August 24, 2008
ONE LAST SUMMER FLING
The Capital Spectator is on vacation. We'll be returning right after the Labor Day weekend, prepared once more to do rhetorical battle in the world of finance and economics.
August 21, 2008
THE PEAK THEORY FOR INFLATION
We've been chatting up the inflation story lately, and for good reason: inflation is rising. But that's yesterday's news. Thus the relevant question: Will it continue to rise?
No one really knows, although everyone has a guess, and those guesses are all over the map, as yesterday's post reminds. On one side are those who expect inflation to remain relatively high, if not rise further. A superficial reading of recent history supports this view, as per the upward momentum in inflation measures of late.
The alternative theory is that inflation will soon fall, courtesy of the economic slowdown. The Federal Reserve subscribes to this theory, and so the central bank remains comfortable with keeping interest rates low. The danger is that inflation's pace doesn't fall, or that it doesn't fall enough to compensate for the low rates.
Not everyone worries about that scenario, and arguably those who do (including your editor) are in the minority. For everyone's sake, let's hope this minority is wrong. On that note, let's consider how the majority thinks. As one example: the latest research from Northern Trust. "If history is a guide, the U.S. economy is probably at the brink of a turning point in inflation," NT's Asha Bangalore writes. "This is entirely conceivable given the projection of weak economic conditions in the near term. Inflation expectations (as measured by the difference in nominal 10-year U.S Treasury note yield and the 10-year TIP yield) as of August 19 stood at 2.15%, down from 2.57% on July 3."
The relevant history is a review of core inflation's behavior as it relates to the business cycles since 1960. "The main conclusion is that both core price measures – core CPI and core personal consumption expenditure price index – peak several months after the peak of the business cycle," Bangalore reports.
By that measure, core inflation is set to peak in the coming months, perhaps before the end of the year. Certainly the Treasury market expects no less, as the inflation forecast via the TIPS market suggests, as per our post yesterday.
The idea that the inflation peak is coming is the last best hope for the optimists that the inflation threat is transitory. The bond market has priced in this future as if it's a forgone conclusion. There is, in short, no room for error in bond prices. And that's what worries us.
We don't doubt that core inflation has a tendency to peak after a business cycle has run its course. Our problem is that the bond market has no doubts that the future will unfold with clockwork precision as it has in the past. Maybe it will, although leaving no room for error in bond prices gives us pause. As we wrote yesterday, expecting headline inflation in the low-2% range for the next 10 years--as per the TIPS forecast--is a bit too optimistic for this skeptic.
August 20, 2008
What's the outlook for inflation?
The question is simple enough. But the answer is complicated these days. In fact, there's an array of inflation expectations to pick from in the summer of 2008. If you're looking to commodity prices as an early warning sign of future pricing trends, the message has been clear: inflation will rise in the months and years ahead.
Skeptical? Perhaps the recent updates on consumer and wholesale price inflation will change your mind. As we noted yesterday, the trend in producer prices has been unmistakably up. Meanwhile, consumer price inflation shows similar symptoms.
Expecting inflation to continue bubbling, in other words, seems like a reasonable proposition. Or so recent history suggests. But such thinking finds no favor in the Treasury market. The prospect of higher inflation is a bond investor's worst nightmare, but you'd never know it by looking at the CPI-adjusted yield on the nominal 10-year Treasury. Buyers of the 10 year apparently have no fear of buying a fixed-rate bond at a yield that, after adjusting for consumer price inflation for the past year, looks somewhat unappetizing.
As our chart below shows, the 10-year Treasury yield less annualized consumer price inflation has been sinking into negative territory for some time. As of July, the 10-year Treasury's CPI-adjusted yield was negative 1.59%, based on using the monthly 10-Year Treasury constant maturity yield and subtracting the 12-month change in CPI, with data courtesy of the St. Louis Fed.
Suffice to say, it's been a while since the 10-year offered so little inflation-adjusted yield compensation. Not since the early 1980s has the prospect of owning a government bond looked so grim as an income producing security once inflation is considered. We can debate what it means, and whether it's even relevant for assessing the future of inflation. Nonetheless, the graph above is worth a close look before one dives headfirst into Treasuries at this point.
Or is it? The inflation-indexed Treasury market, a.k.a., the TIPS market tells us that the outlook for inflation is hardly frightening. As the second chart below suggests, the TIPS market is predicting consumer price inflation will run at less than 2.2%, or far below the 5.6% annual pace of CPI reported for July. (The TIPS inflation forecast is calculated as the spread between the nominal 10-year Treasury and its inflation-indexed counterpart.) This is the lowest inflation outlook in years from the TIPS market.
Clearly, something's amiss in the world of inflation forecasting. Maybe. Deciding where the error lies in real time is a challenge, of course. But that doesn't keep us from guessing. For our money, we doubt that headline consumer prices over the next 10 years will stay tame in the low-2% range. Call us crazy, but expecting something higher looks prudent.
Obviously, not everyone agrees. The glitch is that some believe the risk of recession, deflation and general turmoil in the economy overall will keep pricing pressures low in the years ahead. Investors have run for cover on the assumption that more trouble lies ahead, and the cover includes buying Treasuries, in both nominal and inflation-indexed forms. The higher demand has, of course, pushed yields down. And with the world more inclined to worry about deflation/disinflation, fear of inflation has been virtually dismissed. For the moment, anyway.
Alas, we don't know which forecast is right, but we do know that betting the farm on 2% consumer price inflation through 2018 doesn't look all that attractive as an investment proposition. Even in a world where credit crunches and debt reduction looks likely, one has to expect an especially dire scenario to think that inflation will all but evaporate in the years ahead. Yes, anything's possible, but not everything's probable.
August 19, 2008
PRICE STABILITY IS A TERRIBLE THING TO WASTE
Hope is a wonderful thing, but at some point it becomes the enemy. It's hard to know exactly when a friend turns foe, especially when so many of the old rules go out the window. Hindsight, in other words, is the only true source of clarity, which leaves mere mortals like us with the thankless task of dissecting trends in real time. Good luck with that, as they like to say down at the University of Hard Knocks.
Once again, our work is cut out for us with the challenge du jour: deciding if today's update on wholesale prices reflects momentum or another irregular set of data that will soon reverse. As a preview, it's safe to say that at face value the numbers look bad. The Producer Price Index for July jumped 1.2%, the Bureau of Labor Statistics reports. The good news is that the 1.2% pace is down from June's nosebleed 1.8% rise. But that's about the extent of the positive-spin potential in today's PPI numbers.
On a rolling 12-month basis, PPI is now surging upward by 9.8% a year, as of last month. That's the highest annual rate since 1981, when inflation was universally hailed as a threat to the economy and livelihoods of the men and women in the street. It's debatable how the Federal Reserve views PPI and other pricing data these days, but it's clear what the consensus was among monetary authorities all those years ago.
Meanwhile, forget about looking to core PPI as a reason for optimism that pricing momentum isn't as bad as headline PPI suggests. PPI less food and energy rose by 3.6% for the 12 months through July 2008--the highest since 1991. As our chart below reminds, this surge in core PPI is no recent event. Upward momentum in core PPI has been building for some time. And as economic history so clearly teaches, slowing if not ending a runaway train in matters of pricing takes time; and the longer the train rolls on, the higher the economic price tag.
Considering that PPI is advancing at a time when consumer prices also look threatening suggests that now is a time for action. Why, then, does the Federal Reserve sit on its monetary hands by keeping interest rates unchanged at a 2% Fed funds rate? The answer of course can be summarized by the phrase "dual mandate." The Fed, in contrast to its European counterpart, must promote economic growth and minimize inflation. This may or may not be a plus, but it's definitely a burden. Is it a burden that exceeds the limits of central banking? We may soon find out. Let's just say that your editor is keeping an open mind as to the outcome, at least for the conclusion of this cycle.
Mr. Market is starting to come around to the idea that rates will rise, sort of. The idea of higher rates is embraced reluctantly, as witnessed by the March '09 Fed funds futures contract, which currently is just barely priced in anticipation of a 25 basis point hike between now and next spring. For good or ill, the market's not expecting much change, if any, any time soon in the land of interest rates.
No one should be cavalier about the prospect of job losses and the resulting pain that falls on the average worker. But let's also recognize that Joe Sixpack will be hurt by higher inflation too. Deciding how much pain to allow in one vs. the other is a thankless task, and one that can only be managed generally, if at all. Monetary policy, as economists like to say, is a blunt instrument. As an analogy, think of trying to thread a needle with mittens and you'll have a sense of what it's like to manipulate the price of money as a tool for economic salvation.
Nonetheless, it's time for the Fed to at least send a minor message that it's a) alert to the inflation threat; and b) willing to act, if only marginally. A 25-basis-point hike in Fed funds, unannounced on, say, Thursday, would be a good start. No, that wouldn't cure inflation per se, but it would send a message. A thousand mile journey, as they say, requires a first step. Meanwhile, a 25-basis-point rise by itself would hardly alter the labor market outlook one way or the other. In fact, we can debate how effective the Fed's rate cuts over the past year have been in easing economic pain. Indeed, it's hard to argue that the ills affecting the economy are born of interest rates that were too high.
Still, there are no good choices. We're long past that point. At best, we're now looking at the least-worst decisions and its all down hill from here. But this much is clear: doing nothing at this point looks increasingly reckless. Yes, the inflationary momentum that's been bubbling for some time may suddenly pass away, in which case we can always lower rates again. Let's recognize that a weakening global economy promises to take the edge off inflation. The question: How long should we wait for that day of reckoning? Something less than forever is a reasonable answer, but it get fuzzy beyond that.
That leaves us with: What if inflationary pressures don't soon evaporate? We all know the answer, and so does the Fed. For now, Bernanke and company are betting the farm on a slowdown, both here and abroad. Hope, it seems, will remain official strategy for a while longer.
August 18, 2008
IS DOLLAR-BASED SALVATION COMING?
The hope that the troubling surge in inflation will soon pass draws on fresh hope born of the widely reported outlook for new-found strength in the dollar. And the hope doesn't come a moment too soon.
As we reported last week, the July report on consumer prices was sobering, one of the worst in recent memory. In particular, the upwardly mobile core rate of inflation suggests that inflationary pressures born of the bull market in commodities is now spilling over into other areas of the economy.
But that was last week. Many analysts are now expecting the dollar's reversal of late will come to the rescue. The assumption is that dollar can keep climbing, or at least won't return to its bear market status any time soon.
One analyst spoke for many with a forecast that the formerly battered buck is headed for better days. "The fundamental picture for the dollar has improved substantially in recent weeks," Fiona Lake of Goldman Sachs told the Financial Times over the weekend. "As a result, we now think the dollar has bottomed."
Meanwhile, Forex Factory went so far as to label the rise in the euro vs. the dollar over the past several years as a "Euro bubble" that's in danger of popping. If so, that would be good news for the greenback.
And today's Wall Street Journal asserts that a rising dollar may be the silver bullet that ends inflation's grip for the current cycle. "The buck's rise," the Journal counsels, "should help quell domestic inflation by making imports and commodities cheaper."
Perhaps, although it'll take a month or two--or three or four--to find confirmation, or rejection of the theory. Waiting for the next CPI report, in other words, promises to be a lengthy nail-biting run.
Meantime, it's hard to overlook the numbers. The fact that core CPI is now rising on a year-over-year basis may be dismissed by some, but for others it's a warning sign. Waiting and hoping that it will soon turn agreeable is, at least for the moment, asking a bit too much for some members of the dismal science. For example, Robert Dieli, who runs the economic consultancy Mr. Model, suggests that staying cautious on inflation's outlook is still prudent, a stance that will retain its appeal for at least another month. As he writes in a note to clients over the weekend,
The break to the upside of the change in the core rate removes what little cover the FOMC had to hold rates steady until the financial system could be brought back into better balance. While we don’t think this is going to provoke the hawks into open revolt, we do think it will embolden them to step up their calls for a rate increase and to add to the number of dissenting votes. The FOMC will get a fresh set of inflation numbers on the day they meet next month. If that report is as ugly as this one was the Committee will be hard pressed to issue another mild press release like the one that followed their August meeting.
Nonetheless, commodities prices are falling and to the extent that the trend continues it will offer support to the dollar. Yet it's not yet clear that a stronger dollar alone will solve the inflation ills that harass the U.S. economy. Lower commodity prices and a stronger dollar are a powerful combination for battling inflation. A weakening economy will also help curtail pricing pressures. But the real question is whether the inflation sparked by surging commodity prices in recent years has spilled over into the wider economy, as the jump in core CPI suggests? Stay tuned.
August 14, 2008
A TURNING POINT FOR CORE?
Today's update on consumer prices could hardly send a clearer message: pricing pressure is rising, and it's no longer just about energy. Food prices are now a problem as well. Having jumped 6.0% over the past 12 months, food is now advancing faster than overall consumer inflation.
The Federal Reserve can make a political decision to attack the beast or leave him be. If it's the latter, the central bank can't blame ambiguous data for consumer prices as the rationale.
Last month, headline CPI rose 0.8% on a seasonally adjusted basis. Yes, that's down from June's 1.1% surge, although that's cold comfort once you realize that 0.8% is still near the highest monthly readings for the past 20 years. Even more troubling is the fact that CPI has climbed 5.6% over the past year through July, the likes of which haven't been seen since the early 1990s.
But how about our fail-safe response that core inflation is still under control? That, too, is starting to look thin. CPI less food and energy prices advanced 0.3% last month, which translates to a 2.5% annual pace. The hope that core inflation would slip down to the 2.0% neighborhood has, for the moment, faded.
This is a critical change. Recall that 2.0% is widely reported as the Fed's upper band of tolerance for core CPI. The fact that Bernanke and company have stomached annual core inflation above 2.0% for several years has recently been rationalized as a temporary oversight that would soon be corrected once the economy slows, which in turn would take the edge off pricing pressures.
Well, the economy's slowed, and probably continues to slow. Based on today's CPI report, however, the waiting game appears to be a failure on the inflation front. On the surface, the idea seemed reasonable--last year. Inflation, we were told, was merely a passing storm. The anomalous rise in CPI was due to factors beyond the Fed's control, which is to say beyond the central bank's influence via monetary policy.
Still, higher inflation can't be ignored. What to do? Blame it on food and energy, and claim that the statistical noise emitted by prices in those areas is an unreliable source of inflationary signals for the future. True enough, at least that's been the pattern in years past. But the conceit has always been that food and energy can be ignored only if prices for those commodities cycle, i.e., prices remain unchanged over a business cycle or two. If not, it's a whole new monetary ball game.
Well, one can argue that the new game has begun, and in fact the new game has been unfolding for some time. Arguing otherwise requires hoping that core inflation will soon turn down, which is to say that food and energy prices aren't in a secular bull market. Maybe next month.
Meantime, there's a price to be paid for being wrong. If core inflation keeps rising, at some point the inflationary cat's out of the bag. Are we at that point now? Is higher inflation generally now a done deal? Will the Fed be forced to raise rates? Could this have all been avoided, or at least mitigated if the Fed didn't ease so aggressively over the past year? The fact that we can even ask such questions with a straight face suggests that the hour is already late.
To be fair, every central bank is forced into a tradeoff of growth vs. inflation in varying degrees, depending on the circumstances. There are no absolutes in monetary policy. At times, one comes only at the expense of the other. But history reminds that sometimes economies can be two-time losers on those fronts. Yes, that's rare, which is probably why few central banks make preparations for those twin demons. Nonetheless, rare doesn't mean never.
August 13, 2008
It comes as no surprise, but it's bracing just the same.
U.S. retail sales slipped last month, falling 0.1% from June's level, based on a seasonally adjusted calculation, the government reports. Meanwhile, for the 12 months through July, retail sales rose a modest 2.7%. The casual observer may think that the numbers don't look so bad. Year-over-year growth, after all, is still growth, and in the current environments that's pretty good. Putting the numbers in economic context, however, suggests that the slowdown of late still has the upper hand.
Consider the chart below, which shows the rolling percentage changes in retail sales on a monthly and annual basis through July 2008. The red line shows that July suffered the first monthly decline in retail sales since February. Meanwhile, the black line reminds that year-over-year retail sales continued to retreat in relative if not absolute terms.
Clearly, the slowdown in retail sales is unmistakable. The broader trend can't be denied. But that only reveals what's passed. Thus, the two burning questions: How much longer will the downtrend go on? How bad will it get?
No one knows, of course, but if we anticipate a continued fading of the government's stimulus program that began in May, it's reasonable to think that retail sales will slump further in the months ahead. The counterpoint is that with oil prices retreating recently, perhaps the defacto energy tax will lessen, providing consumers with an unexpected boost in disposable income in the months ahead. Assuming, of course, that the correction in energy prices has legs.
Perhaps, then, it's reasonable to predict some sideways action in retail sales, i.e., neither growth nor decline in the ground-zero measure of consumer spending. Maybe, but we shouldn't get too comfortable with even that benign outlook. Keep in mind that if we look at the more cyclically sensitive corners of retail sales, the trend is unmistakably sobering. Notably, retail sales of motor vehicles and parts fell 2.4% last month and are down more than 8% from a year ago. When it comes to spending large sums of money, Joe Sixpack is speaking volumes by hiding his wallet.
Meanwhile, even among those retail areas that show growth, the trend in real spending is flat, if not down, after adjusting for inflation (running at a robust 5% for the year through June, as per CPI).
The slowdown, in short, still has momentum. What will change the trend? Convincing signs that the housing market is no longer contracting would help. A few months of energy prices treading water, if not falling, would be another plus. It wouldn't hurt if inflation's upside momentum takes a breather too.
But let's not get ahead of ourselves. The prospects for a vibrant rebound are still far off. The consumer is suffering on a number of fronts, and the weak retail sales are only one measure of the financial distress. Much depends on where we go from here for labor income, inflation and employment fronts. For now, caution is still the only game in town.
August 12, 2008
MAN BITES ASSET ALLOCATION
Is extremism in the pursuit of asset allocation a vice or a benefit? To be precise, is routinely holding one asset class to the exclusion of all others a wise choice for the long run?
Anecdotal evidence suggests that most strategists prefer a broad array of asset classes for clients. Arguably, history backs up the advisability of diversification as a prudent strategy when measuring portfolio results in risk-adjusted performance terms. The fact that 50 years of finance theory lends a supporting academic hand to the idea doesn't hurt either.
Nonetheless, seeing how the other half lives is useful, if only to strengthen one's decisions. Or, perhaps a fresh perspective will raise new questions and lead to new insights. In any case, your editor came across a financial advisor who has some very definite views on the issue of asset allocation. In particular, he abstains from diversification completely, instead choosing investment grade bonds as the one and only asset class for clients.
That's an extreme strategy, at least by the standards of what passes for normal on these digital pages and conventional wisdom in the financial planning community. Why would an advisor recommend that clients avoid most of the world's asset classes sans high-grade bonds issued in the U.S.? In the current issue of Wealth Manager, we asked the question, and more, to an advisor who prefers bonds all the time. For his responses, read on...
August 11, 2008
RANTING ABOUT RISK (AGAIN)
Failure imparts more lessons than triumph in money management. Success too often breeds hubris and excess confidence; disappointment invites analysis and reflection about what went wrong, why it went wrong and how to make sure the same mistakes aren't repeated.
Progress in finance and economics, in other words, relies more on failure than success. The truism comes to mind after reading the "confessions" from a "risk manager at a large global bank" in the latest issue of The Economist.
Might progress one day come even before the trouble starts? Perhaps, although the problem is the nature of the beast. Risk is a slippery concept, in part because its preferred method of arrival is in the guise of sheep's clothing. As the anonymous confessor in The Economist relates, risk has a nasty habit of appearing when common sense suggests otherwise.
"In January 2007 the world looked almost riskless," the risk manager recalls. "At the beginning of that year I gathered my team for an off-site meeting to identify our top five risks for the coming 12 months. We were paid to think about the downsides but it was hard to see where the problems would come from. Four years of falling credit spreads, low interest rates, virtually no defaults in our loan portfolio and historically low volatility levels: it was the most benign risk environment we had seen in 20 years."
It was also a time ripe with peril. The fact that few could see it, including the professionals paid to do just that, is a potent reminder that staying vigilant on the risk management front is an ongoing chore, particularly when it seems that risk is nowhere in sight.
The notion of risk's invisibility crossed our mind back in January 2007, when we asked point blank: Is Volatility Set For A Comeback? The question, with the benefit of hindsight, looks prescient, although in truth it was merely a prudent question posed by an otherwise mortal observer of the financial scene. Nonetheless, as we all now recognize, asking if risk was underpriced in January 2007 was the equivalent of wondering in 2001 if $20-a-barrel oil was worth buying; or if stocks should be sold in March 2001.
Why, then, were so few asking such questions? The answer is no doubt tangled up in the fact that turning a profit was so easy. Today, by contrast, profits are hard to come by and risk is on every investor's lips. So it goes in finance: up is down, black is white, and common sense and forward thinking are as wispy as clouds on a windy day.
The good news is that there are countless ways to measure and analyze risk. Sometimes a given technique works, sometimes not. But rather than discourage strategic-minded investors, the weakness and limits of any one risk metric as a fail-safe tool should inspire us to routinely monitor several gauges.
That said, we like to keep a close eye on volatility as a starting point. To be precise, rolling 36-month standard deviations of trailing monthly total returns. (A recent survey of vol can be found here.)
No, volatility is no crystal ball into the future, and most of the time it's of little if any value. Indeed, its best clues spring from radically low or high volatility. Those signs are far more valuable about handicapping the future than the modest levels of vol that prevail most of the time. Thus, in early 2007, we thought maybe, just maybe, a change in the financial weather was coming. Timing, of course, was unknown, as always.
Volatility these days, by comparison, isn't all that helpful for peering into the future. Yes, vol is up from the 2006-2007 trough, but that's like saying the cats are more nervous now that one of their own got his tail caught under the rocker.
Risk management isn't getting any easier and arguably it's become a whole lot tougher compared with a year or so previous. Risk, on the other hand, still flows as easily as rivers after a spring rain.
That stirs some to think that risk is beyond us, outside of our control and in the fates of the financial gods. Acknowledging that no one can see the future, it's easy to think that we're left to invest as conditions of the moment suggest and take our lumps as they come. But it's a mistake to throw up one's hands and say that the future's unknown and so there's no point to risk management. The pain of financial history has taught us something after all.
That starts with the observation that there are always hints about the future, and monitoring vol is just one of the portals that dispense signs about what's coming. As the anonymous confessor in The Economist reminds: "No crisis comes completely out of the blue; there are always clues and advance warnings if you can only interpret them correctly."
Ideally, risk management is practiced as a multi-faceted strategy, as we recently discussed. The value of having multiple choices in our risk toolbox helps reduce the chance of being led astray by the misfiring of any one signal.
Yes, even risk management is risky, which leads us to familiar terrain. Diversification, in other words, is still the only solution. True for pursuing returns, and true for monitoring, managing and otherwise keeping a lid on risk.
August 7, 2008
MORE TROUBLE IN THE WEEKLY JOBLESS NUMBERS
The Labor Department brings more bad news this morning. The short summary: new filings for unemployment benefits rose again last week, as did the rolls of those previously collecting jobless benefits.
As our first chart below reminds, the trend in jobless claims continues to deteriorate, which is to say that the population of the unemployed is still expanding. Last week new filings rose to 455,000, the highest since 2002.
The news isn't any better for the ranks of the formerly employed who continue collecting unemployment checks. As the second graph below illustrates, continuing jobless claims jumped again for the week through July 26 to 3.311 million, an elevation that hasn't been seen since 2003.
The two trends are hardly surprising, given the broader perspective on the weakening economy, as we discussed yesterday. Expected or not, today's news for the job market will provide another jolt of bearish realism to those who think that a rebound from recent ills is imminent.
The economic weakening will get better before it gets worse, in other words. That doesn't mean the pain will get materially worse, although no one should rule out the possibility. But the general trend, at least, is clear. Only the duration and magnitude are in question.
August 6, 2008
BENCHMARKING THE ECONOMY
With the last of the June economic data in hand, it's time to update the CS Economic Index, which is calculated monthly. As our chart below shows, and anecdotal evidence suggests, the U.S. economy is weak and getting weaker.
The black line in the chart above, which runs through June 2008, is our broad measure of U.S. economic activity, comprised of 17 variables, ranging from nonfarm payrolls to retail sales to business loans. The index's biggest weighting (a bit more than 40%) is comprised of leading indicators, which are those measures (such as new building permits and disposable personal income) of economic activity that are considered as windows into the future. Another 30% of our broad economic index is made up of coincident indicators with the remaining 30% in lagging indicators. In short, the CS Economic Index is designed to measure broad economic activity, giving a modest bias to leading indicators.
With that in mind, we take no comfort from the relatively sharp decline in the leading component of our index (the red line in the chart above). As you can see from the graph, the leading indicators are signaling that there are more challenges ahead. In fact, the leading indicators have been flashing warning signs for some time now, although the downside momentum has only been bubbling since late last year.
No wonder, then, that the Federal Reserve yesterday decided to keep interest rates unchanged. Fed funds remains at 2%, and for the moment the market expects more of the same. Looking into early next year, Fed funds futures prices are betting on a rise in interest rates, perhaps by 50 basis points. Yes, there are inflation concerns that come with keeping rates below the general level of reported inflation. But for good or ill, the central bank prefers to err in favor of growth. We'll know in the coming months if that bet pays off. For now, we're all invited along for the ride.
As for our economic index's forecast, keep in mind that's its insight into the morrow, such as it is, is mostly speculation and therefore subject to change. Ours is an intelligently designed measure of broad U.S. economic activity, or so we believe. And while it factors in so-called leading measures of economic activity into the mix, we have no illusions about the true value of our index: clarifying the past. As for the future, we can only guess. Crunching economic numbers, no matter how you slice it, is first and foremost a venture of looking into the past. Nothing wrong with that; in fact, it's quite valuable for context and so we highly recommend the sport. The key is remembering that it's no substitute for a crystal ball.
At some point the economy will heal, and the rebound will take root. Perhaps the leading indicators will give us an early sign of the approaching bounce, perhaps not. The odds are probably stacked against us for correctly divining the future with any precision as to timing, in part because the full range of economic numbers arrive with a considerable lag. Even if the data was dispensed in real time, that still wouldn't change the fact that economic reports are mostly about the past.
That doesn't stop us from trying to peer into the future, but we do so with the full recognition that our vision is heavily clouded. So it goes when swimming in the murky waters of the dismal science.
August 4, 2008
HOLDING ON...FOR NOW
This morning's update on personal income and consumer spending is a complicated beast. On first glance, it looks like the great American income machine has stumbled, and stumbled badly. But looks can be deceiving. Maybe.
The first order of business in digesting today's report on personal income and outlays is looking at the big negative: disposable personal income dropped by a hefty 1.9% (seasonally adjusted) in June. This is income that's left over after Joe Sixpack has paid his bills and so it's a key number about his capacity for running to the mall and picking up an extra TV. In short, this is the front line measure of the American economy's growth potential. GDP, after all, is overwhelmingly dependent on consumer spending. As such, the 1.9% drop in DPI--the first slump since April 2007 and the biggest decline since August 2005--looks ominous, as our chart below suggests.
But the DPI drop isn't quite as painful as it appears. Note in the chart above the large bump in May that precedes June's drop. The rise in DPI is courtesy of the government's stimulus checks. The stimulus is temporary, of course, and so its effects are beginning to fade. No great surprise. If we take out the anomalous jump in May's DPI, June's level of DPI is at an all-time high.
The key issue is deciding how much additional DPI fading awaits. Logic suggests we'll return to trend, short of another round of stimulus. By that reckoning, DPI will fall in the coming months, perhaps to the $10.6 trillion level for August or September. That not-unreasonable assumption means that the market has to brace itself for more red ink on the DPI ledger. Such declines will look troubling, but they won't signal much more than the aging effects of stimulus checks. Up to a point, that is. Indeed, one might reasonably think that DPI is due for some additional retrenching due to the various economic ills of late. In that case, DPI declines may run on for longer than the optimists expect.
The good news is that wages were still rising in June, advancing a respectable 0.2%. That's a sign that Joe Sixpack's still working and receiving a paycheck. For the moment, that's the best news we have, although Friday's report on the rise in the jobless rate to 5.7% and the ongoing loss of nonfarm payrolls last month strongly suggests, if not insures that we can expect the months ahead to be challenging in terms of how many people lose their paychecks. Let's just say that the toughest days still lie ahead.
So much for income. Let's turn to spending. As the above chart illustrates, personal consumption expenditures continue to climb. In June, PCE rose 0.6%. That's down from May's 0.8% rise, but it's clear that Joe Sixpack was still spending at a strong pace in June, at least in nominal terms. Indeed, a 0.6% jump in PCE isn't too shabby, as they say.
But let's not think that all's well. The durable goods component of PCE took a hit big hit in June, falling 1.5%. This cyclically sensitive measure of consumer spending offers evidence that Joe is in fact feeling stressed and he's responding by avoiding purchases of big-ticket items, such as appliances. Looks like buying an extra TV will have to wait after all.
And there's more bad news on spending if we look at PCE in inflation-adjusted terms. By that measure, spending slumped by 2.6% in real dollars in June. Inflation, in short, continues to take its toll.
Overall, let's be clear: the economy faces more challenges. For the balance of the year, and perhaps deep into 2009, strategic-minded investors will be tested by more than a little. That raises the possibility of more investor-friendly valuations in asset classes, although the price of entry will be remaining calm as a bearish aura swirls about.
For now, the economic numbers are surprisingly decent, or at least less threatening than we expected given the backdrop. But the data will get worse before it gets better.
August 1, 2008
REITS POP, COMMODITIES FLOP
July 2008 was one of the more challenging months for strategic-minded investors in recent memory. There was plenty of red ink on last month's tally, as our table below shows, although the headwinds were even stronger than losses alone suggest.
Let's begin by noting that the big stumble last month came in commodities. The DJ-AIG Commodity Index, for instance, dropped by an astonishing 11.9% in July. That's the biggest month setback for the benchmark, as far as we can tell, based on records we can dig up going back to 1991. (Our ETF proxy in our table fared even worse, slipping more than 12% last month.)
Foreign stocks took it on the chin last month, too, although the pain was modest by comparison with commodities.
In the winner's column: REITs, which rebounded in July with a robust gain. Overall, we can say that REITs popped and commodities flopped.
The steep tumble in commodities was due mostly to oil's sharp drop last month. Since most commodities indices are heavily weighted in oil and energy, it's no surprise to learn that commodity benchmarks overall suffered in July. Unexpected? Hardly. Commodities generally have been rallying for years and the corrections along the way, at least on a monthly basis, have been relatively rare and quite mild for the most part. Taking some of the froth out of prices, particularly in oil, is long overdue and it wouldn't surprise us to see more of the same in the months ahead. Commodities generally are a volatile asset class, and if you factor that in with the record prices for many raw materials of late, it's no surprise to see downside volatility has finally come a-courtin'.
Expected or not, the reversal in commodity price fortunes last month weighs heavily on our Global Market Portfolio Index (GMPI), which suffered an unusually steep 4.5% loss in July. That's the biggest monthly setback for GMPI since we began calculating the index in January 2002. (GMPI is our unmanaged proprietary index of the global equity, bond, REIT and commodity markets, initially weighted by the respective market caps--or equivalent for commodities--as of December 31, 2001.)
At the end of 2001, GMPI was set with a 17% commodity weighting, based on the total dollar value traded for the components of the Goldman Sachs Commodity Index. Since then, an all-time commodity-weight high for GMPI was reached in June, at 28%. Last month, thanks to the sharp correction in commodity prices, the asset class's weight in GMPI dropped to about 26%. That's still fairly high, and so future corrections can't be ruled out.
But let's step back and consider the bigger picture. As the table above shows, GMPI for the past year is still down only marginally, by less than 1%. That's impressive if you consider that U.S. stocks are off by more than 10% for the same period. Yes, it's now clear that we should have all owned TIPS and foreign developed market bonds exclusively over the past 12 months. But such valuable information wasn't obvious 12 months ago, just as the big winners and losers for the next 12 months are largely unknowable in the here and now. As such, owning a bit of everything in some informed blend is the next best thing.
The lesson, once more, is that owning a proxy of the world's major exchange-listed asset classes serves investors well over time. That doesn't mean that GMPI is immune to bouts of volatility from time to time, as July reminds. But in the long run, we're confident that diversification will continue to serve strategic-minded investors well. Even after last month, the concept has held up impressively. All the more so if you consider that implementing the strategy costs less than 50 basis points (via ETFs) and requires no trading skills.
At the very least, GMPI or something equivalent is the ideal benchmark from which every strategic-minded investor can begin to analyze and construct a portfolio. Yes, there are reasons to consider changing this benchmark portfolio to suit your particular investment and risk requirements. But we should do so cautiously, and only when we're supremely confident that our adjustments have a decent chance of paying off. Indeed, beating the market--i.e., something that's close to a representative sampling of the true market portfolio--is still tough, and always will be. A monthly snapshot here or there may suggest otherwise, but for most of us our investment horizon isn't measured in single months and so we can't afford to get caught up in the trend du jour.
As a result, when we see performance outliers--both up and down--in monthly GMPI numbers, we should take it with a grain of salt. Ours is a long distance challenge, and monthly returns are a tiny--a very tiny--piece of generating financial success. Yes, we should routinely monitor the markets, and our portfolios, if only to understand what's happening. But let's be careful not to get frightened by volatility cycles, particularly when they're in full bloom, as they are now.
In fact, let's remain opportunistic when volatility comes to town. Extreme volatility breeds higher-than-average rebalancing opportunities if you're looking several years out.
The proverbial glass, in sum, isn't half empty--it's half full. Volatility is our friend in the long run, if only we can keep our emotions in check in the short run and take advantage of Mr. Market's deals as they emerge. Easy to say, tough to do. Nonetheless, that's still the best deal in town.