July 31, 2009
A MIXED MESSAGE IN GDP'S Q2 REPORT
It's official: the economic contraction slowed dramatically in the second quarter. By that standard, the government can claim a victory. But now comes the hard part, and progress won't come easily or quickly.
For the moment, however, there's reason to cheer. The annual real change in GDP in this year's second quarter was a relatively mild fall of 1.0%, the Bureau of Economic Analysis reports today. That's a massively improved number from the first quarter's huge 6.4% tumble.
The sharp slowdown in the rate of contraction isn't necessarily surprising. As we've been discussing for months, a number of economic clues have been suggesting that the recession may be coming to a technical end. At the same time, we've also been warning that the official end of the recession—as defined by NBER—isn't likely to lead to a rebound of any strength any time soon. Instead, we're looking at an extended period of flat to perhaps modestly negative GDP reports between the technical end of the recession and the start of the recovery. In that sense, the business cycle is different this time, and the risk of a double-dip recession is therefore higher than normal as well.
Today's GDP report suggests no less. Indeed, looking behind the big-picture slowdown in the economic contraction reveals quite a few reasons to wonder about what's coming in the quarters ahead.
Consider, for instance, that consumer spending resumed its decline in Q2 after rebounding a bit in the first three months of this year. Recall that in the second half of last year, personal consumption expenditures went into a tailspin amid the dire news of financial crisis and the widespread expectation that the economy was headed into the worst bout of decline since the Great Depression. Predictably, consumers responded by sharply curtailing spending, delivering two straight quarters of 3%-plus declines in personal consumption expenditures in the second half of 2008.
The trend was broken in Q1 of this year, when spending rebounded a bit, posting a 0.6% rise. But now we learn that consumer spending overall fell again in the three months through June, dropping 1.2%. What's more, the fall was across the board, in durable and nondurable goods. Only services managed to eke out a tiny but statistically insignificant gain.
Nonetheless, our forecast that consumer spending is headed for an unusual period of sluggish growth, if any, seems to be coming to pass. In an economy that draws more than two-thirds of GDP from Joe Sixpack's trips to the mall, the trend bodes ill for expecting a dramatic economic rebound anytime soon. Indeed, Joe's tapped out, struggling with various debts and the loss of job opportunities that are essential for repairing the household balance sheet.
Meanwhile, there's more bad news in today's GDP update on the private domestic investment front. This is a measure of the business sector's willingness to invest in new plants and equipment and so to some extent this is a leading indicator. Alas, the fact that private domestic investment fell sharply again in Q2—by more than 20%--suggests that corporate America continues to take a wait-and-see attitude. Unfortunately, this cautious behavior has been running continuously for seven straight quarters. The last time private domestic investment rose was Q3 2007.
So what accounts for the slowdown in GDP's Q2 decline? An acceleration in government spending. Government consumption expenditures rose by a hefty 5.6% during the April-June quarter, the highest rate in many a moon. The government's intervention has stemmed the tide of what would otherwise been an even deeper contraction. But moving beyond government handouts isn't going to be easy in the foreseeable future.
The apocalypse has been avoided, but the tougher challenge has only just begun.
July 30, 2009
ANOTHER RISE IN JOBLESS CLAIMS
Today's update on initial jobless claims reminds that the threat of economic contraction isn't vanquished. There's been progress, but the dark forces of decline are still lurking.
For the week ending July 25, the advance figure for seasonally adjusted initial claims was 584,000, an increase of 25,000 from the previous week's revised figure of 559,000. A rise in new fillings for unemployment benefits is unsettling at this precarious stage in the economic cycle. Still, there's nothing in today's numbers that convinces us to alter our view that the technical end of the recession is near. For the moment, last week's jump looks like statistical noise.
That's not to say that all danger has passed—it hasn't. But as our chart below reminds, the general trend in initial jobless claims remains one of decline. Then again, let's not forget that new filings have risen for two weeks running, albeit off of a relatively low base by the standards of this year. Another week or two of this behavior and it may be time to rethink our otherwise favorable outlook that the cycle's trough is unfolding right about now. We'd become more anxious if initial claims jumped above 600,000 in the coming weeks.
Meantime, weekly jobless claims are still signaling that the recession is about to end, if it hasn't already. Having peaked back in March at 674,000, the decline since then suggests that the worst of the economic contraction is behind us. Then again, history is only a guide, not a guarantee.
There's only one way to resolve the debate of whether we're past the worst of this recession: More data. Jobless claims have been suggesting for several months that there's light at the end of this tunnel. The only question is timing. The numbers of August, it seems, will be critical.
July 29, 2009
PATIENCE IS A VIRTUE...AND TIMELY
There’s been some good news lately, including the encouraging signs in real estate. New home sales rose last month, posting the third straight monthly increase. For some, the writing is now on the wall. “Recession is over, economy is recovering,” declared John Silvia, Wells Fargo’s chief economist, in a research note, according to The New York Times.
We’re of a mind to agree with the first part of the statement, but not the second, at least not yet. As we’ve been discussing for some time, the technical conclusion of the recession is near or perhaps already here. We began considering the end back in March, when we examined the business cycle forecasting powers of the trend in initial jobless claims. In the months since, the reasoning grew stronger for anticipating that the recession’s end was approaching. News such as yesterday’s pop in new home sales only strengthens the case. But as we’ve said many times in recent months, the end of the recession this time is likely to be followed by an unusually long period of stagnation before economic growth returns in earnest.
Today’s update on durable goods offers another statistical clue for thinking so. New orders for manufactured durable goods in June fell 2.5%, the U.S. Census Bureau reports. That comes after two straight increases. As the chart below suggests, the trend looks like one that’s settling into a new period of stabilized but diminished levels.
The danger at this juncture is mistaking the long-awaited arrival of stability for the launch of a robust recovery. Indeed, even the jump in new home sales is reportedly dependent on increased speculation as opposed to the return of the consumers proper to the housing market. Make no mistake: the encouraging news from new home sales and other metrics is critical, and it suggests that the forces of recovery are bubbling. But it’s too soon to expect that the necessary factor—consumer spending—is about to re-emerge until the labor market shows more encouraging signs of life, i.e., growth. We’re still a long way from that happy day.
Meanwhile, the evidence is mounting in favor of the idea that the economy has hit bottom. Our view is that stability will last a lot longer this time around. Some will mistake that for the arrival of a new round of growth, which is premature.
Yes, a full recovery is coming, but it’s not imminent.
July 27, 2009
APPEARANCES CAN BE DECEIVING
Your conventionally minded editor isn't used to seeing a Federal Reserve chairman take his monetary policy show on the road. Then again, we're from the old school, and we're not used to seeing pigs fly either. But we're obviously out of touch in the 21st century.
Ours is a world where formality gives way to "transparency," which comes in an ever-widening rainbow of colors. Fed chairman Ben Bernanke's "publicity tour" is certainly something new in the bag of central banking tricks. We thought that participating in so-called town hall forums and taking questions from the audience was an art reserved for politicians and talk-show hosts. We're wrong. It's also now just another tool in the otherwise dull business of managing money supply.
The old veneer of banking ceremony is fading, giving way to a penchant for empathy and personality tours. Imagine our surprise when we discovered that Mr. Bernanke was "disgusted" by some of the Fed's recent actions, as he explained to an inquiring member of the audience in yesterday's PBS television episode. Speaking of the various bailouts last fall, the Fed head confessed: “Nothing made me more angry than having to intervene, particularly in a few cases where companies took wild bets." Perhaps he might have simply said that the devil made him do it. Personally, we'd have like to see some tears to make the confession more convincing.
In any case, at least we know our Fed chairman is now sympathetic to the working man. Sure, the central bank has made some tough decisions, but it also has a heart. Expressing compassion of a sort for the little guy when setting interest rates and engaging in other activity looks to be the new new thing. Big, impersonal banking institutions are out; warm and fuzzy I-feel-your-pain monetary policy is in.
Is any of this surprising in the media-infested 21st century? Perhaps not. Indeed, Mr. Bernanke, whose term is up next year, is running for re-election to the Fed and of course he's intent on pulling every lever available on his behalf. Of course, before we can decide if his campaign is worthy of support we'll need to see his monetary policy platform. If it's superior to the plans of the rival candidates vying to run the Fed, well, perhaps Ben deserves another term.
To get the word out, Mr. Bernanke may want to consider running television ads in key districts. Sure, it'll be hard to capture viewers' attention by proclaiming to have a better monetary policy than the other guy. Television, it seems, just wasn't made for dispensing the finer points of quantitative easing and the value of watching M1 vs. M2. But, hey, that's a minor obstacle. Ben needs to speak to the man on the street, especially in those swing-voter districts that could tip the balance in what promises to be a tight race.
Actually, there's a bigger problem. Fed chairman aren't popularly elected, at least not yet. And last we checked, there are no obvious rival candidates openly campaigning for the Ben's position, at least not yet. Instead, the Fed chief is appointed by the President and confirmed by the Senate, or so we're told.
As a result, any resemblance between Mr. Bernanke's campaign for re-election—sorry, we meant reappointment—and a political campaign is merely coincidental.
July 24, 2009
THE FIRST STEPS ARE EASY
Investing is complicated, but it begins rather simply. How it ends is the question.
There are infinite possibilities for reassembling the major asset classes. The challenge is finding the one that satisfies your particular set of expectations, risk tolerance and financial situation. The basic choices boil down to choosing some combination of stocks, bonds, REITs and commodities. We can further subdivide those broad categories and we can also employ any number of asset allocation strategies to manage the mix through time. That includes leaving out one or more asset classes, holding some cash, selecting individual securities and venturing into the shadowy realm of alternative betas.
How should we begin? We can start by considering a government bond. The benchmark 10-year Treasury Note offered a 3.72% yield as of yesterday. That's a good place to launch our analysis because we have a high degree of confidence—a virtual certainty, in fact—that we'll receive a 3.72% total return from a 10-year Note if we buy and hold till maturity. Deciding if the rate du jour will suffice depends on various factors, starting with a strong estimate of one's future liabilities.
To keep things simple, let's assume that an investor's time horizon is exactly ten years. If earning 3.72% on current assets will match the anticipated liabilities over that time frame, buying and holding a 10-year Note looks like a good deal. In effect, the investment strategy is solved. On the other hand, if a 3.72% return on the given assets falls short of expected liabilities, we need to consider alternative possibilities.
Of course, even if 3.72% looks like a good deal, the investor may be more ambitious than settling for current yield. And, of course, we haven't yet factored in inflation in the years ahead. As a result, looking at prospective returns and liabilities should be analyzed in real terms, i.e., inflation-adjusted returns. Indeed, the money game has already become more complicated and we've yet to leave the relatively safe terrain of government bonds.
With that in mind, let's reconsider the example above with a modest assumption of 2% inflation for the next 10 years. That means that our 3.72% return on a 10-year falls to a 1.72% real yield. Will that suffice?
For some perspective, let's consider that a 10-year inflation-indexed Treasury offers a real yield of 1.80% as of yesterday. Perhaps we're better off with the inflation-indexed bond since it offers slightly higher real yield than its nominal counterpart, assuming 2% inflation.
Could we do better? Maybe. For instance, in the July issue of The Beta Investment Report, we advised that our conservative long-term equilibrium risk premium estimate for our Global Market Index was roughly 2.4%. For global equities, our equivalent forecast is 4.0%. (By risk premium we mean the return after subtracting a risk-free rate, such as the return on T-bills. If we assume a 2.0% risk free rate, GMI's expected risk premium of 2.4% becomes a 4.4% total return.)
Like a game of chess, the first few moves in asset allocation are easy and even average investors can do well. But the level of complication quickly rises, as do the risks, since we must factor in a rising array of forecasts. Considering historical returns can help shape our outlook, but they're only half the battle. As a result, we need to make assumptions as well to answer such questions as: Should we hold a 10-year alone? How will that fare under a moderate inflation outlook? And what about owning a passively allocated mix of the major asset classes? Should we try to second guess that? If so, how? What's the reasoning?
Yes, the market offers some clues about which asset classes look relatively attractive, or not, but we need to proceed cautiously. The more we move away from benchmarks and passive allocations, the higher the risk, which implies that we should only engage in such activity to the extent that our confidence is above average.
How will we know if our confidence is better than average? There's no easy answer, although we can develop some perspective by projecting risk premia on a regular basis if only to understand the embedded challenge. We engaged in an abbreviated version of just that in March, and we go into more detail on a regular basis of the pages of BIR. Depending on the asset class and the prevailing conditions, sometimes we have a relatively high degree of confidence in our projections, which inspires adjusting the market's weight for the asset class. At other times, we're not so confident, in which case we favor a market weight.
There are no easy answers in designing an asset allocation, all the more so when you consider that we must continually manage it through time. There is, however, lots of work to do. Inevitably, we're going to be wrong sometimes, a fact that keeps us humble and raises the bar for what constitutes above-average confidence about projecting risk premiums.
The future, in short, is generally unclear, although it doesn't appear that returns are totally unpredictable at all times. A few clues, it seems, can go a long way.
July 22, 2009
There are many ways to model expected returns. Unfortunately, not one is even close to being foolproof, which inspires looking at multiple measures of market activity. That includes monitoring relative returns through time among the major asset classes, one of several analytical tools employed in the search for strategic perspective in each issue of The Beta Investment Report.
As a basic example, consider the chart below, which graphs differences in rolling 3-year annualized total returns between U.S. stocks (Russell 3000) and U.S. bonds (Barclays Aggregate), foreign stocks (MSCI EAFE) and REITs (Wilshire REITs). For instance, for the three years through the end of June 2009, the Russell 3000 suffers an annualized 8.3% loss vs. a gain of 6.4% for the Barclays U.S. Aggregate Bond Index. The result is that equities are under water by nearly 15 percentage points relative to bonds (red line). By comparison, stocks have bested REITs over the past three years, with a positive spread of more than 11 points (green line). Domestic vs. foreign stocks, meanwhile, are generally neck and neck as of the past three years through last month (black line).
What's the point of looking at returns in this fashion? It offers some perspective on return on a relative basis. No, it's not a silver bullet, nor does it offer a quick road to easy money. It is, however, valuable when considered in context with other variables.
As for our chart above, what is it telling us? The raw interpretation is that bonds have had a good run but now it's time to emphasize stocks in a strategic-minded portfolio. Meanwhile, REITs too look like a better deal relative to stocks. As for domestic vs. foreign stocks, the chart above suggests we should be agnostic for the moment, which implies favoring a market-cap-informed asset allocation until more compelling evidence arrives.
Should we run out and alter our portfolios based solely on relative return histories? Of course not. But neither we should ignore such data. As part of a larger, integrated portfolio strategy of analyzing the major asset classes on a variety of metrics, this is but one of several tools. Others include estimating equilibrium risk premiums, tracking dividend yields and interest rates, monitoring volatility and correlation trends, and watching the yield curve, to cite just a few of the productive chores that are part of the analytical routine at The Beta Investment Report.
Alas, there are no easy "solutions" in portfolio strategy. There is, however, lots of hard work waiting for intrepid investors. That's no surprise in a world where beating Mr. Market on a risk-adjusted, long-term basis is tough. If you're inclined to try, there's no shortage of paths that may lead to nirvana. But be careful: there are many potholes on these highways and the progress in creating a smoother ride comes slowly. To the extent it comes at all, it begins with strategic perspective.
July 20, 2009
GONE (FOR THE MOMENT) BUT NOT FORGOTTEN
The ascent in the yield on the 10-year Treasury Note during this past spring took a breather after rising to nearly 4.0% by mid-June. That prompted some to claim that the underlying source for the rise—worries about future inflation—were overbaked.
Perhaps, but we beg to differ, and have for some time. Even when the crisis of last fall was exploding with all its ignominious power, we were of a mind to expect a return of inflation at some point. The CPI report last week suggests that such expectations are still valid.
To be sure, the risk an imminent surge in inflation to lofty levels still looks low. Although deflationary forces are fading, the blowback from the financial crisis and the lingering effects of the current recession will reverberate for some time and so pricing pressures are still muted. Nonetheless, it's always been clear that the Federal Reserve's primary goal was to return the system to an inflationary bias. A mild one, if possible, but inflationary just the same. We never doubted the Fed's capacity for success on that front, and neither it seems does the bond market. The question is whether the central bank can let the genie out of the bottle just a little?
The genie already has his nose out. One example comes by way of the outlook for inflation based on the yield spread between the nominal and inflation-indexed varieties of the 10-year Treasury Notes. As our chart below shows, the market's 10-year inflation forecast is creeping up, again. Yes, it's still quite low—under 2.0%. But it's the directional momentum that's the issue. Having elevated the market's inflation expectations from zero to roughly 2% in the last six months, the Fed must soon begin to pull back on the liquidity injections, if only just slightly. Raising Fed funds to 0.5% would be reasonable at some point in the near future, up from the 0-0.25% range that currently prevails, if only to send a signal to the markets about intent.
One reason the message needs to be made is that traders don't think that's likely any time soon, based on Fed fund futures. The September 2009 contract, for instance, is trading at an implied 0.2% Fed funds rate.
A fair chunk of keeping inflationary pressures under wrap is a task of managing expectations, through time. There's currently no danger that expectations are set to run amuck, but neither can we afford to ignore the creeping rise in inflation expectations, even at low levels. Perhaps it's a false alarm, perhaps not. We just don't know. Waiting for definitive confirmation is too risky. Hedging the bet by slowly moving rates up over time--short of more compelling data to do something else--seems reasonable.
The future is undoubtedly full of surprises. But this much is clear: dismissing inflation as yesteryear's worry is asking for trouble.
July 17, 2009
A NEW BOOK ON ASSET ALLOCATION FROM YOURS TRULY...
It's been a long-time coming, but my upcoming book—Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor (Bloomberg Press) is now available for pre ordering on Amazon.com. The scheduled release date is February 2010.
We'll be discussing the book in more detail in the coming weeks and months. Meanwhile, for more information about purchasing a copy, click on the link below...
IS IT REAL THIS TIME?
We've been there before only to end up disappointed. Could this time be different?
One day the recession will end and we'll put a floor on the economy's deterioration. Are we there yet? This week offered several reasons to cautiously answer "yes," or perhaps it's better to say "maybe."
Today's news certainly offers one more reason to think that stability may be returning. Both new housing starts and new building permits issued rose again last month, the U.S. Census Bureau reports today. For the second month running, both series scored respectable gains.
Save for Wednesday's news that industrial production continues to slide, this was a modestly good week for dispensing numbers in favor of the idea that a trough in the business cycle may be near if it hasn't already arrived.
Yesterday delivered another encouraging number for initial jobless claims and on Wednesday we learned that the deflationary threat, if it isn't dead, looked mortally wounded in the wake of news that consumer price inflation was bubbling. Add to this some other positives, starting with the ongoing liquidity injections by the Fed, a la, extraordinarily low interest rates, and you've got some positive catalysts that may signal better times ahead, or at least less-painful times.
So, what's not to like? Well, for starters, even if the technical end of the recession is here, as we think it is or will be soon, that doesn't quickly translate into meaningful economic growth. As we've repeatedly discussed on these pages, we expect an unusually long interim period of subpar growth between the crisis of the recent past and a true recovery worthy of the name that presumably awaits down the road. And that's our positive scenario.
The darker outlook is that all the good news of late turns out to be statistical noise in an ongoing recession that continues to destroy wealth and keep the forces of stabilization at bay. That view looks increasingly unlikely, but no one really knows if we're merely in a transition phase that fools everyone into thinking that the bottom of the cycle has been reached. It's important to keep in mind that as mere mortals, we're inclined to take the latest data point and extrapolate into the future. But as the chart above shows, even a bounce that lasts for several months running barely begins to repair the massive damage that has occurred over the past year or so.
It's also worth reminding once again that even if the recession has technically ended, the labor market promises to remain weak for some time. The magnitude of what's unfolded recently virtually assures that a quick rebound in jobs creation will have to wait, probably until well into 2010. The labor market's always the last to join the rebound party, and that rule goes double this time around. Therein lies the biggest obstacle for a consumer-dependent economy a.k.a. the United States.
So, yes, we're encouraged by this week's numbers, but we also recognize that we'll need additional confirmation of the trend in the months ahead before we break out the champagne.
July 16, 2009
GOOD NEWS, WITH QUALIFICATIONS
Another update on new filings for jobless claims, another reason to keep the faith.
The Labor Department reports today that initial jobless claims fell 47,000 for the week through July 11 to 522,000, the lowest since early January. The decline is all the more encouraging because it suggests that the hefty fall for the holiday week through July 4 wasn't a fluke.
We've been writing since March that jobless claims have a long history of peaking just ahead of or concurrently with the end of recessions (for some background, see here and here). But we've also been careful to note that this time may be a bit different in terms of what it implies for the period ahead.
While jobless claims are predicting the recession's end, we're inclined to qualify the finale in this cycle by calling it a technical end. As we explained back in early June, "the technical end of recession, especially one as painful as the current one, isn't easily forgotten. Indeed, while the leading indicators point to recovery, the lagging indicators, as expected, continue to get worse." The bottom line, we opined at the time: "Even if the recession is over, and one day it will be, there remains the bigger question: What magnitude of rebound awaits? On that point we remain quite wary. One reason is that if a rebound is underway, the shift implies a new set of challenges lurking in the future, starting with the issue of debt, interest rates and inflation, all of which threaten in the medium- to long-term outlook."
Meanwhile, it's not clear that the crowd recognizes the challenges that await, which are unusually potent in 2009 and beyond. A long, extended period of low/flat growth may be coming. Many are celebrating the arrival of the post-apocalypse phase of the business cycle when they should be wary of what threatens to be an unusually long and challenging era in the months (years?) ahead.
Yes, the accumulating numbers seem to tell us that the technical end of the recession is close, if it hasn't already arrived. By that we mean the NBER may date the cyclical trough as sometime in this year's second half. But that means less, perhaps a lot less, in 2009 than it has in previous conclusions to recessions.
July 15, 2009
A HINT OF THINGS TO COME?
If deflation's still a threat, it wasn't obvious in today's update of consumer prices for June.
The CPI jumped 0.7% last month, the government reports. That's the highest since July 2008, which also posted a 0.7% rise.
Much of the gain in CPI last month came from energy. Nonetheless, core-CPI (excluding food and energy prices) still rose by 0.2%. So far this year, core CPI is up every month. In addition, core CPI's three-month annual rate is now running at 2.4% through June, or slightly above the Federal Reserve's long-term top-end target for core inflation. Another intriguing statistic is that while consumer prices overall have fallen 1.4%, based on headline CPI, core inflation is up 1.7%.
What does this tell us? That inflation, while still quite subdued, isn't dead as a threat in the medium-to-long-term horizon. No, there's nothing in today's report that tells us that inflation's about to return as a material hazard. There's still plenty of deflationary/disinflationary pressures bubbling to keep a lid on prices overall for the time being. But today's CPI report reminds that the potential for trouble down the road is still there.
Some have dismissed recent worries about future inflation as misguided. We've argued otherwise for much of this year, including here and here. The latest CPI numbers don't offer any reason for changing our view that worrying about inflation down the road is still warranted, even if deflation is still the more timely concern.
Then again, today's CPI news suggests that deflation may be less of a threat than it was earlier in the year. If so, that means inflation's more of a threat. We're still talking marginal changes in risk potential on both sides. But nothing remains the same in the capital and commodity markets and it's hard to ignore the numbers du jour.
As we've been discussing for some time now, the post-apocalypse world that we're now in will be far more complicated and nuanced in what we expect will be an extended period no/slow growth. All the more so if inflationary pressures return, even at the margins.
Everything from monetary policy to strategic decisions on asset allocation will be tougher as a result. Welcome to the new era.
July 14, 2009
A GOOD WEEK SO FAR...
This week's economic reports are off to a rousing start with today's updates on retail sales and wholesale prices for June.
Seasonally adjusted retail sales jumped 0.6% last month, the U.S. Census Bureau reports. That's the best monthly rise since January.
The wholesale price report for June also brings good news: deflation was MIA. The Producer Price Index climbed 1.8%, seasonally adjusted, according to the Bureau of Labor Statistics. Quite a bit of that was due to a rebound in energy prices, but even after stripping out fuel there was a clear rise: core PPI advanced 0.5%. Overall, headline PPI is up three months running.
No, these numbers still don't give us the all-clear signal—not even close. But the reports are encouraging nonetheless. One reason is that the numbers could have been worse, a lot worse.
As we've been discussing for some time now, the first step is stabilizing the economy, which begins with insuring that the deflationary risk is banished. We may be close to declaring victory on that front. Perhaps it's time to say as much now. In any case, we're still making progress. The apparent peaking in new filings for jobless benefits have been telling us that for several months.
But we're still of a mind to expect that while the economy may be stabilizing, meaningful growth is still a ways off. One reason is that consumer spending, despite the latest number for retail sales, is likely to be weak for some time. Indeed, the labor market continues to destroy jobs at a robust clip. Repairing the trend will take time. Meanwhile, consumer spending will suffer. But at least it's no longer in freefall. That's no minor point for an economy that derives ~70% of GDP from Joe Sixpack's spending habits.
July 13, 2009
THE WEEK AHEAD IN THE DISMAL SCIENCE…
Every economic report these days seems to dispense a crucial piece of the puzzle for deciding what comes next, and this week promises (threatens?) to offer no less.
The question now is whether the stability of recent months is in danger of giving way, pushing the economy once again toward the forces of contraction. It's been tempting to conclude that we moved beyond that in the spring, thanks to some encouraging numbers. Growth still was a ways off, but at least the recession wasn't getting any worse, or so it seemed. If anything, the cycle appeared poised for some flat lining and perhaps a modest uptick down the road.
But in the wake of the June payrolls report, which surprised on the negative side, it's become fashionable once more to wonder aloud if another round of trouble awaits. In that case, do we need another round of stimulus? Several key economic numbers updated this week will offer some pivotal clues.
As for newly minted numbers, the fun starts tomorrow with the producer price report, which will offer the latest sign of whether deflation is dead or set for a revival. When we last heard from this corner of statistics, wholesale prices rose 0.2% for May, the second month running of increases. Will the update for June make it three? If so, that would help further diminish deflation worries.
We also learn on Tuesday if May's encouraging 0.5% rise in retail sales carried over into June. Some estimates are in fact calling for another rise, as reported by Bloomberg News.
On Wednesday, June updates arrive for consumer inflation and industrial production. CPI's last data point showed a thin increase of 0.1% for May, which comes after no change in April and a slight fall in March. Meanwhile, we're looking for some good news in industrial production to break the trend of losses for each of the seven months through May.
On Thursday, the weekly update on initial jobless claims will tell us if there's still reason to think that the "technical" end of the recession might be in sight.
Another leading indicator of economic activity is updated on Friday: housing starts for June. Optimists are looking for a follow-through on May's strong 17% rise—only the second time this year that the series posted a gain (the first is February).
By the end of the week, we may have a quite a bit more context for projecting the next phase of the business cycle. The only question is whether we'll be smiling or frowning when the last batch of numbers roll in on Friday afternoon.
July 9, 2009
A SETBACK, OR JUST MORE DATA VOLATILITY?
Forecasting is tough, especially about the future, runs the old joke. But the dark art of prognosticating these days is no laughing matter.
Case in point: the burning question at the moment is whether the so-called green shoots of economic recovery turning brown? It's getting harder to answer "no" these days. It's not clear if we're headed for a second slump, but the risk has gone up a bit in recent weeks. The hope that the economy had at least stabilized looked increasingly persuasive over the past several months, a trend that inspired the hope that the recession might soon end.
That's still our view, although the transition from the end of the contraction to robust economic growth threatens to be a long and rocky period, as we've discussed, including here. But the outlook on the economy is in continual flux. As new information arrives, strategic-minded investors adjust their forecast and perhaps their asset allocation. No wonder, then, that expected risk premiums vary through time. Unfortunately, the current view for the economy looks a bit less encouraging these days; or, if you prefer, the future is a bit more problematic relative to what looked likely from June's vantage. In any case, the green shoots have wilted, if only slightly.
But it's too early to expect the worst (again). Indeed, the catalysts that brought us the first round of optimism are still alive and kicking, namely, massive liquidity injections on the fiscal and monetary fronts. What's more, it's clear that these twin doses of stimulus have been critical in stabilizing the economy, which is to say keeping a deep and protracted deflationary virus from spreading. But as we've discussed all along, pulling the economy back from the precipice is one thing. As policy prescriptions go, that was relatively easy. Figuring out how to play the game in the second half, however, promises to be much more nuanced and therefore difficult.
Promoting economic growth, in short, is quite a bit harder than staving off implosion of the financial system. All the more so in the deepest recession since the 1930s. No wonder, then, that as we move into the next phase of this crisis, the signals emanating from the economy won't seamlessly dispense rising doses of good news.
One example comes in today's Wall Street Journal, which advises that the generally encouraging decline in initial jobless claims in recent months may not be as potent this time around. The reason: new fillings for unemployment benefits "typically fall fairly sharply after peaking. Instead, they have hovered above 600,000 for an unprecedented 22 consecutive weeks," writes the Journal's Mark Gongloff. The implication: this data series may not be signaling the recession's end after all, as it has in business cycles over the past 40 years.
But shortly after the Journal article appeared this morning, the Bureau of Labor Statistics offered its weekly update, reporting that seasonally adjusted claims fell by a hefty 52,000 for the week through July 4, dropping to 565,000. That's the lowest since January. Of course, last week's fall may simply be a one-time drop tied to the Independence Day holiday. Stay tuned.
More broadly, the recent readings of economic activity have been sagging. One example comes by way of the Aruoba-Diebold-Scotti Business Conditions Index, published by the Philadelphia Fed. The latest reading of the index, based on data available as of July 2, shows a notable downturn relative to previous weeks.
Meanwhile, the yield on the 10-year Treasury and the price of oil have both fallen in recent weeks, suggesting that the economic outlook has softened.
Or perhaps markets have just gotten ahead of themselves. Since March, the capital and commodity markets have been pricing in economic stability if not recovery. The question, then, is whether these trends signals something more troubling, or merely represents a pause that refreshes?
The transition from the apocalypse to the post-apocalypse world was always sure to be a confusing, perhaps more so than some of us thought. Nonetheless, we're still optimistic that the technical end of the recession is near. Unfortunately, we're a bit less optimistic these days. At the same time, we're more confident that reaching the promised land of recovery will be a tougher trek than it appeared last month. Rest assured, this outlook too will change. Let's hope it changes for the better.
July 7, 2009
A SMALL DOSE OF PERSPECTIVE
You can't generate robust forecasts of risk premia by looking only at the past, but you can certainly learn a lot about how the capital markets fluctuate.
With that in mind, we present a cursory look at recent history. In particular, the chart below compares the Global Market Index to a few of the major asset classes since the late-1990s. (For a larger view, click on the chart.) We'd like to include all the corners of the capital and commodity markets, but the chart would be far too busy.
Nonetheless, you can grasp a sense of how a passively allocated mix of all the world's major asset classes (as defined by GMI) has fared against a few of the usual suspects. As the chart suggests, GMI tends to deliver middling performance relative to its major components over time. That's one reason why GMI, or an equivalent, is worthy as everyone's benchmark.
Does that mean we should never deviate from GMI's asset allocation? No. In fact, every investor should hold a customized asset allocation that fits his particular needs and expectations. But strategic-minded investors should wander from GMI cautiously and for reasons that are economically sound.
Beating GMI over the long haul isn't easy, at least on a risk-adjusted basis, but it can be done. But even if that's your goal, the first step is analyzing GMI and building projections for each of its major asset class components. That's not easy, nor does it lend itself to quick profits. No wonder, then, that the finer points of multi-asset class investing tend to be an afterthought, if that.
July 6, 2009
PONDERING U.S. EQUITY ALLOCATION & THE BROAD PORTFOLIO MIX
The case for seeing equities as one global beta is compelling if you're looking out over very long time frames. But in the shorter term, perhaps even as long as 10 or 20 years, the rationale for making geographic distinctions is persuasive. Why? The answer begins by recognizing that valuations differ, as do trailing returns, throughout the world at any given time. As a result, expected returns vary, sometimes by quite a lot among the regional components that collectively make up the global equity market.
Add in the fact that different investors have different risk tolerances, investment horizons and financial situations and you're looking at a persuasive argument for adjusting global equity allocations through time to match your particular outlook and personal outlook.
With that in mind, comparing recent performance among the world's major equity regions offers some ideas about how the future may unfold, with an emphasis on "may." We go into a bit more detail about our thoughts in the soon-to-be published July issue of The Beta Investment Report.
Meantime, let's observe here that the U.S. stock market is a laggard midway through 2009, as it is for the five years through June 30, 2009. That alone doesn't tell us much. But as we consider other market metrics and put some of the information into broader context with a multi-asset class portfolio, the trend suggests that maybe it's time to begin raising U.S. equity allocations, or at least thinking about doing so, within a global equity asset allocation mandate.
The U.S., to be sure, has its share of troubles and so there are reasons why this equity market has fallen behind the rest of the world. What's more, the relative sluggishness in performance may continue for some time. Risk, in short, is still alive and kicking. But to the extent the U.S. lags, it suggests that it's time for strategic-minded investors to start considering holding an above-market weight share of U.S. equities within a global stock market mix. (Keep in mind that an above-market-weight allocation in U.S. equities doesn't necessarily mean its time to own an above-market-weight share of stocks overall. That's a separate although critical question.)
Regardless of whether this is a good time to adjust equity allocations, or not, every investor faces a basic choice: Allow Mr. Market to manage the asset allocation vs. taking control of the mix. If you opt for the latter there's no getting around the fact that you'll have to continually assess the delicate balance of risk and return. Easier said than done, particularly in real time.
The challenge inspires the idea that Mr. Market's allocation may be preferable. And to some extent it is, although in a narrow sense. Indeed, the market portfolio, which holds all the major asset classes in their market-value weights, is the optimal portfolio for the average investor over the long haul.
To the extent that you're not average, you may want to hold something different than the market portfolio. That's a core principle for strategic-minded investing, and an eminently simple one too. The dirty little secret for managing asset allocation is that once you recognize that you're something other than average, and decide to do something about it with asset allocation, the details get messy fast.
That's one reason for thinking that deviating too far from Mr. Market's asset allocation may be asking for trouble. Indeed, consider that almost no one holds a passive asset allocation, although collectively it all adds up to the market portfolio, broadly defined among the world's major asset classes, i.e., stocks, bonds, REITs and commodities. But while most of the world's investors each hold something other than the market portfolio, it's unlikely—indeed impossible—that everyone's smarter than Mr. Market. No wonder, then, that a little humility is necessary for survival in a world where everyone thinks they're above average.
July 2, 2009
STILL FLOUNDERING BETWEEN THE ROCK & THE HARD PLACE
The pundits are shocked, shocked to learn that jobs are still being lost. But there's really nothing surprising in today's jobs report for June, released this morning by the Bureau of Labor Statistics. Recessions have a habit of doing that, and for longer than the crowd expects. Disappointing and discouraging? Absolutely. Unfortunately, more of the same is probably coming.
Meantime, that doesn't change our view that the recession may be close to a technical end. But before we get into that point—again—let's look at how the latest nonfarm payrolls stack up.
As our chart below shows, last month's job loss was steeper than May's. Nonfarm payrolls were lighter in June by 467,000, quite a bit deeper than May's 322,000 decrease. The good news is that last month's decline is still a lot better than the worst monthly tumble so far in this recession—January's 741,000 slump.
But let's not mince words here: job destruction remains potent. The month-after-month declines are adding up and the economy is sure to take a heavy blow as a result. At the top of the list of likely victims: consumer spending, as we've been discussing, including here.
In short, there's minimal hope for the moment that we're about to turn the corner and return to the glory days of 2007, when conspicuous consumption created a powerful tailwind for bull markets in just about everything.
Why, then, do we continue to talk about the technical end of the recession? In previous posts, we talked about why we're inclined to distinguish between a formal end to the recession but one without clear and obvious improvement on Main Street anytime soon—see our posts here and here, for instance. As we wrote back in mid-May, "the official end of the recession isn't likely to bring a material change in the discouraging economic news. The technical ends of recessions still bring plenty of pain for Joe Sixpack in the ensuing quarters. The fact that this recession is the deepest since the Great Depression suggests that the recovery period, whenever it commences, will be unusually slow and sluggish. And that's the optimistic outlook!"
Today's jobs report certainly doesn't inspire us to change our view. At the same time, there's still reason to think that when the NBER gets around to dating the recession's end, it'll be sometime in the next several months. One reason for adopting that optimistic outlook is the weekly trend in new claims for jobless benefits. As we explained in March, the historical record for this data series suggests that new unemployment claims peak concurrently or slightly ahead of the NBER's terminal dates of recessions over the past 40 years. On that point, today's update on jobless claims—for the week through June 27—report a total of 614,000. That's well below the peak so far of 674,000, set back for the week through March 28. In short, the trend in jobless claims is still signaling the recession's end in the foreseeable future.
To be sure, that's no guarantee. What's been true in the past isn't always true in the future. But there are other indicators—low interest rates, for instance—that, when considered in context with jobless claims, suggest that the technical finale to the recession may be near.
Even if that's true, there's still plenty of reason to remain humble on the near-term outlook for the economy. As today's employment report reminds, the labor market is still quite weak. That's not necessarily surprising, since employment is a lagging indicator and so positive net jobs growth tends to arrive late to newly minted cycles of growth. That tends to be true even in mild recessions; the fact that this is the deepest pullback since the Great Depression only emphasizes the point.
The bottom line is that while we continue to cautiously anticipate the end of the recession, we're still reluctant to predict the start of economic growth worthy of the name. The interim between the two—an economic no-man's land, if you will—threatens to run on for longer than usual in this cycle. Therein lies the main challenge that awaits, and it's only just begun.
July 1, 2009
THE COOL WINDS OF JUNE
The weather in June was cool and rainy in the New York region, and something similar prevailed over the capital and commodity markets last month as well.
As our table below shows, June was a month of mixed messages, ranging from a healthy rally in high-yield bonds to loss in REITs. Disappointing, perhaps, given the previous bout of good times. But the arrival of red ink is hardly unexpected. The March-to-May rally, after all, elevated all the major asset classes by dramatic levels. That couldn’t last. But what comes next?
The optimistic interpretation is that June was a month of backing and filling. The markets are reportedly digesting the recent gains and building a foundation to capitalize on the expected economic recovery. Prices got ahead of themselves in recent months, and bit of profit-taking was inevitable.
A less-forgiving outlook is that the recent rally in almost everything was a sucker’s game. The great bear market of 2008 is still with us, runs this line of thinking, and so the rest of the year will suffer.
Your editor tends to come down in the middle of these two extremes. As we’ve been pointing out in more detail in recent issues of The Beta Investment Report, the foreseeable future for returns in the major asset classes looks increasingly unexceptional. The sharp snapback in prices so far this year looks warranted as it became clear that the worst fears for the economy were overdone. All the more so as it appears that the technical end of the recession may be near.
Then again, we can’t be sure. There are still lots of reasons to remain cautious. Forecasts, after all, are created by mere mortals and so predictions are subject to revisions as new information arrives. Meanwhile, the stock market looks fairly valued at the moment, which is to say that it’s no longer undervalued, as it was as this year opened. Similarly, yield spreads, while still attractive, are no longer extraordinarily high.
In short, the markets have rallied on the expectation that the aggressive liquidity injections of governments around the world would bring stability and, eventually, expansion. That still looks like a good bet, but no longer are markets offering massive discounted prices tied to that outlook.
Then again, none of this is a surprise. Expected returns vary, as they must in order to attract buyers through time. No one would be willing to buy risky assets in January 2009 without an unusually high expected risk premium. Now that the macroeconomic risk looks lower, albeit still substantial, assets are priced accordingly.