-zone inflation may be more robust than the European Central Bank expected at the end of last year but this is a 'temporary phenomenon' linked to high food and energy prices, ECB Executive Board member Juergen Stark told a German magazine.
'We are highly dissatisfied with the current inflation rate. But it is a temporary phenomenon, caused by a strong rise in food and energy prices,' Stark told WirtschaftsWoche in an interview." --Reuters via Guardian.co.uk, February 23, 2008
* "China's consumer price index (CPI), the main gauge of inflation, retouched an 11-year monthly high with a 7.1-percent rise in January ." --Xinhua via ChinaDaily.com, February 25, 2008
And, of course, the U.S. inflation appears to be marching higher again, too, as we noted last week.
Perhaps all the inflationary bubbling will fade under the weight of an economic slowdown that's widely expected in the U.S. and Europe. A number of central banks are forecasting just that, and for good reason. If a slowing economy takes the edge off inflationary pressures, the cycle will do the heavy monetary lifting for central bankers, who will be free to focus their monetary efforts on juicing growth.
But stagflation--slowing economic growth and rising inflation--can't be ruled out just yet. Indeed, Federal Reserve policymakers seem to be expecting a touch of stagflation in the foreseeable future. According to minutes from the Fed's policy meeting in January, policy makers raised their predictions for inflation and lowered their forecasts for growth. "The central tendency of participants’ projections for real GDP growth in 2008, at 1.3 to 2.0 percent, was considerably lower than the central tendency of the projections provided in conjunction with the October FOMC meeting, which was 1.8 to 2.5 percent," according to the minutes. Meanwhile, "The central tendency of participants’ projections for core PCE inflation in 2008 was 2.0 to 2.2 percent, up from the 1.7 to 1.9 percent central tendency in October."
To be fair, inflation generally in the global economy is still low by historical standards, at least as measured by official statistics. But it's not the absolute level that concerns us; it's the trend, and the trend is up. What's more, the upward trend didn't drop out of left field; it's the byproduct, in our view, of the easy money policies that have swept the globe earlier in this century, a trend aided and abetted by one central bank at a time. The hope is that slowing economies will save the day. We'll see. If not, a more hawkish monetary policy is the last defense, assuming it's deployed.
No, we don't know the outcome, but at least we're reasonably conversant in the rules of the game.
February 22, 2008
Several astute observers of the financial scene have noticed recently that the yield on the 10-year inflation-indexed Treasury bond (a.k.a. the 10-year TIPS) has fallen to levels that look distinctly unattractive. Of course, one might ask: Unattractive compared to what?
There's no doubt that the 10-year TIPS yield has fallen sharply in recent months. As of last night's close, buying a 10-year TIPS equated with locking in a real (inflation-adjusted) yield of 1.43% for the next 10 years. Meanwhile, the always-perfect clarity of the rear-view mirror tells us that a better time to buy was last June, when the 10-year TIPS yield briefly rose to 2.83% at one point that month.
Since then, the TIPS yield has been falling virtually nonstop. Of course, the same is true for the nominal 10-year Treasury yield. Last June, the nominal 10-year was temporarily available at 5.23%, a relatively alluring yield that's since fallen to 3.77% as of yesterday.
Suffice to say, yields generally are now lower--a lot lower, in fact, compared with the prevailing rates of last June. But the decline has not been distributed evenly in the land of Treasuries. On that note, consider the chart below, which compares the yields of the 10-year TIPS with the nominal 10-year Treasury, the latter adjusted by the 12-month rolling CPI rate. (Both series are based on constant 10-year maturities using monthly data, as per the St. Louis Fed.) The result is a back-of-the-envelope attempt at putting the two Treasuries on roughly equal footing in terms of comparing real yields.
The striking feature of the chart is that inflation-adjusted yield in the nominal 10-year Treasury has sunk to an unappealing depth of roughly negative 50 basis points. In other words, adjusting the nominal 10-year yield by the latest CPI number (which reports annual inflation running at 4.3%) means that a buyer today would suffer a loss after subtracting inflation's bite.
By that standard, a 10-year TIPS yield looks pretty good. It doesn't take a Ph.D. in finance to choose a roughly real 1.5% TIPS yield over a slightly negative real yield in a nominal Treasury. Of course, if one's expecting deflation, then even a negative real yield may be a fleeting disturbance since the expected capital gain from generally falling prices may more than compensate for the current red ink in the real yield.
In any case, the current chasm in real yields won't last. As the above chart shows, sometimes the nominal Treasury offers a better deal, only to give way to superior pricing in TIPS. For the moment, the choice is clear, at least on a relative basis. Tomorrow, of course, is another day.
Indeed, it's worth reminding that the ever-changing mix of inflation and Treasury yields is forever reshuffling the opportunities, and the risks. In addition, the above chart offers clarity about the past and only the past. As such, one should consider the above chart in context with prudent forecasts of inflation and the respective yields on the nominal and inflation-indexed Treasuries, along with other asset classes too. The glitch is that no one can say for sure what's coming, although some of us aren't shy about making some educated guesses, for which all the usual caveats apply. The past, meanwhile, is forever clear and sometimes it even offers a crumb of perspective. The future, alas, is always up for grabs.
February 20, 2008
ANOTHER DISCOURAGING INFLATION REPORT
Anyone who thinks inflation isn't a problem isn't looking at the numbers. It's not a huge problem, it's not a catastrophic problem. But it's a problem, and it requires attention. Left untended, it'll only get worse. And once the public thinks it's destined to get worse, the Federal Reserve's looking at a much bigger problem and one that could take a generation to reverse. The good news is that the problem is still manageable. Nonetheless, the clock is ticking.
Consumer prices rose 4.3% during the 12 months through last month, the Bureau of Labor Statistics reported this morning. As our chart below shows, that's near the peak for the past 10 years. Core inflation (which excludes food and energy prices) is also pushing higher these days, running at a 2.5% annual pace, which is near its highest levels in recent years too.
Headline inflation is now far above the overall growth rate of the economy, which expanded by a paltry 0.6% in annualized real terms in last year's fourth quarter. Even GDP's 3.2% growth in nominal terms remains comfortably under CPI's pace.
The inflationary pressure is all the more troubling with the Federal Reserve aggressively lowering interest rates of late, a course which increasingly looks like the monetary equivalent of throwing gasoline on a fire. Fed funds are currently 3.0%, down from 5.25% as recently as last September. As a result, Fed funds are now negative in inflation-adjusted terms. And more rate cuts may be coming. The April '08 Fed funds futures contract is priced in anticipation of another 50 basis-point cut, which would bring rates down to 2.5%, or nearly 200 basis points below CPI's pace.
Meanwhile, no one should mistake the inflationary momentum as a statistical artifact. The bubbling pricing pressure is evident in several crucial corners of goods and services. Food, energy, transportation and medical care prices are all advancing at annual rates above headline CPI's pace, according to the government's report today.
The Fed has been expecting that the slowing economy would take the edge off inflation. So far, however, nothing of the sort is happening. As GDP's pace has slowed, inflationary pressure has only risen. So much for wishful thinking. That leaves the traditional solution, which is one of embracing a hawkish monetary policy, at least relative to what currently prevails. That's an awkward prescription in an election year, especially one in which recession threatens. But no one ever said that running a central bank is a short cut to popularity. It remains to be seen just how much popularity Mr. Bernanke and company seek.
February 19, 2008
DISTRESS & TRANSITION
The future remains as murky as ever, but the questions are becoming increasingly obvious.
Let's start with three. There are many more, of course, but these three seem particularly topical and so knowing the answers to the following questions—topics, really-- would be immensely helpful for enhancing investment returns and all but eliminating risk. Unfortunately, that would require financial and economic clarity, both of which remain in short supply.
There's always a delicate balance of risk and reward, of course, and it's always laden with mystery as to what comes next. But the current outlook carries a bit more potential for each. So it goes in moments of distress and transition. In theory, asset allocation may warrant more extreme strategies when (and if) the valuations become immoderate. On the other hand, if valuations are generally middling, the case remains strong for broad diversification among the asset classes.
For the moment, broad diversification remains the more compelling choice, but the potential for something more extreme can't be ruled out in 2008. In fact, the debate tied to questions/topics below seems likely, in our view, to cast a long shadow on the asset allocation opportunities that await.
* The first is Chinese inflation. Consumer prices in China are now at their highest levels in 11 years, AP reports. Given the growing influence of the country in the world economy, investors should consider the implications if Chinese inflation continues rising. Indeed, China's economy has been a critical force in exporting disinflation for the past decade; the question is whether the country has the capacity for exporting the opposite?
* Another subject on our mind is the U.S. economy and whether it's headed for recession, or just a period of unimpressive growth. The answer will matter a great deal to the bond market, which seems intent on pricing Treasuries in anticipation of recession. If that forecast turns out to be misguided, the fixed-income set will suffer and long rates will rise, perhaps sharply. On the other hand, some analysts say the bond market's right: tough times are coming and rates are headed lower.
* The outlook for the world economy may determine if the bull market in commodities still has legs. History suggests that when growth slows, or certainly when it turns negative, commodity prices tumble. Oil is usually on the leading edge here. By that standard, there's little sign in the price of crude that the global growth is set to tumble. Oil, at nearly $100 a barrel, has rarely been higher. Of course, there's no shortage of fear that the economies of U.S. and Europe are due to downshift.
As the world learns more about where we're headed on the trio of subjects above, it may be possible to rationalize a more extreme asset allocation if—a big "if"—valuations become compelling in one or more asset classes. We'll keep you posted. Meantime, broad diversification, along with a cash overweight, still look like the best deal in town. For today, at least. But don't nap for too long. As the academics have been telling us for years now, expected returns for asset classes drift. The trick is catching them when they're relatively high. That day will come, but history suggests that it'll arrive on a first-come, first-serve basis. Stay tuned.
February 14, 2008
READING BETWEEN THE LINES IN JOBLESS CLAIMS DATA
Today's update on weekly jobless claims is encouraging, but no one should confuse last week's sizable decline in new filings for unemployment benefits with the all-clear signal for the economy. There are still too many risk factors bubbling to convince us that full-bore optimism is now the sentiment of choice.
The Labor Department reported that jobless claims fell to 348,000 for the week through February 9, down from a revised 357,000 the week before. That's a handsome tumble, but as our chart below reminds the broader picture (as indicated by the black line, which graphs the linear trend) still doesn't look encouraging.
Weekly jobless claims are, of course, a volatile series in the short run. Extreme weather conditions, for instance, can arbitrarily reverse long-run trends in any given week. But if we step back and consider the big picture, it's hard to dismiss the rise in initial jobless claims as anomalous and unrelated to economic conditions of late. Indeed, it's because we know of the pain unfolding in the wider economy that we see the growing jobless claims trend for what it is: a warning sign.
Weekly jobless claims are, of course, a volatile series in the short run. Extreme weather conditions, for instance, can arbitrarily reverse long-run trends in any given week. But if we step back and consider the big picture, it's hard to dismiss the rise in initial jobless claims as anomalous and unrelated to economic conditions of late. Indeed, it's because we know of the pain unfolding in the wider economy that we see the growing jobless claims trend for what it is: a warning sign.
That said, it's important to remember that jobless claims will eventually stop rising. Alas, no one knows in advance when the apex will arrive. Despite what the human mind is inclined to believe, economic trends often start and end for reasons that don't look obvious or logical in real time. After the fact, all becomes clear and we all berate ourselves for not seeing what was obvious, albeit in hindsight.
That said, how does the current trend compare with history? A subjective, back-of-the-envelope reading of the past offers some perspective on the present rise in jobless claims, which began in January 2006, or so it appears to your editor. Claims fell to 279,000 for the week through January 14, 2006, which marks the previous low for the current cycle. By that measure, we're now in our 25th month of generally rising jobless claims.
The good news is that 25 months looks elderly for upturns in this data series. The last three major increases in jobless claims lasted an average of roughly 20 months. Of course, there's a fair degree of variation in any one cycle. Consider that rising jobless claims lasted a relatively brief 17 months during April 1981-September 1982. Next is the February 1989-March 1991 rise, which lasted 25 months. Brevity returned in the April, 2000-September 2001 increase, which lasted 17 months. Statistically, one could argue that the current rise is due to end. If so, that implies that the economy is due for a rebound in the near future.
That said, speculations are always dangerous for the simple reason that forecasting is subject to any number of risks that necessarily haunt looking into the future by analyzing the past. Nonetheless, a bit of historical perspective is useful if only to help frame the question of what comes next. With that in mind, we pose the following: Is the current rise in jobless claims due to end? Or, are we due to suffer an extraordinarily long rise in new filings for jobless benefits?
One reason for answering "yes" to the latter is that when we adjust for magnitude, the current rise in jobless claims still looks like it has legs. Although the trend is two years old, the peak in major upturns in jobless claims has historically come at well above the 400,000 mark. As such, the fact that new filings currently are in the 350,000 range implies that there's more upside left.
Unless, of course, we're in a new era, in which case the old standards no longer apply. That's always a possibility with economic analysis, as history reminds in many, many ways. But until and if we see some corroborating evidence supporting the new era view, we remain cautious on thinking salvation is just around the corner.
February 12, 2008
Repricing of risk is, in theory, a fertile time for minting new opportunities for strategic-minded investors. But, of course, there's a catch: the financial gods always forget to send instructions for making sense of the upheaval. That leaves mere mortals with the task of sifting through the data in the hope of finding order amid the chaos.
With that prelude, we present the widening spreads in two asset classes that have caught our eye in recent weeks: high yield bonds and REITs. Both have fallen on hard times of late, and so it comes as no shock to learn that their respective trailing yields over the 10-year Treasury's counterpart looks compelling, relative to recent history.
Consider the chart below, which shows that spreads in junk bonds (represented here by monthly data for the Citigroup High Yield Index through the end of last month) have risen to the highest level since mid-2003. REIT spreads have improved too, but less so. Nontheless, FTSE NAREIT Equity REIT Index's spread over the 10-year has climbed to its highest mark since the spring of 2004.
Of course, higher spreads by themselves are no guarantee of easy profits from here on out. Indeed, Mr. Market never reveals his game in advance and so all the usual caveats apply when reading the past in the hope of divining the future. Nonetheless, we're a believer in the proposition that lower prices equate with higher prospective returns. The trick is deciding when prices are at or near the end of their descent, at which point expected returns are at their highest. No one really knows, of course, at least not in real time, which suggests that diversifying one's opportunistic buying efforts over time and over different asset classes is still the best game in town.
And while we're pointing out caveats, let's point out too that today's higher spreads enjoy that label only because the previous spreads were extraordinarily low by historical standards, as the above chart reminds. Taking in a longer-term perspective shows that what looks like juicy spreads by the standards of the past 12 months are merely middling, if that, when measured against the record of the past decade.
Finally, investors should keep in mind that a fair amount of the recent upturn in spreads is due to the forceful downturn in the 10-year's yield. Consider our second chart below, which shows the Treasury yield taking a fresh dip.
For the moment, the diverse trends bring opportunity in the form of higher risk premia, although that's no assurance that tomorrow won't bring an even better deal. Nonetheless, we'll keep watching and nibbling.
February 11, 2008
THE DOLLAR, THE EURO & OIL
The notion of pricing oil in something other than dollars has been around for some time. In fact, there's been a bull market in predicting just that, motivated in recent years by the buck's general descent in foreign exchange markets and the resulting financial pain the trend has imposed on foreign oil exporters. But rarely, if ever (as far as your editor can tell), has any high-ranking OPEC official discussed the idea in public in direct and transparent terms. Until now.
On Friday, OPEC Secretary-General Abdullah al-Badri told The
Middle East Economic Digest: "Maybe we can price the oil in the euro. It can be done, but it will take time," according to AFP. He also observed via The Guardian: "In oil exchanges in New York, Singapore or Dubai, you can see the currency is the euro or the yen. But as long as we see the final sign in dollar, that means the pricing is in dollars. It took two world wars and more than 50 years for the dollar to become the dominant currency. Now we are seeing another strong currency coming into the [marketplace], which is the euro."
Talking about pricing oil in something other than dollars is easy, of course. Doing it is something else entirely. The world's oil market is still firmly tied into pricing crude in dollars, and changing the financial infrastructure will, as al-Badri said, take time--years, perhaps decades. At the same time, no one should dismiss the growing incentive to tackle this task, and where there's a will there's a way.
Economic logic certainly suggests that an evolutionary process that allows more oil pricing in other currencies is virtually inevitable. The U.S. no longer dominates the world economy the way it did in 1960s, when OPEC was founded. That's less about America's decline than it is about the rise of developing economies and the birth of the euro. Competition, in other words, is on the rise, and so the no-brainer decision to price oil in dollars decades ago looks a heck of a lot less compelling in capitals beyond the U.S. shoreline.
Still, let's not go off the deep end. A large segment of the market in oil will probably always be priced in dollars for at least two reasons. One, the U.S. is the world's largest consumer of crude. And for obvious reasons, sellers of oil aren't eager to annoy their biggest customer with disruptive ideas about pricing. That's not to say that they won't engage in such actions, but they'll likely be on the margins and evolve slowly.
Two, the U.S., for all its troubles of late, real or perceived, remains the planet's biggest economy and the giant will remain a potent, if not dominant economic force for the remaining days of all who are reading this post.
Still, a rationale investor can't ignore the implications of euro-priced oil, however remote the odds look in the here and now. With that in mind, it seems reasonable to consider why China, Japan and other nations are so willing to hold dollars when the value of that paper has declined in terms of the home currency. One reason, although hardly the only reason, is oil. There's a certain economic logic to holding dollars if that's the medium of exchange for a strategic commodity that you routinely purchase. Then again, if it's possible to buy oil in some other currency, it's only reasonable to expect that such a shift will negatively impact demand for dollars. In turn, anyone paying for oil in dollars (hint, hint) will have to pay that much more for the commodity, and all other imports for that matter.
Clearly, the prospect that oil is destined to be priced in multiple currencies is bad news for the dollar, which has enjoyed something of a monopoly to date. At the same time, to the extent that this change is measured and evolutionary, the fallout in any given year should be minimal and perhaps even invisible to the man on the street. Also, oil is but one factor in establishing the dollar's international value. Nonetheless, the tectonic plates of the world economy are shifting and strategic-minded investors are well advised to pay attention and hedge themselves accordingly.
February 8, 2008
The repricing of risk in the capital and commodity markets may be intimidating, but it's a natural, recurring process, and one that often brings fresh opportunity (along with new and so perhaps unexpected risks) for strategic-minded investors.
Periodic rebalancing as a general rule is a good idea, perhaps more so than usual these days given the rise in volatility in some asset classes and the growing sense that more than the usual demons haunting the markets and the economy may be lurking in the shadows. All of which provides a timely excuse to update the correlation trends between stocks, bonds, REITs and commodities if only to see how the recent turmoil in markets has reshuffled the relationships between the asset classes.
To keep things manageable, we've crunched the correlations from a U.S. stock market perspective (see chart below by clicking for larger image). The decision doesn't mean that looking at correlations from the vantage of bonds or REITs or commodities is unproductive. Indeed, a full and prudent study of correlations demands considering all the angles. But in the interest of brevity, today we look exclusively at how correlations have evolved vis a vis U.S. equities, as represented by the Russell 3000, which is a broad measure of the market.
click for larger image
Indices used in calculation: Russell 3000, Lehman Bros. Aggregate Bond, DJ Wilshire REIT, DJ-AIG Commodity, iBoxx High Yield, Citigroup
Non-$ World Govt (un Hdg, $), MSCI EAFE, MSCI EM
Before we start analyzing the trends, let's first define some terms. The chart above profiles 36-month rolling correlations based on monthly total returns for the respective markets. For example, the correlation between U.S. stocks and commodities for January 2008 comes from a correlation derived on the previous 36-month total returns for each asset class. Correlation measures the relationship between two data series, in this case monthly total returns. A correlation of 1.0 equates with perfect positive correlation, meaning that the two markets are effectively one and the same, or at least highly similar. A correlation reading of 0.0 is no correlation, and a correlation of -1.0 is perfect negative correlation. And, of course, there's a strong case for building portfolios by mixing asset classes with low and negative correlation. The devil's in the details, but as a general rule this one carries a lot of weight in our book.
Ok, so what is the above chart telling us? The first lesson is that correlations evolve, which means that the diversification opportunity of any given asset class relative to other varies over time. Consider, for instance, that correlations between U.S. stocks and REITs (red line) have been rising since 2002. As of last month, the trailing 3-year correlation between the two was 0.62, up sharply from 0.19 five years ago.
Another example: the correlation between U.S. stocks and foreign government bonds in developed markets (based on unhedged dollar returns) has fallen dramatically and relatively quickly (pink line). As of last month, the two posted a negative correlation: -0.35 vs. a modestly positive 0.31 in November 2006.
If we step back, we can see four broad trends in the data. Correlations between U.S. stocks with foreign stocks in both developed and emerging markets have been slipping, albeit from the high levels in the recent past, which was a byproduct of the powerful bull market in equities around the world that's now just a memory.
The second trend: rising correlations between U.S. stocks and REITs; and U.S. stocks and high-yield bonds.
The third trend: falling correlations between U.S. stocks and U.S. bonds; and U.S. stocks and foreign bonds.
Fourth, the low but still modestly positive correlation between U.S. stocks and commodities seems to be oscillating within a range so far in the 21st century. A fear that the securitization of commodities via ETFs, ETNs and mutual funds in recent years would destroy commodities' diversification value isn't supported by the correlation data, at least so far.
The past, of course, is always clear; it's the future that's always the mystery. In fact, the only thing that really matters in portfolio design is the future path of correlations. Alas, can only guess. That leaves us with the quantitative crumbs, namely, Does the past provide any insight into the future on the matter of correlations? Some, although caveat emptor still applies. Indeed, we know that correlations are constantly changing, though not necessarily in smooth and predictable trends.
We'll close with one speculative reading of the trend: the diversification benefits of owning foreign and domestic stocks will modestly improve in the coming months and years, which is another way of expecting the correlations between the two will continue falling. Again, that's just a guess, but knowing that the correlations in this case have been quite high in the recent past, and that correlations evolve, there's a case for arguing that lower correlations are coming. Maybe.
February 7, 2008
WILL THE PEAK HOLD?
The theory of peak oil remains as contentious as ever and by definition unresolved. The supporting evidence starts with the bull market in crude prices in recent years, inspiring some to proclaim that global production is about as high as it ever will be.
The optimists counter that technology will save the day, through new discoveries that offset declining production from aging fields and recovering more oil from older wells that would otherwise run dry.
The jury is still out on the big picture, and it may remain so for years. In the meantime, there is no shortage of data to review. Case in point: the reported peak (so far) in global crude oil production came in May 2005 at 74.3 million barrels per day (bpd), as our chart below shows, according to numbers from the U.S. Energy Information Administration. In fact, there's been only three months when global production crossed above 74 million bpd, the latest one coming last October at 74.1 million bpd, or just below the May 2005 summit.
It's any one's guess if the old high will stand or not. And, of course, there are questions about the accuracy of EIA's numbers. In fact, there's skepticism regarding any database attempting to consolidate such an unwieldy beast as the world's oil production into one number. Nonetheless, everyone will be watching the updates, eager to declare victory for their side. All the more so considering how close last October's total was to the May 2005 apex. As we write, EIA's monthly production figures run through October 2007; the November report is coming soon.
Meantime, as the world ponders the supply side of the oil market, there's far less mystery on the demand side. In fact, it's the same old story: up, up and away.
February 6, 2008
26 YEARS AND COUNTING...
There's been a lot of talk of bubbles lately, including speculation on where the next one lies. Some say it's in the energy sector; others claim that gold's a bubble. Here's our nomination: bonds.
Our proxy for fixed-income is the ever-popular 10-year Treasury, the benchmark for U.S. debt markets and in some cases foreign markets too. Exhibit A in our bubble thesis is the chart below, which shows the daily closing yield of the 10 year for 40 years-plus through last night's close. Restating the graphically obvious: the great decline in yield for the past 26 years. Since the peak of 15.84%, set on September 30, 1981, the 10-year Treasury's yield has, with fits and starts, become a shadow of its former self.
As of yesterday's close, the 10 year trades at 3.61%--a tidy 1200 basis points below the 1981 summit. In fact, that's not the lowest yield in recent memory. In June 2003, the 10-year yield briefly dipped to 3.20% (measured by daily closes) and 3.09% on an intraday basis. As we write, those troughs are theoretically just a few trading sessions away--if the bond market is willing.
So far, the fixed-income set has seen fit to follow the Federal Reserve down the slippery slope of fading rates. That's unsurprising, given that falling rates are the fuel that's lifted bonds to the upper levels of the performance horse race among the major asset classes. No wonder, then, that bonds generally have been faring well recently in relative and absolute performance terms. The iShares Lehman Aggregate Bond ETF (AGG), for example, boasts a 2.5% total return so far this year through yesterday and 8.9% for the past 12 months. Inflation-indexed Treasuries and foreign bonds in developed markets, along with the broad commodity indices, have done even better over those time frames. Otherwise, lesser performance and red ink prevail among the major asset classes.
It's anyone's guess how long the bond party can roll on, but there's no getting around the fact that a bull market that will mark it's 26th anniversary come this September 30 is no spring chicken. At the same time, the bond bulls are encouraged by their patron saint, a.k.a., the Federal Reserve. And at the moment, there's still reason for cheer. The April '08 Fed funds futures contract is current priced in anticipation of another 50-basis-point cut, and the August '08 contract expects a further 50-basis-point reduction on top of that. Hope, in short, is alive and well in the bond market.
But make no mistake: this is a dangerous game and it's not entirely clear that the long yields will continue to follow the Fed's lead like a fawn follows its mother. The key risk factor now is that the inflationary winds are blowing. Yes, the absolute level of pricing pressures still looks low by historical standards, but the long slide in inflation may be over. That doesn't mean that we're about to suffer a sudden surge in prices generally. But once the bond market embraces the idea that inflation risk is rising, if only marginally, then the bond bubble (if we can call it that) may burst.
Of course, all bets are temporarily off if the economy weakens dramatically from here. If the slowdown is deeper and longer than the crowd expects, the party in fixed income may roll on. More than a few bond investors are expecting no less. But that will only delay the inevitable. Nominal yields can only go to zero. Practically speaking, the bottom in the 10-year's yield will probably be much higher. We don't discount the possibility that the 10-year Treasury may trade below 3% at some point this year. The real question: what are the odds of 4%?
February 4, 2008
TAXES IN THE REARVIEW MIRROR
Taxes are forever topical, especially in an election year, particularly one in which big ideas about government programs, old and new, are increasingly front and center. Government action, of course, means government spending, which in turn leads to the inevitable question: Who's going to pay for it?
With that backdrop we offer a bit of perspective about where we've been. The future of tax policy is, as always, unclear. The past, by contrast, is eternally crystal. In the February issue of Wealth Manager, your editor took a look backward, if only as an antidote to the bull market in political-speak. By this reporter's reckoning, a dose of context is always useful and sometimes it's even refreshing.
February 1, 2008
After 52 straight months of gains, job growth finally gave way in January.
The Labor Department reported that non-farm payrolls dipped by 17,000 last month, the first case of red ink since August 2003. Granted, a loss of 17,000 in a labor pool of nearly 159 million is insignificant. In fact, we wouldn't rule out a revision to positive territory next month. Indeed, the first report of December's paltry 18,000 rise in nonfarm payrolls was revised up today to a more respectable 82,000 gain.
But revisions can't reverse the downturn now gathering momentum throughout the economy. The all-important trend in job creation is clearly downshifting. It's obvious in one-month and 12-month comparisons. And as today's numbers suggest, the warning signs are no longer confined to manufacturing.
The service sector, which accounts for more than 80% of U.S. employment, eked out a tiny gain last month, creating just 34,000 new jobs. That's a rounding error in the context of 116 million people working in the service sector. It's also the first time since October 2005 that the service sector employment growth was effectively flat.
Is it a blip? An anomaly? It doesn't look that way, given the supporting evidence. Consider yesterday's weak GDP, for example, as we discussed in Thursday's post. Another item: yesterday's update on weekly new jobless claims, which is particularly worrisome for surveying the weeks and months ahead. As our chart below shows, the number of new filings for unemployment benefits spiked higher last week, rising to 375,000—the highest since the labor market upheaval in the wake of Hurricane Katrina in 2005.
The debate now is about how long the slowdown will last, how much pain it will inflict, and how successful Congress and the Federal Reserve will be in attempting to mitigate the downturn. There's no question that the tide has turned. The optimists say that it'll all be over in a quarter or two. Perhaps, although we're not prepared to bet the farm on that one.
We've been hearing for more than a year that the real estate crisis was behind us and that the economy wasn't vulnerable. Now we're told by some that the slump will be mild and brief. In fact, the last 20 years support the optimists. The Great Moderation, as it's been dubbed, has given us fewer and milder recessions. The past, of course, is not necessarily indicative of the future.
So, we'll let the data guide us and try to keep our emotions in check. From an investment perspective, we expect 2008 will deliver a rainbow of opportunities. But not just yet. This storm is only just beginning to blow. Yes, we're opportunistic and eager to exploit any sale prices in asset classes. We're also prudent and mindful of the fact that even in 2008 there's no way to know what's coming. Balancing risk and reward is still job one.
THE JANUARY EFFECT
Asset allocation has regained its rightful place as the only game in town for strategic-minded investors, as January's tally of performance among the major asset classes reminds.
The range of returns was a robust 14.1 percentage points last month among the major asset classes. On top: foreign developed market bonds, which posted a 5.2% total return in January, by way of our proxy, the PIMCO Foreign Bond (Unhedged) D mutual fund. At the bottom was emerging market stocks, which shed 8.9%, as per iShares MSCI Emerging Markets ETF.
Long gone are the days when everything went up, which meant that the stakes tied to asset allocation and rebalancing were minimal. In 2008, the reverse is true and rising volatility and falling correlations among the major asset classes are the reasons. We expect no less going forward.
As the economic cycle turns, risk is reassessed and repriced on a case-by-case basis. Investors will become increasingly selective in weighing the potential outlook of bonds vs. stocks, domestic vs. foreign, commodities vs. equities, and so on. Such discriminating behavior fell on hard times during 2002-2007. But the fog is thicker than usual for gazing into the future, and investors are becoming more discerning.