April 30, 2008
APRIL SHOWERS BROUGHT PERFORMANCE FLOWERS
The major asset classes had their best performance month in April since last October. Only TIPS and foreign developed market bonds suffered red ink last month, as our table below shows. On balance, April was the strongest monthly tally since the perfection of October 2007, when everything was in the black.
April fell short of the October standard, but not by much. Meanwhile, the leading performers were anything but subtle last month. Indeed, April's big winner was emerging market equities, which soared more than 9%. That's about as high a monthly rise as this corner of equities has ever posted.
In a strong second-place showing: REITs, up 6.4%, which is another performance that's rarely topped in any one month, based on the historical record.
Meanwhile, stocks across the board were up, and so were junk bonds and commodities. Let's just say that April was a success for investors with diversified portfolios. Unless you were loaded to the gills in inflation-indexed Treasuries and/or sovereign bonds issued by the major foreign governments, you almost certainly saw your portfolio's value rise last month.
Proving, if nothing else, that the link between sentiment on the economy and performance in the markets can be weak if not missing in action in the short run. As everyone now recognizes, the U.S. economy is challenged these days. As our post yesterday suggests, the economy may remain challenged for some time. Even so, don't assume that in any given month the capital and commodity markets will provide corroborating performance evidence in sympathy with what ails on a macro level.
Meantime, diversification across asset classes is still the only prudent game in town. Since we don't know what the future has in store for us, we're inclined to own everything. The value added (if any) comes by focusing on whether, and how much to deviate the weightings of the major asset classes relative to Mr. Market's weights, as per capitalization for stocks and bonds and an equivalent for commodities. But proceed cautiously. As we detailed last month, beating the global market portfolio is no mean feat. Most investors could do a lot worse than tapping into the passively allocated portfolio of all the world's major asset classes.
On that note, last month reminds again that the value of diversification endures, even if the details aren't always predictable in any given month. For example, it doesn't surprise to see foreign developed market bonds take a modest tumble last month. This, after all, is a prized asset class in part because of its low/negative correlation with equities and, yes, even domestic bonds at times. Case in point: foreign developed market bonds as an asset class posted gains during each month in this year's first quarter. That provided some much-needed ballast for portfolios that held stocks, an asset class that generally suffered in the first three months of 2008. But in the context of April's broad rebound, it's no wonder that foreign bonds slipped last month, which is in keeping with their low and negative correlations to almost everything else.
But let's not get too cute. Low and negative correlations may come in handy once more before the year's out. Details, however, are yet to be determined. Stay tuned.
JOE TURNS DEFENSIVE
The economy managed to grow slightly in this year's first quarter, the government reported today. GDP rose by an annualized 0.6% in this year's first three months, matching the growth rate in Q4 2007. Given all the recession anxiety of late, that's a victory of sorts. But this is no time for celebrating. As a closer reading of today's GDP report shows, consumers are turning defensive in their spending habits in a big way.
Personal consumption expenditures (PCE)--which represent about 72% of total GDP-- rose by a meager 1.0% (seasonally adjusted annual rate) in the first quarter--down from 2.3% in Q4 2007. That's the lowest pace since Q2 2001, which also witnessed a 1.0% expansion. The reason for the current slowdown: two of PCE's three major components posted declines in the first quarter. Spending on durable goods was particularly hard hit, dropping by a hefty 6.1%--the first case of red ink here since 2005. Nondurable goods also slipped in Q1, falling 1.3%. This marks only the fourth instance in the past 15 years that nondurable goods spending contracted in a quarterly reading.
The lone source of consumer spending salvation came via services expenditures; the only member of the three broad gauges that define consumer spending that posted a gain in Q1. Fortunately, services spending posted a healthy 3.4% jump. But that only reminds that consumer spending overall would be shrinking if it wasn't for the resilience in services.
Nonetheless, no one should misunderstand what's unfolding: Joe Sixpack's sentiment to buy, buy, buy has taken a hefty blow, at least for the moment. And no wonder: prices are soaring for basic staples, i.e., energy and food. Meanwhile, the family home is worth quite a bit less and Joe's investment portfolio probably suffers a similar discounting. Logic suggests that saving more and spending less is eminently reasonable at this juncture. The only question now: How long will the newly defensive sentiment last?
Clearly, it's premature to say that the worst of the economy's downshifting is past. Anecdotal evidence for the second quarter, which is barely a month old, suggests that the correcting process is still underway. Perhaps May and June will deliver better news, perhaps not. But based on the numbers presented in today's GDP update, combined with an objective survey of finance and economic conditions in the month of April, there's still a case for staying cautious and defensive in one's investment strategy. The proverbial "other shoe," it seems, is in the process of dropping as we write.
THE MEANING OF "REFOCUS"
Perhaps it signifies nothing, but the timing is suspicious.
Last December, the Treasury Department announced that it was sharply reducing the annual limit on investments in the inflation-indexed series of U.S. Savings Bonds, a.k.a., I-Bonds, to $5,000 a year as of January 1, 2008--down from $30,000 a year previously. (The $5,000/yr limit also applies to conventional Savings Bonds as of January 1.)
No big deal in the grand scheme of finance, although we can't help but notice that the new lower limit comes at a time when inflation-linked portion of payouts for I-Bonds look set to rise, as per the methodology that ties a portion of the bonds' interest rate to the consumer price index.
The official reason for the reduced investment maximum, as per the Treasury's press release, was rationalized this way: "The reduction from the $30,000 annual limit in effect for both series since 2003 was made to refocus the savings bond program on its original purpose of making these non-marketable Treasury securities available to individuals with relatively small sums to invest."
Refocus? That's an odd way of refocusing if you consider that the new rules have no relevance for "individuals with relatively small sums to invest." If you were investing $5,000 or less a year previously, the new limit has no impact. On the other hand, those who saw fit to put $30,000 a year into I-Bonds now must look elsewhere to satisfy their efforts at inflation hedging. And, in fact, there are other options, including inflation-indexed Treasuries and related mutual funds and ETFs.
As for the Treasury's decision on I-Bonds, could the real motivation be one of limiting the growth in future liabilities tied to paying out a higher interest rates if inflation continues to march higher in the years ahead? It's worth considering as an explanation, all the more so if you consider that I-Bonds can be held for 30 years and taxes on the interest income can be deferred until the bonds are sold.
To be fair, we don't have a problem with the Treasury making decisions that will save the government some money. In fact, we'd like to see more of that kind of thinking in Washington. But what irks us is the effort to whitewash the explanation. Then again, no government agency is going to publicly state that it expects higher inflation, least of all the U.S. Treasury. Under that constraint, the "refocus" explanation is perfectly logical.
April 28, 2008
THERE WILL BE INFLATION?
The Federal Reserve's two-day FOMC confab begins tomorrow and the
Leaning toward the view that this will be the end of the cutting is Peter Berezin, Goldman Sachs' global economist. "We expect this to be the last cut, but the Fed will be flexible in responding to economic conditions," Berezin tells AFP. "Obviously if the turmoil resurfaces, they will be apt to cut rates again. But barring that, they would like to stabilize rates."
Meanwhile, senior financial analyst at Bankrate.com Greg McBride tells AP: "We are entering the stage where it is time for the Fed to wind down and move to the sidelines. A quarter-point reduction is a nice segue to that transition. Short-term interest rates could stay low longer than many currently expect."
Judging by long-dated futures contracts, Mr. Market's calling for another 25-basis-point cut on Wednesday. The Dec '08 contract, for instance, currently prices Fed funds at roughly 2.0%. If the Fed cuts by a quarter point, 2.0% Fed funds at the end of the year would represent the longest stretch of interest rate stability for this series since Bernanke and company kept rates at 5.25% for the 15 months through September 2007.
But let's not get ahead of ourselves. First, let's see what the monetary czars will do (and say) this week. While we're waiting, let's observe once more that cutting interest rates at this juncture may be politically intelligent; it may even look shrewd as the ongoing economic slowdown/recession gathers momentum. But it's also risky with inflationary winds blowing. We'll know if cutting is savvy or something else in a year or so. Meanwhile, it's every investor for herself, forcing everyone into their own speculative craft to weather the macroeconomic seas as they come. With that in mind, let's take a dip and consider one blogger's view of the universe.
As we've written many times in the recent past (such as this post in 2006), the warning signs on inflation have been lively for some time. And yet those signs have gone largely unheeded by the central bank. There are any number of explanations, ranging from the view that inflation doesn't threaten all the way to charges of conspiracy and/or incompetence at the Fed. For strategic-minded investors, the true answer matters a whole lot less than whether inflationary momentum has been let out of the monetary bag, and on that score only time will tell.
That leaves us with the distasteful task of forecasting, which invariably is subject to error. For those of us without supreme confidence in predicting the future, hedging one's bets in degrees looks prudent. Yes, we may be wrong, which is why we never bet the house on any one outlook. Still, it's hard to read the various warning signs and remain neutral on the potential for ongoing inflationary risks. Inflation, after all, will affect every investor. The question, then, is deciding how much you can, or can't stand in a world of higher inflation?
Only very wealthy or highly confident investors should opt to do nothing. For everyone else, some degree of inflation hedging looks eminently reasonable. The good news is that a range of choices await, starting with inflation-indexed bonds and commodity funds. The bad news: hedging inflation's potential at this point isn't cheap. In fact, it's downright expensive. Just as buying water in a drought will cost you, so too will the price of buying protection from pricing pressure in late-April 2008. The time for overt inflation hedging is now past. That ship has sailed. We say that because as compelling as the inflation forecast may be, it's not preordained and so buying insurance at this point may entail more risk than is weathering the underlying hazard. Losing 20% in an oil ETF doesn't look all that smart in a world of even 6% inflation.
But all's not lost. There are still indirect means of hedging higher inflation risk, and they're relatively inexpensive too. One example: bonds. Nominal 10-year Treasuries will take it on the chin if inflation rises over, say, the next 12 months, or so we're predicting. One reason is that Treasuries have rallied over the past year, pushing the 10-year's yield down to a current 3.87%, as of Friday's close, from roughly 5.30% as of last June. During that time the annual pace of consumer prices has risen to 4.0% as of last month, up sharply from CPI's 2.6% annual pace in June 2007.
It's no mean feat to see a bull market in 10-year Treasuries as inflation gains a robust head of steam. All of which reminds that in the short run anything's possible in the financial markets, including any number of apparently illogical-looking trends. Still, expecting Treasuries to post another big rally over the next 12 months if CPI keeps rising from current levels may be asking for too much, even in a world of absurd financial news. Accordingly, those who think inflation will still be a problem through 2009 may be inclined to hold a bit more cash than usual with an eye on buying Treasuries at materially lower prices (and therefore higher yields) somewhere in the spring of 2009.
Of course, that brings us back to the question before the house: Will inflation keep bubbling? Ah, if we only knew for sure...
April 24, 2008
ECONOMIC DATA DU JOUR
Today's update on durable goods orders reinforces the notion that the economy is slowing if not contracting. But then there's the initial jobless claims news, which reports somewhat better numbers of late. So, what's the deal?
In search of an answer, let's start with the raw numbers. Durable goods orders slipped last month by 0.3%--the third month in a row of declines. Looking at the annual pace of durable goods orders shows weakness as well, as our chart below illustrates. Clearly, the trend is down, as it has been for some time on a rolling 12-month basis. Notably, red ink has been showing up with increasing frequency in the annual trend.
What, then, should we make of new filings for unemployment claims? The Bureau of Labor Statistics reports that since new claims hit a recent peak of 406,000 for the week through March 29, 2008, filings have dropped to 342,000 through last week, as our second chart shows.
It's tempting to see the drop in new filings as a sign that the economic ills are now behind us. Nonetheless, we're skeptical. One reason is that corporate America has been running its payrolls rather lean in recent years compared to previous expansions. Between outsourcing, technology and heavy pressure to run a tight ship, businesses don't go overboard in swelling its ranks, at least not relative to what passed for average in decades past. As a result, this data series may not surge as much on an absolute basis this time around compared with past cycles.
Meanwhile, weekly jobless claims are a "noisy" bunch, suffering lots of volatility in the short run. Ultimately, the broader trend is the only reliable signal and by that standard it's clear that jobless filings have been turning up on a relative basis since last fall. Until and if there's fundamental reasons to think otherwise we continue to expect more of the same.
Based on other economic variables we track, it still looks like the economy's suffering. Today's update on new home sales, for instance, reveals the lowest level in 16 years. But recession isn't our biggest worry, at least not yet. Rather, it's the outlook for the rebound that makes us anxious. Everyone knows that recessions are painful. Fortunately, salvation comes, eventually. But for a number of reasons that we'll detail in future posts, the upcycle may not be quite so strong this time. But let's not get ahead of ourselves. By our reckoning, we're still grappling with a downturn and on that score there's still plenty of mystery left, starting with: how long, how deep?
April 23, 2008
Has the maximum point of stress in the capital markets passed?
There's no one measure for answering the question. In fact, there's no convincing answer short of letting time pass. But for those looking for a bit of perspective in real time, among the worthy gauges to watch in search of clues is the spread in junk bond yields over the 10-year Treasury yield. By that standard, a minor milestone recently passed considering that this spread touched a recent peak of 7.93% last month (based on closing yields on March 17, 2008), as our chart below shows. The question: Will the peak will hold?
Only time will tell, of course. Meantime, what lessons does recent history offer? For starters, an investor who bought junk bonds as an asset class at the peak, i.e., at the close on March 17 is now sitting on a 4.5% return, based on the price change of iShares iBoxx High Yield ETF (HYG) from that date through last night's close. So far, that's middling compared with other asset classes. The S&P 500, for instance, has jumped 7.5% over the same period--as per the Spider ETF (SPY)--while U.S. bonds generally have slipped by around 80 basis points over those weeks, as measured by iShares Lehman Aggregate Bond ETF.
Buying when risk premiums are high, or selling when they're low, is eminently reasonable and in the long run it may be the closest thing to a free lunch for strategic-minded investors. Accordingly, one might wonder if the 793-basis-point risk spread embedded in junk bonds last month was a buy signal for the long haul.
Perhaps. Looking at spreads going back to 1999, as we did last November, reminds that a near-800-basis-point risk premium looks pretty good based on the knowledge that the spread's high point over the past 9 years is only modestly higher, at roughly 1,000 basis points, reached for a time in 2002.
But let's not fool ourselves and think that spreads can't go higher, perhaps much higher. Even better bargains may be coming for those with investment horizons of five years or more. Alas, if we're honest, we must admit that we don't know for sure.
So, where does that leave us? In a familiar spot, actually, at least for readers of this blog: diversifying across asset classes and through time while favoring those assets that offer relatively attractive valuations and pulling back on those that look pricey.
The "catch" is that the best, and worst valuations will only be obvious in hindsight. That suggests two basic plans for dealing with the unknown.
* One, attempt to pick peaks and troughs and concentrate all buying, selling and rebalancing around those points in time.
* Alternatively, diversify the bet by recognizing that it's hard, very hard, to forecast valuation peaks and valleys ex ante. As such, we can invest a portion of our risk capital earmarked for new deployments over a period of time, concentrating those investments over spans of months or quarters that appear to be favorable to our long-term objectives.
The downside to the latter is that results will trail those of the investor who correctly allocates money at or near the peaks of valuation opportunities. On the other hand, diversifying across time will deliver superior results relative to the investor who tries and fails to identify tops and bottoms ex ante.
How to decide which approach is best? Much depends on one's skills and confidence as an analyst. No doubt there are some who excel in assessing risk and return opportunities. But for those of us who are less than brilliant in that regard, hedging our bets a bit is preferable, across asset classes and time. In fact, it's worth reminding that the population of less-than-brilliant investors is quite large, larger in fact than some investors realize. The real hazard, then, is that some of us don't yet realize our limitations.
April 21, 2008
MR. MARKET ALWAYS KEEPS US GUESSING
Veteran investors--otherwise known as anyone who's gotten burned at least once in the capital markets--are rightly skeptical when someone comes along and says they've got the money game figured out. Someone says that, or its equivalent, about once every three seconds these days.
The reasons for staying skeptical are no less legion. Suffice to say, the proof is in the pudding and so it's no accident that there's a huge spread between the number of people who claim to have the secret investing sauce and those who can point to some real-world evidence. With that in mind, you may want to take the following with a grain of salt as well. Your editor too is a card-carrying member of the mere mortals club.
We say that because even a judicious, enlightened approach to investment strategy (which, we humbly believe, is a label that applies to our approach to portfolio design) is laden with risks, both known and unknown. It's the latter that potentially pose the biggest dangers.
As an example, first consider a known risk, such as shunning diversification. Whether it's a particular asset class or a broad asset-allocation strategy, everyone knows (or should know) that concentration risk is easily avoided and so anyone who suffers at the hands of this particular demon probably hasn't been paying attention to the last 50 years of financial research. That's not to say that one should never, under any circumstances, move away from complete diversification. But at the very least, know what you're getting into before jumping off the cliff.
Meanwhile, it's the unknown risks that keep us awake at night. By definition, this class of hazards is mysterious, of course, although we have some clues about how they materialize. Exhibit A is the evolving nature of markets, including the relationships between asset classes. It's all too easy to look back on history and draw tidy conclusions about how the capital and commodity markets interact with one another. But finance is not physics, and so yesterday's iron laws can and do turn into something less, something more or something entirely unfamiliar by yesterday's standards.
Today's Wall Street Journal observes: "After decades of moving up and down more or less in tandem, the relationship between commodity prices and bond yields has broken down, leaving a yawning gap between them." Simply put, the relatively high correlation of the 10-year Treasury yield and the CRB/Reuters Commodity Index has, in the last few years, faded significantly. The usual signals dispensed by this relationship, as a result, may now be of questionable value, if not wholly irrelevant. Unless of course the shifting relationship is a "bubble," in which case normality will one day return.
Meanwhile, a new working paper posted on the San Francisco Fed's web site details the strange state of affairs of late in the money markets. It began last August, when "the interest rate on overnight loans between banks—the effective federal funds rate—jumped to unusually high levels compared with the Fed’s target for the federal funds rate," relates "A Black Swan in the Money Market." "Rates on inter-bank term loans with maturities of a few weeks or more surged as well, even though no near-term change in the Fed’s target interest rate was expected. Many traders, bankers, and central bankers found these developments surprising and puzzling after many years of comparative calm."
As we now realize, the August turmoil was "the start of the start of a remarkably unusual period of tumult in the money markets, perhaps even qualifying as one of those highly unusual “black swan” events that Taleb (2007) has recently written about..." the paper advises.
There are numerous implications and explanations associated with the two examples. In fact, we could cite many more instances of how some bit of recent market activity doesn't conform with the historical record. Some of these "anomalies" are temporary, in which case fresh investment opportunities may be spawned. But some events that deviate from the perceived norm are enduring and so they signal a fundamental change in market structure. Figuring out which is which is devilishly difficult and for all practical purposes impossible. That doesn't mean we shouldn't try, but let's not kid ourselves that the future is any less cloudy simply because we have a full boat of data in our spreadsheet.
In any case, we can't simply give up and leave our futures completely to fate. Fortunately, there are some enduring truths for strategic-minded investors. That starts with the default portfolio, which is the global market portfolio as determined by Mr. Market. For the average investor, this is the ideal portfolio. Of course, no one is the average investor and so we proceed to the second task: determining how we're different from the average investor and how to translate that into a different asset allocation strategy relative to Mr. Market's portfolio.
A few quick examples. Assume an investor works in the energy industry, in which case a fair amount of the investor's future earnings are tied up with the expected fortunes and risks of the energy industry. In that case, there's a sound argument for owning a global equity index that lessens or strips out the energy industry exposure.
Another reason for deviating from Mr. Market's portfolio is when an investor believes she has better information than the collective wisdom of investors. Let's say you're confident that REITs are undervalued, or that bonds are poised to suffer a bear market. In those cases, you may feel compelled to alter Mr. Market's asset allocation accordingly. Before you do, however, ask yourself: Am I supremely confident in my forecast? If not, you may want to reconsider.
In the end, any portfolio strategy relies on some amount of faith, which is unsurprising since the future's largely unclear. But don't despair: the uncertainty of the morrow is the reason why there's a expected risk premium today. Absent the premium, there's no point to investing in the first place. On that point, we can all agree. But the consensus starts and ends there.
April 18, 2008
IS THE CLOCK TICKING ON THE 'GREAT MODERATION'?
It's called the Great Moderation, and it's roughly 20 years old, give or take. The burning question: will it get any older.
The moderation is a reference to the fall in macroeconomic risk in the U.S. since the mid-1980s. GDP volatility has fallen dramatically since the roller coaster ride of the 1970s and early 1980s. The primary catalyst: shorter, shallower recessions that occur less frequently. In short, economic nirvana. But what's behind the fading of recession risk?
Among the various theories for why the angels of moderation have graced the U.S. economy: the Federal Reserve has learned a thing or two over the decades in how to dispense monetary policy that's not too hot, not too cold. The rise of the services economy, which tends to be less cyclical, is a factor too.
But is the Great Moderation now living on borrowed time? It's a timely question for a number of reasons, starting with the fact that the U.S. economy is probably already in a recession, as we've discussed. Will this one be short and shallow too?
Meanwhile, there's some debate about whether the Fed's now planting the seeds for higher inflation down the road. Consider yesterday's comments by Dallas Fed President Richard Fisher, a voting member of the FOMC who bluntly warned that further monetary easing at this point may cause trouble later on, and so he advised against "repeating the oft-prescribed remedy of inflating our way out of our predicament with a wing-and-a-prayer promise that it can always be reined in later. It is for this reason that I have maintained a strong reluctance to further general monetary accommodation."
The Fed meets again at the end of the month to consider interest rates anew. Meantime, it's clear that low inflation was a crucial factor in the Great Moderation of the past generation. If inflation's headed higher, one can imagine that the Great Moderation may become somewhat less moderate in the years ahead, as your editor detailed in the latest issue of Wealth Manager. As a preview, there are a number of clues that suggest the era of calm economic cycles may have run its course. For a closer look as to why, read on....
April 16, 2008
STILL WAITING, STILL HOPING
For five months running, the annual pace of consumer price inflation has been running at 4%-plus, the Bureau of Labor Statistics reports in today's CPI update. That hasn't happened since 1991. (As of last month, CPI is up 4.0% for the past 12 months.)
Core CPI inflation (which excludes food and energy) has been running at the 2%-plus level on an annual basis consistently since September 2004! (The latest numbers show that core CPI rose by 2.4% for the 12 months through last month.) The Fed is widely said to be concerned whenever core inflation is running above 2% with any consistency.
It would seem that inflation generally has jumped a few notches to a higher plateau. The idea that inflation will soon return to lower levels now looks increasingly unlikely. To be fair, headline inflation at 4% and core inflation in the mid-2% range is hardly the apocalypse. We're still a long way from the inflationary troubles of the 1970s.
But make no mistake: inflation has moved higher to a level that looks likely to endure short of a more hawkish monetary policy. That's not to say that the Fed's going to start hiking rates anytime soon, although we're inclined to think that the days of cutting are just about over. Even so, leaving Fed funds at 2.25% while headline inflation's at 4%-plus looks like a state of affairs that's asking for trouble.
It's important to recognize that history reminds that higher inflation tends to come gradually, almost imperceptibly over time. No one puts out a press release warning that the new inflationary era began last Tuesday at 3:45pm. Rather, the process of transitioning from contained inflation to something less contained unfolds slowly, in fits and starts. Only with hindsight is it obvious that pricing pressures have increased by more than a little.
In 2008, the crowd's hoping that the cooling economy will take the wind out of inflation's sails. That's possible, although so far the idea of waiting for macroeconomic salvation for managing pricing pressures has a discouraging track record. Perhaps that's about to change, or not. But given the data so far, one could argue that waiting and hoping seems like an increasingly dangerous strategy when it comes to monetary policy these days. But for the moment, that's the plan and the Fed is sticking to it. But for how long?
April 15, 2008
THE CLOCK IS TICKING...
No one will find encouragement in today's update on wholesale prices, which posted a troubling 1.1% rise last month. So far, however, the Fed funds futures market is still inclined to see another rate cut when the FOMC meets again on April 29 and 30.
Perhaps, although the time has passed for swashbuckling 75-basis-point slashes in the Fed funds. The hour is late when it comes to nipping pricing momentum in the bud. Today's producer price report is just one more clue that it's time for the central bank to pay more attention to pricing pressures bubbling. This idea is all the more compelling when you consider that while the Fed can't do much more at this point to juice the economy via broad changes in interest rates, but it can still act as the defender of last resort when it comes to inflation.
Tomorrow, we'll learn if consumer price inflation remains a problem, via the government's update for March CPI. Meantime, it's clear that PPI inflation is still a threat. The 1.1% jump in PPI last month is the highest so far in 2008, and in the upper range for monthly numbers over the last few years. On an annual basis, PPI is now advancing by 6.9%. That's down slightly from the 7.7% peak set in January, but it's still too high to ignore.
Yes, both food and energy costs are the main sources of inflation in today's PPI. The Fed likes to ignore such "noise." That may have worked in the past, but for the moment the idea that core inflation is a better measure of future inflation continues to look outdated. The political realities are such that at some point one of two things has to happen: food and energy costs stop rising or go down; or the Fed attacks the problem with a more hawkish monetary policy. The challenge is deciding when to act, if at all. Sitting around for another six months to get better data no longer looks like a viable option.
In the context of the next few weeks, however, there's still hope that commodity prices will fall, which will give the central bank cover for at least one more crowd-pleasing FOMC announcement. The May '08 Fed funds futures contract is priced in anticipation that a 25-basis-point cut is probably coming. But there's some anxiety hanging over the market. Until and unless the economic slump deteriorates dramatically in the coming weeks, the Fed may feel compelled to stand pat later this month. Perhaps everyone's waiting for tomorrow's CPI update for a better handle on assessing the odds.
In any case, it seems prudent to consider the prospect that FOMC meetings may come and go without a rate cut announcement from here on out. The risk is that the markets haven't yet fully priced in that scenario.
April 14, 2008
A MINI BOUNCE IN RETAIL SALES
At long last a bit of good news: retail sales rose last month by 0.2%, reversing February's stumble and bringing hope to the dwindling number of optimists who think economic growth will remain intact. But while Wall Street may be inclined to jump on the news as a reason to buy, the bigger trend in retail sales can't be denied.
Indeed, as our chart below reminds, the cycle in consumer spending is still clear, which is to say: down. Over the past year through March 2008, advance estimates of U.S. retail and food services sales rose 2.3%, or near the lowest annual pace since the previous down cycle of 2001-2003.
What's more, other than the positive sign that precedes the number, last month's rise in retail sales isn't all that impressive as increases in this data series go. In fact, March's gain of 0.2% (0.15% if you carry it out to two decimal points) could hardly be more frugal relative to past monthly reports of recent vintage, as our second chart below shows.
So, yes, monthly data is filled with statistical noise, tempting false impressions for those looking for broader trends. As such, no one should be surprised to see a month or two of relatively large gains in the near future. But that by itself doesn't change the fact that the economy's slowing and probably is set to contract for at least a time this year. No, it's not the end of the world, nor is the contraction doomed to run on for anything longer than what passes for a normal stretch. Of course, no one really knows and so the guessing game rolls on.
Keep in mind, too, that a reprieve, if only temporary, is coming. Just don't let it overwhelm your sense of cyclical perspective. In any case, The Treasury's so-called stimulus checks are set to begin rolling out next month, and the expectation is that more than a few consumers will spend their manna from Washington. Retail sales, no doubt, will enjoy a boost, perhaps as early as June or July. Of course, it's unclear what percentage of those who receive a check will run out and spend it vs. saving it or paying off debt previously incurred. Meanwhile, we won't have a clear picture of the effect, one way or another, until the government updates us, which will probably come no sooner than August, courtesy of the lag in retail sales numbers.
Even if the stimulus juices growth for a time, it stands to reason that the effect will be temporary and that the slowdown/contraction will return in the third or fourth quarter. At that point, the burning question will be one of deciding if the economy has recovered sufficiently on its own to provide self-sustaining growth.
April 11, 2008
IMPORT PRICES STILL SOARING
Today's update on import prices once again paints a troubling picture on pricing pressures.
Import prices jumped 2.8% last month, the U.S. Labor Department reports. That's the highest since last December's unnerving 3.2% spike. More troubling is the fact that the 2.8% rise in March is in the upper range for monthly changes going back to the 1980s. Adding insult to injury, import prices soared 14.8% measured over the 12 months through last month, as our chart below shows. That's the highest 12-month rate in the Labor Department's archives, which goes back to 1982 as per the web site.
The "good news," if we can call it that, is that much of the rise in import prices was due to higher energy costs. And energy prices can't rise forever--we hope. In any case, the 14.8% surge in import prices over the past year falls to 5.4% after stripping out energy. But the lesser rise in non-petroleum import prices is hollow comfort once you recognize that the 5.4% annual pace is the highest since the 1980s. The basic trend, in short, is not in doubt, no matter how you slice the import-price pie.
How troubling is a 5.4% rise in non-petroleum imports? In search of an answer, consider that inflation generally in the U.S. is climbing by 4.0%, based on the annual rise in consumer prices through February. And the nominal (pre-inflation adjusted) annualized pace of economic expansion in 2007's fourth quarter was 3.0%. In other words:
* non-petroleum import prices are advancing at a roughly 33% faster rate than general inflation
* non-petroleum import prices are rising 80% faster than the nominal growth of GDP
And if we add energy back to the mix, import prices are, well, let's just say they're skyrocketing.
It should be obvious to everyone that the current scenario can't last. Something, as they say, has to give. Among the possible scenarios:
1) The Federal Reserve will say enough's enough and pull a Volcker and hike rates. Of course, at this point in the cycle that decision would exacerbate the already weakened economy, although it probably would take the edge off import prices by more than a little.
2) The economy will weaken of its own accord, doing the Fed's dirty work without the political blowback that would arise if the central bank took the lead. In that case, tempering import prices seems inevitable if energy costs merely stay flat, although a drop of oil prices to, say, $80 a barrel would have a huge soothing effect on import price calculations in the near term.
Given that this is a presidential election year, the odds for #1 look dim. As for the medium and longer terms, there's reason to wonder if a new era of global inflation has begun, as the new IMF outlook for the world economy suggests. No, a return of the 1970s isn't likely, short of a colossal failure of policy makers. We've learned a thing or two over the decades, and one of them is that central banks do, in fact, have a large influence over inflation rates. Of course, that assumes central bankers will act decisively, but that's another matter. The central lesson of the 1970s was that the Fed stumbled in keeping inflation in check. Presumably, that mistake won't be repeated, at least not intentionally. Still, considering monetary policy over the past year or so, one wouldn't be out of line in expecting inflation of a somewhat higher level to prevail.
Yes, an interruption in the new era of inflation may be coming, depending on what happens in the global economy. It wouldn't take much on the marginal-demand front to deflate the oil bubble a bit from current levels, which would go a long way in pushing pricing benchmarks down.
But the underlying forces that are pushing commodity prices higher are fundamentally driven, which is to say a combination of rising demand and supply that hasn't been able to keep up, at least so far. Some of the pricing pressure is related to central banking missteps. To the extent that monetary policy can be improved in the months and years ahead, inflationary pressures will fall, or at least stop rising. But the fundamental catalysts behind higher prices are immune to central banks, and there's reason to think that these fundamental forces will be harassing the global economy for some time.
April 10, 2008
THE IMF'S BIG-PICTURE ANALYSIS
Global economic growth is slowing, the International Monetary Fund announced yesterday in its new World Economic Outlook (WEO).
"The global expansion is losing speed in the face of a major financial crisis," WEO advises. The leading offender is the U.S., the report says, thanks to the correction in the housing market. "The emerging and developing economies have so far been less affected by financial market turbulence and have continued to grow at a rapid pace, led by China and India, although activity is beginning to moderate in some countries."
How bad will it get? Judging by IMF's estimates, the outlook is more about a slowdown rather than an outright contraction. Last year, global GDP rose by 4.9%, according to the IMF. The projection for 2008 is 3.7% growth, followed by 3.8% in 2009.
If the prediction proves accurate, the deceleration will still bring pain to various segments of the world economy. Then again, world GDP rising by 3.7% is hardly a disaster. Indeed, 3.7% growth is the upper range that's prevailed since 1970, as the chart below shows.
Source: IMF's World Economic Outlook (April 2008)
But no one should ignore the other risks bubbling that aren't obvious in estimates for GDP. Inflation remains a threat, for example, particularly in the developing world (see chart below). The trend threatens the ability of the developing world to export disinflation to the U.S. and the developed world generally, as has been the case in past years. At some point, if prices keep rising, might the emerging markets export inflation? In fact, that seems to be the case now for certain items, starting with oil, which yesterday touched another new record high of $112 a barrel in New York. The U.S. is the world's biggest consumer of oil, and more than half of its crude is imported, much of it from the developing world.
Source: IMF's World Economic Outlook (April 2008)
Meanwhile, monetary policy threatens to fan inflation's fire. According to the IMF, real short-term interest rates have turned negative in the U.S., Europe and Japan, as the third chart below shows.
Source: IMF's World Economic Outlook (April 2008)
Of course, the argument for such a loose monetary policy is that the global economy needs an antidote to the deleveraging that's sweeping financial systems from New York to London to Tokyo. The IMF report warns that a "further broad erosion of financial capital in a climate of uncertainty and caution could cause the present credit squeeze to mutate into a full-blown credit crunch, an event in which the supply of financing is severely constrained across the system."
In fact, one could argue that a fair degree of the global economy's future path over the next year or so is tied to whether or not the credit crunch mutates into something worse from this point onward. The challenge for policy makers is that addressing each scenario requires different medicine. If greater liquidity troubles are coming, central banks may feel compelled to act by effectively printing more money than is otherwise prudent. The danger is that the liquidity injections turn out to be unnecessary, in which case inflationary pressures will be that much more troublesome and difficult to control. If and when that becomes the leading issue for central banks, the easy money party will end, perhaps for an extended period.
The IMF report leans toward the conclusion that the credit crunch may yet get worse before it gets better. Unfortunately, no one really knows and so the risk of dispensing the wrong policy medicine remains higher than usual at the moment. Risk, in short, is still with us even if the world economy is set for modest growth.
April 8, 2008
INDEXING THE GLOBAL MARKET PORTFOLIO
Buying Mr. Market in all his various asset class flavors is easy these days, thanks to the proliferation of ETFs and mutual funds that mine all the major (and increasingly minor) niches in the capital and commodity markets. But what is Mr. Market offering exactly? And what does his track record look like?
That's a crucial question for strategic-minded investors, if only to catch a glimpse of the true global market benchmark, which by definition is diversification in full. Alas, there's no off-the-shelf index for the global portfolio, at least none that we've come across. The vacuum inspired your editor to put one together, and so today we unveil the Capital Spectator Global Market Portfolio Index (GMP), which is an approximation of the global capital and commodity markets and weighted as per Mr. Market's valuation. We'll be using the index in future posts to compare and contrast various trends in the financial markets.
The methodology behind the benchmark in discussed in some detail below, but first let's address the obvious question: how has GMP performed? The quick answer is in the chart below, which shows the relative total return performance of GMP against the S&P 500. As you can see, GMP handily beat the S&P 500, from the end of 2001 through March 31, 2008.
Looking at the trailing performance numbers, the GMP index generated a 13.4% annualized total return for the five years through the end of last month vs. 11.3% for the S&P 500. In addition to outrunning the S&P, the GMP index did so at about three-quarters of the S&P's volatility over those five years (measured by annualized standard deviation of monthly total returns). The practical evidence of this smoother ride is evident in recent history. From the S&P's peak back in October 2007, the stock market suffered a -13.8% tumble through the end of last month, vs. a mild -3.2% loss for GMP.
What's behind GMP's impressive risk-adjusted performance? It's rather elementary, actually, in that our index embraces modern portfolio theory and builds a benchmark that holds all the major asset classes in their market weight on the start date (Dec. 31, 2001). Make no mistake: this is passive investing writ large, with all its faults and benefits.
Accordingly, Mr. Market is the investment strategist with full authority over the portfolio and so he incessantly adjusts the weights as he sees fit, letting the financial chips fall or fly where they may. After the initial market cap settings, subsequent investment performance alone determines the rise or fall of any asset class's weight in the index. Meanwhile, because the portfolio holds some assets that post low and negative correlations with one another, financial intuition suggests that this index is superior in many ways compared to the stock market by itself, or any one asset class index for that matter, as a long-run proposition.
As for GMP's basic design, we recognize 10 asset classes for the index and use some familiar and not-so familiar benchmarks as proxies:
1. US stocks (Russell 3000)
2. US bonds (Lehman Bros. U.S. Aggregate)
3. Foreign stocks/developed markets (MSCI EAFE)
4. Foreign emerging market stocks (MSCI Emg Mkts)
5. Foreign bonds/developed markets (Citigroup WGBI)
6. Foreign emerging market bonds (Citigroup ESBI)
7. US REITs (DJ Wilshire REIT)
8. Inflation-indexed US Treasuries (Lehman Bros. US TIPS)
9. Commodities (DJ-AIG Commodity)
10. US high yield bonds (Citigroup High Yield)
note: the foreign bond and stock indices are in unhedged dollar terms
The initial portfolio weights were determined by the relevant market caps at the end of 2001, as per the capital asset pricing model's idealized instructions. This is simple enough for the stocks, bonds and REITs. The challenge was figuring out how to weight commodities, which of course have no market capitalization.
Indeed, commodities are inherently a speculative asset since there is no formal cash flow, earnings, or other fundamental data available for analysis. Yes, supply and demand factors are relevant and so they ultimately dictate price. But the task of figuring out what commodities in the aggregate are "worth" in an accounting sense requires guessing in more than trivial doses. Ideally, the guessing is rooted in something approximating hard numbers and financial theory, which is why we settled on using the total dollar value traded (TDVT) figure, as calculated by Goldman Sachs. By our reckoning, that seems to be about as close to a market capitalization-equivalent in terms of what's available to the public. The TDVT number is calculated over several months for a given year and encompasses roughly two dozen futures contracts traded in Chicago, New York, and London.
Nonetheless, there are a number of caveats. First, a global market portfolio, even if it was calculated with absolute perfection as per financial theory (and GMP falls short of that idealized standard), is appropriate for the average investor. Any given investor will have particular financial objectives, risk tolerances, cash flow needs, etc., that call for some deviation from the true global market portfolio. There are also those investors who believe (rightly or wrongly) that they're in a position to correctly second-guess Mr. Market, in which case there's an argument for doing something different, perhaps radically so, relative to the global market portfolio. In addition, our index at the moment goes back to only 12.31.01, which is far from a robust sample.
Still, it's important to know what's available as a default investment portfolio, courtesy of the global capital and commodity markets. Such a benchmark reminds us what's available to everyone, at minimal cost. No skills required. The GMP index ,we believe, provides such a rough approximation of the true default portfolio.
Keep in mind that there are a number of moving parts to calculating a global portfolio index. Different researchers may reach different conclusions about building such a benchmark, and so different benchmarks probably will dispense different results.
A few examples for why that's so: The choice of indices can alter results. Meanwhile, certain asset classes were left out of our index. Notably, we don't use foreign REITs or foreign inflation-indexed bonds. Different start dates can produce different track records. We choose 12/31/01 because we have yet to find data for all the asset classes prior to that date. As we find older data, we'll recalculate going back further in time.
Perhaps the most important caveat is that turning the GMP index into a real world portfolio would incur costs in terms of fees, taxes, etc.—burdens that paper benchmarks can blithely ignore. So, yes, you can buy the relevant mix of ETFs and/or index mutual funds and create your own global market portfolio, with or without your own tactical overlays. But jumping from paper portfolios, regardless of the underlying strategic design, invariably introduces new and perhaps expected risks.
Then again, one has to begin somewhere when it comes to pondering the investment challenge and the global market portfolio seems like an obvious place to start if only to offer a bit more perspective on the money game.
April 7, 2008
THE PUSH-ME PULL-ME INFLUENCE OF ALTERNATIVE INVESTING
Alternative investing is hot. But you already knew that. Assets under management in hedge funds, private equity, venture capital and other formerly obscure realms have been exploding for the better part of a decade now. Slightly less obvious in the financial universe is the trend's influence on the conventional money management business. For several years now, more and more investment shops are offering something a bit different, which generally means indulging in portfolio engineering of one kind or another. One quick measure of the trend can be found in the growing list of mutual funds and ETFs for which the underlying strategy can't be described in 10 seconds or less.
Meanwhile, selling beta with minimal tweaking is a commodity, of course, and it's becoming more so all the time. There's nothing wrong with beta, which comes in a rainbow of flavors. Indeed, the art/science of blending various betas offers robust opportunities for the strategic-minded investor. Nonetheless, alternative betas in a single-fund format are all the rage in the 21st century and, as it turns out, it's not a bad business either. Caveat emptor applies for buyers, of course, but from a distribution perspective the alternative marketplace is manna from heaven because it's an enormously profitable business. Why? Because fees are usually much higher for alternative strategies compared with conventional money management concepts generally. No wonder that a fair share of the brain drain on Wall Street since the 1990s has beat a path into the alternative space.
It seems as though no one's immune to the trend, including Vanguard, which sold the first plain-vanilla beta fund to the public back in 1976. Since then, Vanguard has broadened its index fund menu considerably. But the allure of non-conventional betas is too enticing to ignore, and so late last year Vanguard offered its first alternative investing fund for public consumption: Vanguard Market Neutral Fund (VMNFX). To be precise, Vanguard adopted an existing market neutral fund (the former Laudus Rosenberg U.S. Large/Mid Capitalization Long/Short Equity) and rebranded it.
The event seemed like something of a minor milestone to this editor. With that in mind, we interviewed a spokesman at Vanguard for the March issue of Wealth Manager.
April 4, 2008
THREE MONTHS RUNNING FOR JOB DESTRUCTION
Another day, another symptom of recession to digest.
Today's statistical confirmation is brought to you by the monthly change in nonfarm payrolls, which lost ground in March, reports the U.S. Labor Department. Meanwhile, unemployment popped up to 5.1% last month from 4.8% previous, pushing the jobless rate to its highest since May 2005.
The loss of 80,000 jobs last month was only slightly worse than the 76,000 slippage the month before. More troubling is the fact that the economy has suffered job destruction for three months running, a stretch of red ink that hasn't occurred in this data series since 2003. As economic signals go, the triple-month slip is quite robust. Any one month is subject to revisions, of course, but the general trend can't be denied for such a crucial economic indicator as payroll changes.
"Strong relationships exist between the employment data and virtually every other economic indicator," advises Richard Yamarone, director of economic research at Argus Research, in his book The Trader's Guide to Key Economic Indicators. "The growth rate of nonfarm payrolls, for instance, is strongly correlated with the growth rate of GDP, industrial production and capacity utilization, consumer confidence, spending, income--even with Federal Reserve activity. If it's relevant to economic activity, it will have links with the payrolls data."
Alas, as you can see from our chart below, the trend in nonfarm employment has turned decisively down. Meanwhile, today's news only corroborates the negative signal in yesterday's update on weekly jobless claims,
It's easy to jump to conclusions and assume that the Fed will now cut interest rates again in the wake of the employment picture. Perhaps, but it's not yet obvious in Fed funds futures prices. The Fed funds rate currently stands at 2.25%, down from 3.0% previously after a hefty cut at the March 18 FOMC meeting. The next scheduled confab is April 29 and 30. Judging by the futures market, however, the jury's still out on whether another cut is imminent, suggesting that the central bank has already dispensed its monetary medicine for this cycle.
Indeed, if the current downturn proves to be short and shallow, one could argue that the Fed's pre-emptive liquidity injections will suffice. All the more so if one is worried (as is your editor) about the inflation outlook. Of course, all bets are off if upcoming economic reports show a worse-than-expected economic contraction is unfolding. Unfortunately, it'll be a month or two at least before the downturn's true nature will begin to emerge. The future is as cloudy as ever no matter where we are in the cycle. Worrying and nail-biting, of course, roll on with full transparency in real time.
April 3, 2008
A SPIKE ENDS THE DEBATE
No one should be surprised by this morning's discouraging news on weekly jobless claims, which surged to 407,000 last week--the highest since the anomalous but temporary spike in September 2005 directly after Hurricane Katrina. The warning signs have been bubbling for months, as CS and others have pointed out. And so, this time, the rise in new filings for unemployment insurance is a reflection of a weak economy rather than a one-time weather event. In short, there will be no sudden and sharp drop in new claims this time, as there was in 2005.
As our chart below reminds, the rise in jobless claims has been unfolding since late last year. The message in the graph is clearly that the tide has shifted in no uncertain terms. No one can say that jobless claims are still in a range that reflects a healthy economy. Those days are over. The front line of optimism now turns to looking for light at the end of the tunnel. As we discussed last Friday, the recession is here and the debate necessarily moves to the questions: how long, how deep?
Fed Chairman Bernanke set the official tone yesterday, when he said "recession is possible" in testimony on Capitol Hill. By this editor's reckoning, Bernanke was being charitable. As the above chart suggests, the odds of sidestepping economic contraction look virtually nil. Yes, anything's possible. But if we look at a broad range of economic indicators in addition to today's jobless claims report, it's hard to miss the obvious trend.
It'll take time to get a handle on how short and shallow (or long and deep) the recession will be. Given the lag in economic data, the coming weeks and months are likely to provide ongoing confirmation of what's already obvious. As a result, the focus turns to the various leading economic indicators for clues about where the cyclical trough lies and what will spark an eventual upturn. But let's not strain our eyes at this point; it's too early for that. For the moment, patience and prudence, along with a modest dose of opportunistic buying sprees here and there are still a strategic-minded investor's best friends.
April 2, 2008
It comes as no surprise to learn that volatility in the capital and commodity markets has been rising of late. Confusion and uncertainty (both of which have been in surplus in recent months with regards to economics and finance) typically sow the seeds of wider trading ranges. Monitoring volatility is no short cut to easy profits, of course, but as we've discussed from time to time, the ebb and flow of volatility sometimes offers strategic-minded investors some valuable clues about investment cycles.
With that in mind, below we present a freshly updated chart of rolling 36-month volatility over time for several major asset classes, with data through March 31, 2008. Consider that volatility looked unusually low in '06 and '07, which we now know was a prelude to a reversal. Note too that trailing returns back in '06 and the first half of '07 looked exceptionally strong across the major asset classes. The two trends looked long in the tooth, suggesting that the cycle was poised to turn. And turn it did. But now that it's turned, what's next?
That's always a relevant question and it's forever unclear in real time. To the extent that strategic-minded investors can generate informed guesses about the future, tracking volatility cycles is one among many factors to survey on a regular basis. For the moment, there are no obvious signals springing from volatility, at least nothing comparable to the signs of '06 and '07. As such, volatility remains one more metric we watch and will continue watching, always in context with other factors, starting with valuation.
Meantime, volatility has been rising and returns have been falling. But that too will end...at some point. Cycles, in short, remain very much alive and kicking.
April 1, 2008
SEAT BELTS ARE RECOMMENDED (corrected version)
Whipsawed is the best way to describe recent action in the major asset classes. What was down is up; what was up is down.
Consider the horse race for March, as per our table below. Commodities were the bottom performer, posting a total return loss of -6.5%. A month earlier, commodities were the leading asset class, posting a 12.2% gain in February. Meanwhile, REITs were the big winner in March, completely reversing their last-place status the month before.
In fact, what little postive-return consistency there was in February and March among the major asset classes was concentrated in cash and foreign bonds.
The back and forth is hardly surprising. The unfolding drama in finance and the wider economy leaves investors jumpy as they ponder where the next shoe will drop. We're already up to our necks in fallen footwear and few pundits (including this one) are prepared to say it's over.
Yesterday was a perfect example. It's not every day that the U.S. Treasury Secretary gives press conferences outlining ambitious proposals for overhauling financial regulation in the U.S. and dramatically expanding the powers of the Federal Reserve. Yes, the plan may be dead on arrival in Congress, as has been widely reported. But it's clear that the turmoil on Wall Street continues to reverberate throughout the wider economy and the government.
Meantime, large financial institutions keep announcing the price tag of previously believing that bull markets last forever. The Swiss banking giant UBS announced yesterday that its first-quarter loss would top $12 billion, thanks largely to mounting troubles from the subprime mess.
If investors are skittish in such an atmosphere of uncertainty, no one should be shocked. Strategic-minded investors, however, should be looking to take advantage of the volatility when opportunity arises. For equities in particular, there's a recession premium associated with buying when the crowd wants cash. The catch: the recession premium probably won't pay off for years and the only way to boost the odds of success are buying at lower prices and extending one's investment horizon.
These are extraordinary times and markets are likely to be whipsawed for the foreseeable future, interrupted by periods of calm that give way to a fresh round of drama. Once the economic outlook stabilizes will something approaching a more normal state return to the risk/reward profile of the major asset classes. But for the moment, ours is a fluid period. As Wall Street and Main Street grapple with the prospect of recession, prices will be volatile. So it goes when uncertainty comes in larger-than-usual doses.