March 30, 2009
WHAT ARE MONEY MANAGERS THINKING?
What are professional money managers thinking these days? A new poll by Russell Investments offers an answer. Among the highlights:
• 67% of managers are now bullish on corporate bonds
• 61% are bullish on high-yield bonds
In both cases, the percentages are a bit higher compared with the previous poll from last December. "In this environment of caution and realism, managers are finding opportunity in spreads between high-quality corporate bonds and Treasuries that are at historic levels," Erik Ristuben, Russell's chief investment officer, says in the accompanying press release. Expectations for junk bonds are also higher from late last year.
U.S. equities, on the other hand, have fallen in the eyes of managers. Value and small-cap equities suffer the most in terms of the current outlook, according to the Russell survey. Here's an overview of how the changes in expectations for the various asset classes stack up:
March 28, 2009
THE NATURE OF THE BEAST
Jeffrey Lacker, president of the Richmond Fed, is a voting member of the FOMC and a card-carrying hawk on matters of inflation. So when he warns that monetary policy faces new hurdles, our ears perk up. As we've been discussing, minting money is easy.;taking it away is something else. The hazards on the latter have rarely been higher at this juncture. At a talk a few days back at the College of Charleston, Lacker summarized the approaching task on soaking up the massive liquidity that's now in the system, albeit much of it sitting idle for the moment:
"Whether it has an inflationary impact or not depends on our skill at the Federal Reserve in withdrawing the stimulus in a timely way when the economy begins to recover. That is a very delicate, very hard policy...The economy when it recovers is spotty...Inevitably, we face this dilemma. Do we keep policy easy and stimulative because of the sectors that are lagging behind in this recovery or do we get ahead of the curve...it is going to be a tough call."
March 27, 2009
SAME CRISIS, NEW CHALLENGES
Today's update on personal income and spending reminds that the attack on the consumer rolls on.
As our chart below suggests, the recession is bearing down on Joe Sixpack and the pressure isn't likely to ebb for some time. Disposable personal income was flat to slightly down last month on an annualized seasonally adjusted basis. Personal consumption expenditures fared a bit better, posting a roughly 0.2% rise in February, but that looks like statistical noise and a reaction to the sharp pullback from previous months. Given the sober outlook for the labor market, there's little hope that we'll see much improvement for spending or income any time soon. As the crowd comes to terms with the economic backdrop, we're likely to see ongoing retrenchment in the late, great consumption binge.
But for the moment there's another threat to watch: inflation. Yes, we've been talking about deflation these past few months, and based on the numbers published late last year it looked like the potential for a deflationary spiral was quite real. But it was only a true threat if the Federal Reserve dithered and let deflation take root. As we've discussed, the Fed did no such thing and instead has acted aggressively in combating the threat by flooding the system with liquidity. Given the economic context, a fair amount of the liquidity is sitting idle—i.e., the classic problem of pushing on a string, as they say. Indeed, quite a bit of the newly minted liquidity has been redeployed into nonproductive areas, i.e., safe havens, which is why short-term Treasury bill yields remain at roughly zero, if not slightly negative. When the liquidity starts to come out of hibernation, the potential for inflation will rise.
Meantime, the "D" risk appears to be passing…maybe. And that's while much of the liquidity is locked up in safe havens. The nascent signs of price bubbling is no surprise, even at this early stage. The Fed has been working overtime to deliver higher inflation and there's no reason to think that it'll fail. We've been confident that the central bank would win this war eventually, perhaps sooner rather than later, if it was willing to go the extra mile. Clearly, Bernanke and company haven't been shy on this front, but it may be time to start pulling back.
One reason for thinking so comes by looking at the inflation measure in today's income and spending report. The personal consumption expenditures price index, or PCE Index, is showing signs of stabilizing. To be sure, the February PCE inflation rate remains quite low compared with last summer. PCE prices rose by 1.0% for the year through last month; as recently as last July, the annual pace of the PCE Index was 4.5%.
But a closer look at the components of PCE suggests that inflation, though largely dormant for the moment, is no longer falling. That suggest that it may be poised to reassert itself in the coming quarters. Given all the liquidity sloshing about, that's a real and present danger if we look forward by a year or so, which is typically how long it takes for monetary policy decisions today to ripple through to the broader economy. Much depends on what happens in the next quarter or so, but it's not too soon to consider the possibilities.
On that note, the core PCE Index, which excludes energy and foods, is no longer falling. Last month, core PCE prices advanced 1.8% on an annualized basis, up from 1.7% in January. The Fed targets core inflation generally and it's widely assumed that a ~2% rate on the upside is the goal. Yes, core PCE is still down from 2.4% last July, but a look at the trend since last summer suggests that the pricing trend may be forming a bottom.
Monetary policy necessarily evolves slowly, largely because it takes time to establish confidence about how the economic signals are unfolding in real time. It's all obvious after the fact, but central bankers don't have the luxury of looking at last year's trend for making decisions today. That doesn't mean they can speculate wildly about what may happen. The trick is finding a balance between the two extremes. That's tough in the best of circumstances; these days it's particuarly challenging, given all the volatility.
In any case, we may be at the end of the apocalypse-now realm that has dominated monetary policy since last September. We're not quite willing the declare the war on deflation over, but we're close. Let's see how pricing data looks over the next few weeks.
Meanwhile, we must be mindful of the stagflation risk. That's not an imminent threat, but it's starting to cross our minds these days. Yes, the economy still looks quite weak. But if inflation retains its capacity to bubble higher down the road, even if it's only on the margins, that will complicate the recovery effort and make a strong case for a change in strategy.
In short, the recent optimism that the worst is past is premature. The real work of navigating the financial and economic crises has only just begun. The threat is evolving. What worked for the past six months isn't likely to be effective for the rest of this year into 2010. Wars have a life of their own, and the generals need to stay vigilant. The next phase may be here.
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March 25, 2009
MORE ENCOURAGING SIGNS. ON THE OTHER HAND...
The first order of business in repairing the economy is reestablishing a stable rate of inflation, ideally a small dose just above zero. There's inherent danger in targeting higher inflation, but it's a necessary evil at the moment, and there are signs that the effort is working.
Exhibit A is the yield spread between the nominal and inflation-indexed 10-year Treasuries. The spread is considered the market's inflation forecast. Although no one should confuse this outlook with perfection, it does reflect market sentiment to a degree and it's also monitored by the folks at the Federal Reserve, among countless other statistics.
As our chart below shows, this spread continues to exhibit an upside bias, and in the current climate that's encouraging. As of last night's close, the Treasury market is forecasting a 1.3% inflation rate for the next 10 years—up from virtually zero late last year. Certainly the extreme lows of last November and December appear to be history, at least for the moment. That's heartening because it suggests that the market's modestly encouraged that deflation's threat is passing.
Insuring that deflation doesn't take root has and remains the priority for stabilizing the economy and laying the foundation for recovery, as we've been discussing in recent months, including here and here. The good news is that progress in this battle continues to accumulate, and the above chart is but one example.
A more general measure of the improvement in the reflationary war is suggested by today's update on new orders for durable goods, which posted a healthy seasonally adjusted rise of 3.4% last month—the first monthly rise since last July.
The jump in new orders, although not consistently positive across the board, was broad enough to suggest that the gain wasn't a statistical fluke. A few examples: new orders for machinery advanced more than 13% last month while new orders for computers and electronic products climbed nearly 6%. Excluding defense department-related items, new orders increased 3.9% in February.
No one should read too much into this report, of course, as one month could easily be statistical noise. After six months of declines, durable goods were due for a pop even if the recession roars on. Deciding if it's the start of stability vs. a pause in the ongoing contraction will take time and a fair amount of corroboration from other economic and financial measures. But one implication is that businesses are starting to react to lower prices by taking advantage of the bargains.
In other words, we can't dismiss the prospect that the massive liquidity injections engineered by the Fed and Congress are starting to work. Once there's more confidence on that front, it's time to adjust monetary policy and begin soaking up all the excess dollars floating about. Timing is always a gray area of course, but it's certainly prudent to go on heightened alert at this point.
Consider the latest new from Britain, which reported that inflation took a surprising jump higher last month. Consumer prices climbed 3.2% for the year through February, raising fresh questions about whether monetary policy in England is too loose. Alas, it's unclear if the inflation news is a sign of things to come or just a "hiccup along the way" to more falling prices generally, as one economist tells Bloomberg News. Of course, with many economists forecasting more economic weakness for Britain, the inflation report raises the specter of stagflation.
In short, there's still plenty of volatility harassing the global economy. The idea that the worst is behind us is tempting, but it's not yet convincing. Stay tuned.
March 24, 2009
THE PRICE OF LUNCH
In the long run, equilibrium prevails, supply matches demand and something close to pure efficiency in market pricing reigns. In the short run, on the other hand, stuff happens.
The idea that Mr. Market wins eventually crosses our mind as we consider the massive government intervention of late. There are some who are expecting something for nothing as the Federal Reserve, the Treasury and other state entities step into the vortex of market turmoil. In fact, there’s a cost to everything, and that includes the intervention du jour.
The rationale for intervening is compelling at the moment, but no one should think it won’t come at a price. The question is: What price?
To put this question into its proper context, we need to think about what’s going on in a broad macroeconomic sense. To put this succinctly, the government is borrowing from future consumption to fund stimulus today.
It’s clear that the government is borrowing money, lots of it, and far more than it’s borrowed in the past. One direct measure of this borrowing comes from the Fed’s balance sheet. Reserves at the Fed were nearly $780 billion, as of March 18--a colossal surge from a year earlier, when reserves totaled less than $16 billion.
There’s a strong case for flooding the system with money in the short term. Any student of financial history knows that banking crises are an especially potent virus that, left unchecked, can wreak havoc on the wider economy. All the more so when the troubles are global, as they are now.
The cure, if we can call it that, is clear: government intervention in the form of playing the lender-of-last-resort role and extending guarantees to depositors and other holders of debt. Executed well, such a policy can be beneficial, mainly in the form of sidestepping a deeper crisis that keeps the economy humbled for years.
Recent experience supports this view. Perhaps the gold standard in the modern era is Sweden in the early 1990s. The country’s banking system was nearly broke at the time, and the debt threatened to throw the economy into the abyss. Through a deft policy of bailing out the financial institutions at the heart of the crisis, the government of Sweden managed to avert a prolonged slump. The total cost of the bailout has been estimated at 4% of Sweden’s GDP at the time, although some economists say that the true cost was much lower after factoring in revenue paid back to the government in the years after the intervention.
So, how much is the U.S. spending to solve the current ills? Using the latest GDP numbers, and assuming a total cost of around $3 trillion (based on estimates by various economists) works out to a price tag of about 20% of GDP. Keep in mind that some analysts would call the $3 trillion estimate of total cost as overly optimistic, in which case the true cost will be much higher.
In short, the price tag for intervening will be substantial. But there’s likely to be additional costs that aren’t yet obvious, namely: inflation. Once it’s clear that the apocalypse has been averted, the big challenge will be unwinding all the stimulus. That implies that interest rates will rise. Indeed, investors will one day decide that the current bias for holding excessive amounts of short-term government bonds is no longer acceptable. At that point, selling will increase and yields will rise.
In the long run, there’s no benefit to intervening in the economy. Prices will settle based on supply and demand and there’s nothing the government can do to change that. In the short term, of course, manipulating prices is possible and even desirable, depending on the context. The recent crisis certainly calls out for intervention, even though the price tag may be steep in the long run.
The best we can hope for now is that the price tag is lower than the market expects. That’s a possibility, but it’s also true that negative surprises are possible too. There are no free lunches in the long run. What happens next Thursday, on the other hand, is wide open to almost anything.
March 23, 2009
TAKE IT SLOW...
The March rally in the stock market has people talking, and asking questions, such as: Was that a bottom?
For the moment, the answer is “yes.” Deciding if the answer holds is debatable. We’re skeptical largely because the rally this month has drawn power primarily from a new round of hope that Washington’s various experiments to right the economy will finally hit pay dirt. Perhaps, but it’s not the stuff that powers sustainable rallies, much less secular bull markets. We're closer to that point than we were 3 months ago, of course. But uncertainty still dominates.
The latest chatter may put a floor on equity prices, and for the moment that's what we're looking for, although it'll only be obvious in hindsight. Clearly, the government is integral in the healing process. But expecting the latest press release from the Treasury or the Fed to unleash something more substantial than a bounce is probably expecting too much at this point.
Nonetheless, it’s tempting to look at the trend in recent weeks and draw an optimistic conclusion. As the chart below shows, March has been kind to owners of equity. After taking another drubbing in February, investors were primed for anything that even remotely looked like good news.
And more of it appears to be coming in today’s news cycle. The latest from the Treasury is yet another freshly hatched plan to subsidize private purchases of the toxic securities that are weighing on the banking industry’s balance sheets. The size of the plan is a tidy $1 trillion, which is to say it’s sizable. Asian markets responded positively to the news and as we write the U.S. stock index futures are up ahead of the opening bell on Wall Street. It’s not over till it’s over, but with just over a week to go, it’s looking as if the S&P 500 may post a modest gain for this month…maybe.
Treasury bonds, meanwhile, received another round of support last week when the Fed announced it planned on buying government debt directly in a bid to lower interest rates. The announcement alone was enough to shave a massive 50 basis points off the yield for benchmark 10-year Treasury Note in a single trading session. Treasury prices, in short, exploded higher.
Suffice to say, it’s been a profitable run for stocks and bonds of late, and the crowd’s keen on expecting more.
Don’t misunderstand: the government efforts at cleaning up the mess are critical. But the government’s engineering of prices, even for fundamentally sound reasons, has limits. Since the implosion of Bear Stearns more than a year ago, Washington has been stepping into the breach and (sometimes) propping up the market, only to watch the true market sentiment return. Prices, in other words, keep falling.
At some point the declines will cease and desist. For all we know, that point may have come earlier this month. But even in these extraordinary times, finding equilibrium isn’t solely a function of government announcements, or so history reminds. Ultimately, the crowd has to come to terms with the reality that awaits, in which case prices will fully and fairly reflect the future estimate of what’s coming.
The enlightenment isn’t likely to come in a press briefing at the Treasury. Yes, the state's efforts will have an impact on the economic fundamentals, but assessing the degree of the impact takes time. And before we can run, we have to prove that we can stop falling. That tends to be a tedious and unexciting process, revealed over time.
The bottom will be obvious in hindsight. In real time, almost everyone will be clueless. The price of risk looks a lot more reasonable these days, and so strategic-minded investors should be increasing exposure to various betas, albeit slowly. Expecting it to pay off by next month, or even next year, however, is inherently speculative.
March 20, 2009
TALKING ABOUT THE YIELD CURVE ON THE INSIDE VIEW
Economic research published since the late-1980s tells us that watching the Treasury's yield curve is a productive exercise for analyzing the outlook for the business cycle and interest rates. In 2006, for example, the New York Fed offered a primer on why the yield curve is useful as a forward-looking indicator. As it turned out, the yield curve was set to invert at the time, offering an advance warning that the economy was headed for trouble. Few heeded the warning, thanks largely to a bull market in virtually everything. The recent past, once again, has a habit of clouding the crowd's ability to look ahead.
Normally, the Treasury yield curve is upward sloping: yields rise along with bond maturities. When the curve inverts—short rates above long rates—that’s often a sign of trouble brewing. For some thoughts on why that’s so, we recently talked with Bob Dieli, an economist who runs RDLB Inc, an economic consultancy that publishes research at NoSpinForecast.com.
On the new episode of the Inside View podcast, Dieli explains why the yield curve is a critical measure of current and future economic and financial trends...
March 18, 2009
REFLATION, PART II
Today’s report on consumer price inflation (CPI) for February confirms yesterday’s news on wholesale prices for last month: deflation is on the run. For the moment, anyway.
That’s good news, but if it’s true, then monetary policy becomes increasingly tricky in the months ahead. We say if it’s true because it’s hard to make definitive conclusions on just a few months of data. At the moment, the case for arguing that deflation has been banished rests on January and February numbers. Deciding if that’s a trend with legs remains speculative, albeit less so than in the past several months. Only once it's clear that the economy is past its worst point in the current downturn will it be obvious that deflation is no longer a threat. Where and when that point lies, alas, isn't yet obvious, at least to this obsever.
Meanwhile, the Labor Department reports this morning that consumer prices rose 0.4% last month on a seasonally adjusted basis. That’s up from January’s 0.3% and both numbers stand in sharp contrast to the previous three months (Oct through Dec), when CPI dropped sharply.
Core inflation (excluding food and energy) was up 0.2%, as it was in January, suggesting that overall prices, as defined by the Federal Reserve, are more or less stable. For the year through February, core CPI advanced 1.8%, roughly in line with where the Fed would like to see it remain through time.
Does this mean the all-clear sign for deflation worries is past? Perhaps, but it’s still too soon to say. There was never any doubt that a determined central bank can engineer inflation. Indeed, that’s the natural order of economic behavior and many a central bank has unwittingly fostered higher inflation without necessarily trying. The fact that the Fed has been working over time to generate higher inflation as an antidote to elevated deflationary risks should surprise no one when the effort bears fruit.
One clue that the reflation efforts are more than noise comes by noting that CPI’s major subcatagories all posted higher prices last month save for food and beverages. The same was true for January, a month when food prices climbed as well. That’s a big and productive shift from 2008’s fourth quarter, when price declines were running hard. At the time, the fear was that the negative price momentum would build a head of steam and, left unchecked, would develop into sustained deflation.
As we write, there’s reason to think the Fed’s policy of nipping deflation in the bud is working. Is it time to pull the plug on the massive liquidity injections? No, not yet. There's still a strong, negative headwind blowing in the economy, starting with the labor market. Until we learn more about how the current business cycle is unfolding, the case for keeping Fed funds just above zero is compelling. One metric to watch closely in the coming weeks is initial jobless claims, which is one of several critical components for estimating the current state of the business cycle, as we’ve discussed.
Meantime, Bernanke and company begin their two-day gab fest today at the Fed. As we write, the Fed funds futures market is expecting more of the same: leaving the Fed funds rate unchanged at just over zero. For the moment, that’s prudent, but it may not be so for much longer. When it’s clear that deflation is no longer a clear and present danger, it’ll be time to start raising interest rates to keep the inflationary medicine from bubbling over down the road. That’s not going to be easy in an economy that, even in the best of scenarios, is likely to be struggling for the foreseeable future.
In short, we may be nearing the end of the heightened risk for deflation. That suggests that a new era for monetary policy is coming, and it promises to be a difficult one, which is to say that the risk of error will be quite high. As inflationary pressures return, albeit slowly and tenuously, the central bank will have to navigate a fine line of keeping prices under control without creating excessive drag for economic growth. The previous run of monetary policy decisions look like child’s play by comparison.
March 17, 2009
SPRING HAS SPRUNG?
Is the Fed’s liquidity attack winning the war on deflation? This morning’s update on wholesale prices, new housing starts and new building permits offers a few reasons for answering with a tenuous “yes.” Maybe. Even if that's true, we're a long way from a "recovery" that's worthy of the name. But perhaps the blood will run a little slower; perhaps it'll stop flowing altogether. Stranger things have happened.
First let’s take a look at prices. The Producer Price Index (PPI) for February rose a modest 0.1%, the Bureau of Labor Statistics reports. That follows January’s roaring 0.8% jump. And not a moment too soon, in the wake of large back-to-back monthly declines last year in PPI from August through December. A similar run of deflation has weighed on consumer prices as well.
Is it safe to declare the deflation risk over? No, not yet, but it’s not too soon to start thinking about the light at the end of the tunnel, dim though it's likely to be for the time being. We’ve been arguing for some time that the first priority for the economy is nipping deflation in the bud. Without that, broader progress on 1) stopping the bleeding; and 2) laying the groundwork for recovery isn’t possible.
Ultimately, returning the economy to a state of inflation (ideally in a modest dose) is within reach for a determined central bank. Printing money, after all, comes naturally the Fed and so reversing deflation is possible and even probable. Assuming the leadership pursues the goal. Cranking up the printing presses a bit more--perhaps a lot more—offers a solution. Only timing is unclear. As for minting fresh currency, there’s no question of the recent trend. M1 money supply rose by nearly 24% during the 6 months through last month, at a seasonally adjusted annual rate, the Fed advises. Suffice to say, that’s an unmistakable sign of easy money at a time when the economy’s contracting.
To its credit, the Fed has been aggressively battling the deflation risk, and we’re starting to see some of the fruits of that struggle. Particularly encouraging is the fact that core PPI (excluding food and energy) rose last month as well—up 0.2%. In fact, that’s the third straight month that core PPI has posted a monthly gain.
There’s also good news in the housing market this morning. New housing starts jumped 22% last month vs. January, the Census Bureau reports. That’s the first rise since last June. Meanwhile, new building permits climbed 3% in February, which is also the first advance since June. Since permits are a measure of future activity, it’s clear that someone out there is beginning to respond to the low interest rates and the recognition that the economy will one day (gasp!) expand, if only a little.
No one should overestimate the implications here. Although the news on prices and housing is welcome, it may yet prove to be noise in an otherwise receding economy. Given the extent of the problems near and far, prudence suggests that today’s reports are, at best, a sign of a bottoming-out process for the economy, and an early one at that. Let’s not forget that just yesterday the Fed told us that industrial production continued its decline in February. The negative momentum, despite today’s news, still has the upper hand.
The idea that growth might one day soon is still too much to fathom at this point. More likely, the correction will continue to take a toll, as consumers pay for their years of binging by jumping on the savings bandwagon. Indeed, the labor market remains weak and there’s no reason to think that job destruction has yet run its course, as we discussed earlier this month.
That leaves us to look for signs of confirmation that today’s new is more than just a dead cat bounce. We can start by looking at tomorrow’s consumer price report for February, followed by the weekly jobless claims news on Thursday.
March 16, 2009
A FRESH LOOK AT AN OLD IDEA: THE FUTURE'S COMING (STILL)
What if the apocalypse is delayed once again? What if the depression turns out to be a nasty recession? We don't have the definitive answers, but we know how to ask the questions and consider the odds.
When the last investor has sold, when the appetite for risk has completely vanished, the markets will bottom and the cycle will turn in earnest. Deciding in advance when that moment arrives is an inescapably speculative venture, and investors with weak constitutions will want to avert their eyes, and portfolios. For everyone else, it's time to go to work.
That starts by recognizing that waiting for a clear confirmation that the turning point is here is likely to miss the big gains that typically come in the early weeks and months of the eventual rebound. Navigating those two extremes is a big fat slice of risk. Finding a reasonable balance, which differs for every investor, is the core of the investment challenge at the moment.
The generic solution is to keep the risk allocation of the portfolio fully invested, through thick and thin, boom and bust, while keeping a stash of cash. Of course, that doesn't feel so good when the bust actually arrives. Looking at long-term numbers is easy; weathering the day-to-day pain of a bear market, especially one as deep and devastating as this one, is sheer torture for all but the most disciplined of investors.
It's a safe bet that the bears now outnumber the bulls by a wide margin. In fact, unless you look real hard, you might assume that bulls have gone the way of the dodo and the prospect of having a satisfying career on Wall Street—or Detroit. Just thinking about adding risk exposure to portfolios these days is like sticking needles in your eyes. That's just one reason why you should consider it.
The unwinding, intellectually and otherwise, is now in full swing. Today's news that Barclays is discussing a possible sale of its iShares ETF unit is a sign of the times. As recently as 2007, the financial industry was falling over itself in trying to launch new ETFs, with increasingly speculative reasoning, as we reported in those halcyon days. Barclays, one of the original firms that helped spark the exchange-traded fund revolution, is now having second thoughts. The urgent need to raise capital among companies near and far is part of the reason.
Have we come full circle? It sure looks that way, or at least pretty close to full circle. We won't know—can't know for sure until after the fact, of course. As such, there's always reason to sleep with one eye open and to question pundits and analysts, including yours truly. Accordingly, keeping a portion of your asset allocation firmly focused on the long term, which is to say shunning short-term tactical adjustments, is prudent. But it shouldn't dominate every last bit of your investing decisions. Some portion—and reasonable minds can debate how big, or small a portion—should be dedicated to tactical asset allocation. Invariably, each investor's personal circumstances, including risk tolerance, investment objectives and time horizon, are crucial variables.
Generally, the financial literature, and a fair amount of real-world investment results, makes a compelling case for recognizing that asset class returns are partially predictable. But only partially, and even then there's no guarantee. Still, the implication is that investors—even so-called conservative, long-term investors should avail themselves of the opportunities, to a degree. Yes, we must be cautious, wary and otherwise suspicious of thinking (dreaming) that there's easy money in attempting to forecast the future. But if you're looking out at least three years—five or 10 is even better—Mr. Market drops a number of clues about what may be coming.
Ideally, you were doing no less in 2005-2007, when the bull market looked increasingly extended. For those who ignored the signs, it's going to be tough to take advantage of expected risk premia now. But for those who are still standing, the future now looks bright, or at least brighter than it has in quite some time. Yes, that's a contrarian view, but that's the only way to fly in the money game.
Summarizing the details takes time, of course. A fair amount of The Beta Investment Report is focused on just that: Analyzing the clues in the context of dynamic asset allocation for strategic-minded investing. In addition, we're finishing up a book on asset allocation for Bloomberg Press. Meanwhile, let's say that the collective evidence in the here and now suggests reason to raise risk allocations. Not aggressively—yet—nor with the expectation that it offers a quick buck. By our reckoning, we're still early, perhaps very early in the market rebound that awaits. Suffice to say, we're far from betting the farm on any one scenario, or asset class.
That said, we have a bit more confidence that the hour is late for severe and crushing bear market debacles. Yes, the markets could tread water for quite a long stretch. They could also prove us wrong and take another sharp leg down. We simply don't know. But not knowing also includes being clueless about a future that's surprises everyone on the upside. We're reluctant to bet heavily either way at this point.
The financial markets usually begin recovering well ahead of the economy, and so looking for convincing signs that the recession (depression?) has passed harbors quite a bit of timing risk. And as we discussed earlier this month, there's still plenty of reasons to wonder when the economic contraction will cease.
We do know that this bear market is now the steepest in the post-World War II era in terms of percentage loss for the S&P 500. In terms of its duration, on the other hand, the current correction is still middling. At the moment, the selling is in its 17th month since the October 2007 stock market highs. That puts us currently at just under the average length of bear markets since 1945. The longest one lasted 3 years, so one has to stay mindful of the malicious possibilities.
Nonetheless, if we look at the full range of clues, everything from volatility to fundamental valuation, from the term structure of interest rates to monetary policy, along with other metrics, strategic-minded investors should be increasingly focused on taking advantage of the alluring price of risk in the capital and commodity markets. Do so cautiously, and by using broad index funds and ETFs. In any case, do so.
Yes, that's advice with an embedded forecast, which is primarily one of betting that we'll sidestep the apocalypse after all. No guarantees, of course. If you need to be absolutely, positively sure, we've got the perfect investment for you: 3-month T-bills. Otherwise, history reminds that the recession beta, if you will, is the primary driver of risk premia. We're supremely confident that history will repeat itself on this point. As always, the timing is the great question.
March 12, 2009
A SLIM REED OF HOPE...MAYBE
It's hard to look ahead by looking back, but since there's no alternative it's everyone's favorite sport.
So it goes in economic forecasting. We're all reliant on yesterday's numbers. Beggars can't be choosy, but they're always busy, which brings us to this morning's update on retail sales for February. The news isn't good, but it's not necessarily getting worse, or so it appears. For the moment, that constitutes progress and perhaps even reason for hope.
As our chart below shows, retail sales contracted in February by a slight 0.1% on a seasonally adjusted basis. That's no reason to cheer, but it's a heck of a lot better than the steep 1%-3% monthly drops in the last four months of last year.
January's 1.8% advance for retail sales suggested that maybe the bleeding had stopped, although that idea is again on the defensive in light of last month's modest setback.
Although no one thinks consumer spending is poised for a roaring comeback any time soon, there's still reason to think that the worst of the declines in retail spending is behind us. One reason is that while sales overall slipped last month, a few corners managed to post gains.
Electronics and appliance stores reported higher sales by 1.7% last month on a seasonally adjusted basis. Meanwhile, furniture and home furnishings eked out a 0.7% rise in February. Clothing stores and general merchandise establishments were also higher on the month.
Encouraging, but it's still much too early to draw conclusions. Sales could just as easily take a general turn down again in the coming months given the depth of the current economic troubles. In fact, the limited bright spots last month may simply be a temporary bout bottom fishing as consumers snap up goods at bargain prices born of the recession.
It's going to take quite a few more months to convince this editor that something approaching stabilization has arrived in retail sales. Even then, it's a long way to expecting a sustained rebound in consumer spending. The economy is still suffering and consumers are wary, and they're likely to remain wary for the foreseeable future.
Indeed, today's news on initial jobless claims reminds that the outlook for the labor market remains troubling. New filings for unemployment benefits rose by 9,000 to 654,000 last week, a sign that the economy is still under quite a bit of negative stress. The health of the labor market is closely tied to retail sales so until we also see some signs that the job less is at least slowing, no one should expect much for the retail industry.
That said, maybe, just maybe, there's a bottom in sight for retail sales. Deciding if today's numbers are a down payment on that hope will take time, and much depends on what happens next in the labor market. But the first step in a 1,000-mile journey has to start somewhere.
March 10, 2009
THE TROUBLE WITH JAPAN
Japan has been a thorn in portfolio strategy's side for over a decade, and more of the same is on tap for the foreseeable future.
As the world's second-largest economy after the U.S., with a stock market capitalization to match, Japan looms large as an influence in the global economy and the capital and commodity markets. Unfortunately, the influence has been largely negative since the early 1990s on matters of asset allocation.
A summary of the trouble can be found by comparing the MSCI Pacific Index to its counterpart that's identical save for excluding Japan's equity market. The disparity in annualized total returns (in $ terms via Morningstar Principia) for the 15 years through January 2009 is striking:
• MSCI Pacific -1.4%
• MSCI Pacific ex-Japan +1.8%
Excluding Japan has clearly been a boon to allocating assets in Asian markets, and to global equity allocations generally. To the extent you lightened up on the Land of the Rising Sun over the past 15 years, the better your investment results. That wasn't necessarily true if you engaged in tactical asset allocation with Japan as a distinct variable, but it held true for a buy-and-hold investor with a global equity position.
As always, the strategy you should have embraced is unambiguous. Deciding if it'll work in the future is something else. It's tempting to simply steer clear of Japan, as many investors have done in global equity mandates over the years. It's hard to imagine many investors will act much differently going forward. But avoiding Japan as a general rule opens up a can of strategic worms, and so no one should rush to judgment.
Simple answers may look appealing, but they're not always the slam-dunk they appear to be when it comes to designing and managing a multi-asset class portfolio. As such, we'll be taking a closer look at the question, and the portfolio implications in the April issue of The Beta Investment Report.
Meanwhile, a few observations:
* Japan's current economic outlook, unsurprisingly, has fallen on hard times, along with the rest of the global economy. The immediate cause of the latest round of Japan problems is suggested by BCA Research, which recently advised that "the Japanese manufacturing sector has collapsed, and further production cuts lie ahead."
* Japan's equity market is currently 10.8% of the total global equity market capitalization, according to Standard & Poor's. That compares with the current U.S. equity market weight of 43.2%.
* The S&P Japan BMI equity index's total return is -41.2% for the 12 months through last night. That compares with -47.6% for S&P Asia Pacific BMI over the same period (both in $ terms), -48.0% for the S&P U.S. BMI and -51.7% for the S&P Global BMI index, which represents the entire world's equities.
March 6, 2009
WHEN WILL IT END?
Another monthly employment update, another dismal report. So it goes in a vicious recession. The only question: When will it end?
We take a stab at some perspective below, but first let's recap this morning's ugly numbers. Last month suffered another sharp fall in nonfarm payrolls, the U.S. Bureau of Labor Statistics reports. The economy lost 651,000 jobs in February—the 14th consecutive month of payroll declines and the third month of losses above the 600,000 mark. In this year's first two months alone the economy has already shed nearly 1% of total nonfarm payrolls. Unfortunately, the outlook for March doesn’t look good either.
That brings us to the burning question: When will this nightmare end? We don't have the answer, nor does anyone else. That said, a fair reading of the economic data, including a review of past recessions through history, suggests that the bleeding will go on for some time. That's just a guess, of course. Can we do better than simply guessing?
Perhaps. One small effort on that front comes by considering the trend in initial jobless claims, which is a leading indicator of sorts in that it previews the state of the economy in the immediate future. If more workers file for jobless benefits today, the ranks of the unemployed next month will reflect the fact in official jobless tallies.
Looking to the trend in initial jobless claims offers some perspective on how the cycle is unfolding and where we are in the current cycle. Let's start by looking at the four-week moving average of weekly jobless claims from 1967 through yesterday's update, which shows that weekly claims fell substantially to 631,000 for the week ended February 28, 2009. That's a step in the right direction, but anything over 600,000 clearly suggests the recession fires are still burning hot.
But looking at jobless claims numbers alone can be misleading because the size of the labor pool changes through time. Generally, nonfarm payrolls expand, even if recent experience tells us otherwise. Nonetheless, over the long haul, the labor force increases, at least it has over the long stretch of history in the U.S. As such, we need to look at jobless claims in context with current nonfarm payrolls through time, as we do in the next chart.
Putting jobless into perspective with the overall level of nonfarm payrolls suggests that initial jobless claims will peak before the recession end, or at least peak as the recession ends. That's potentially valuable information if you consider that the official notice that the recession has ended won't coming for many months after the fact. That leaves us to look for other indicators in real time, and initial jobless claims are on the short list.
In the past six recessions, the four-week moving average of weekly jobless claims as a percentage of current nonfarm payrolls peaked either in the month the recession formally ended (as per NBER) or the month directly ahead of the recession's formal end. By this measure, in just one case since 1969 did the jobless claims peak arrive much earlier: the 1969-70 recession ended in November 1970; the jobless claims peak came in May 1970.
Where does that leave us currently? The latest bar in the far right-hand side in the chart above is simply the latest batch of numbers. The four week moving average of initial jobless claims through February 28, 2009 represents 0.48% of last month's total nonfarm payrolls. History suggests that we have a ways to go before the employment pain ends. That forecast is based on the following: The high point for the past 40 years is 0.75% in 1982—well above the current 0.48%. Adjusting for the fact that this is likely to be the worst recession since the Great Depression implies that we might go to well above 0.75% this time.
In short, there's more pain to come, or so we expect. We're probably beyond the halfway point in this process, although there's still too much uncertainty to say for sure. Perhaps we'll see some concrete evidence, one way or the other, in the coming months. But for the moment, the economy continues to bleed and there's not much reason to expect an imminent end to the pain. The recession, in short, roars on.
March 4, 2009
TALKING ABOUT ASSET ALLOCATION ON THE INSIDE VIEW PODCAST
The bear market is roaring, investors are running for cover and the economic fallout is everywhere. Casual observation suggests that asset allocation is among the victims, or so it appears.
Dismissing the concept of multi-asset class investing is easy these days, not to mention tempting. Many corners of the capital and commodity markets are licking wounds, leaving virtually no place to hide. But this is no time to abandon asset allocation, as our two guests on today's edition of The Inside View explain.
Strategic perspective, in short, is essential for recognizing the power of asset allocation through time, including tough times. But perspective tends to take a holiday in bear markets, which compels most investors to consider only the recent past. That risks ignoring the opportunities that arise in periods of high stress and lofty price volatility. So says our first guest, Gary Brinson, a veteran money manager and strategist whose name is most familiar as a co-author of a famous 1986 research study that helped put the concept of asset allocation on the investment map, so to speak. These days, Brinson is president of GP Brinson, a Chicago investment firm in Chicago. He's also a board member at The Brinson Foundation.
Our other guest is Adrian Cronje, director of asset allocation at Wilmington Trust. Cronje is an expert in asset allocation and he shares his thoughts, as does Brinson, on how to think about strategic portfolio design in the current environment.
As a preview, this is no time to abandon asset allocation. To understand why, tune in…
Please visit CapitalSpectator.podbean.com for additional options with episodes of The Inside View.
March 3, 2009
THE VALUE PROPOSITION...
In your editor's "other" life as an independent financial journalist, the resulting stories appear near and far. The latest comes by way of Financial Advisor. In the February issue, I take a look at how we're all value investors now, or at least should be. Take a look at the story here...
March 2, 2009
AND FEBRUARY MAKES THREE...
Since all hell broke loose last fall, February marks the third month that everything went down. September and October 2008 were across-the-board losers, and so was last month. The only thing that gained, by a thread, was cash, based on 3-month T-bills, as our chart below shows.
The deep pain now coursing through the capital and commodity markets needs no explanation at this point. The global recession strangling the planet inspires only selling, hoarding cash and otherwise retreating from debt in any way, shape or form possible. This is a toxic combination and one that explains the various economic ills that are likely to roll on. The unwinding is also necessary to cure the problems that afflict the global economy, but no one expects the process to be pretty or speedy.
The fact that there's no place to hide necessarily means that exposure to risk is like swimming with lead balloons. The only question is when we'll touch bottom. Alas, this observer expects that the negative surprises still have legs, economically and financially. The economic and financial indicators that comprise our routine data analysis offer little in the way of hope for an imminent reprieve. It'll take more time and fresh numbers in the coming weeks and months to even make a determination of whether the end of this year will be a floor on the pain, or just another signpost for additional trouble in 2010.
In the meantime, the trend is down. That said, the middling performance of our Global Market Portfolio Index (GMPI), while nothing to celebrate, is more or less what you'd expect from the true market benchmark. Second-guessing the market is never easy, and it's getting harder by the day. Fear and emotion will take a hefty toll on mere mortals as they try to sidestep the ongoing pain while trying to position portfolios for the inevitable rebound. Mr. Market tends to get this balancing act right more often than not.
Looking ahead, it's likely that the markets will begin a bottoming process well ahead of the economy. Picking troughs, of course, is still a dangerous game and then some in this climate. Yet some of the future is clear, or so your humbled editor thinks.
Consider that bonds have generally held up in the crisis, particularly government bonds. That's no surprise, since the flight to safety usually means running to those institutions that can print their own money. The flip side is that risk has been hit over the head with a shovel, and it continues to take a beating. Something that approximates the opposite scenario is coming: risky asset prices will rise and safety will suffer. Timing, unfortunately, is unknown, and therein lies the primary hazard in money management going forward.
The only thing we can say for sure is that future rebound is now closer now than it was six months ago. (Yes, we know: that observation and $2 gets you a cup of coffee.) The expectation implies that our GMPI will deliver another middling performance on the upside once the healing process begins. Detailing why it will be middling, and why it will look so appealing once the dust clears, is one topic of discussion in the March issue of The Beta Investment Report. As a preview, let's just say that the best-laid-plans of mice and active managers are no match for the dumb wisdom of Mr. Market's passive asset allocation. Same as it always was.