November 30, 2009
The debt crisis in Dubai is probably overblown in the media in terms of global economic consequences, but the fear that the problems will spill over into other markets is certainly real enough. But if this sounds like deja vu all over again, you're right.
Been there, done that, you might say. Of course, that doesn't mean the global economy is immune to debt-fueled crisis. In fact, it's a safe bet that this strain of financial crisis--red ink--is ongoing, waxing and waning through time. All the more so these days, when government and consumer balance sheets are loaded up with liabilities.
All of which inspired us to take another look at the recently published This Time is Different: Eight Centuries of Financial Folly, which we reviewed in the October issue of The Beta Investment Report and is republished below. On that note, you can see the entire October issue of the newsletter here.
As for debt and delusion, history has much to teach us. The only question is whether we're listening.
* * *
The following originally appeared in the October 2009 issue of The Beta Investment Report
This Time Is Different: Eight Centuries of Financial Folly (Princeton University Press)
by Carmen M. Reinhart and Kenneth S. Rogoff
Kindleberger labeled it a "hardy perennial." Minsky developed a theory called the "financial instability hypothesis." And now comes a monumental new book on the subject of financial crises, dispensing a data-rich review of an affliction that recognizes no political border, time period or (apparently) policy prescriptions aimed at preventing such events.
Admonitions of this sort presumably need no introduction at this juncture. The world is once again in tune with the finer points of a financial crisis and what it means for markets and economies. Although these debacles are a chronic scourge through time, it seems that every generation must relearn a fundamental truism: The potential for calamity on a broad scale is always lurking in the future, which means that thinking otherwise lays the groundwork for the next disaster.
Few will argue the point at this late date, but if you're looking for supporting details (or you simply enjoy poring over the statistical artifacts of financial crises through time) you're in for a treat with This Time Is Different. As the title suggests, this book analyzes the various financial contortions that have harassed economies over the centuries. Penned by economics professors Carmen Reinhart (University of Maryland) and Ken Rogoff (Harvard), the tome is an academic tour de force. Analyzing the history of financial crises, including the current one, the authors bring some much-needed perspective to a corner of economic history that's too often ignored or misunderstood.
Although This Time Is Different abounds in statistical analysis, the chief lesson is unambiguously succinct. "No matter how different the latest financial frenzy or crisis always appears," Reinhart and Rogoff write in the opening, "there are usually remarkable similarities with past experience from other countries and from history." The remaining 400-plus pages dispatch the details in all their astonishing if terrifying grandeur.
The fundamental catalyst for the crises is debt, the authors conclude. There are many paths that deliver the red ink, including the finance industry's innovations, aided and abetted by our friends at the central banks. But the end result is usually the same. To be fair, debt alone doesn't create the problem; an equally pernicious condition of underestimating debt's potential for creating havoc is part of the equation too. As the book explains,
…excessive debt accumulation, whether it be by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom. Infusions of cash can make a government look like it is providing greater growth to its economy than it really is. Private sector borrowing binges can inflate housing and stock prices far beyond their long-run sustainable levels, and make banks seem more stable and profitable than they really are. Such large-scale debt buildups pose risks because they make an economy vulnerable to crises of confidence, particularly when debt is short term and needs to be constantly refinanced.
A related case of this-time-is-different thinking afflicts decision-making in the halls of central banks. For a time, it seemed like the Federal Reserve and its counterparts around the world had tamed inflation and the business cycle. Recessions became less frequent and milder; inflation was stable if not falling. The Great Moderation, as it was dubbed, appeared to be the new new thing. This, alas, was a temporary condition; the critical error was thinking it was permanent and that central bankers had discovered the secret for managing the economy.
Thinking it was different this time isn't new, of course. Martin Wolfson, in Financial Crises (published in 1986) writes that the 1966 credit crunch "came as a shock" to the financial elite. Why? The previous calm was almost certainly part of the answer, he explains. "During the period immediately following World War II, when financial crises seemed to have disappeared forever from the economic scene, mention of them also disappeared from the economics literature," Wolfson reports. "Nearly an entire generation of economists was trained without ever studying the origins and causes of financial crises."
Crises don't drop unannounced from the sky. Clues are dropped along the way, through every boom and over every extended period of economic calm. It's not always obvious that the crowd is watching, but it's hard to argue that the seeds of a given crisis were invisible.
Accepting the idea that economic cycles had been banished in the golden days just ahead of 2008, for instance, required ignoring the accumulating warning signs. A few examples noted in This Time Is Different:
* The extraordinary rise in inflation-adjusted housing prices. The reversal of fortunes in real estate, of course, was a central catalyst in the financial crisis of 2008.
* The dramatic rise in U.S. government deficits—deficits that were increasingly financed with foreign monies.
What's the relevance for our agenda at The Beta Investment Report? First, the business cycle endures, sometimes to extremes. Second, careful observers can find hints about prospective turning points in the business cycle, although the implications for timing are invariably obscure. Three, economic research increasingly identifies and analyzes the connection between the business cycle and risk premia, which suggests that studying the details of both is essential for managing asset allocation.
The great challenge, as always, is deciding when to act and to what degree? Some observers of the economic scene were warning that the housing market was an accident waiting to happen just ahead of 2007-2008. But saying so in 2006 and pulling the plug on risk meant leaving quite a bit of return on the table over the ensuing quarters.
What's a strategic-minded investor to do? For our money, asset allocation should be adjusted modestly but routinely. If the warning signs, or opportunity signals, are unusually potent, there's a case for acting decisively. Most of the time, however, the indicators tend to lie in a gray area and so dramatic, sudden changes to asset allocation are generally inappropriate.
Then again, by holding a broad array of asset classes, and watching how they perform in absolute and relative terms, we establish our front line of defense against uncertainty. The market's telling us something when one asset class soars or stumbles by an unusual degree over a period of time. In those cases, rebalancing opportunities arise.
But it's worth repeating that opportunity and risk aren't usually at extreme levels, which strengthens the case for a relatively mild-mannered asset allocation as a general rule. Sometimes, however, something more dramatic is called for, and the reason is usually linked to the macroeconomic trend. Such strategic insight isn't always obvious; in fact, it's rarely obvious if you can't see the forest for the trees. For those whose financial vision is strategically challenged, practice in the art of taking a more expansive view is one solution. Spending some time with This Time Is Different is a productive first step.
November 25, 2009
Another holiday is upon us and your editor will be vacating the digital premises for some downtime with drinks, dinners and various diversions. The routine returns on Monday, November 30.
WAITING (HOPING) FOR CLARITY
“We have to be sure that the recovery is final, that domestic demand is self-sustaining and the peak in unemployment is on the foreseeable horizon,” Dominique Strauss-Kahn, managing director of the IMF, said yesterday in London yesterday in connection with a speech he gave at a British industry conference.
The topic of discussion was the exit strategy, and the ever-topical question of when to begin retreating from the massive liquidity injections that remain the status quo in the global economy, particularly in the U.S. Straus-Kahn emphasized that “a premature exit is the main danger,” and that’s probably true. But the risk associated with keeping the stimulus running too hot for too long isn’t exactly chopped liver either.
Waiting for absolute certainty is waiting for the impossible in central banking. As we discussed last week, prescience is the stuff of dreams in a world where mortals manage monetary policy. Mistakes are inevitable, which implies that central bankers should hedge their bets if only slightly.
Should the Fed start hiking rates immediately by a large degree? No, but it’s time to begin the inexact science of sending a message to the crowd that the price of money will climb in the months and years ahead. A 25-basis-point increase in Fed funds wouldn't derail the stimulus efforts but it would send a timely reminder of things to come.
The soaring price of gold suggests it’s time for a nudge upward in the price of money. A similar message arises from the internal discussions at the Fed these days. As discussed in the FOMC earlier this month, “members [of the Fed] noted the possibility that some negative side effects might result from the maintenance of very low short-term interest rates for an extended period, including the possibility that such a policy stance could lead to excessive risk-taking in financial markets or an unanchoring of inflation expectations.”
But while the Fed is on record as worrying about irrational exuberance and the possibility that the central bank might be promoting the next bubble, the official position is that such a risk is at present “relatively low.” And the Fed funds futures market is inclined to agree. Futures are priced in anticipation that the current 0-0.25% target rate will endure at least through next year's first half.
That's no surprise, of course. Central banks prefer to err on the side of inflation, modestly so if possible. It's what they know and monetary policy works better with a little pricing juice. That implies that even a small 25-basis-point hike is probably far off in the future. Ultimately we won’t know for sure if the Fed made a timely decision to keep inflationary pressures at bay until several years down the road. Of course, by that time it’ll difficult to retroactively correct any mistakes. Waiting for absolute clarity is a nice idea, but only if it works.
November 24, 2009
IN DEBT WE TRUST?
Is it time to consider more radical strategies for repairing the U.S. economy? Perhaps, although as a recent essay from the Levy Economics Institute argues, it’s also clear that the old game of trying to reflate bubbles isn’t going to work this time.
“Like the Bush administration before it, the Obama team appears to be trying to re-create the bubbly financial conditions that led to disaster,” a research paper from LEI asserts. “This tack is not likely to succeed, and it is displacing policies that might actually prevent a recurrence of the Great Depression.”
The paper continues,
In our view, most administration proposals are fundamentally misguided, since they are based on the twin presumptions that Big Banks face only a liquidity problem and that, if this problem is resolved, the economy will recover. We believe these presumptions are entirely mistaken. The Big Bank problem is insolvency, and these banks should not be saved because they form a barrier to a sustainable recovery. Given a chance, they will resurrect the bubble conditions that led to the current crisis.
What’s the solution? LEI argues that a banking “holiday” is needed. The biggest institutions are temporarily closed and the books are closely analyzed, including a careful look at cross-bank liabilities. The immediate goal is “consolidating the balance sheets” in order to “downsize the financial sector and reduce monopoly power.”
The basic motivation for these changes, according to LEI, is that borrowers can’t service their debt. But the think tank’s solution isn’t exactly novel. “A major increase in government spending is the only way to smooth the deleveraging process.”
The reasoning, the paper concludes: “It is better to spend on a much bigger scale now in order to create jobs and rekindle private sector growth. If we do that, the budget deficit will shrink and GDP will grow, while government debt- and deficit-to-GDP rates will fall.”
Even assuming that huge amounts of new spending are the intelligent choice (a debatable proposition, to say the least), the conceit here is that Congress will make intelligent decisions when it comes to directing the new monies.
Ultimately, there’s a question of whether the government, any government, can create jobs worthy of the name on a grand scale over long periods of time. One problem: the funding of such a massive public enterprise has to come from somewhere, which raises questions of whether we're simply borrowing from Paul to pay Peter. There are three basic methods for such programs: raise taxes, borrow more, or quietly devalue the currency. Perhaps a mix of all three is coming.
Yet the burden should be on those who call for a colossal increase in government’s role at this juncture in the economic cycle. Does history suggest this is a logical path that will bear fruit? We think not, although the devil's in the details. But as a general proposition, economic growth doesn’t flow from government mandates. Governments have some capacity for keeping disaster at bay, but that's quite a different state of affairs than promoting growth.
We can make a case for intervention to stave off some immediate threat. But let’s not fool ourselves into thinking that economic expansion can be engineered as one more state program. The limited response (so far) of the so-called stimulus program from earlier this year suggests as much. Clearly, many disagree, although the "solution" in some corners is always: spend more. If $800 billion wasn't enough, $1.6 trillion would have been. Ah, if it was only that easy.
And so we ask a simple question: What does history say? To be precise, what does history say about government spending on promoting growth beyond some immediate crisis?
By all means, we need to encourage economic expansion by all reasonable methods and use government levers in a prudent fashion. But there are limits to everything, just as public spending at some point becomes counterproductive. And so let’s not kid ourselves: we’re looking at a period of subpar growth on a number of levels, and the brilliant ideas cooked up in, say, the U.S. Senate or the Department of Energy probably can't save us from this fate.
The only thing worse than an unsatisfactory recovery is one that's also laden with an even higher level of excess debt and questionable expansions of the public sector.
DOWNSIZING THE FIRST ESTIMATE OF Q3 GDP
Today's release of second estimate of third-quarter GDP reveals that the economy expanded at a slower pace than originally reported. The initial 3.5% annualized real growth in the U.S. for Q3 was, we're now told, just 2.8%.
Meantime, corporate profits skyrocketed in Q3. As companies shed payrolls, the cost saving flowed to the corporate bottom line. Profits jumped 13.4% during the July-September 2009 period at an annualized rate. That's the biggest percentage gain since 2004.
Meantime, consumer spending wasn't quite as strong as originally estimated in the first print of the GDP report. Consumer spending was revised down to a 2.07% increase from 2.36% initially.
In addition, imports exceeded exports by a higher degree than originally calculated. The change helped trim the second round of estimating GDP for Q3. The U.S. appetite for foreign goods and services surged nearly 21% in the third quarter, the most since 1985.
Inventories slipped a bit more than the first Q3 GDP numbers advised, dropping by a bit more than $133 billion. That's slightly more than the $130.8 billion initially reported. But that may be good news in the sense that the inventory drop implies that production will ramp up that much more in the future to compensate for lower supplies.
But don't start celebrating just yet. Perhaps we should wait for the third and final estimate of Q3 GDP, which will be dispensed on December 22, just in time for the holidays.
November 23, 2009
UPBEAT SURVEY FROM ASSOCIATION OF ECONOMISTS
Are the days of the jobless recovery numbered? Yes, according to the latest survey that was released today.
The Capital Spectator has obtained a copy of the full report. Among the highlights:
* NABE-member economists predict a moderately higher pace of economic growth for this year's fourth quarter compared to the outlook made in October. According to the report, "The fourth quarter of 2009 is now slated for a 3.0 percent pace of real GDP growth and 2010 is predicted to experience a gain of 3.2 percent over its four quarters. For the two years combined, growth is expected to be one-half of a percentage point above the forecast made in October. Economic growth is projected to slightly exceed its trend pace—which NABE panelists estimate at 2.7 percent—over the next five quarters."
* The household sector is still expected to post sluggish results for the near term. "Past wealth losses, and initially stagnant employment conditions," the NABE advises, "are predicted to result in lackluster consumer spending gains over the coming year."
* Meanwhile, the recovery "will not remain jobless for long," the report forecasts. "With more than 7.3 million jobs lost since December 2007, NABE panelists believe the end of net employment losses is near, with modest declines during the fourth quarter followed by a 'bottom' in the first quarter of 2010 and gains thereafter."
In addition, the report expects that the "nascent housing recovery… will gather momentum" and business investment will be "an engine of growth driving the economic recovery."
Overall, the new NABE survey reaffirms the polling's previous conclusion that the Great Recession is over. "NABE panelists have marked up their predictions for economic growth in 2010 and expect performance to exceed its long-term trend," the survey notes.
The November 2009 NABE Outlook offers the consensus of macroeconomic forecasts made by a panel of 48 professional forecasters. The current survey was taken October 24 through November 5.
SOVERIGN RISK, REFLATION & THE NEW NORMAL
Sovereign risk doesn’t usually dominate the headlines on any given day, but in the wake of last year’s financial cataclysm there’s a sharper focus on the fallout that flows from governments that mismanage their debt and economy.
The elephant in the room, of course, is the U.S. The discussion of America’s fiscal condition has heated up in recent history for obvious reasons, starting with ballooning debt. As the overseer of the world’s reserve currency, which happens to reside in the world’s largest economy, the U.S. enjoys certain advantages that other nations can only dream of. That includes the ability to harbor mountains of red ink.
But as we learned last year, chickens have a habit of coming home to roost. That doesn’t mean the rebalancing of excesses arrives suddenly. And there's no law says that rebalancing can't unfold gradually. Indeed, much of what’s unfolded over the past 12-18 months is a rebalancing in the global economy. And the rebalancing continues. Perfect equilibrium is elusive, but market forces are continually pushing economies toward that target, although various frictions can and do intervene. Timing, in short, is always an open question. Nonetheless, strategic-minded investors shouldn’t ignore the risks that arise from the shifting tectonic plates of global imbalances.
Perspective is a valuable thing, though not necessarily as a tool for day trading. But even short-term players assume undue risk by ignoring history. As an antidote, spend a little time with the recently published This Time is Different: Eight Centuries of Financial Folly, which excels in reviewing the capacity for cyclical persistence in the troubles that afflict markets and economies through time. "This time may seem different, but all too often a deeper look shows it is not," the authors advise. "Encouragingly, history does point to warning signs that policy makers can look at to assess risk—if only they do not become too drunk with their credit bubble-fueled success and say, as their predecessors have for centuries, 'This time is different.'"
Having just lived through one of these episodes, it's tempting to think that we may not see another for years, perhaps a generation or two. But some are now talking of the extreme low rates of interest as fueling yet another period of excess. Perhaps, although intentional reflation is the tactic du jour. In any case, a bit of perspective never hurts. With that in mind, here are a few worthwhile views on related matters from around the web:
* "Wave of Debt Payments Facing U.S. Government"
NY Times (Nov. 22, 2009)
Excerpt: "With the national debt now topping $12 trillion, the White House estimates that the government’s tab for servicing the debt will exceed $700 billion a year in 2019, up from $202 billion this year, even if annual budget deficits shrink drastically…Americans now have to climb out of two deep holes: as debt-loaded consumers, whose personal wealth sank along with housing and stock prices; and as taxpayers, whose government debt has almost doubled in the last two years alone, just as costs tied to benefits for retiring baby boomers are set to explode."
* "Will sovereign debt be the new subprime?"
Financial Times (Nov. 23, 2009)
Excerpt: "It is even easier to anticipate a sharp rise in bond yields - and a corresponding sharp fall in bond prices - particularly when central banks stop their quantitative easing programmes. Some smart hedge funds are betting on just that. Yet there has been precious little debate about whether banks should keep loading up on sovereign debt."
* "Trichet warns banks risk addiction to support"
Reuters (Nov. 20, 2009)
Excerpt: "Banks risk becoming addicted to cheap central bank cash used to fight the financial crisis and must prepare for its eventual withdrawal, the head of the ECB warned at a Frankfurt banking conference on Friday."
* "Britain could lose its AAA status"
Irish Independent (Nov. 10, 2009)
Excerpt: "THE UK is most likely to lose its 'AAA' status among those countries still in the top tier of sovereign credit ratings, the Fitch rating agency said yesterday."
* "Sovereign risk continues to rise, says CDR"
Creditflux (Nov. 20, 2009)
Excerpt: "Credit Derivatives Research reports that sovereign risk continued to rise this week as all members of its GRI index except Japan added risk. The Government Risk Index broke through the fifty basis point mark this week for the first time since late July. Japan’s standout rally came only after the name experienced a run up in risk the week before even as the other majors rose only modestly."
* "Anything but .01%"
Investment Outlook/Bill Gross, Pimco (Dec. 2009)
Except: "The Fed is trying to reflate the U.S. economy. The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher-risk bonds or stocks. Once your cash has recapitalized and revitalized corporate America and homeowners, well, then the Fed will start to be concerned about inflation – not until. To date that transition is incomplete, mainly because mortgage refinancing and the purchase of new homes is being thwarted by significant changes in down payment requirements. The Treasury as well, has a significant average life extension of its own debt to foist on investors before the Fed can raise short-term Fed Funds."
November 20, 2009
THINKING ABOUT THE GREAT EGRE$$ION
Everyone knows it’s coming, but when? Everyone recognizes that at some point it’s essential, but the associated benefits and risks are debatable.
One thing we can be reasonable sure of, as we discussed on Monday, is that central bankers are prone to misjudge the future. Indeed, there's plenty of that to go around. In any case, it comes with the territory when wielding supernatural decisions over money with the conventional processing power of wetware.
Thus the great conundrum: What to do next? It’s always lurking, of course. The only difference is that the stakes are higher than usual. Not for tomorrow, next week or next month necessarily. But sometime down the line, in the amorphous future, monetary policy decisions will make a big difference, for good or ill. But how? And when? Ah, the debate has only just begun.
“The main concern surrounding exit policies… is not technical, but one of timing: can the timing and pace of the exit be properly judged?” reminds a newly minted essay published by the Bank for International Settlements, a think tank and quasi-regulatory body for central banks the world over.
And thanks to the somewhat experimental nature of the current round of monetary stimulus—i.e., quantitative easing and the like—there’s that much more mystery surrounding what to do and when and what it all means when the inveitable change of plan comes. “The possible long-term collateral damage in terms of market functioning and central bank operational autonomy of balance sheet policies underlines the need to put in place clear exit strategies,” the BIS paper advises.
Of course, the only clarity we have at the moment is largely related to the stated discipline to maintain the status quo for the foreseeable future. Or as the Fed’s FOMC explained earlier this month at its regularly scheduled confab, “The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”
That may suffice for the moment, but the crowd will demand more details in the weeks and months ahead in terms of how to end, or at least begin winding down this love affair with cheap money and related commitments.
Indeed, the stimulus extends well beyond the Fed's purview. To cite the other elephant in the room, the U.S. government is on the hook for any number of prop-‘em-up strategies. The Troubled Asset Relief Program, or TARP, for instance, isn’t open ended, even if it appears otherwise. Perhaps Congress should consider letting it die as this year concludes. Treasury Secretary Geithner made comments to that effect yesterday. But President Obama may be leaning in the opposite direction.
TARP, of course, is just the tip of the iceberg. It’s easy to dig a hole. Climbing out of it requires a different skill set. At some point, someone will have to start talking tough, which is a prelude to acting tough. In a perfect world, with perfect foresight, the Fed and Congress would know exactly when and how to start pulling back. In the real world, however, uncertainty abounds. To be sure, the risk of acting prematurely shouldn’t be dismissed. But neither should we overlook the hazards that await if we do nothing for too long. History is full of examples of the fallout from both extremes.
As with most things in life where absolute clarity is missing, some happy medium that hedges the risk is preferred. We might start with a small hike in Fed funds, if only to remind the crowd that the price of money can move in more than one direction. Perhaps it stands as the only hike for months ahead, but every risky journey must begin somewhere.
We can’t see the future clearly and so we have to make compromised decisions. True for investing, true for central banking. That implies that gradual change is the least worst of all decisions unless you know something that eludes everyone else.
There’s a case for arguing against the idea that the central bank should try to overtly pop bubbles. The same logic says we should leave interest rates at virtually zero until a politically satisfying recovery is virtually assured. Perhaps there’s a middle ground. Perhaps some in Washington are actually willing to act on that reasoned assumption.
There are no major economic reports scheduled today and so a day of the data vacuum awaits. That offers an opportunity to review the latest numbers in the dismal science in search of clues about where we’ve been in recent history and where we might be going.
First up is the Philly Fed’s Aruoba-Diebold-Scotti business conditions index. Its steady climb for much of this year through late-August suggested that the economy was rebounding, albeit off of severely low levels of commercial activity. More recently, the index slumped, although the latest albeit incomplete data hints at the possibility of an uptick in the weeks (months?) ahead, as the chart below shows.
That mildly positive view jibes with the overall outlook of 41 economic forecasters surveyed by the Philly Fed. The economy will expand in each of the next five quarters, this survey advises. For the current quarter, the economists surveyed predicted that real growth in GDP will rise 2.7% in Q4. If so, that's down from the 3.5% rise reported in the initial estimate of GDP for Q3. All of which implies a slowing in the rebound but well short of sinking.
But as we've suspected for some time, the labor market will remain conspicuously MIA in the rebound for a while longer, which probably explains why the overall pace of growth is expected to weaken somewhat. Quoting from the Philly Fed's survey report,
Unemployment is now seen at an annual average of 9.3 percent in 2009 and 10 percent in 2010, before falling to 9.2 percent in 2011 and 8.3 percent in 2012. These estimates mark upward revisions from the forecasters' previous projection. Likewise, growth in jobs looks weaker. The forecasters see nonfarm payroll employment falling at a rate of 160,000 jobs per month this quarter and 35,000 jobs per month next quarter. Both estimates mark downward revisions from the previous survey. The forecasters see jobs beginning to grow in the second quarter of 2010. Over the second half of the year, jobs will grow at a rate of 150,000 per month.
The mildly rising headwinds relative to past months are also evident in our proprietary U.S. economic index, which is published and analyzed in each issue of The Beta Investment Report. As we wrote in the November issue of the newsletter, the percentage of rising components in this index slumped to under 50% in September, indicating a possible slowdown in the recovery process. Meantime, a preliminary update of the October data for our index shows as of this morning shows that of the 14 components reporting through last month (out of 18 tracked for our broad economic index), 8 were positive in October and 6 lost ground.
Tempering expectations for the economic rebound is also underway elsewhere in the developed world. In Germany—Europe's largest economy—fourth-quarter economic growth “will be less dynamic…as private consumption pales,” said Deputy Finance Minister Walther Otremba via Bloomberg News.
Back in the U.S., another sign that the recovery may continue to lose momentum can be found in yesterday's update on The Conference Board's index of leading economic activity. The index rose 0.3% last month, the Conference Board reported, down from a 1.0% rise the month before. “The data indicates that economic recovery is finally setting in," said Ken Goldstein, an economist at the consultancy, in a press release yesterday. "We can expect slow growth through the first half of 2010. The pace of growth, however, will depend critically on how much demand picks up, and how soon.”
"The gears are starting to click but very, very slowly," Philly Fed Chief Charles Plosser said yesterday via Reuters. "The economy is still quite flaccid." Even so, he downplayed the risk of a double-dip recession. One reason is that the Fed plans on keeping short-term interest rates just above zero for the foreseeable future.
Meantime, next week brings the second update on Q3 GDP (Tuesday) and the latest on durable goods orders and personal income and spending. Will these numbers change the perception that the recovery's slowing but not necessarily fatally? Stay tuned.
November 19, 2009
WASHINGTON’S NEW MATH
Only in the hallowed halls of Congress could the notion of spending vastly higher amounts of money convince so many that the net result will be a reduction in spending. But such is the conceit with the new health care bill being hammered out these days.
The new legislation to expand health care insurance will reportedly cost $849 billion. But this massive increase in government spending will, we’re told by Senate Majority Leader Harry Reid, reduce the federal budget deficit by $130 billion.
If $849 billion will get us $130 billion in deficit reduction, will $1.698 trillion bring us a $260 billion decline in red ink? Have we, in other words, stumbled upon a budgetary fountain of youth? Ah, if it were only that easy. But attempts at spending our way to prosperity has a long and discouraging record. We can debate the social merits of expanding health care coverage by way of colossal increases in public expenditures, but promoting it as a deficit reduction measure as well strikes us as, well, unhealthy. Progress, or apparent attempts at such, cost money. There's just no way to turn that mule into a horse.
Meantime, the last time we check, two plus two still don't equal 5, or 3. In most cities, at least.
The danger is not the past, but the future.
Today’s update on weekly jobless claims may be the warning sign. New filings for jobless benefits were unchanged last week, hovering at 505,000, matching the previous week’s tally. Although this number is down sharply from it’s recessionary peak of 674,000, set back in late-March, 500k reflects distress in the labor market. In other words, job growth is largely MIA.
It’s too soon to tell if the drop in claims is stalling. But there’s a case to be made that the big, easy reductions are behind us. As we discussed many times this year, there was always a strong case that a snapback on multiple economic and financial levels was in the offing for 2009. Unless the system was truly headed for a collapse, the natural order of the business cycle was righting itself after such a sharp deviation from equilibrium. In short, much of the events in 2009, particularly since the spring, aren’t a huge surprise to students of economic history. But the world is likely to become increasingly nuanced and complicated, and not necessarily for the better.
We’ve commented often in 2009 that the main threat was a stalled rebound in the job market. The risk was less about a double dip recession and another cataclysm and more of meager growth in the all-important labor market. Today’s data point in jobless claims isn’t proof that our forecast is turning into reality, but neither does the latest number do anything to dispel our worry of what may be looming.
The crowd’s been taught to expect that extreme outcomes are the new norm, courtesy of the drama of the past year or so. But we think the hazards will come quietly, softly, sneaking up on us like burglars in the night. Rising inflation, weak job growth, a tepid recovery, and the increasing pain that comes with servicing the debt boom of the past generation all conspire to make the foreseeable future challenging.
None of these problems will change very much over any given period. Nor will the associated fallout appear materially worse from month to month or even quarter to quarter. That raises the possibility that the dangers will be ignored or underestimated, which in turn suggests that the crowd may adopt a degree of optimism that’s unwarranted.
But the chickens are coming home to roost, one seemingly inconspicuous and unthreatening data point at a time. Still, there's a danger in becoming too pessimistic as well. The excess will be worked off and progress will come. But it won't be quick or easy this time. And for some with limited patience, it'll be far too slow. Regardless, the future can't be rushed. That's always true, of course, although in the months and quarters ahead this truism will resonate on a deeper level than we've witnessed in many a moon.
November 18, 2009
THE NEW NEW BALANCING ACT
Definitive statements about the future are always suspect in finance and economics, but it’s reasonable to assume that the threat of deflation as a clear and present danger has passed. But we can’t say for sure. To the extent that a double-dip recession remains a possibility, so too will does hazard of a fresh round of deflationary pressures.
Yet those concerns look minimal at this point. The primary challenge, as we’ve discussed routinely this year, is tied to the headwinds of growth. The risk of another of follow-up cataclysm to last year’s drama, by contrast, fades with each passing month. In short, the central issue is one of managing the chronic problems that await rather than the acute ones that recently passed.
Yet we shouldn’t underestimate the complications and potential fallout that are likely to accompany what we expect will be a subpar economic recovery, in large part because of what’s likely to be a sluggish rebound in the labor market. (For some background on our thinking about the job market, take a look at this post from earlier this month and our analysis here, for example.)
Even before the debacle of 2008, the recovery momentum in the labor market in post-recession periods was waning in the U.S. in both relative and absolute terms. There are many reasons for this troubling trend, none of which are easily resolved. Given the current environment, the "solutions" are even less likely to yield results.
We're hardly alone in worrying about the U.S. employment trend. "A sharp rise in unemployment, coupled with the recognition that it will stay high for a while, changes the behavior of the employed, and it changes government behavior,” Pimco's Mohamed El-Erian told Investment News this week. "I guarantee you that within six months' time, there will be talk of another stimulus plan related to unemployment."
As challenging as the job market's future will be, it's even more complicated because of what we might think of the coming disconnect, however temporary, between headline changes in the economy and a struggling labor market. On the one hand, the near term outlook seems set to deliver relatively favorable comparisons in such metrics as retail sales and GDP vs. the declines of the recent past. Looking out beyond the next 6-12 months, however, may be more problematic.
Paul Zemsky, head of multi-asset strategies at ING Investment Management in New York, makes a distinction between the optimism for the near-term trend vs. a more cautious view on the longer-term. It's the cyclical vs. the secular, he explained yesterday at a press briefing at the firm's office in Manhattan. The odds for a double-dip recession are quite low, he said. Meantime, retail sales need only tread water to generate encouraging year-over-year comparisons in the quarters ahead, courtesy of the sharply lower absolute levels in consumption in the recent past.
Overall, Zemsky projects a "mild recovery" in 2010 that will fuel additional increases in the prices of risky assets, starting with the stock market. He also expects that consumer consumption will average 2.5% for much of next year. That's a welcome change from the past 12 months, of course, although he notes that a 2.5% rate of consumption for Americans will be well below the 3.5% pace for the past generation or so. Nonetheless, he opines that "financial markets respond to the change, not the level" in key economic comparisons such as retail sales, which leads him to call for a rising stock market for at least the near term. Supporting this optimism is Zemsky's call for the U.S. economy to expand by 2.4%-2.8%, comfortably above the consensus forecast.
If so, one might expect that inflation will continue to bubble higher, if only marginally. Once again, the year-over-year comparisons are likely to climb, in part because the recent past witnessed such sharp declines, i.e., a brief flirtation with falling prices. In today's consumer price report for October, the government advised that CPI rose 0.3% last month, up slightly from September's 0.2% increase. For the past 12 months, CPI has fallen, but as we move beyond the data from the months of last year's financial crisis, the inflation comparisons are likely to turn positive on an annual basis.
Indeed, if we look at so-called core inflation (less food and energy), consumer prices climbed 1.7% over the past year through October. That's still modest, but the trend of late suggests that pricing pressures are likely to rise, if only modestly. But what's troubling for the goose is likely to be a headache for the gander. If year-over-year comparisons in retail sales, GDP and other metrics offer some reason for optimism, the shifting trend in inflation is likely to deliver the opposite. No, we don't expect inflation to suddenly take wing. But let's consider the big picture.
First, the Federal Reserve continues to flood the economy with liquidity, and for the moment there are no plans to change this state of money printing. The central bank wants higher inflation. If it's going to err, it's going to err on the side of higher prices. Meantime, the prospects for favorable year-over-year comparisons in several economic yardsticks look encouraging, albeit relative to depressed absolute levels of the recent past. But waiting in the wings is the sobering outlook for job growth.
All of which suggests that near-term events will tempt the crowd to think that all's well. But the biggest challenges are yet to come. Transitioning between the snapback in progress and the longer-term reality awaits. There's always a reason to worry, of course. Meantime, markets have been known to climb a wall of worry. Somewhere between these two extremes lies a reasonable outlook for strategic-minded investors. But no one should expect the answer will come easy. As always, finding a happy medium between the tactical and the strategic is the goal, but finding the optimal mix isn't likely to get any easier.
November 16, 2009
THE BURDEN OF FIAT MONEY: REAL-TIME DECISIONS
Central bankers are a powerful lot and so it’s an easy to assume that they’re also prescient. When you’re making decisions that affect the livelihoods of millions of people—billions on a global scale—confusing people with their institutional authority can become habit forming. But central bankers are mortal, and therefore prone to mortal decisions, a.k.a. flawed decisions. Heck, it happens to the best of us at times. The only difference is that most people’s day jobs don’t cast a long shadow over a nation’s money supply.
No less an expert on central banking than Paul Volcker, the patron saint of inflation slayers everywhere, advises that “central bankers suffer from hubris like everybody else.” That’s not surprising, but it does have consequences.
The monetary policy du jour, as a result, may not be exactly what the macroeconomic gods ordered. A mismatch between the optimal monetary policy and current events is in some sense fate. Working with limited information makes it hard to know if today’s actions will suffice for the uncertainty that arrives tomorrow. As a result, we can talk of monetary policy in terms of its degree of inaccuracy or accuracy.
Intelligently dispensed or not, monetary policy steers economic activity, ranging from decisions in asset pricing to lending preferences to choices that affect the labor market. Alas, poor decisions have a habit of delivering less-than-satisfying results.
Remember all the talk of the Great Moderation? “One of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility,” Ben Bernanke pronounced in early 2004 in his then-current position as a Fed governor. “Reduced macroeconomic volatility,” he went on to explain, “has numerous benefits. Lower volatility of inflation improves market functioning, makes economic planning easier, and reduces the resources devoted to hedging inflation risks. Lower volatility of output tends to imply more stable employment and a reduction in the extent of economic uncertainty confronting households and firms. The reduction in the volatility of output is also closely associated with the fact that recessions have become less frequent and less severe.”
It’s debatable how much the Fed was influenced by the past for setting monetary policy in 2004 and beyond, but some observers of central banking suggest that the calm history in those halcyon days led policymakers astray. Anna Schwartz of the National Bureau of Economic Research speaks for many dismal scientists when she charges in a recent essay that the Fed kept interest rates too low for too long earlier in this decade. In turn, the inappropriate interest rates distorted markets, she says, and the fallout wasn't trivial. “In the case of the housing price boom, the government played a role in stimulating demand for houses by proselytizing the benefits of home ownership for the well-being of individuals and families.” The net result, to state the obvious, was less than optimal.
Volcker has commented that the preference for low interest rates earlier in this decade was based on a “misreading of the Japan situation.” The worry that deflation threatened in 2001-2005 was simply wrong, as was the resulting prescription: low interest rates.
Economist Scott Sumner opines that another Fed mistake of some consequence was the decision in September 2008 to leave interest rates as is. “On September 16, 2008, the Fed made one of its most costly errors ever,” he recently wrote. “Immediately after the failure of Lehman Brothers, the FOMC decided to leave the target rate unchanged at 2.0 percent.” Monetary policy, in other words, should have been far more supportive given current events. It wouldn’t have prevented the financial crisis, but it might have minimized the fallout, perhaps by more than a trivial amount.
The idea that central banks have power of the ebb and flow of economies isn’t new. In 1963, Milton Friedman and Anna Schwartz reordered perceptions of the Great Depression with their the monumental A Monetary History of the United States, 1867-1960, which indicts the central bank’s monetary policy for the events of the 1930s. Friedman and Schwartz argued that the central bank’s errors in managing the money supply were the primary catalyst that turned recession into something far worse. “Prevention or moderation of the decline in the stock of money, let alone the substitution of monetary expansion, would have reduced the [economic] contraction’s severity and almost as certainly its duration,” they wrote.
Today, central bankers the world over are faced with another decision of above-average consequence. The exit strategy, as it’s called, requires that the Fed and its counterparts choose when to begin drawing back the enormous liquidity that’s been injected into the global economy.
“It is clear…that our exceptional support cannot last for too long a period of time since there are negative side effects,” Jürgen Stark, a member of the European Central Bank’s executive board, said last week. Jan F Qvigstad, deputy governor of the Central Bank of Norway, also remarked last week that the country’s current target policy rate of 1.5% “will be 2.75 per cent around the end of next year.”
Some central banks have already begun raising rates, as we noted a month ago. The Fed too must return monetary policy in the U.S. to something approaching a normal state. As always, the possibility of raising rates too early, too late or insufficiently keeps everyone guessing. Accordingly, inflation may or may not be a problem in the years ahead.
“At some point, the economic trends will shift and waiting too long to raise interest rates will be the primary hazard,” we wrote in March. “We don't know if the turning point will come in a few months or a few years, but we shouldn't delude ourselves that it's never coming.”
The risk tied to the timing and magnitude of the exit strategy isn’t necessary limited to inflation, as the tumultuous history of this decade reminds. We might add that we also shouldn’t kid ourselves that the Fed will make exactly the right decisions at exactly the right time.
There are many advantages to fiat money. But the main advantage is also the primary risk: flexibility. As with democracy and investing, choices matter. Rarely are those choices perfect. Sometimes they’re egregiously wrong, sometimes they’re more or less productive. The great question is what outcome will the decisions give us this time?
November 12, 2009
THE RECESSION FADES AS QUESTIONS OF GROWTH LINGER
The news on new filings for unemployment benefits once again favors the idea that economic recovery is continuing. It’s a tenuous rebound, one ripe with caveats, including a big one we’ll discuss below. But it’s a rebound nonetheless.
The Labor Department today reports that initial jobless claims dropped to 502,000 last week, down from the previous week’s 514,000. That leaves us at the lowest level since the week through January 3, 2009. As our chart below reminds, the trend has certainly been our friend this year for the general change in jobless claims.
Back in March, we wrote about the possibility if not the likelihood that a peak in jobless claims would signal the end of the recession. In subsequent months, we revisited the mounting evidence that the initial claims pattern was on a sustainable downtrend, including here and here. Jobless claims alone don’t suffice as a definitive sign of things to come, but this data series is on the short list of clues to watch for judging turning points in the business cycle.
Changes in the yield curve are also worth monitoring, and this too has been flashing a positive signal for some time. History tells us that when the yield curve turns negative (short rates above long rates), the odds of recession go up sharply. The subsequent return of a positively sloped yield curve (short rates below long rates) provides the opposite message: rebound is coming. As we've discussed in the past, when the yield curve turned positive after signaling recession in 2007, the implications were bullish. The signal was early, as it usually is, but proven durable once more.
Today, a variety of economic trends continue to point in the direction of recovery. We routinely dissect and analyze a variety of macro indictors in each issue of The Beta Investment Report, your editor's monthly review of asset allocation, portfolio strategy and economic news. The newsletter’s proprietary set of economic yardsticks are still flashing encouraging signs, as illustrated in the second chart below (republished from the current issue of the newsletter). Based on the last full month of data reported (through Sep. 2009), our composite measures of U.S. economic activity remain upward biased. The October data reported so far, along with today’s initial jobless claims update, further support the idea that recovery momentum remains intact.
The natural tendency of the economy to snap back after stumbling is still alive and kicking, strengthened by ongoing monetary and fiscal stimulus efforts. But this isn’t a normal recovery, in part because the labor market losses have been unusually deep and long lasting. Indeed, the great challenge still lies ahead, as we’ve been discussing for some time. The problem isn’t so much job loss from this point forward; rather, it’s the lack of job creation that may threaten.
In essence, we should distinguish between recovery and growth. The business cycle is now in recovery mode, but growth of a meanginful, sustainable sort has yet to arrive.
There are other ills afoot as well. As we discuss in the current issues of the newsletter, lending activity continues to shrink. Commercial and industrial loans fell nearly 6% in September from the previous month and are off by nearly 11% over the past year. Lending is a critical factor in fueling future growth and so the trend here suggests that expansion will be muted for the foreseeable future beyond the snapback effect that’s prevailed recently.
Minting new jobs and juicing lending are among the last great cleanup actions for mending the Great Recession. But the statistical clues at the moment don’t offer much encouragement for an imminent recovery on these fronts. Yes, the forces of contraction per se are rapidly fading, as suggested in today’s jobless claims report. It's the weakness on the outlook for growth that worries us.
November 11, 2009
TWO RULES THAT CAST A LONG SHADOW OVER INVESTING RESULTS
The world is filled with recommendations and research on what works best in the money game. But when you reduce the sea of study down to the essential lessons, we're left with rule number one—diversify within and across asset classes, i.e., asset allocation—and number two—rebalance.
There are other rules, of course, and some of them are actually useful. But for most individual investors, and perhaps many institutional investors, these two rules are the foundation of intelligent money management. That’s another way of saying that it’s hard to succeed in investing if we ignore or abuse these rules.
Granted, it’s possible to violate these rules and still earn big returns. But finding success on this path requires that you’re smarter than everyone else and/or willing to take big risks that will sink most investors. For the rest of us, asset allocation and rebalancing are the building blocks of prudent investing. Intelligent investing needn't end there, but it's a valuable beginning.
That’s good news in the sense that it streamlines the investing process. We can certainly go beyond these two rules, but it’s not necessary. If you have reasonable investment goals and a time horizon that extends forward over several business cycles, asset allocation and rebalancing are likely to satisfy.
Of course, that’s assuming you make informed decisions on diversifying the portfolio and managing the mix intelligently through time. It’s not necessarily rocket science, but it does take some thought, a fair amount of discipline and healthy respect and understanding of market history. Ideally, you’ll also make routine projections of return and risk for the major asset classes. In The Beta Investment Report, we regularly forecast equilibrium risk premiums for the major asset classes. This isn’t a silver bullet, but it’s a productive beginning because the process provides a neutral reference point for thinking about long-term market returns. In turn, that gives us some context for deciding how to second guess Mr. Market’s asset allocation for the intermediate term.
The reasoning behind asset allocation and rebalancing starts by recognizing that owning a mix of asset classes taps into the benefits that flow from holding assets that don’t move in lockstep with one another at all times. As powerful as this force is, it fluctuates in the short term, as last year reminds. In other words, asset allocation is only a partial solution. We also need to rebalance the asset allocation, which further enhances the odds for success in generating risk-adjusted returns that satisfy our long-term goals.
At a basic level, rebalancing is simply buying asset classes that have stumbled and selling those that have done well. For most investors, rebalancing should be marginal but continual. Sharp, sudden changes in the asset allocation, in short, should be avoided. Instead, continually rebalancing at some fixed interval--or opportunistically if you're so inclined--will provide a good deal of the benefits.
The value of asset allocation and rebalancing is self evident. A careful analysis of the full range of asset classes tells us so. For example, over the past 3 years, the range of returns is quite wide, as you can see in our monthly updates on asset classes on these pages and in our more in-depth reviews in The Beta Investment Report.
Tapping into the enduring tendency for different asset classes to dispense varying results is the essence of why asset allocation is a critical piece of investing. Alas, most investors are woefully underdiversified. Simply fixing this oversight and owning a wider array of assets will likely enhance results over the long haul. The next step is harnessing the rewards that come from exploiting the fluctuations in the major asset classes and their principal subgroups. Overall, a simple rebalancing strategy will capture the lion's share of these rewards for most investors when measured over several business cycles.
Yes, we can go beyond asset allocation and rebalancing. We can even do much more detailed analysis on these bedrocks of investing strategy. But for most investors, focusing on these two aspects of portfolio management in an uncomplicated way will reap rich rewards. Accordingly, paying too little attention to asset allocation and rebalancing carry big risks.
In short, Pay close attention to designing and managing the asset mix. Much of the world practices a far more complicated form of money management, but that doesn't mean that greater complication leads to better results.
November 9, 2009
INFLATION EXPECTATIONS CONTINUE TO INCH HIGHER
One of the supporting pillars in the recent rally is the recognition that inflation isn't a problem. Last year's financial crisis knocked the stuffing out of the system's tendency to devalue the purchasing power of fiat currencies over time. The net result is an unusual level of economic cover for keeping interest rates low--really low. Indeed, the primary goal of the Federal Reserve and its counterparts around the world over the past year has been the unbridled pursuit of higher inflation, though not necessarily high inflation.
In the depths of the crisis, the immediate objective was simply to deliver some level of inflation, which is to say something other than deflation. Allowing deflation to fester is simply too great a threat. The basic prescription has been printing money. How's it working?
The good news is that deflation is no longer a clear and present danger, as it appeared to be late last year and into early 2009. Measured by the consumer price index (CPI), the official benchmark of inflation in the U.S., the last monthly decline in consumer prices overall was in March. There have two months with flat prices, but the general trend since the spring is up, if only marginally. In September (the last reported month), CPI advanced 0.2%, down from August's 0.4% rise, the Labor Department reported. The latest CPI reading shows that consumer prices fell on a year-over-year basis, but that statistical quirk will soon fall away as we move beyond the events of 2008.
The October update on CPI arrives next week (November 18), and the consensus forecast is looking for a 0.2% rise, according to Briefing.com—unchanged from September.
Meantime, the Treasury market's outlook for inflation is climbing. As our chart below shows, the implied outlook for inflation based on the spread between nominal and inflation-indexed 10-year Treasuries is now above 2%. This is the first sustained move above 2% since the financial crisis of 2008, save for a brief rise over this level back in June.
A 2% inflation rate is hardly the end of the world, of course, assuming the forecast proves accurate. Indeed, before last year's crisis, the Treasury market was consistently predicting inflation in the 2.5% range. By that benchmark, the inflation outlook remains muted. Much of the recent rise is simply a return to levels that prevailed under less extraordinary times.
But expected inflation is a slippery concept, as is all other efforts at divining the future. What's more, there's no lone methodology for forecasting inflation, much less one that's persistently accurate. Rather, the crowd is constantly reassessing the future and making guesstimates about what's coming. But while we can debate exactly what constitutes a fair outlook for pricing pressures, the general trend is clear, as the chart above shows. Slowly but surely the market is raising its inflation expectation.
There's some corroborating evidence that this is more than rank speculation. The gold market, for instance, has been pushing higher too. An ounce of gold now trades for roughly $1,100, a roughly 50% rise from a year ago. Meantime, the U.S. dollar has weakened over the past year. The twin trends suggest that inflation is on the rise, if only marginally.
That's no surprise, given the Fed's instinct and decisions over the past year. But in pulling the levers that engineer a higher level of inflation, the great question is whether Bernanke and company can slow and/or turn off the upward momentum in pricing pressure at the appointed time?
One of the Fed's own, James Bullard, president of the St. Louis Fed, tells FT yesterday that for the foreseeable future “you have inflation that will be possibly substantially above target over a horizon of two to four years, and that, I think, is because of the combination of very large fiscal deficits in the US with very easy monetary policy.”
We keep hearing that the central bank shouldn't repeat the mistake of the 1930s, when the Fed started raising interest rates too early, which derailed the nascent recovery. But it's becoming clear that the problems of the moment don't constitute another Great Depression. There are still huge challenges ahead, but they're different challenges than those that confronted policymakers in the mid-to-late 1930s. Nor is it clear that interest rates just above zero are the magic solution to what ails us now.
One can make a case that it was easy money that got us into the current mess and that easy money isn't necessarily going to get us out of the hole this time, as it seemed to in past business cycles. Yes, stabilizing the system was a priority over the past year, starting with preventing deflation. That battle seems to be won. Deciding what comes next, and what it means for portfolio strategy, is now the topic du jour, and it's only just begun. Unfortunately, easy answers aren't forthcoming.
As the FT story on Bullard advises,
Mr Bullard said historically the Fed had waited until two-and-a-half to three years after a recession ended before raising rates. That, he said, “would put you in the first half of 2012”. But the committee might take into account a wider set of factors this time, including the danger that ultra-low rates could fuel asset price bubbles.
“What is different this time is that the argument about staying too low for too long is going to weigh pretty heavily on the committee. It is more than just: ‘What does the output gap look like; what does inflation look like?’”
November 6, 2009
MORE JOB DESTRUCTION, BUT THAT'S JUST THE TIP OF THE ICEBERG
Today's update on October's employment status is neither surprising nor encouraging. The U.S. economy is still bleeding jobs, but that's hardly shocking at this point. It's been clear for some time now that the risk of a jobless recovery is high.
Nonfarm payrolls shed another 190,000 positions last month, a modestly lower pace than September's 219,000 loss but still far away from anything suggesting stabilization in the labor force much less growth. Most of the job destruction came in the goods producing industries, although the services sector managed to shrink by 61,000 jobs in October. The conspicuous points of light were education and health services (a rise 45,000 jobs) and professional and business services (+18,000). But on balance, there's nothing to cheer in today's employment report other than to recognize that the pace of decline overall is considerably lower than it was during the height of the financial crisis late last year and early in 2009. Slim pickings after nearly two years of labor-market contraction.
The good news is that the magic level of zero job loss is coming, and perhaps soon. If we're lucky, it'll arrive before the year is out, although our guess at this point is that the first quarter of next year is a more likely forecast. Rest assured, stability in the labor market is near. Short of some new cataclysmic change in the current economic profile, the stars are aligned for an end to the job destruction that has been nonstop since January 2008. Alas, the bigger problem is not ending the job destruction; rather, the bigger challenge will be minting new jobs.
As of last month, the U.S. economy has lost 7.3 million jobs, or more than 5% of total nonfarm payrolls in December 2007, when the recession began. Given the hefty monetary and fiscal stimulus that's coursing the economy, job destruction can't go on for much longer without a dire change for the worse in the current conditions. We don't foresee such a change and neither do most economists. The positive pull of a rising GDP, as implied by the robust 3.5% annualized growth in the economy in Q3, will act as a brake on further job loss in 2010. Indeed, the natural tendency of the economy to right itself after the recent contraction, along with the liquidity injections from the government, will soon stem the loss in nonfarm payrolls. Yesterday's fall in initial jobless claims suggests as much. New filings for unemployment benefits dropped to the lowest weekly level last week since January.
The great challenge is what comes after the arrival of zero change in the labor market. Turning it into something sustainably positive of some magnitude promises to be one of the biggest macroeconomic policy problems since the Great Depression. One of the dangers associated with this future is minimizing its potential for havoc, if not ignoring it altogether. As the job losses fade on a monthly basis and eventually reach zero and move into modestly positive territory, the crowd's initial reaction is likely to be one of celebration. That is likely to be premature.
Afterward, once reality sets in, the potential is high for ill-advised macroeconomic responses intent on fixing the problem. As the political establishment comes to grips with the future, the body politic will respond with its usual array of poor economic decisions. That penchant has been suppressed for much of the past generation, thanks to strong economic growth that expanded the U.S. labor market. But with a jobless recovery in the offing, and perhaps for some extended period, Washington's inclination to act, and in ways that may be less than economically productive, will grow stronger.
Meantime, corporate America is learning how to be more productive with fewer workers, which bodes ill for hiring, at least for the moment. Nonfarm business sector labor productivity increased at a 9.5% annual rate during the third quarter of 2009, the Bureau of Labor Statistics reported yesterday. This was the largest gain in productivity since the third quarter of 2003, when it rose 9.7%.
Creating jobs on a scale that Americans have come to expect in post-recession periods will prove difficult this time around. At the same time, the non-labor-market recovery will proceed apace, giving rise to what threatens to be the greatest divide between main street and Wall Street in decades if not in all of American economic history.
The biggest challenge, in short, is yet to come. Meantime, first things first: we're still waiting for the job destruction to end after 22 months.
November 5, 2009
THERE'S AN EXIT STRATEGY LURKING OUT THERE SOMEWHERE
Sometimes one comment says it all. That describes Jim O’Neill's observation that a fair amount of levitation work awaits central bankers the world over. Timing, of course, is unknown. Meantime, there's a few (or many) potholes on the road to economic salvation.
The chief global economist at Goldman Sachs Group in London tells Bloomberg News that "there are all kinds of risks” bubbling these days at the intersection between the price of money, inflation, economic cycles and everything else in between. Some central banks have already started hiking, if only slightly. Meantime, as the market ponders the future, there's debate over how much of the reflation of recent vintage is engineered vs. a reflection of fundamental improvement in business and economic conditions. Perhaps it's a mix of both. In any case, Mr. O'Neill said a mouthful when he opined that "We don’t know how much of the improvement in markets is due to central banks’ largesse, and neither do they. They’re pretty nervous, but they’ve got to get out of it at some stage.”
November 4, 2009
MINING THE WEB FOR STRATEGIC INSIGHT AND PULLING UP A FEW NUGGETS
The first rule in the money game is recognizing that there are no silver bullets. Asset pricing is a black box. It's become somewhat less of a black box after a half century of analysis by financial economists, but what we don't know about how markets work still dominates by far.
Much of what we do know has come from reverse-engineering the system's output. We can see prices and we can measure their fluctuations and linkages in countless ways. The trouble is that the financial gods forgot to give us the code that produces the output. That leaves us with the thankless ask of predicting returns indirectly. But even then we're working with imperfect information. Ours is a world of ex post data. We know the past, but that's a poor window into the future. We have the output but we're forever debating the input. As a result, the link between ex post and ex ante data is shaky. That doesn't mean we should ignore the historical record, but it should only be one of several layers of analysis for developing capital market assumptions.
Much of what we discuss on the pages of The Beta Investment Report is focused on developing equilibrium risk premiums and then integrating those long-range forecasts with our near-term outlook. To the extent there's a divergence of some magnitude, and we're reasonably confident in our assumptions, we have some basis for adjusting the asset allocation for the market portfolio, which we define broadly, as per finance theory. A global value-weighted mix of stocks, bonds, commodities and REITs is a reasonable definition, a.k.a. our proprietary Global Market Index.
You can't spend too much time studying history and applying what finance has taught in the quest to anticipate prospective risk premiums for the major asset classes. It's tempting to think that a few metrics will do the trick, but it's never quite so simple. Any given factor has limits as a window into the future. An intelligent blending of factors helps minimize those limits, if only slightly. But we need all the help we can get.
That's one reason why we routinely review how other strategists think and act. In a world where no one has absolute knowledge, sharing and comparing capital market assumptions is productive if only to test our own notions of how markets price assets. As a small sampling of what's out there, we offer three recent perspectives on how to look ahead, along with a tidbit from each paper.
The first comes from EnnisKnupp, the institutional investment consultant. In a July 2009 paper reviewing capital market modeling assumptions, the firm reasoned that expected return for equities can be divided into three main components: dividend income, nominal growth in corporate earnings and changes in valuation levels.
Next, WellsFargo advised last month that recent market history posted contradictory results in terms of what standard finance theory predicts, namely, that higher risk is rewarded with higher return. "Asset class returns over the past two years have not provided investors with better performance in exchange for higher risks," the paper notes. "In fact, the better performing asset classes have been bonds, which usually are associated with lower risk." But this divergence offers clues about the future, the author explains. "Over the full market cycle, the relationships we expect to see between asset classes should generally hold." Thus the paper's lead question: "Back to Normal?"
Finally, Wurts & Associates opined on the future in its capital markets expectations report published back in January. Setting the tone for the rich quantitative survey that followed, the author wisely observes:
There are several methods for forecasting capital markets returns, none of which has proven predictive value. So regardless of which methodology is used, one must accept the results thereof are simply an educated scientific guess as to the future. There is one truth to be found in return forecasting though – the longer term your outlook, the better your chances of being correct. This is because capital markets tend to reflect human irrationality over short periods of time, but are ultimately rationale and reflective of the underlying economic theories that govern financial relationships. In our opinion a ten year outlook is the minimum time frame in which we can expect markets to behave in line with theoretical expectations, and is the time frame for our return forecasts.
You can surely find more exciting market commentary on the web, but rarely will you uncover more strategically relevant fare. The crowd loves to talk about the trees, but sometimes you can locate intelligent discussion of the forest too.
November 2, 2009
THE RETURN OF MIXED RESULTS
A month ago, we surveyed the latest numbers for the major asset classes and wondered how long everything could continue rising. A month later, we have our answer. As our table below shows, divergence has returned to the world's capital and commodity markets.
The switch to a wider array of results was inevitable. As we've been discussing for some time, the great snap-back period of 2009 was destined to be a temporary fling. When it became clear earlier this year that the world would not end, assets were repriced accordingly. But the first hint that something other than uniformity will prevail in performance trends arrived in October's tally of asset class results.
From the leading gain in commodities last month to the bottom performance in REITs, the markets have returned to something approximating normality in terms of return distributions on a monthly basis. Rest assured, the leaders and laggards will evolve, but the odds look higher now for a divergence in returns in any given month.
As a result, the case for owning and managing a multi-asset class portfolio is stronger. Much of what's unfolded over the past year suggests otherwise, of course. The crash of late-2008 slashed prices in most asset classes, which was followed by a sharp rally in the same this year since March. But the high-correlation roller coaster in everything may be over. If so, nuance and subtlety are returning to the business of designing portfolio strategy. That's no surprise given the outlook for the global economy, which reflects a diverging mix of expectations.
The all-or-nothing trade is over. In fact, that constitutes progress. But you'll have to work harder in the months and years ahead to beat the market portfolio. In fact, that's the norm, the last 12 months being the supreme exception of modern times.
The shift back to a standard profile of return, correlation, volatility and other metrics among the major asset classes has only just begun. But this trend has legs and strategic-minded investors should take note.