January 29, 2010
A CONTINENTAL QUESTION
Unemployment in Europe is now at 10%, matching the jobless rate in the U.S. Does this undermine the argument in favor of European-style bigger government that's more proactive in trying to minimize the perceived limits of capitalism? One response is that Europe didn't do as much as the U.S. to mitigate the recession. For instance, the European Central Bank didn't cut interest rates as quickly or as deeply as did the Fed. If the problem was a slow and weak monetary response, maybe the so-called friendlier face of capitalism in Europe isn't all that helpful after all in the grand scheme of economic cycles. In that case, perhaps the lesson is that it's best to let free markets bloom and intervene only when and if it's necessary during financial panics a la Bagehot's lender of last resort doctrine.
Q4 GDP SURGES. WILL THE LABOR MARKET FOLLOW?
First, the good news. This morning’s release of the government’s initial estimate of fourth-quarter GDP is a blow-out number: +5.7%. That’s the highest annualized quarterly real (inflation-adjusted) rise in GDP since 2003 and it’s also up sharply from Q3’s 2.2% rise. In addition, the Q4 number exceeded what most economists were expecting, and most were predicting a healthy increase.
Nice. We needed that. We need more of it. As we’ve discussed recently, 2010 promises (threatens) to be challenging relative to the rebounding aura that prevailed last year and so at this point a rosy tailwind from GDP is especially welcome.
But (you knew one of these was coming) there’s less in today’s GDP Q4 bounce than it appears. A 5.7% increase is a big number and there’s no doubt that the general upswing in the last three months of 2009 was strong. We’d be looking at a whole different ballgame now if the Q4 change in GDP was only modestly higher, much less negative. In that respect, we dodged a bullet. There’s some recovery traction underway in the economy.
In fact, it’d be surprising if it were otherwise. After more than a year of massive monetary stimulus, supported with the fiscal equivalent as 2009 unfolded, it was virtually assured that the reflationary efforts would bear fruit on the overall GDP ledger. A number of observers of the economic scene have been saying as much in recent weeks. PIMCO’s Paul McCulley, for instance, predicted last month that “the fourth-quarter 2009 gross domestic product (GDP) is likely going to be 4%-plus.”
So what’s not to like? A powerful rise in GDP is just what the doctor ordered. Alas, there’s still reason to worry. Let’s start by recognizing the obvious: Today’s estimate is the first of three, and so the risk that the final tally of GDP may be lower can’t be dismissed. That’s always true, of course, but the risk is especially potent now, given the volatility in the economy generally in recent quarters, which raises the bar in terms of getting a handle on economic activity and estimating the future.
Meanwhile, keep in mind that the primary source of GDP’s Q4 rise came primarily from inventory rebuilding and exports. Indeed, the inventory restocking effect was the strongest in 20 years. That’s hardly a problem today, but there’s some doubt as to how long the restocking effect will continue. As companies return to normal, after turning sharply defensive in late 2008 and early 2009, there’s a limit to the positive rebounding effects on this front.
Exports too may headed for more middling results in the year ahead. The falling dollar’s general decline last year was a shot in the arm for exports. A lower valued greenback in foreign currency terms makes American products cheaper in overseas markets. But if the buck stabilizes this year, as it now appears, the forex-driven export wind may slow. There are many reasons to doubt the dollar as a store of value, but there's hardly a compelling argument for its two main paper rivals: the euro and the yen. Economics underpinning both of those currencies face their own set of troubles and so its not obvious that the dollar's headed for sharply lower levels at this point vis-a-vis the euro and yen.
Meantime, 70% of GDP is based on consumer spending. How did Joe Sixpack fare in Q4? Personal consumption expenditures rose 2.0%. Not a bad showing, but that’s down from 2.8% in Q3. In other words, the overall economy grew at a much faster pace in Q4 vs. Q3, but the surge had little to do with consumer spending--the elephant in the room for the dollar value of GDP.
That’s more than a trivial point with a labor market that’s still ailing. It’s hardly a surprise to find that the pace of consumer spending is slowing when the last employment report showed a net loss in nonfarm payrolls. Perhaps next Friday’s monthly payroll update will deliver better news.
This much is clear: Without a positive change in nonfarm payrolls in next week's update, today’s GDP report is far less encouraging than it appears. The jig is up. A week from now, if the net change in payrolls remains negative, no one will be talking up the 5.7% GDP rise. There’s really only one way to keep the economy expanding on a meaningful level for the year ahead: a rebound in the labor market.
Today's GDP is encouraging, but the real news for the economy arrives a week from today. The question is all about future GDP reports. A big piece of the answer will unfold in the trend in nonfarm payrolls.
January 28, 2010
BEN'S BACK IN TOWN
Fed Chairman Ben Bernanke was confirmed for a second term today in the Senate, albeit by a relatively thin margin: 70-30. That's reportedly the "thinnest approval ever extended to a chairman in the central bank’s 96-year history." Just a few days ago there was some question as to whether he would survive the populist political backlash that threatened to vote him out of his position as head of the central bank.
For the moment, Bernanke has won. The question is whether his victory will turn Pyrrhic. At least expectations are uncomplicated:
"Now that the Senate has confirmed him for a second term as chairman of the Federal Reserve, Ben Bernanke has, or ought to have, a very simple agenda: improve confidence," writes Newsweek's Robert Samuelson. "That isn't his job alone, of course. President Obama and Treasury Secretary Timothy Geithner are hardly bit players. But what Bernanke does and says—how he projects himself and the Fed—matters a great deal, and he faces an exacting challenge."
DIAGNOSING THE PANIC
His basic argument: "the signature event of this financial crisis was the 'run,' 'panic,' 'flight to quality,' or whatever you choose to call it, that started in late September of 2008 and receded over the winter. Short-term credit dried up, including the normally straightforward repurchase agreement, inter-bank lending, and commercial papermarkets. If that panic had not occurred, it is likely that any economic contraction following the housing bust would have been no worse than the mild 2001 recession that followed the dot-com bust."
Was that really the source of the crisis? Maybe, although no one really knows. This is economics, after all. Certainly there's no shortage of competing notions of about what happened. But even if you don't agree with Cocgrane 100%, he makes a number of salient points that, at the very least, demand consideration in the months and years ahead as the powers in Washington attempt to "fix" the system.
With that in mind, here are a few points in Cochrane's article that are worth debating...
Why was there a financial panic? There were two obvious precipitating events: the failure of Lehman Brothers investment bank in the context of the Bear Stearns, FannieMae, Freddie Mac and aig bailouts; and the chaotic days inWashington surrounding the passage of legislation establishing the TroubledAsset Relief Program (tarp). Why would Lehman’s failure cause a panic?
Why, after seeing Lehman go to bankruptcy court, would people stop lending to, say, Citigroup, and demandmuch higher prices for its credit default swaps (insurance against Citi failure)? Nothing technical in the Lehman bankruptcy caused a panic. The usual “systemic” bankruptcy stories did not happen:We did not see a secondary wave of creditors forced into bankruptcy by Lehman losses.Most of Lehman’s operations were up and running in days under new owners. Lehman credit default swaps (cdss) paid off. Sure, there was some mess — repos in the United Kingdomgot stuck in bankruptcy court, somemoneymarket funds “broke the buck” and had to borrow from the Fed — but those issues are easy to fix and they do not explain why Lehman’s failure would cause a widespread panic.What ismore, Lehman’s failure did not carry any news about asset values; it was obvious already that those assets were not worth much and illiquid anyway.
We are left with only one plausible explanation for why Lehman’s failure could have had such wide-ranging effect: After the Bear Stearns bailout earlier in the year, markets came to the conclusion that investment banks and bank holding companies were “too big to fail” and would be bailed out. But when the government did not bail out Lehman, and in fact said it lacked the legal authority to do so, everyone reassessed that expectation. “Maybe the government will not, or cannot, bail out Citigroup?” Suddenly, it made perfect sense to run like mad.
The critical issue, Cochrane writes, is that...
Bank deposits, subject to runs, pose an externality.We all understand that markets can fail when there are externalities. If we need to allowbank deposits,we need a guarantee or priority in bankruptcy, which leads tomoral hazard and puts taxpayer at risk. Some regulation and a forced separation of these “systemic” contracts fromarbitrary risk-taking are necessary. But this is a veryminimal level of regulation compared to the too-big-to-fail guarantee and extensive discretionary supervision and regulation now being applied to the entire financial system.
The stakes, as a result, are clear, he asserts:
We are in an ever-increasing cycle of risk-taking and too-big-to-fail bailouts, going back decades. Now we know that bank holding companies, insurance companies, and investment banks are too big to fail in the government’s eyes and their activities are not going to be fundamentally restricted in size and scope. This crisis strained the fiscal limits of the United States to make good on bailout expectations. The next one will be bigger. Where will it come from? State and local government defaults? Defined benefit pension funds? Commercial real estate? A new “Asian bubble?” Default by Greece, Italy, or Ireland? Who knows? We do know this: when the government no longer has the fiscal resources to bail out its financial institutions, the crisis will be much, much worse. Iceland can happen in the United States if we do not get this right.
THE STRUGGLE CONTINUES
Last week we considered the possibility that the declining trend in new jobless claims had run its course. Today’s update on new filings for jobless benefits offers a reprieve from that ominous possibility. The reprieve may be temporary, of course, but for today at least it appears as though the nearly year-long decline in new filings remains intact--weak but intact.
Initial claims dropped by 8,000 last week from the week before, falling to 470,000. As our chart below shows, the general decline continues to look to look alive if not exactly well (the blue line is the linear trend). It’s too early to declare that the fall in jobless claims has run out of momentum, but this dire possibility can't be ruled out.
One reason for remaining anxious comes via the continuing claims report, which suggests that the long-running descent in this data series has hit some turbulence, as our second chart below shows. Of course, continuing claims are reported with a one-week lag and so the latest numbers (through January 16) may simply reflect the jump reflected that week in initial claims--a jump that now seems to have given way to a resumption in the decline.
In any case, the next few weeks will be critical, for good or ill, in the recovering labor market, such as it is. In order to instill a new round of optimism, we need to see jobless claims dip below 400,000 and continuing claims fall under 4.5 million over the next month or so. Otherwise, one might seriously wonder how much expansionary momentum remains in the labor market.
It’s clear that much of the “progress” we’ve seen in the job market so far has been a function of sidestepping economic apocalypse. In other words, the negative momentum of shedding jobs has slowed over the past year, arguably to the point that employment is now simply treading water rather than sinking. The great question is whether we can generate net growth on a sustained basis. We are knee-deep in the middle of this transition and early clues of how the shift is faring will come from initial and continuing jobless claims reports as well as from the employment report. So far there’s still reason to remain optimistic but the hour is late. More convincing signs of positive momentum are required, thus the numerical benchmarks noted above.
Meanwhile, new orders for durable goods rose last month, the Census Bureau reports. And not a moment too soon. December’s 0.3% rise is the first since September.
"The jobless claims number suggest that the job market is still struggling,” Alan Gayle, senior investment strategist at Ridgeworth Investments, tells Reuters today. “However, it is encouraging that orders were up. To me, that reflects a continued return to normalization in production levels, which will be a positive for growth during the first quarter."
Nonetheless, there's still a risk that the economy may stall later this year, as we discussed here and here. Initial jobless claims will continue to offer some clues as to the depth and magnitude of this risk. On that front, there's still reason to worry. The numbers that arrive in the weeks ahead will determine if we should also panic.
January 27, 2010
LOOKING (AND FEELING) BLUE
What shade of blue are you?
The Federal Reserve voted to keep rates unchanged today, but the vote came with glitch. "Voting against the policy action was Thomas M. Hoenig, who believed that economic and financial conditions had changed sufficiently that the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted," the FOMC statement explained.
In addition, the FOMC statement has been revised to say that "the pace of economic recovery is likely to be moderate for some time" vs. the previous view that the economy is "likely to remain weak for a time." Today's statement also reported that "information received since the Federal Open Market Committee met in December suggests that economic activity has continued to strengthen and that the deterioration in the labor market is abating."
What does it all mean? Here's a brief sampling of opinion in the hours immediately following the Fed's announcement...
● "...at least one of the FOMC's 10 voting members thinks things have gotten so good that a rate increase is now within sight." --Globe and Mail
● "Michael Englund, the chief economist for Action Economics, says that in a vacuum, the Fed should be ready to fix the interest rate at 25 basis points by June or July. But given the dicey political climate, he expects that any decisions will likely be postponed. 'Our call at this point is going to be after the November elections,' he says. 'Not at the November meeting, which is [right] after, [because that] would look excessively political, but probably at the December meeting.' -- U.S. News & World Report
● "...the Fed 'sees the light at the end of the tunnel for the economy,' said Sung Won Sohn, economist at California State University. 'Uncertainties in the economy have diminished.' --AP
● "'It is far too early to drop any hints about tightening policy,'" said Avery Shenfeld, chief economist at CIBC World Markets in Toronto." --MarketWatch.com
● "In the first dissent at a Federal Open Market Committee meeting in about a year, one of the voting members publicly wouldn’t go along with the crowd. Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, wouldn’t make it unanimous today to keep short rates at zero and tell the world they will continue to stay that way for an extended period. Good for him. Though the Fed is unlikely to move on rates at all in 2010, the emergency conditions that required them to stand at zero have dissipated, regardless of how fragile the economic recovery remains." --Dow Jones
THE FED'S SHOCKING DISCLOSURE (NOT)
The Fed announced that the target range for Fed funds would remain at 0% to 0.25%. This will suprise no one, given the weakness in the labor market, the rising political vulnerability of the President (who makes his State of the Union speech tonight), and recent questions about Bernanke's reappointment prospects. Is the Fed funds rate really that susceptible to political factors? Probably not, but thinking that it might be is no longer beyond the pale. How it's come to this isn't easily explained, but it's clear that insuring monetary policy remain independent of politics is as compelling as ever. Arguably the potential for politicizing the Fed is higher than at any time in recent memory. At the very least, there's more confusion than usual.
A SMALL DOSE OF PERSPECTIVE FOR EQUITIES
A little perspective never hurts when surveying the equity landscape. There are no silver bullets, of course. But we must start somewhere in the thousand-mile journey of analyzing the possibilities in the land of equities, and a big-picture review of the global playing field is a reasonable way to begin.
For reasons of tradition and the usual obsessions, ranking the major slices of the world’s stock markets by trailing return gets the ball rolling. As our first chart below shows, recent history has been kind to equities, although the benevolence was far from evenly distributed. On one extreme was the 108% surge in Latin American equities last year; U.S. stocks, by comparison, were the low man at just under 30%, based on total returns via S&P BMI Global Indices.
One might wonder how these markets stack up in terms of valuation. A good question, for which there are many answers. For the moment, we offer just one, as indicated by the chart below, which graphs trailing 12-month dividend yields as of 2009’s close.
In the yield ranking, Europe tops the list with a 3.0% payout rate over the previous 12 months. Emerging European markets, meanwhile, are at the opposite extreme, posting a 0.9% trailing dividend yield.
Expected return and yield are related, as a number of studies show through the years. That said, the relationship isn’t perfect, at least not if we're trying to assess the future in real time. Nor is it necessarily all that useful if we’re comparing various regions around the world. A more productive review of dividend yield comes by looking at the history of a given market. As an example, consider our third chart below.
The third graph above compares the current 12-month yield for the S&P 500 with the subsequent 10-year return on $1 invested in the index, as per analysis of data from Professor Robert Shiller. So, for instance, a dollar invested at the end of 1999, when the S&P 500’s yield was 1.15%, resulted in a loss over the subsequent 10 years. The last entry for the red line is about 78 cents, meaning that $1 dollar invested at 1999’s close was worth 78 cents at the end of 2009.
Looking over the trend in the past decades suggests that the current dividend yield offers a clue for future return in the long run. No guarantees, of course, which is why we should look to a range of metrics and analytical techniques for assessing the expected return on equities. But it's hard not to notice the connection between relatively higher yields and relatively higher subsequent return, and vice versa. Again, no one should look at one chart and assume that the future is clear. But used in context with other evaluation measures, dividend yield is useful.
That said, what does the current yield on the S&P 500 suggest for returns looking out a decade or more? The good news is that yield is telling us that expected return appears to be positive, albeit less so than a year ago, when current yield was unusually high. That’s no great surprise. U.S. equity return in 2009 was extraordinarily high in terms of its own history. Dividend yield, along with a great many other market signals, now tell us to reduce our expectations relative to a year ago.
Deciding how much should we reduce expectations is another question entirely.
January 26, 2010
A BRIGHTER OUTLOOK FOR THE WORLD ECONOMY, BUT...
The global economy will expand by 3.9% for 2010, the IMF predicts in an update released today. That's up from its 3.1% forecast for 2010 that was published last October. Of course, today's forecast update contrasts sharply with last year's modest contraction in the global economy. For 2011, the IMF expects global output will accelerate to 4.3%.
Progress, it seems, is unfolding as we write. But there are caveats as well.
"The recovery is proceeding at different speeds around the world, with emerging markets, led by Asia relatively vigorous, but advanced economies remaining sluggish and still dependent on government stimulus measures," according to the IMF update. “For the moment, the recovery is very much based on policy decisions and policy actions. The question is when does private demand come and take over. Right now it’s ok, but a year down the line, it will be a big question,” IMF Chief Economist Olivier Blanchard said in an interview.
Leading the way in growth is China, which is expected to report a 10.0% rise in output this year, according to the IMF. A bit of corroborating support comes from news that China's oil imports continued rising last year, despite the general retreat in economic activity around the world.
The U.S., by comparison, is expected to generate subpar growth this year and next, relative to the global economy. America's expansion will bring a growth rate in the mid-2% range this year and next ,the IMF projects.
But there are new concerns that threaten to derail the recovery, including anxiety over efforts at tightening credit lines in China. "Reports that Chinese banks have begun to restrict new loans and the sheer reality of this happening is making traders realize that China is getting very serious about slowing their economy," Kathy Lien, director of research at GFT Forex, tells Reuters.
Meanwhile, the hazards of sovereign risk continue bubbling. CNNMoney.com reports: "Credit rating agency Standard & Poor's raised the prospect of a downgrade in Japan's sovereign debt rating Tuesday. That's reigniting fears that the U.S. could be next."
The financial gods give as well as take. The question, as always, is whether there's a net plus or minus after the dust clears. There's a bit more concern that the bottom line overall will fall into the negative column this time around. The main challenge: The solution to the Great Recession is also the problem of the future. Or as the latest missive from the IMF warns,
"Due to the still-fragile nature of the recovery, fiscal policies need to remain supportive of economic activity in the near term, and the fiscal stimulus planned for 2010 should be implemented fully. However, given growing concerns about fiscal sustainability, countries should also make progress in devising and communicating exit strategies."
BANKING REFORM VS. BANKING REFORM
David Champion of the Harvard Business Review is unimpressed with the Obama administration's proposal on banking reform. In fact, he's downright dismissive:
"The Obama reform... seems to be neither radical nor particularly useful, except perhaps as political theater," Champion writes.
Of course, that's far from the consensus view, at least when surveying the movers and shakers. Britain's central banker Mervyn King seems to be in favor of Obama's plan. Ditto for OECD's secretary general.
Meanwhile, a pair of finance professors from NYU weigh in and offer support, with some caveats: "On balance, President Obama’s plans – a fee against systemic risk and scope restrictions - seem to be a step in the right direction from the standpoint of addressing systemic risk, if their implementation is taken to logical conclusions."
But this is all beside the point for the moment. What will the reform really look like once it runs through the political sausage grinder? Meantime, one might wonder if the core of the alleged solution--separating conventional banking from the trading-oriented aspects of financial institutions--is a touch misguided. It certainly plays well as headline material. But wasn't the real problem one of poorly designed loans? In that case, what do proprietary trading desks at investment banks have to do with any of this? Is it really the case that if we separate prop desks from banks the odds of another real estate buying frenzy will be diminished? Or might there be other factors to consider? Such as extraordinarily low interest rates?
A FRESH REVIEW OF AN OLD IDEA
A new research paper from the New York Fed connects some of the dots for thinking that monetary policy, balance sheets in banking, leverage, credit cycles and macro risk premiums are related ("Macro Risk Premium and Intermediary Balance Sheet Quantities"). That's hardly shocking, or at least it shouldn't be. But revisiting the economic plumbing is refreshing, not to mention necessary, as far too many pundits go off the deep end in assigning blame and evaluating cause and effect.
"Monetary policy affects risk appetite by changing the ability of intermediaries to leverage their capital," the paper observes. Using yield spreads as a proxy for the macroeconomic risk premium, the authors show that the financial sector's risk appetite fluctuates inversely with the macro premium, as per the chart below (reproduced from the paper).
One implication is that credit supplies flowing from the banking sector drives the business cycle. But what's the source of fluctuations in the credit supply? The Federal Reserve, for obvious reasons, plays a role, and more than a trivial one. How could it be otherwise when your primary asset is the printing press that determines the nation's money supply?
"A lower Fed funds target precedes higher risk appetite," the paper demonstrates. Meanwhile, "A higher Fed Funds target increases the costs of leverage of financial intermediaries, and thus lowers their risk appetite. A lower risk appetite reduces the supply of credit and is hence associated with higher spreads and lower real activity."
Such ideas constitute radical thinking in some circles, or perhaps this linkage is simply ignored to make a political point. Regardless, "Monetary policy actions that affect the risk-taking capacity of the banks will lead to shifts in the supply of credit," the paper advises. It follows, then, that during "the run-up to the global financial crisis of 2007 to 2009, the financial system was said to be 'awash with liquidity,' in the sense that credit was easy to obtain."
Why is this a critical point? The paper lays out the basic framework: "When asset prices rise, financial intermediaries' balance sheets generally become stronger, and – without adjusting asset holdings – their leverage becomes eroded. The financial intermediaries then hold surplus capital, and they will attempt to find ways in which they can employ their surplus capital. Monetary policy can affect the balance sheet behavior of financial intermediaries, which in turn influence the supply of credit, risk premia, and ultimately the level of real activity."
The central bank, it seems, is front and center in the business cycle, for good or ill. A small library of research demonstrates no less. Granted, there's more to the business cycle than monetary policy. But at the very least, minimizing the role of credit policy risks ignoring the elephant in the room. That doesn't mean that the basics are forever understood and recognized. In some corners of punditry and economic analysis, the basics seem to be overlooked, forgotten or simply dismissed.
January 25, 2010
IT'S ABOUT THE MONEY...REALLY
Economist Scott Sumner at The Money Illusion is exactly right when asserts that what we should be debating re: Bernanke's reappointment as Fed Chairman is monetary policy. To be precise, Sumner writes that the key economic issues are:
1. Whether to cut the fed funds target from 0.25% to 0%
2. Whether to put an interest penalty on excess reserves
3. Whether to do additional QE
4. Whether to set an inflation or NGDP target
5. Whether to target growth rates or levels
6. And of course the key overarching question: Would the economy benefit from an increase in AD, or nominal spending?
Yes, there are political considerations, as Sumner recognizes. It's Washington, after all. Nonetheless, it's striking how little attention is being given to the issue of monetary policy proper and the role it played, or didn't play, in the provoking if not causing the Great Recession. The usual suspects in economic commentary would have you believe that other issues take priority, but there are some weighty policy questions lurking, and a fair amount of it rests with decisions made (and not made) in the halls of central banking in recent years.
As we said earlier this month, "The question is less about blame and more of figuring out how to improve monetary policy going forward. Indeed, the stakes are higher than ever for the years ahead."
Indeed, there are other perspectives, such as the Austrian view. But unless you're looking hard and digging deep, you might think that the only stakes in new new debate over Bernanke's nomination are political. In fact, there's quite a bit more hanging in the balance than whether the President scores points in the next news cycle.
DEBT, DELEVERAGING AND…DEFAULT?
The three Ds are lurking, thought not necessarily in equal amounts. That's hardly surprising, but the details are somewhat sobering, as a new McKinsey & Co. report shows: Debt and Deleveraging: The Global Credit Bubble and its Economic Consequences.
Among some of the notable points in the analysis:
• "Enabled by the globalization of banking and a period of unusually low interest rates and risk spreads, debt grew rapidly after 2000 in most mature economies. By 2008, several countries...had higher levels of debt as a percentage of GDP than the United States."
• "Deleveraging has only just begun…"
• "…Specific sectors of five economies have the highest likelihood of deleveraging…[in the U.S., the household and commercial real estate sectors have a relatively high likelihood of deleveraging]"
• “While we cannot say for certain that deleveraging will occur today, we do know empirically that deleveraging has followed nearly every major financial crisis in the past half-century…The historic episodes of deleveraging fit into one of four archetypes:
1)…credit growth lags behind GDP growth for many years;
2) massive defaults;
3) high inflation; or
4) growing out of debt through very rapid real GDP growth caused by a war effort, a 'peace dividend' following war, or an oil boom.”
WILL HE STAY OR WILL HE GO?
The media’s all a buzz with the question of whether Fed Chairman Ben Bernanke will survive the political gauntlet and be reconfirmed. The latest chatter leans toward an affirmative answer, including this overt prediction from Senate Republican Leader Mitch McConnell yesterday: ""He's going to have bi-partisan support and I would anticipate he will be confirmed."
At the very least, it's hard to imagine that the majority party would inflict a political wound on their President, who's already on the defensive in the wake of last week's election in Massachusetts. Obama's bona fides are being questioned left and right (politically speaking and otherwise) on matters of finance and economics. There's a chance to repair some of the political damage on Wednesday, when the President delivers the annual State of the Union speech. “He’s got to convince the American people that [jobs are] his number-one focus,” Jason Johnson, a professor of political science at Hiram College in Ohio, tells The Hill today. Call us crazy, but opening what surely would be a hornet's nest at this late date with questions of Bernanke replacements doesn't look all that savvy at this juncture.
In any case, clarity has become a top priority for the administration. "It's not clear what Obamanomics is," says Robert Atkinson of the Information Technology and Innovation Foundation, via today's L.A. Times. "That does hurt the administration. It becomes harder to convey a vision of where you want to go."
It's unlikely that that the Democrats would raise the bar significantly in this climate by putting the kibosh on Bernanke's appointment, which the President wholeheartedly endorsed last summer. Throwing Ben to the sharks now is problematic for the White House on a number of fronts. Never say never, but political considerations alone strongly suggest that Bernanke will be confirmed.
But let's imagine that the unimaginable happens and Bernanke ends up at his desk back in Princeton. What does that mean? One thing's for sure: interest rates still aren't likely to rise any time soon, and certainly not sharply. The President and the Senate Democrats, assuming it comes to this, would favor a dovish Bernanke replacement. Heck, even Goldman Sachs is saying that raising rates now would be a "disaster." No big surprise: Financial institutions aren't inclined to bite the hand that feeds them. An absurdly steep yield curve is the mother of all punch bowls for minting profits these days on Wall Street.
Meanwhile, back in Washington, it's going to be hard to throw Bernanke overboard when the political risk that would accompany such a move is likely to be harsh. Deciding if Bernanke is in fact the right man for the job is another question, but who says economics has anything to do with these decisions?
January 22, 2010
QUANTITATIVELY MEASURED HOPE CAN BE DECEIVING...SOMETIMES
The Conference Board yesterday reported that its closely watched index of leading economic indicators (LEI) was up 1.1% in December. The LEI for the U.S. "increased sharply in December, and has risen steadily for nine consecutive months," Ataman Ozyildirim, economist at The Conference Board, said in an accompanying press release.
That’s good news for the forces of revival and recovery—assuming you’re inclined to believe that LEI is reliable as a measure of forward-looking economic activity. Skeptical? You’re not alone.
For what it’s worth, our own measure of leading indicators, which is published monthly in The Beta Investment Report, is similarly upbeat in its recent performance. Ditto for the OECD's globally focused measures of future economic activity. Does this mean that all’s well and that a recovery worthy of the name is imminent? No, not necessarily, although the hands of growth are at least trying to grab the bull by the horns, or so these benchmarks suggest.
But we should be aware of the limitations of trying to measure the unmeasurable, educational though the effort may be. Much of what shows up as an upturn in so-called leading indicator indices these days is simply a reflection of low interest rates and a bounce in some--not all--of the other measures of what are thought of as forward-looking economic metrics, such as the stock market, new permits for housing construction and initial jobless claims. Is it a silver bullet? No, but nothing else is either. Sometimes leading indicators are misleading indicators, but not always. The problem is distinguishing one from the other in real time.
Definitive answers, as always, arrive after the fact. Does that mean it’s time to ignore leading indicators? No, although maintaining a healthy skepticism is advisable, particularly these days, when the Fed is manipulating interest rates in more than a casual manner. Meantime, we’ll consider the embedded forecast. All's not lost with leading indicators, as one recent study suggests. Still, we’ll also look at lots of other data too, thank you very much.
Decoding the business cycle still suffers from the standard problem of attempting to figure out what’s coming by looking at yesterday’s numbers. It’s an awful way to run a railroad. Unfortunately, it’s the only game in town.
MEASURING THE EMPLOYMENT TREND
Economist Bill Conerly brings some much-needed clarity to the task of analyzing the trend in the U.S. labor market. Yes, there's still trouble ahead, but let's at least be sensible when assessing the decade just passed.
TOO MUCH OF A GOOD THING?
BCA Research yesterday made the case for seeing emerging market stocks as “fully priced” on an earnings basis. Or, if you prefer, they’re “no longer cheap.”
It doesn’t help that the MSCI Emerging Markets Index soared last year to the upper realms of bull market records, rising nearly 80% in 2009. A chart in the January issue of The Beta Investment Report, published earlier this month, made this point in a way that only graphics can:
Is any of this related to the recent weakness in emerging market equities and related funds, such as iShares MSCI Emerging Markets (EEM)? Bloomberg News today advises that emerging-market stocks are "heading for their steepest weekly decline since October, as commodity prices dropped amid concern higher interest rates in China and proposed U.S. banking reforms will slow economic recovery."
What we do know for sure is that gains and losses in the extreme tend to be reversed--eventually. Timing is always a question, of course. But if you weren’t at least a little suspicious of massive trailing gains in emerging market stocks for 2009, you weren’t reading the lessons from history.
Momentum is a powerful force, particularly in the short term. Traditionally it’s been on the short list of tools for traders. But momentum’s signals are valuable sources of intelligence for strategic-minded investors too, as a number of studies in recent years suggest. How you use this intelligence is open to debate, but then again so is everything else. In any case, keeping an eye on momentum for managing of portfolio of the major asset classes has appeal for the medium and long term, as Mebane Faber has detailed in a study that evolved into The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets.
Is momentum a silver bullet? No, of course not. But it’s not chopped liver either. Momentum is one of several quantitative and qualitative tools for managing asset allocation. Strategic insight doesn’t come easy in the money game. But if you look hard enough, and keep your eye on a range of metrics, sometimes you'll pick up a few clues.
January 21, 2010
STILL LOOKING FOR LOANS
A month ago we discussed why the dearth of loans is especially troublesome at this point in the economic cycle. The news that Fed Chairman talked today with Sen. Majority Leader Harry Reid in an effort to change the state of frozen lending isn't exactly encouraging, even though that's exactly the goal. "I believe more pressure needs to be applied to banks to lend money to small businesses and keep more Americans in their homes," said Reid said after his confab with the Fed head. You can lead a horse to water, but can you beat him over the head to make him drink? Meanwhile, at the other end of Pennsylvania Ave., the White House is trying to put a lid on big banks assuming "reckless risks." So why isn't any one smiling yet?
AN UNEXPECTED JUMP IN JOBLESS CLAIMS RAISES SOME FAMILIAR WORRIES
There are two ways to interpret this morning’s disappointing news on jobless claims for last week. One is that the jig is up and the economy’s set for a fresh round of trouble. The other is newly minted confirmation that the post-recession recovery this time really is going to arrive in fits and starts, take longer than usual, and deliver subpar performance for an unusually long time.
We’re still in the latter camp, as we have been for some time, although critics can rightly ask: What’s the difference in these two viewpoints? At the moment, precious little. Until and if we receive more encouraging news on the labor market, and soon, the jig may in fact be up. But not yet, or at least we don't think so.
Nonetheless, there’s no way to soft pedal this morning’s news on the last week’s tally for new claims for jobless benefits. Initial claims unexpectedly jumped by 36,000 to 482,000 for the week through January 16, the Labor Department reports. That’s disturbing for a number of reasons. Let us count the ways.
First, last week’s increase is the biggest weekly jump in absolute terms since early May. It’s also the largest weekly percentage rise since January. In addition, the increase to 482,000 initial claims last week is slightly higher than the previous peak of 480,000 from mid-December. The trend, it seems, has turned against us, at least for the moment.
The optimistic view is that last week’s surge is still only statistical noise in a broader trend of still-falling jobless claims. Indeed, the thin reed of hope at the moment is basically one of remembering that weekly jobless claims numbers can be quite volatile, up and down. "The trend in employment is still toward improvement,” James O’Sullivan, chief economist at MF Global Ltd., tells BusinessWeek today. "This level of claims is still associated with net declines in payrolls, but the message is that declines are getting smaller and smaller."
Meanwhile, ABC News today quotes a Labor Department source as saying that last week’s surge was due to "administrative backlogs" that piled up during the holidays. Maybe, but until we see more numbers in the weeks ahead, we really don’t know if today’s news is a blip or a sign of new troubles to come.
Even if the decline in jobless claims resumes in the weeks ahead, as we expect it will, let’s not forget that there’s still a big test ahead for the economy. Having rebounded from the apocalypse of late-2008/early 2009, the challenge now is one of creating and sustaining growth that ends up as a net plus. That's a much tougher job than printing money. With today’s news, there’s one more reason to wonder if the economy is up to the task.
Meanwhile, the potential for muddled sentiment is lurking. The first estimate of GDP scheduled for release next week (Friday, Jan. 29) promises to create a bullish aura that may be misplaced. It’s not unreasonable to expect a strong fourth-quarter GDP number, although extrapolating that into 2010—particularly in the second half of this year—is still premature if not foolish, as we’ve discussed recently, including here.
Bottom line: it’s still going to be quite a long year. Meantime, the winter just turned a bit colder.
January 20, 2010
STIMULATING STIMULUS DEBATES
Was last year’s $787 billion fiscal stimulus too small? Or just ill-conceived? Or was it doomed to fail from the start? Or perhaps the money was spent too fast. Or too slow. At least it’ll be easier to access broadband in a few states.
A BEAR MARKET IN MYSTIQUE...
Warren Buffett has become more accessible over the years, and there's nothing wrong with that. Some of our best friends actively seek out attention from the media. Still, it's hard not to notice how things have changed. Once upon a time, a Buffett quote was a rare and wonderful thing. Now, he's just one more talking head on TV. Oh, well. It's the 21st century. And it's really all about the money anyway, right?
THE BETA INVESTMENT REPORT: 1-YEAR OLD THIS MONTH
Our subscriber-only newsletter--The Beta Investment Report--is one year old this month. To celebrate, we're offering all Capital Spectator readers a bonus issue with a paid annual subscription. That's right, 13 issues for the price of 12. There's never been a better time to hone your strategic investment intelligence. And now you can do it at a discount, albeit for a limited time.
Here's how it works. Subscribe for 12 months at BetaInvestment.com. Once your subscription is confirmed, send us an email with the word "Bonus" in the headline, along with a reference to the date you subscribed, and we'll add an extra issue to your subscription--no extra charge. (Even better, if you subscribe for 24 months, we'll throw in 2 extra issues for free.)
But remember, this offer is only good through Jan. 31, 2010.
A FRESH LOOK AT SOME OLD HOPE FOR HOUSING
The housing market has been looking for a bottom for years. Has it finally located the floor? There’s a fresh glimmer of hope on that front via this morning’s update on new housing starts and building permits issued. Sort of.
Although housing starts slipped 4.0% last month vs. November, new building permits last month jumped 8.3%, the U.S. Census Bureau reports. More importantly, the long-suffering trend in this pair of critical measures of the housing market finally seems to have found a base, as our chart below suggests. Maybe.
Predictions that the suffering was over have come and gone only to see the red ink keep spilling. Suffice to say, we’re humble in expecting too much too soon. But it’s starting to look like the end of the great housing collapse has arrived. Finally. Of course, even a broken watch is right twice a day.
That’s not to say that a powerful rebound is imminent. Echoing the trend in the labor market and the economy overall, a period of treading water may be in store, and for an unusually lengthy run relative to post-recession revivals in the past. But while everything’s in slow motion this time and “good news” has been adjusted down, we still need to sit tight before we can walk. One day, perhaps, we’ll run. But the sneakers are likely to collect quite a bit more dust before it’s time to take them out of the closet.
THE ELECTION OF SCOTT BROWN
Politics doesn’t normally infiltrate these pages, but sometimes the news is too potent to ignore. The upset election last night of Scott Brown as the Bay State’s U.S. Senator certainly fits the bill. Indeed, Republicans are a rare bird in Massachusetts, but they're slightly less unusual today. Meanwhile, the ramifications for economic policy, healthcare and some other issues swirling about in Washington are suddenly ripe for rethinking.
One election can sometimes mean a lot, although it remains to be seen if the hype surrounding last night's upset lives up to the reality of life in Washington. In any case, rest assured that the fourth estate, the politicians, economists and the blogosphere will be spilling copious amounts of digital ink over the implications for weeks to come. Meanwhile, a few of the early speculations on what it all means…
“This is a giant wake-up call,” said Terry McAuliffe, the former Democratic National Committee chairman who lost a bid for the Democratic nomination for governor in Virginia last year. “We have to keep our focus on job creation. Everything we have to do is related to job creation. We have to do a much better job on the message. People are confused on what this health care bill is going to do.”--The New York Times
Most immediately, Brown's win Tuesday over Martha Coakley to replace the late Edward M. Kennedy will deprive Democrats of a filibuster-proof Senate majority. That could kill the Democrats' effort to revamp health care unless House Democrats reluctantly embrace a previously passed Senate version that many of them dislike.
--The Washington Post
Republican Scott Brown’s startling victory is a “catastrophe” for President Obama’s agenda and a wake-up call to pols from Beacon Hill to Capitol Hill that the political landscape is shifting under their feet, experts said.
The most immediate challenge facing Democrats after Republican Scott Brown's victory is how to salvage healthcare legislation now that they no longer have the 60 votes needed to break GOP filibusters.
Republican candidate Scott Brown has won the race to replace the late Senator Ted Kennedy in Massachusetts and, as I wrote earlier today, this does not bode well for the clean energy and climate change legislation currently being considered in the Senate.
Finally, here's what Scott Brown says on some key issues, via his web site…
I believe that all Americans deserve health care coverage, but I am opposed to the health care legislation that is under consideration in Congress and will vote against it. It will raise taxes, increase government spending and lower the quality of care, especially for elders on Medicare…
I am a free enterprise advocate who believes that lower taxes can encourage economic growth. Raising taxes stifles growth, weakens the economy and puts more people out of work. Our economy works best when individuals have more of their income to spend, and businesses have money to invest and add jobs. I have been a fiscal watchdog in the state legislature fighting bigger government, higher taxes and wasteful spending….
I support common-sense environment policy that will help to reduce pollution and preserve our precious open spaces. I realize that without action now, future generations will be left to clean up the mess we leave. In order to reduce our dependence on foreign oil, I support reasonable and appropriate development of alternative energy sources such as wind, solar, nuclear, geothermal and improved hydroelectric facilities. I oppose a national cap and trade program because of the higher costs that families and businesses would incur.
January 19, 2010
ASSET ALLOCATION...YET ANOTHER CLUE
Owning multiple asset classes isn't everything, but assuming you own a broad spread you'll probably generate middling results if not slightly better over time. That doesn't sound like much, except when you consider how real-world results stack up--especially after taxes and trading costs are deducted. Can you do better? Maybe, but you'll have to work at it. Yes, there's lots of above-average performance records out there. But the opposite is true as well, a point that tends to be overlooked in all the marketing materials pumping the latest gee-whizz product.
The benefits of going broad, meantime, requires mostly discipline as opposed to hope and talent. It helps if you understand the nuances of why this strategy offers so much for so little effort. The details, of course, can get messy, particularly when it comes to deciding on when and how to rebalance and which products to use. That's one reason why we tackle the challenge of managing asset allocation in some depth via The Beta Investment Report, its proprietary benchmark (the Global Market Index) and the associated model portfolios.
Meantime, the clues in support of the general concept are everywhere, including Paul B. Farrell's Lazy Portfolios. Yes, investing is still a thousand-mile journey, but the first few steps, at least, are clear. Even better, you don't need a Ph.D. in finance to figure out the basics. No, it's not a free lunch. Instead, think of it as a deeply discounted tiffin. The perennial question, of course, is whether there'll be any dessert.
MOMENTUM & EQUILIBRIUM
The momentum effect in securities prices has long been a thorn in the side of modern finance. Why does momentum exist? How can it exist in an equilibrium-based view of economics? It's still a puzzle, but it becomes less so with time, as the research study du jour on this thorny subject reminds.
WHAT'S UP (OR DOWN) WITH THE INVENTORY CYCLE?
Will the inventory cycle help or hurt in the latter half of 2010?
It’s just one question in a sea of inquiries in the quest to get a handle on how the economy fares in the months and quarters ahead. Arguably it’s one of the more topical issues looming. One view is that the burst of economic activity that gave aid and comfort to last year’s third-quarter GDP (the economy grew by 2.2% in Q3, ending a string of GDP declines) was largely inventory related.
Recall that the financial crisis and Great Recession took a heavy toll on corporate America by early 2009, slashing production activity and leaving warehouses relativley depleted. By the end of last year, a recovery of sorts had set in and one of the catalysts has been the rebuilding of inventories, as suggested by our chart below. Inventory relative to sales fell to a 1.3 ratio by last November, down sharply from about 1.45 early in 2009.
But with the inventory-to-sales ratio back in “normal” territory, the restocking effect is fading. That inspires some to predict that economic growth will turn sluggish in the near future as the benefits of refilling warehouses and the like fades as a stimulus for GDP.
In an essay from last month, PIMCO’s Paul McCulley advised…
It’s true that the fourth-quarter 2009 gross domestic product (GDP) is likely going to be 4%-plus. The inventory cycle is a turbo charger right now. But when we talk about the New Normal growth rate, we’re talking in trends as opposed to single quarters.
The real story here will be told not in the GDP numbers, which are being driven by the inventory cycle, but by real final sales, which will continue to face the headwind of balance sheet deleveraging in the household sector.
One of McCulley’s colleagues at PIMCO—Mohamed El-Erian—tells Bloomberg News: “After an inventory-driven bounce in the GDP growth rate, we are expecting a 2 percent annual pace,” he said. “Also, importantly, it will take years for the U.S. economy to recover to the level of GDP attained before the crisis.”
But not everyone’s so anxious about the inventory effect. Economist Bill Conerly offers a somewhat more upbeat view on the subject, if only marginally so. He still expects a restocking effect that’s a net positive. “The meek economic forecasts may not be anticipating a bounceback in inventories, which make them too pessimistic,” he wrote last week. “However, after four quarters of inventory recovery, the end of re-stocking will push down GDP growth for a quarter, so look for a little bit of roller coaster in your economic data.”
Lest we become too optimistic, Calculated Risk offers a diagnosis to keep us immunized from reading too much into the approaching fourth-quarter GDP report that’s likely to be strong but unsustainable in the near term. The source of this sobering analysis: a fading inventory boost. As Calculated Risk advises, "we are seeing a transitory boost from inventory changes and underlying demand remains weak.”
Nor is this worry limited to the U.S., as a Fistful of Euros explains.
We wrote yesterday that the trend in the labor market will dictate the economic trend in 2010, for good or ill. Perhaps that means inventories will be the second-most critical variable for the economy in the year ahead.
January 18, 2010
THE LONG YEAR AHEAD
The U.S. labor market is far from healthy, and the prospects are low for changing that diagnosis any time soon. But there’s a small ray of hope for thinking that the net loss of jobs is over and maybe, just maybe, some degree of expansion is near. Last week’s update on new hires is one of the positive smoking guns for expecting a better job market in the weeks and months ahead, if only marginally so.
It’s hard to overestimate how much influence the labor market will color the details of the economy in 2010. Suffice to say we’re at the point that the trend in jobs will have an outsized effect on what unfolds in the year ahead, for good or ill. A surprisingly strong recovery? A double-dip recession? Or something in between? We think the third choice is the right answer, although there’s a lot of play even there in terms of the details. In any case, much of the true answer will come via the labor market, now more than ever.
On that note, there are some statistics that are encouraging, albeit with all the usual caveats. Nonetheless, the upturn in the so-called hires rate in the economy provides a small bit of light in a dark tunnel. As the chart below shows (courtesy of the Labor Department), the new hires rate continues to rise off the bottom established in mid-2009. A pick-up in job creation, in other words, appears to be gaining momentum.
The problem is that the economy is still losing more jobs than it creates, i.e., the separations rate (the ratio of employment terminations to total workers employed) has been sticky on the upside. But the gap between hires and separations is closing. Is there enough momentum in the recent rise in new hires to overtake separations in the months ahead? Perhaps. If so, the shift will reflect a minor milestone in favor of growth.
Of course, we should be cautious in expecting too much too soon. Charles Thibault of Wanted Analytics considered the positive implications via a rise in new hires back in September. But the optimism, even though it was statistically warranted, was premature. The net change in nonfarm payrolls was still down in December.
Midway through the first month of 2010, there are enough headwinds facing the economy to keep our expectations in check. That includes the dire trend in the tally of the long-term unemployed (out of work for 27 weeks or more), which hit the highest rate since 1948, when data on this series was launched. Forty percent of the unemployed were jobless for 27 weeks or more last month, according to the Labor Department. “This is not your typical cyclical downturn where hiring is just postponed until business improves,” Richard DeKaser of Woodley Park Research tells the Christian Science Monitor. “This is really more about structural unemployment.”
The economic rebound faces “three significant headwinds,” Eric Rosengren, president of the Boston Fed, warned earlier this month: weak lending by banks, cautious consumers and a slow recovery in the labor market. “It appears that this recovery will likely experience only a slow improvement in the employment picture, and that the unemployment rate will remain quite elevated during the early phases of the recovery,” he said. “GDP growth is expected to be strong enough to produce some employment growth, but that rate of employment expansion will not likely be rapid enough to put a large dent in the unemployment rate.”
Even the most optimistic forecasters must face facts: It’s going to be a long year.
January 17, 2010
INFLATION RISK IN A NUT SHELL
Harvard's Greg Mankiw today rounds out the basics of inflation risk in his NY Times column. And nicely done, we might add. The bottom line: the variables for inflation are present, but the weak interaction may keep the threat of higher prices at bay for some time. Maybe. Here are some key excerpts:
One basic lesson of economics is that prices rise when the government creates an excessive amount of money...
...governments resort to rapid monetary growth because they face fiscal problems. When government spending exceeds tax collection, policy makers sometimes turn to their central banks, which essentially print money to cover the budget shortfall...
Yet, despite having the two classic ingredients for high inflation, the United States has experienced only benign price increases...
Part of the answer is that while we have large budget deficits and rapid money growth, one isn’t causing the other. Ben S. Bernanke, the Fed chairman, has been printing money not to finance President Obama’s spending but to rescue the financial system and prop up a weak economy.
In summary, he explains that...
Investors snapping up 30-year Treasury bonds paying less than 5 percent are betting that the Fed will keep these inflation risks in check. They are probably right. But because current monetary and fiscal policy is so far outside the bounds of historical norms, it’s hard for anyone to be sure. A decade from now, we may look back at today’s bond market as the irrational exuberance of this era.
January 15, 2010
A BIT OF SCHOLARLY RECOGNITION FOR THE CAPITAL SPECTATOR
The Capital Spectator has been labeled as one of several "top economics bloggers by scholarly impact" in a paper--"Blogometrics"--published in the Winter 2010 issue of the Eastern Economic Journal. See Table 1 (p. 4) and Table 2 (p. 6) of the PDF in the link. Actually, we're tied with some other sites in the rankings. But, hey, now it's only a matter of time until we're offered a reality show, right? Meantime, here's the paper's abstract:
This study gathers information on a wide array of economics bloggers and blogs in order to develop a ranking of economics bloggers that is based on citations to their academic research. This ranking is used in an iterative process that next presents a ranking of economics blogs that is based on the ranking of economics bloggers, and finally a ranking of economics departments that is based on the ranking of economics blogs. The ranking of blogs included in this study is positively correlated with an external ranking based on their productivity (popularity), whereas the department ranking presented here comports quite well with department rankings in Coupe´ (2003) and Roessler (2004) that are developed with more traditional measures, such as the impact of the scholarship of an economics department’s faculty.
And in case you're wondering, the top-ranked economics blog is Gary Becker and Richard Posner's site, a.k.a. The Becker-Posner Blog, according to the paper. We're nowhere near the ranking of this influential site, of course. In fact, we're at or near the bottom, depending on the details of the particular ranking. But simply showing up on the same list as a few of the big boys is something. Or as they say in Hollywood, just being nominated is an honor.
EXPECTED RISK PREMIUMS, UNCERTAINTY AND LOTS OF CHOICES
There’s nothing new under the sun in the money game, but there’s always a fresh perspective. Sometimes that makes all the difference. Sometimes that’s all there is.
In the quest to offer something productive, let’s imagine that reviewing the whys and wherefores of risk premia can help sober us up about what’s necessary to keep the red ink at bay and maybe, just maybe, turn a profit with a multi-asset class portfolio.
For those who are interested in the details, including a broad review of the academic literature and the empirical record, you’re in luck. Your intrepid editor has a book coming out next month from Bloomberg Press—Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor. We also analyze the markets, portfolio strategy, and otherwise crunch the numbers on a monthly basis for subscribers to The Beta Investment Report. As for the aforementioned investment perspective, allow us to take you on a brief (very brief) tour.
As readers of these digital pages know, we begin with the market portfolio, broadly defined. A reasonable proxy for most investors can be modeled on a global mix of stocks, bonds, REITs and commodities, weighted by their respective market values. In fact, we do just that by calculating our Global Market Index, the benchmark for The Beta Investment Report.
GMI is hardly a silver bullet, but it’s a powerful place to start for considering asset allocation and how to customize portfolios to satisfy each investor’s expectations, risk tolerance, investment horizon, etc. For perspective (there’s that word again), financial economics tells us that the unmanaged market portfolio a la GMI is the optimal portfolio for the average investor for the very long run. The question, then, is how you and I are “different” from the average investor. Although definitive answers are elusive, everyone should spend some time thinking about how to respond and what that implies for designing and managing a portfolio.
Unsurprisingly, we spill a good deal of ink on the topic in the book and in the newsletter. As this is billed as a “brief” tour of strategic investing perspective, however, let’s skip over this question here and move right to the red meat of money management: risk premiums, or the return generated by securities and asset classes over and above a risk-free rate, such as a 3-month Treasury bill. The details on risk premia can get tangled, not to mention voluminous, and so we’ll (again) favor an absurdly concise treatment here, starting with the question: Why do you expect to earn a premium in, say, stocks relative to T-bills?
The basic answer, of course, is risk, ergo the term risk premium. An obvious if circular answer, perhaps. But this simple framework is worth pondering for a moment. Why is there a risk premium? Why should it exist? Again, the answer is quite long, but on very simple level we can begin by recognizing that risk premia are linked with uncertainty. There are other factors involved, but some degree of risk premia are a function of uncertainty. When you buy a stock or an index fund that represents the equity market, you’re purchasing shares with the view that the economy will grow (eventually), earnings will rise (hopefully), and so your investment will increase in price (let's assume). History, at least, offers some context for embracing this connection.
But we can’t be sure of this rosy outlook, particularly in the short run. The economy might contract between now and next year; earnings might fall; equity prices might decline. The expectation of earning a risk premium is in some sense a compensation for bearing this uncertainty.
This is a good point to mention as well that expected risk premiums vary. Sometimes the equity risk premium, for instance, is relatively high; sometimes it’s relative low. Usually, it’s middling. In any case, it’s far from static. Why? Because the level of uncertainty varies too, or at least the perception of uncertainty does.
That's largely a byproduct of the fact that there's a thing called the business cycle. To cite the extreme case, at the height of a financial crisis in the middle of a deep recession—late-2008, for instance—uncertainty is extraordinarily high. Will the economy collapse? Or will it rebound? Will the economic world as we know it end next week? Or will stability eventually return?
Normally, such life-and-death questions aren’t topical for making investment decisions. But sometimes, those are the only questions in town. Investors are consumed with a “yes” or “no” response. At such moments when the economic landscape is simple—survival or death—so too is the level of uncertainty unusually high. Why would anyone buy stocks, or an equity index, at such a time? The expected risk premium is extraordinarily high. And, yes, somebody was buying securities in late-2008.
By contrast, expected risk premiums are usually rather bland, relative to the long run of history. That’s not surprising. If there’s no obvious death threat hanging over the economy, you shouldn't expect to receive an unusually rich level of compensation for holding risky assets.
Of course, let’s also recognize the existence of the opposite extreme. When everything seems to be going well, and the crowd believes that the future is rather transparent in terms of the view that the good times will roll on, the expected risk premium is modest if not thin. It may even be MIA. Again, no great surprise.
There’s a caveat, of course, which is that estimating expected risk premiums is somewhat precarious. Arguably it’s easier at extreme points, such as in late-2008, when bearish sentiment was exploding. Similarly, when the bulls are on steroids, as in late-1999, our confidence is somewhat higher for predicting a relatively low risk premium for equities. Arguably it's also easier to projectc risk premiums if you're looking out over relatively long stretches of time.
Alas, our confidence in the task of projecting risk premia is always, always well below 100%. Yet the confidence level fluctuates, as do expected risk premia, and to some degree we should attempt to exploit such fluctuations a la dynamic asset allocation. But ultimately we’re never fully sure what’s coming, which inspires various risk-management techniques, starting with a cautious stance on straying too far from the market portfolio a la our Global Market Index or something comparable without a compelling reason. We can also apply some simple applications to minimize uncertainty’s blowback, such as regular/semi-rebalancing of the asset allocation. In addition, perhaps we can engage in forecasting of one kind or another, based on what financial economics has taught us over the years.
Ultimately, there’s no cure for uncertainty, which is to say there’s no free lunch. That’s why the financial gods invented risk premia. Is all of this unpersuasive? If so, there’s another alternative—avoid risk altogether. There are, in fact, several choices of assets with expected risk premiums forever set at zero. Or perhaps you’re inclined to own some of each, i.e., cash and risky assets. Choices, choices.
January 14, 2010
2010's BIG TEST
No one should doubt that an economic recovery is underway. But no one should assume that the rebound is robust or destined to quickly bring economic healing on a broad scale. It's different this time.
The trend, at least, remains positive on a number of metrics, including the latest numbers on workers filing unemployment claims last week for the first time. New jobless claims rose 11,000 last week to 444,000, the Labor Department reports. But as our chart below suggests, the latest data point is statistical noise. The declining trend, in short, remains intact.
Since peaking in March 2009, weekly jobless claims have been on a steady downshift. As we’ve written many times, starting with this piece from early last year, a sustained decline in this measure bodes well for an upturn in the economic cycle. We’ve been arguing for some time now that the downshift in jobless claims has legs and so the natural forces of recovery are set to grow stronger. The latest report on this front offers no reason to change our view for the near-term future.
Confirming the trend is the update on so-called continuing claims, which measures the number of workers who've been receiving unemployment benefits. This tally is also falling, as our second chart below shows. For the week through the first of the year (the latest number available on this data series), continuing claims were just under 4.6 million, a drop of 211,000 from the previous week and the lowest in almost a year.
These two trends, along with a range of other metrics we routinely follow and analyze in The Beta Investment Report, tell us that there’s a rebound underway. This isn’t necessarily surprising. Indeed, we’ve been anticipating no less on these pages for some time.
To be honest, forecasting an end to the recession and a rebound of some degree required no great powers of prognostication in the recent past. Although some were skeptical, we’ve been of a mind that the usual course in economic history would reassert itself once more. So far, so good. But as we’ve also been advising all along, the recovery is likely to be weak, particularly on the variable that matters most: job creation. The latest news on employment suggests no less. Another major sore point on looking ahead is the weakness in lending.
The danger is that the recovery process is at risk of faltering. But not yet, thanks to the organic forces of economic recovery, supported by the still-extraordinary degree of monetary stimulus. The combination is still quite potent (labor and lending being the primary exceptions). Nonetheless, the first test of the new normal will come in the second half of 2010, or so we believe.
In most post-recession periods of recent generations, the labor market came roaring back, albeit in lesser degrees in recent years. But for a number of reasons, that's not likely this time. In any case, much will depend on how the trend in job creation fares in the coming months and quarters. For the moment, the good news is that the layoffs are receding and the ranks of the unemployed are no longer climbing. In fact, we expect that the jobless rate will turn lower in the months ahead, if only marginally. But the big test is still ahead of us.
The transition this time from an economic climate that's no longer destroying jobs to one that's generating new positions of some magnitude is likely to be rocky. It’s not yet clear how much job-minting capacity is coming, but we’ll find out soon. For what it's worth, our expectations are muted relative to past cycles.
FED'S BEIGE BOOK: THE RECOVERY REMAINS SLOW & SLUGGISH
The U.S. economy is recovering, but slowly, the Fed advised yesterday in its latest "beige book" report. That's no great surprise and in fact we'd have fallen off our chair if the central bank said anything different. Indeed, we've been forecasting no less for some time on these pages, such as our view from last June, when we worried that "the past and current ills weighing on the economy will remain a heavy burden for many quarters and, to some extent, several years."
The arrival of the so-called anecdotal news of regional economic trends in the various Fed districts offers one more reason to think that the post-recession period that awaits will be a long and painful struggle to repair the damage of the Great Recession. The old normal is nowhere in sight.
As an example, here are some choice quotes from the report:
* Most Districts reported that consumer spending in the recent 2009 holiday season was slightly greater than in 2008, but still far below 2007 levels.
* Toward the end of 2009, home sales increased in most Districts, especially for lower-priced homes. Home prices appeared to have changed little since the last Beige Book, and residential construction remained at low levels in most Districts. Commercial real estate was still weak in nearly all Districts with rising vacancy rates and falling rents. Since the last report, loan demand continued to decline or remained weak in most Districts, while credit quality continued to deteriorate.
* Labor market conditions remained soft in most Federal Reserve Districts, although New York reported a modest pickup in hiring and St. Louis reported that several service-sector firms in that District recently announced plans to hire new workers. In the Richmond District, temporary employment agencies gave mixed reports, but some noted increased demand for administrative and sales workers, laborers, and warehousing and distribution workers. Wage pressures remained subdued in most Federal Reserve Districts, and Atlanta noted continued wage freezes at some employers in that District. However, Boston reported some modest pay increases, and Minneapolis indicated that wages in that District have been level or rising moderately.
January 12, 2010
WHAT ARE TREASURIES TELLING US?
Inflation isn't a concern these days, affording the Federal Reserve elbow room to keep interest rates at, well, virtually zero.
The futures market doesn't expect the free-money train to end any time soon. Even looking a year out, Fed funds futures are still pricing the central bank's target rate at under 1%. The FOMC hasn't done anything to disabuse the crowd from that view. Last month's official monetary confab press release advised that "the Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent…for an extended period."
One of the reasons that the Fed can keep the monetary pumps primed in excess is that the velocity of money (a measure of the frequency that money is spent) is quite low, as a recent reading via the St. Louis Fed shows. (Velocity is calculated as nominal GDP divided by some measure of money supply.) In some schools of economic thought—notably those who ascribe to the quantity theory of money—a rising velocity is a harbinger of future inflation. By this standard, the muted change in velocity suggests that the risk of higher inflation remains relatively low, enabling the central bank to print money to a degree that would otherwise raise alarm about future pricing pressure.
But while the threat of imminent inflation is minimal, the market is slowly but consistently rethinking the wisdom of giving away money. Indeed, as our chart below illustrates, the Treasury market's 10-year inflation forecast has just about returned to the levels that preceded the great debacle on Wall Street in the fall of 2008.
The implied inflation outlook, based on the spread between the nominal and inflation-indexed 10-year Treasuries, reached 2.38%, as of January 11, 2010. That's nearly the level the prevailed before all hell broke loose in September 2008. Having returned to a "normal" inflation outlook, the question is, Now what? We've come full circle. But while the inflation outlook is back where it started, almost everything else has changed.
The leading difference is that the Fed's expansionary monetary policy is on steroids, which stands in contrast to the last time that Treasury based inflation forecast was roughly 2.5%. This isn't particularly worrisome to some economists, including Asha Bangalore of Northern Trust. One explanation for why there's no immediate cause for concern is that banks aren't lending, which is keeping a lid on inflationary pressures.
So far, so good. But strategic-minded investing is as much about looking forward as it is assessing what's known in the here and now. With that in mind, the operative question: Would you tie up a significant chunk of money in a nominal 10-year Treasury today? It's tempting to answer "yes," based on a stellar trailing returns in bonds over the past year or so and the comforting news that inflation isn't an obvious threat. Alas, rear view mirrors only get you so far in finance, and sometimes (if you're not careful) they can throw you in the ditch.
To be fair, we agree that the inflation threat is likely to stay muted for the foreseeable future, for the reasons cited above along with other factors. The real danger is assuming that today's truth will remain tomorrow's wisdom as well. But for now, the risks of printing money remain low. Each day, however, the risks rise. At some point, the frog will jump out of the pot. That's virtually assured. As always, timing is an open question.
January 11, 2010
IT'S ALL ABOUT JOBS…AND INTEREST RATES
After Friday's disappointing update on the labor market in December, the debate about how to boost employment will take on an even greater import, if that's possible, in the months to come. All the more so as this is a mid-term election year.
Inextricably intertwined in the debate over jobs is the question of when to raise interest rates. The two primary goals: nipping any future inflationary pressures in the bud without derailing the economy's still-weak capacity for minting new jobs.
Suffice to say, it may be impossible to find a productive solution that a) promotes job growth; b) keeps future inflation sufficiently contained for the long haul; and c) keeps the political powers that be in a satisfied state. Ideally, there's a compromise that offers some degree of satisfaction on all three. But juggling this trio isn't going to be easy. That's partly because quick and easy answers aren't forthcoming. It's primarily a question of deciding which leg of the stool will suffer the most. Meantime, there's lots of debate. Here's a selection in recent days:
--Yardeni Research, Jan 11, 2010 (subscription required)
…the Democrats passed a program last February that had paid out only 33% of the $787bn appropriated for the job of creating jobs as of the end of last year, according to the administration’s official recovery.gov website. Of the $257bn spent so far, more than a third was for entitlements. The rest was tax benefits, contracts, grants, and loans. The website claims that 640,329 jobs were created by this program as of the end of October. If we generously assume that one million jobs were created last year by the program, that would amount to $257,000 per job!
There must be a more cost-effective way for the government to create jobs. There is indeed: Let the private sector do it without so much government meddling in the economy and such large deficits. This seems to be the increasingly conservative opinion of more and more voters, according to the major national polls. During December, according to Gallup, 40% of American claimed that they are conservatives. That’s the highest on record for this annual survey, which started in 1992.
--David Kotok, Cumberland Advisors, Jan 11, 2010.
To be blunt: in our view the jobs data were plainly miserable and disappointing. Like many of our readers, I listened to the debate on CNBC and read numerous analyses. We will set aside the perennial optimists who find positive outcomes in any data set. Simply put: a 10% unemployment rate and a 17.3% underemployment rate are two extremely serious numbers.
They help explain the market’s immediate reaction, which was a Treasury bond price rally and a drop in the 2-year note yield to an intraday low of 0.936%. The 2-year note yield under 1% is a very important figure for market watchers. It is a key market-based pricing of expectations for the Federal Reserve’s interest-rate policy. This reaction essentially suggests that the Fed will maintain the policy-setting Federal Funds interest rate range of 0.0% to 0.25% for at least the first half of 2010.
That has been Cumberland’s expectation for some time. The assumption of a very low US interest-rate policy continues to drive our investment decisions as we conduct stewardship over portfolios through these extraordinary times. Talk about an imminent exit strategy by the Fed is just talk. It is quite possible that the Fed will maintain the zero-bound rate for the entire year. Maybe, they will firm the rate to 0.25% instead of a range this summer. Our longer-term estimate is that we will not see the Fed Funds Rate above 1% until 2011 at the earliest.
--Gary Burtless, The Brookings Institute, Jan. 8, 2010.
The latest employment report shows that the nation’s job market continues to make a painfully slow recovery from the worst labor market downturn since the Great Depression…
Both the labor force participation rate and the employment-population ratio reached low points we have not seen since the mid-1980s. Although the number of newly laid off workers was considerably smaller than the numbers we saw earlier this year and late last year, unemployed workers face a very grim job search. The average duration of unemployment spells set an all-time record in December. Unemployed workers have now been jobless for more than 6½ months, a record high.
The payroll employment, hours, and wage data reported in the employer survey are a bit more heartening. Payroll employment fell 85,000 in December after remaining essentially flat in November…
The good news is that hours worked in the private sector remained above the level we saw last summer. Hourly wages continue to inch up, although very slowly.
--BCA Research, Jan. 6, 2010
Economic cycles associated with financial traumas such as banking crises or asset price collapses tend to have deeper downturns and weaker upturns. The current uptrend in U.S. economic growth should be sustained, but the rebound will remain subdued compared to recent recoveries.
--Asha Bangalore, Northern Trust, Jan. 8, 2010
The details and tone of the December employment report indicate that labor market conditions remain bothersome. A meaningful pace of hiring is unlikely in the next few months given the structural unemployment in the economy, the shortened workweek, and large number of part-time workers. In other words, the December employment report reinforces expectations of the FOMC on hold in the near term.
The FOMC will need to ensure that a self-sustained economic recovery in underway before it can tighten monetary policy and justification for its actions in the current politically charged environment has to be rock solid. Therefore, the Fed is unlikely to undertake a reduction of monetary accommodation until the unemployment rate has peaked. In the jobless recoveries following the 1990-91 and 2001 recessions, the Fed waited it was abundantly clear that the unemployment rate had peaked before implementing a tightening of monetary policy, despite gains of real GDP for several quarters.
January 8, 2010
LIFE DURING DOWNTIME
Today’s jobs report for December reminds (as if we needed reminding) that the economic “recovery” will be slow, sluggish and prone to setback from time to time.
Nonfarm payrolls were lighter by 85,000 last month, according to this morning’s monthly employment update from the Department of Labor. That’s a blow for quite a number of economic projections, some of which predicted a small gain. MarketWatch.com, for instance, reported that a poll of economists had predicted a rise of 15000 in the December nonfarm payrolls number.
There is some good news in today’s report: the slight retreat in November jobs that was originally reported (-11,000) was revised upward to a feeble gain of 4,000. Of course, in a labor force of 130 million, such changes are insignificant. Indeed, nothing short of potent growth in the labor market over an extended multi-year period is required to repair the damage from the Great Recession. Even a sustained rise of 300,000 new jobs a month would take more than 2 years simply to return the labor force to its pre-recession high. Unfortunately, almost no one is predicting such a rosy scenario and there's nothing in today's numbers to suggest such a positive turn of events any time soon.
That’s no surprise at this late date. Our view on these pages since last summer has been that the recession was probably over but that it would bring an unusually weak recovery, particuarly on the labor front.
We’ve been writing for some time now that the technical end of the recession seemed set to arrive sometime in mid- to late-2009. Last June, we advised that the recession appeared on track to fade midway or so in 2009. The forecast was partly driven by the decline persistent decline in initial jobless claims, which we discussed extensively last year (including here and here), along with the extraordinary monetary stimulus and other factors.
But we’ve also recognized the post-recession cycle rebound for the foreseeable future looks unusually weak. As we noted in October, "the practical implications in a revival of GDP this time threaten to be quite unsatisfying for the immediate future."
Certainly today's employment report offers no reason to change our view. Although the job loss for December overall was mild by the standards of the past year or so, the fact that virtually every corner of the labor market retreated is a sign that the economy is still on the defensive. Indeed, even the normally buoyant services industry shed jobs last month, albeit mildly so.
Despite the gloom, net growth in jobs on a national basis is near. One clue comes by way of the recent upturn in the average workweek in terms of hours. In November, the average number of hours logged by workers turned up for the first time since July and to the highest level (33.2 hours a week) since March (see chart below). A rise in this measure tends to precede a return to net growth in the labor market after a recession. The question, of course, is whether the latest rise in this metric has legs. Today's jobs report shows that the average workweek remained unchanged in December relative to November. At least it didn't decline.
Barring some new event that surprises on the downside, the first half of 2010 is likely to witness a recovery in jobs. In fact, we'd be surprised if the first quarter of this year doesn't show a net gain of several hundred thousand in nonfarm payrolls. But even this optimistic scenario pales by the standards of post-recession recoveries for the past half century. This, then, is the great challenge that awaits in the aftermath of the Great Recession. Alas, there are no easy solutions. Nor is it obvious that the crowd has yet come to terms with the potential for the political and economic blowback that the new normal seems destined to bring.
January 7, 2010
WHAT WENT WRONG WITH MONETARY POLICY?
January 6, 2010
THE PRICE TAG FOR DAMAGE CONTROL
The monetary and fiscal stimulus dispensed by governments around the world was arguably effective in containing a recession and staving off depression. But if so, the question becomes: At what price?
Nothing is free in economics and so the world must grapple with the mountain of debt that now weighs on the global economy. In effect, policy makers have traded the acute for the chronic. Was it a worthwhile tradeoff? Perhaps, although the true answer won't be known for some time, perhaps as long as a generation.
Meanwhile, no one should underestimate the potential risks. A new research paper by professors Carmen Reinhart (University of Maryland) and Kenneth Rogoff (Harvard) bluntly lays out the stakes and the hazards that may be lurking. A working version of "Growth in a Time of Debt," forthcoming in American Economic Review, makes three key points. Quoting the paper, the authors advise:
* The relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more.
* Emerging markets face lower thresholds for external debt (public and private)—which is usually denominated in a foreign currency. When external debt reaches 60 percent of GDP, annual growth declines by about two percent; for higher levels, growth rates are roughly cut in half.
* There is no apparent contemporaneous link between inflation and public debt levels for the advanced countries as a group (some countries, such as the United States, have experienced higher inflation when debt/GDP is high.) The story is entirely different for emerging markets, where inflation rises sharply as debt increases.
Reinhart and Rogoff's recently published book—This Time is Different: Eight Centuries of Financial Folly, which we reviewed here—made a timely statement with its arrival last year and this academic pair continues the tradition with their latest work. As their paper notes, the U.S. is among the nations with the biggest percentage increase in debt since 2007. A recent estimate of U.S. debt-to-GDP ratio is 84%, according to Reinhart and Rogoff--dangerously close to the 90% threshold, as illustrated in the following chart taken from the paper.
The bottom line: Bailouts are expensive, perhaps more expensive than generally realized. The worst of the financial crisis and Great Recession may be over, and perhaps that's due partly to the intervention of central banks and governments around the world. (The business cycle was a factor too.) But let's not celebrate just yet. The cleanup era has only just begun and it's not yet clear how much it's going to cost.
January 5, 2010
PASSING (AND PRINTING) THE BUCK, PART II
On Sunday, we discussed Fed Chairman Ben Bernanke’s view that monetary policy played no role in the extraordinary bull market in real estate during 2002-2007. The operative quote from his speech: "Monetary policy during that period [2002-2006] -- though certainly accommodative -- does not appear to have been inappropriate, given the state of the economy and policymakers' medium-term objectives."
A number of monetary economists beg to differ. Among the smoking guns: a negative inflation-adjusted Fed funds rate for three years from late-2002 onward.
The issue, to repeat what we said on Sunday, is less about placing blame and more of learning from past mistakes in monetary policy. Progress, alas, is that much tougher if the powers that be aren't willing to admit policy error. But not all central bankers think alike, at least on the margins. Consider this excerpt from a speech last month by New York Fed President William C. Dudley:
Turning to the first issue, identifying asset bubbles in real time is difficult. However, identifying variables that often are associated with asset bubbles—especially credit asset bubbles—may be less daunting. To take one recent example, there was a tremendous increase in financial leverage in the U.S. financial system over the period from 2003 to 2007, particularly in the nonbank financial sector. This sharp rise in leverage was observable. Presumably, this rise in leverage also raised the risks of a financial asset bubble and the impact of this bubble on housing certainly raised the stakes for the real economy if such a bubble were to burst. This suggests that limiting the overall increase in leverage throughout the system could have reduced the risk of a bubble and the consequences if the bubble were to burst.
Turning to the second issue of how to limit and/or deflate bubbles in an orderly fashion, the fact that increases in leverage are often associated with financial asset bubbles suggests that limiting increases in leverage may help to prevent bubbles from being created in the first place. This again suggests that there is a role for supervision and regulation in the bubble prevention process. For example, it might be appropriate for the Federal Reserve—working with functional regulators such as the SEC (Securities Exchange Commission)—to monitor and limit the buildup in leverage at the major securities firms and the leverage extended from these firms to their clients and counterparties.
Whether there is a role for monetary policy to limit asset bubbles is a more difficult question. On the one hand, monetary policy is a blunt tool for use in preventing bubbles because monetary policy actions also have important consequences for real economic activity, employment and inflation. On the other hand, however, there is evidence that monetary policy does have an impact on desired leverage through its impact on the shape of the yield curve. A tighter monetary policy, by flattening the yield curve, may limit the buildup in leverage
Progress in monetary policy may not be so far-fetched after all.
January 4, 2010
ARE THE EASY GAINS BEHIND US?
December was a mixed bag of performance for the major asset classes, mainly because fixed-income was weak. Foreign developed-market government bonds were particularly hard hit last month, shedding nearly 6%, as the table below shows. But that's not necessarily a recurring offence, since a fair slice of the loss is due to a strong 4% rally in the U.S. Dollar Index, a rare jump in the buck and its biggest monthly gain since January 2009.
Meanwhile, REITs led in the winners circle for December, rising by nearly 7%. And equities the world over showed handsome gains as well. But thanks to the selling in most of the world's bond markets, our Global Market Index (a passive mix of all the major asset classes and the benchmark for The Beta Investment Report) slipped a bit in the last month of 2009.
For last year overall, however, there was no reason to complain. As calendar year gains go, 2009's were among the best on record. Indeed, our own GMI rose by more than 21%. Not bad for an index that requires no investing skills or portfolio decisions, other than to own everything in its market-cap weight and let it ride.
But the rebound in assets last year is almost certainly elevating expectations that can't be sustained. The year ahead will be tougher for the bulls, starting with the headwinds that await bonds. The combination of expanding supply as government borrowing explodes plus the potential for rising interest rates, if only marginally, will make it hard to keep upward momentum bubbling in fixed income in 2010. The one exception is if the economic challenges prove more challenging than they appear from the vantage of January 4. In that case, a rush back into the safe haven of bonds is likely and so prices could rise yet again.
Therein lies the great question for 2010: Will the economic rebound build a head of steam that's self sustaining? It's going to a close call. The key variable may be inventories. As economist Bill Conerly explains, "The change in inventories is the greatest uncertainty regarding the timing of the recovery." The sharp downturn in inventories last year is now in the process of reversing, which has been a boost for GDP. But this snapback can't go on forever. The debate is over how the return to normal, or what passes for normal, unfolds in the second half of 2010.
January 3, 2010
PASSING (AND PRINTING) THE BUCK
Fed Chairman Ben Bernanke says the central bank's monetary policy played no role laying the groundwork for 2008's financial debacle. The issue here is one of debating if interest rates were too low for too long and if that was a catalyst for sending the real estate market into overdrive.
"Monetary policy during that period [2002-2006] -- though certainly accommodative -- does not appear to have been inappropriate, given the state of the economy and policymakers' medium-term objectives," he said at a speech today in Atlanta at the American Economic Association, CNNMoney reports. The culprit, Bernanke added, was ill-conceived mortgages that made buying homes too easy.
The Fed head is half right. It's hard to imagine that the real estate boom would have been as strong as it was if interest rates weren't as low as they were in 2002-2006. Consider our graph below, which shows the effective Fed funds rate less the annual change in inflation, as defined by the consumer price index.
It's obvious that for a roughly three-year period starting in late-2005, the real Fed funds rate was negative, which is to say that monetary policy was aggressively stimulative. The case for keeping rates low was compelling in the wake of the 2000-2002 stock market correction and the mild 2001 recession. But the central bank misjudged what the economy needed at the time. That's clear now, with the benefit of hindsight, as a number monetary economists advise.
For example, Anna Schwartz, an economist at the NBER, recently opined that "the Fed was accommodative too long from 2001 on and was slow to tighten monetary policy, delaying tightening until June 2004 and then ending the monthly 25 basis point increase in August 2006."
We can argue if central bankers should have made better policy decisions in real time. In a world of fiat money, mistakes are inevitable when mere mortals are at the monetary helm, as we discussed recently. That's the price of doing business in central banking as it's currently practiced. What's troubling is arguing that the Fed played no role in stoking the fires of the former real estate bubble. Policy is never going to be perfect, but the degree of error in 2002-2006 now looks extraordinary. Yes, hindsight is 20-20, and so we should be careful here in arguing that another crew might have done things differently. But if we can't at least recognize an error, the odds of learning from past mistakes look virtually nil.
The question is less about blame and more of figuring out how to improve monetary policy going forward. Indeed, the stakes are higher than ever for the years ahead.
Progress comes slowly in economics and finance. It's even slower with a brick of denial tied to your legs.
January 1, 2010
SHOCKING DISCLOSURE: THERE'S NO FREE LUNCH
Easing the pain in the wake of the Great Recession may be politically if not morally correct. It may even be smart economics, depending on the details and the timing. But 1 +1 still equals 2 and in the end there's a risk that we're stimply trading the acute for the chronic. Ideally, finding some middle ground is the goal, but it's devilishly hard in practice. Meantime, what looks like progress on paper all too often ends up as counterproductive in practice. The best laid plans and all that jazz.
The latest example comes from a report in The New York Times that the government's efforts at easing the fallout from rising foreclosures in residential housing may be making things worse. The key quote in the article comes Kevin Katari of Watershed Asset Management, a hedge fund in San Francisco:
“The choice we appear to be making is trying to modify our way out of this, which has the effect of lengthening the crisis. We have simply slowed the foreclosure pipeline, with people staying in houses they are ultimately not going to be able to afford anyway.”
We can debate the merits of providing aid to homeowners at risk of losing their homes. We can also discuss the details of how to structure a plan that makes sense in offering financial support. But let's be honest and recognize that assistance comes with a cost. The price tag may be tolerable, perhaps even negligible. But not always. Sometimes the blowback from helping and intervening can be substantial, even if it's not immediately obvious today.
There's still no free lunch, but that doesn't stop us from thinking (hoping) that it's different this time.
OUT WITH THE OLD, IN WITH THE NEW...
To all our readers, thank you for your support. Happy New Year! All the best for 2010.