March 31, 2010
LOOKING FOR THE RIGHT MIX OF PREDICTORS
There is only one U.S. stock market, but there are countless strategies for estimating the expected risk premium for domestic equities.
The choices come in two broad flavors: fundamental and technical. We could, for instance, crunch the numbers using one of the many variations of discounting future cash flows to assess if stocks are "cheap" or "expensive." Meanwhile, there are a number of so-called trend-following measures that are worth studying. How to choose? Actually, there's a persuasive case for routinely analyzing a mix of so-called predictors for evaluating the outlook for stocks, and other asset classes, for that matter. To the extent that a broad and varied menu on this front represents opportunity, the world is brimming with possibilities.
In our research for The Beta Investment Report, one of the technical factors we consider is long-term return performance. One approach is putting the latest number in context with history. As an example, the chart below graphs the rolling 10-year annualized price return for the S&P 500 since 1910—a century of performance history.
We've identified the last three extreme points in the chart. The most recent is March 2009, when the rolling 10-year price return for the S&P was an annualized negative 5.1%. If you didn't know anything about stocks or investing, simply looking at that point on the chart above tells you something valuable: an annualized loss of 5.1% for the previous decade is an unusually poor return relative to the historical record. That alone is a short cut the promised land, but neither is it chopped liver.
At the opposite extreme is October 2000. At that juncture in the autumn of the new century, the previous decade delivered an annualized price rise of 16.3%. Once again, a naïve review of the chart tells us that the decade that had just passed in October 2000 was extraordinarily good to investors in the S&P 500.
If we extend the history lesson back through time, the larger message is that returns fluctuate. The great question, of course, is whether they fluctuate with any degree of predictability? Yes, although this answer comes with a truckload of caveats.
That starts with the reminder that the future is always and forever uncertain. You can't get blood out of a stone, or flawless predictions mined from historical data. But while no one can see the future with absolute clarity, estimating expected risk premiums isn't always a random crap shoot that's definitively hopeless. It's taken decades of financial research to establish this fact, as we discuss in some detail in our recent book Dynamic Asset Allocation. Better late than never.
What's the glitch? There are many. Arguably the first is that you can't look to any one predictor and rest easy. In other words, every risk premium estimation methodology is destined to fail at some point. Indeed, everything fails regularly. It's not always in advance, but as a general proposition, this caveat is a sure thing. As one example, the equity dividend yield is quite valuable for assessing the stock market's outlook, but it falls well short of perfect. But as we've discussed over the years, including here, keeping an eye on this metric is productive for strategic-minded investors intent on minimizing risk and maximizing performance. Certain times are better than others, in fact.
The crucial issue is diversifying the set of predictors so as to survey the future using tools that a) offer some degree of robust forecasting power; and b) don't all fail at the same time in the business cycle.
There's a growing array of research studies that documents the power and necessity of using an array of predictors. In the next issue of the newsletter, we review several recent additions to this worthy corner of financial economics. One of the key lessons is that investors should spend time evaluating and assembling a diversified mix of predictors. All the more so for managing a multi-asset class portfolio. Different asset classes rely to some degree on different predictors.
As for rolling 10-year returns and its relevance to the stock market's outlook: Yes, this too is one variable and it doesn't always offer timely information about expected return. In fact, it's fair to say that its forecasting powers are limited. But sometimes, those capabilities are unusually potent. There's always some reason to wonder in real time, of course, but it's a mistake to look away, particularly at extreme points.
The central challenge is looking for other variables that float when another predictor sinks. Alas, there is no optimal mix that fills all the gaps and delivers perfection in the aggregate. On the other hand, we can do better than simply throwing up our hands and hoping for the best. A careful review of the academic literature, along with real-world money management records, suggests no less. Therein lies our newsletter's raison d'être: dynamic asset allocation isn't a mug's game after all.
It's not always easy to fully explain why, or to cash in on the opportunity. But if you're willing to put in the time, and crunch the numbers on a mix of variables (we regularly look at more than 30), there's reason to think that enhancing the market portfolio's risk premium is more than the stuff of dreams.
ADP SAYS PAYROLLS SHRUNK (AGAIN) IN MARCH
Nonfarm employment slipped by 23,000 this month vs. February on a seasonally adjusted basis, according to today's update of the ADP National Employment Report. That's disappointing news, and it suggests that Friday's employment report from the Labor Department may be less than stellar. Or does it?
Maybe not. The consensus forecast for the government's Friday nonfarm payrolls number calls for a gain of 190,000, according to Briefing.com. That's a long way from -23,000 via today's ADP report. Why the wide gap? Joel Prakken, chairman of Macroeconomic Advisers, which co-publishes the ADP data, offers an explanation by way of CNNMoney.com:
Since employment as measured by the ADP Report was not restrained in February by the effects of inclement weather, today's figure does not incorporate a weather-related rebound that could be present in this month's [Bureau of Labor Statistics (BLS)] data. In addition, today's figure does not include any federal hiring in March for the 2010 Census. For both these reasons, it is reasonable to expect that Friday's employment figure from the BLS will be stronger than today's estimate in the ADP National Employment Report.
The ADP press release also cites weather issues, advising:
…today’s figure does not incorporate a weather-related rebound that could be present in this month’s BLS data. In addition, today’s figure does not include any federal hiring in March for the 2010 Census. For both these reasons, it is reasonable to expect that Friday’s employment figure from the BLS will be stronger than today’s estimate in the ADP National Employment Report.
Hope still springs eternal, or at least until Friday's news on the Labor Department's jobs report.
March 30, 2010
BONDS, STOCKS, JOBS & YIELDS
The 30-year bull market in bonds is fading, predicts Pimco’s Bill Gross, according to Bloomberg News. We've heard that one before. In fact, we've suspected no less for some time. In our newsletter and on these pages we've made the case that the path of least resistance for interest rates is probably up from here on out over the long haul. We continue to expect no less. But the same challenge lurks: timing.
Looking at the history of the benchmark 10-year Treasury yield, as we did two years ago, implied that the long decline in interest rates from the early 1980s to the present was near an end. But then things happened, namely, the Great Recession and the near-collapse of the global financial system. That introduced a potent new round of bullish momentum into bond prices, primarily government bonds. In turn, yields dropped sharply. The end was no longer near.
Fast forward to the waning days of March 2010 and we find ourselves again considering the end of the great bull market in bonds. We're not alone. We may even be right in the sense that yields are set to begin an upward journey for an extended period, perhaps for years. But we remain humble in deciding when exactly the future begins.
Long-term rates are "finally on [the] verge of breaking out," wrote Michael Kahn, co-manager of the EAS Genesis Fund, on Barrons.com yesterday. Perhaps, although the fate of rates is still tied to the pace and depth of the economic recovery. And on that front there's still debate. But as we struggle to figure out what's coming and when, it's still all about jobs, or the lack thereof.
"The Fed doesn't usually raise rates until 12 months after unemployment peaks," Bob Whalen, principal at Tower Bridge Advisors, tells USA Today. "That means we'll see an increase in rates sometime before the end of the year."
As we wrote yesterday, this Friday's update on nonfarm payrolls for March is widely expected to show a net gain in jobs. If so, that will be only the second month of net job creation since the recession began in December 2007. And, if the consensus outlook is correct, Friday's news will be more than a token gain for the labor market.
It's hard to gauge how relevant Friday's update on jobs will be for the capital markets, but we're guessing that the stakes are fairly high, one way or the other. A surprise on the upside could very well bring higher rates fairly quickly, delivering stinging losses to bonds. Stocks, meantime, would likely rally on the news, and perhaps deliver a fresh round of gains for some period after.
Of course, a disappointing jobs report on Friday would likely bring the opposite: another rally in Treasuries (accompanied by lower yields) and a fair degree of selling for equities. (Keep in mind too that the stock market will be closed on Friday, but the bond market will be open.)
We're speculating, of course, and so all the usual caveats apply. Holding stocks and bonds still makes sense, as long as uncertainty lurks. The debate is always about how much to hold of this or that, and in what form. Asset allocation, in sum, is a perennial favorite point of discussion, not to mention an ongoing driver of results.
Meantime, this much is clear: the labor market may be at a crucial juncture. It's been more than two years of virtually non-stop job losses. Is patience (and hope?) running thin?
The bond market is starting to smell a recovery of sorts for nonfarm payrolls. As such, perhaps it's all quite cut and dry at this stage. Good economic news will be bad for bonds, and good for stocks. But if the labor market continues to falter, bonds will rise and stocks will stumble. Same old, same old, albeit with some potential complications, as Salon.com's Andrew Leonard explains:
A good job number will be bad for treasuries, because of fears that the Fed will tighten monetary policy by raising interest rates. Bad news for treasuries, theoretically, is bad news for the government, because borrowing costs will rise, thus placing even more pressure on government finances.
But one reason why the government is borrowing a lot of money, aside from the various left-over unfunded profligacies of the Bush administration, is to pay for the stimulus and the automatic increases in social welfare spending that are a direct function of the recession. A "much larger-than-expected gain in March jobs" would be the best possible signal that the economy might be about to turn the corner -- which would lead, in turn, to lower social welfare spending, higher tax revenues, less pressure for additional stimulus, and, ultimately, a lower deficit.
In other words, a key contributor to bond investor nervousness is a robustly growing economy, but a robustly growing economy is exactly what we need to assuage bond investor nervousness.
It's always the same… until it's not. Friday will tell us what constitutes reality du jour.
March 29, 2010
WILL GOOD FRIDAY BE GOOD TO THE LABOR MARKET?
Is the labor market finally set to create jobs on a sustained basis? If not, will the stock market continue to shrug off the delayed rebound in the labor market? Such questions promise (threaten?) to be topical this week as Friday’s update on payrolls for March draws near. Whatever the answers, there's a bit of timing glitch.The stock market will be closed for Good Friday and so equity traders will have to wait till the following Monday to react to the news.
Meantime, the consensus forecast calls for a 190,000 rise in nonfarm payrolls for March, according to Briefing.com. Briefing’s internal forecast is far lower but still positive: +75,000.
A gain of any degree is sorely needed at this point. February payrolls dipped modestly by 36,000, the Labor Department reported. As we noted earlier this month, winter storms were reportedly the culprit for keeping a lid on labor market gains. As for March's weather in the U.S., it's been wet, but blaming the weather won’t wash this time around.
Other than last November’s slight gain, the nation’s nonfarm payrolls have shrunk in every month since January 2008. To fully grasp the depth of the fallout in the labor market in terms of how it compares with previous recessions, consider the chart below, which comes from analysis published by the Minneapolis Federal Reserve. The red line at the bottom of the chart is the percentage change in employment since the recession began in December 2007. Relative to every previous recession since 1948, the current hole in lost jobs is unusually deep. In addition, the trend in job destruction this time suggests that repairing the damage will take longer compared with the past 60 years of economic recovery.
The decline in employment over the past 24 months is obviously way out of line with fall and rebound trends in the post-war history in the U.S. "It has generally taken a little over a year for employment to bottom out," writes UCLA economist Edward Leamer in last year's Macroeconomic Patterns and Stories: A Guide for MBAs, which relies on data published just prior to the Great Recession. But the momentum in job loss is now more than two years old, suggesting that economics textbooks on such matters need to be rewritten. The same might be said for investor expectations.
On the bright side, there’s quite a bit of hope among economists that the long road to recovery in the labor market is finally poised to begin. The recent rise in corporate profits is one reason. Friday's news that corporate profits rose by 8% in last year's fourth quarter--and delivering the biggest year-over-year gain in 25 years--inspires thinking positively in terms of jobs.
"Profits are a leading indicator of the economy and suggest continued growth and likely job gains in the second quarter of this year," opines John Silvia, chief economist at Wells Fargo Securities. Meantime, Jonathan Basile, an economist with Credit Suisse, says: "The fact that you see a sustained recovery in profits over the last four quarters, that's a vote of confidence that the next phase of the recovery could be upon us. And that phase is when companies begin to spend those profits, with more investment and more hiring."
Another reason for optimism comes in this morning’s update on consumer spending, which rose 0.3% last month—the fifth straight month of gain, according to the Bureau of Economic Analysis. "Spending is a function of the labor market, and we believe the labor market is improving right now," Dean Maki, chief U.S. economist at Barclay’s Capital, told Bloomberg News before the report. "That improvement in income growth will provide some support to consumer spending going forward."
After the income and spending report was published, Chris Low, chief economist at FTN Financial, advised via Reuters: "I guess the big takeaway is that consumers are comfortably consuming again. We have positive numbers five months in a row since October, which I guess is a good sign."
But there's also a warning sign in today's personal income and spending report: incomes were flat. Looking at the spending and income trends from last July, to take a month at random, shows that personal consumption expenditures have risen twice as fast as disposable personal income: 2.8% vs. 1.4% (annualized seasonally adjusted data).
How long can spending outrun income? The answer depends partly on when the labor market begins posting gains on a sustained basis. The next clue arrives at the end of the week with the government's payroll update. Stay tuned…
March 26, 2010
TALKING ABOUT DYNAMIC ASSET ALLOCATION
The newly enacted health care reform legislation may be a net plus when it comes to expanding access to medical services, but it's not free, or at least not for taxpayers in the upper brackets and certain investors. The new health care reform "will raise taxes for many Americans," according to a report by RSM McGladrey, a consulting firm in Atlanta.
The two new pieces of legislation that comprise the health care reform "significantly increase taxes on individuals with higher incomes and those with more costly health insurance plans," says Mike Metz of RSM's vice president of tax services via the firm's web site.
The overall cost of the reform for the next decade is roughly $940 billion. "To pay for these changes," Metz continues, "the bills impose $438 billion in new taxes and fees on insurers, businesses and individuals. The remainder of the cost is paid for by cuts in Medicare funding. The bills are expected to reduce federal deficits by $143 billion over the next ten years. The bills are also expected to expand health insurance coverage to 32 million individuals."
RSM's web site goes on to report...
The bills significantly increase taxes on individuals with higher incomes and those with more costly health insurance plans. At the same time, the bills provide significant tax credits for some individuals and small businesses, including:
• a credit to qualifying small businesses to reimburse them for the cost of providing health insurance to their employees, and
• a credit for up to 50 percent of investments made in 2009 and 2010 for new therapies to prevent, diagnose and treat acute and chronic diseases.
Considering the investment implications, the Aperio Group, a quantitative money management shop in Sausalito, California, projects the following changes to the federal marginal capital gains rate in terms of today vs. January 2013:
The not-so-subtle implication, according to Aperio, is that returns on tax-inefficient investments, such as bonds, active equity strategies and hedge funds, are set to shrink, all else equal.
Speaking of taxes, the Tax Foundation yesterday published its 2010 Facts & Figures Handbook. Among the taxing tidbits in the booklet is a ranking of tax burdens by state. The top three with the highest combined state and local tax burdens for fiscal year 2008:
New Jersey: $6,610
New York: $6,419
And the bottom three:
West Virginia: $3,000
The U.S. overall weighs in at $4,283.
GDP ROSE 5.6% IN Q4 2009
The economy grew by 5.6% at a real annualized rate in the final three months of last year, the U.S. Bureau of Economic Analysis reported this morning. Today's update is the third and final estimate of Q4 2009 GDP. The first estimate was 5.7%; the second was 5.9%. Although the final number has been revised down from the previous estimates, the 5.6% gain in GDP for the last three months of 2009 is the highest pace since the 6.9% gain in Q3 2003.
The government's initial estimate of this year's first quarter GDP is scheduled for release on April 30. "GDP isn't expected to have gone up by as much in the first three months of 2010" compared with Q4 2009, The Wall Street Journal reported today. Early estimates for 2010's first quarter GDP range from 2.5% to 3.0%, according to the article.
IS THE HOUSING MARKET RECOVERING?
The Fed is talking about an exit strategy these days, including selling its existing stockpile of mortgage securities, which it purchased in large quantities over the past 18 months to boost the sagging fortunes of the housing industry. It may be coincidence, but the Obama administration is reportedly rolling out a new program to address the still-high rate of foreclosure in the residential housing market.
"We would like to get back to an all-Treasury portfolio within a reasonable amount of time," Fed chairman Bernanke said yesterday in testimony in a session of the House Financial Services Committee. But not any time soon. We're unlikely to see an imminent unwinding of the central bank's massive portfolio of mortgage-backed and debt securities issued by Fannie Mae and Freddie Mac. The reason is hardly a secret. The real estate market is still weak, as suggested by the latest updates on new home sales and existing home sales.
But new purchases are reportedly set to end. "The Fed is on track to shut down a $1.25 trillion mortgage-securities-buying program at the end of this month," the AP reports.
Meantime, the housing market remains a drag on the economic recovery. Echoing the troubles in the labor market, the housing industry, while no longer contracting across the board at a steep rate, isn't yet showing clear signs of health. Recognizing the challenge, the White House is moving ahead with a fresh effort to stem the tide of foreclosure and the related financial turmoil it brings to homeowners.
The Obama administration has "recognized that the complexion of the mortgage crisis has changed," Howard Glaser, a mortgage industry analyst, writes in a note to clients, according to Reuters. "This is no longer about risky subprime loans -- its about home value declines that have made default a rational economic choice for homeowners."
It's not hard to find supporting evidence for Glaser's concern. In Massachusetts, for instance, the pace of foreclosure rose last month vs. January. Today's Boston Globe explains:
More than 2,000 Massachusetts homes went into foreclosure in February, a sign the state’s housing problems are not going away soon.
The number of foreclosure petitions, the first step in the process, increased 13.2 percent to 2,122 from January, according to data released yesterday by the Warren Group, which tracks real estate. Though the number of petitions was down 7.5 percent from the same month in 2009, the figures still point to a steady flow of homeowners who are struggling to pay their mortgages, said Timothy Warren Jr., the firm’s chief executive.
"The petitions are a leading indicator of people getting into trouble," he said. "It remains at a fairly high level."
The data for foreclosure deeds, the last step in the process when a lender takes back a property, were mixed last month. The number of deeds dropped 19.6 percent to 917 in February, compared with the January figures, but increased 10.4 percent from the same month a year before.
The number of foreclosure auctions tracked by the Warren Group more than tripled in February to 2,771, compared with the same month last year.
Recognizing that foreclosure remains a challenge, Bank of America earlier this week announced it would start forgiving a portion of mortgage loans. This isn't necessarily an act of charity—The Wall Street Journal reports that BoA is "under pressure by Massachusetts prosecutors."
In any case, no one doubts that the housing market is struggling. In fact, some economists say that the real estate recovery, such as it is, may be at risk, according to an Associated Press story published this week:
Only a few months ago, the housing market had been showing signs of strength as it recovered from the most painful downturn in decades. Much of the improvement, though, came from government programs that held down mortgage rates and provided tax breaks for buyers. Since the fall, sales have sunk. And the government support is running out.
The latest sour news came Wednesday, when the Commerce Department said sales of new homes fell last month to their lowest point on record. It was the fourth straight drop.
"While bad weather could well have suppressed the February result, it was dismal no matter how one tries to slice and dice it," wrote Joshua Shapiro, chief U.S. economist at MFR Inc.
That news followed a report a day earlier that sales of existing homes fell for the third straight month in February, to their lowest level since July.
March 25, 2010
JOBLESS CLAIMS IMPROVE, BUT THAT'S (STILL) ONLY HALF THE BATTLE
This morning's update on initial jobless claims suggests that our previous anxiety over the recent rise in new filings for unemployment benefits was a false alarm. Good thing, too, since being right would have meant looking at a much bigger problem. Fortunately, the Labor Department reports today that new claims dropped last week to 442,000, or down 14,000 from the week before. Except for the first week of February, that's the lowest reading since this data series peaked in March 2009. A collective sigh is in order, or so it seems.
Was that the all-clear signal for the labor market? No, not by a long shot. But what today's report does suggest is that the population of the newly unemployed is declining once again, at least according to official statistics. That's a positive trend, although the pace of the decline remains sluggish by previous post-recession standards. But that's a different problem, and far from the biggest one for the labor market these days.
In any case, worrying that initial jobless claims had hit a floor, or was set to rise, isn't quite so compelling today. True, we'd prefer to see a new post-peak low to seal the deal—dipping below 400,000 would do the trick. But even the arrival of that minor milestone alone wouldn't say much about the prospects for job creation directly.
For much of the past year, the decline in new jobless claims has been a crucial sign for thinking that the economic contraction was slowing and that the overall business cycle trough was near. Indeed, the low point for GDP seems to be behind us. But then the trend last month offered some reason to second guess that assumption, in part because of the sideways action in jobless claims. But if that's no longer a concern, we're still stuck with the problem of growth--or the lack thereof. A labor market that's no longer deteriorating isn't the same thing as one that's expanding.
Initial jobless claims become less valuable as a relevant data point with each passing week at this stage of the business cycle. Yes, last year's persistent decline in new filings for jobless benefits retained its forecasting prowess in anticipating the technical end of the recession, which will probably be in 2009's second half, once the NBER gets around to officially identifying the recession's end. That's par for the course with initial jobless claims, based on its history of peaking ahead of cyclical troughs, as we discussed a year ago.
But at this point, the trend in new jobless claims is less important. In fact, it's safe to say that its main value is one of signaling a fresh round of trouble ahead—if it starts rising. If that's no longer likely, as today's numbers suggest, then the heavy lifting for evaluating the future shifts to various reports reflecting the labor market proper, such as nonfarm payrolls.
On that front, the best we can say is that the economy is no longer shedding jobs, at least not in significant numbers. But we're still waiting for signs that the economy can create jobs on a net basis for some period of time. So far, that critical point has yet to arrive. The next batch of evidence, for ill or good, arrives next week with the monthly jobs report for March. Meanwhile, optimism on the labor market is defined as recognizing that it's (still) not getting worse, and perhaps the trend is on the cusp of getting better, if only marginally. That's better than the alternative of decline and contraction, but it's still not good enough.
WHO IS JANET YELLEN?
The White House says that San Francisco Fed president Janet Yellen is President Obama's leading candidate for vice chairman of the Fed—the number two spot after Fed Chairman Bernanke. The open position comes by way of the retiring Fed governor Donald Kohn, who plans to step down in June. Meantime, Yellen says she'll accept if nominated.
It's also clear that Yellen's in no rush to raise interest rates. The key reason is the weak labor market. As she explained in a speech earlier in the week,
I’m happy to see evidence that the job market is turning around. The pace of job losses has slowed dramatically. Had it not been for blizzards back East, we might have seen payrolls expand in February. Temporary jobs are growing, and that’s usually a signal that permanent hiring is poised to rebound. I was heartened when the unemployment rate dropped in January to 9.7 percent from 10 percent the month before. I was further encouraged when the rate remained at 9.7 percent in February, suggesting it was not just a flash in the pan. In the months ahead, we could get a bump in employment from census hiring. But that, of course, would be temporary. Given my moderate growth forecast, I fear that unemployment will stay high for years. The rate should edge down from its current level to about 9¼ percent by the end of this year and still be about 8 percent by the end of 2011, a very disappointing prospect.
Some central bank observers worry that Yellen will be too soft on future pricing pressure. She's "dovish" on inflation, says Alan Meltzer, an economics professor at Mellon University and author of a multi-volume history of the Fed, including A History of the Federal Reserve 1970-1986.
Not so, counters Larry Meyer, head of Macroeconomic Advisers and a former Fed governor with a reputation as a hawk on monetary policy. He wrote a book about his tenure—A Term at the Fed: An Insider's View—and offers some observations about Yellen. Both were Federal Reserve governors on the interest-rate setting Federal Open Market Committee for a time during the late-1990s. In his book, Meyer recalls one discussion on price stability. "In other words, what level of inflation should the FOMC short for—and why?" He continues,
Janet Yellen, who had taught economics at Harvard, the London School of Economics, and most recently at Berkeley, was the first to address this question. She was very much respected by the members of the Committee, the staff, and the Chairman. I soon became her biggest fan on the Committee.
There is no doubt that low inflation is advantageous, Governor Yellen began. But, she argued, there are also significant costs to very low inflation. If there is zero inflation, for instance, then monetary policymakers cannot lower the "real" interest rate below zero. A little inflation, therefore, gives monetary policymakers a greater degree of latitude to stimulate the economy, permitting them to drive real short-term rates into negative territory, if necessary, to stimulate the economy.
Further, she said, a little inflation "greases the wheels" of the labor market. Relative wages across different industries and occupations must be free to change, thereby signaling workers to migrate from one industry or occupation to another.
In recent days, Meyer continues to support Yellen, opining last week that she's the "best possible choice" for vice-chairman.
Larry Kudlow thinks otherwise. The supply side economist and television talk-show host quips that " Yellen Is Spellin' Future Inflation." In a recent column, he writes,
The president has nominated Janet Yellen to be vice chair of the Federal Reserve. Yellen is a distinguished economist who unfortunately subscribes to the Phillips-curve model that trades off unemployment and inflation. In other words, rather than excess money creation as the cause of rising prices, she focuses on the unemployment rate, the volume of new jobs being created and the growth of the overall economy. For Yellen, inflation is caused by too many people working and too much economic prosperity.
Meantime, what does Yellen think of the healthcare reform legislation that the President signed into law earlier this week? In particular, is she concerned that it might boost the red ink on the federal government's balance sheet? No, she explains: "My guess is, without having done a detailed analysis, that it will not have very significant impacts over the next several years."
Ultimately, it matters not what Yellen thinks, or how Kudlow, Meltzer or Meyer see Yellen's role in monetary policy going forward. What matters is what the bond market thinks. It's not yet clear how this opinion will unfold, but the mystery will be solved soon. Stay tuned…
March 24, 2010
EURO WEAKNESS, DOLLAR STRENGTH & THINKING ABOUT ZERO
The debt problems of Greece and Portugal are punishing the euro, The Wall Street Journal reports. That's another way of saying that the U.S. dollar is rising sharply against the euro. ""Sovereign credit worries in Europe and Japan are leading to some general risk aversion," Michael Malpede, a market analyst at Easy Forex in Chicago, tells Reuters.
What's interesting about the euro's current troubles is that the currency was the darling of forex not that long ago. As the chart below shows, back in early 2008, the world couldn't get enough of the euro, or so it seemed from a dollar-based perspective.
But currencies are a volatile beast, and so today's accepted wisdom is tomorrow's radical idea. So it goes in forex. The euro started out at parity with the dollar more than a decade ago; it reached roughly $1.60 about two years ago. Is it headed back toward a buck? Probably, or at least if that's the future, it shouldn't come as a great shock.
It's long been standard in financial economics for thinking that the expected return on currencies in the long run is zero. But that "consensus," which is far from universal, ends the agreement over how to treat currencies. Even for those who agree that the expected return is zero, there's debate about whether that implies that hedge forex risk is prudent ("The Free Lunch in Currency Hedging: Implications for Investment Policy and Performance Standards") vs. avoiding the expense of hedging ("Currency Hedging over Long Horizons")
If that's not sufficiently complicated for assessing forex in a strategic-minded portfolio setting, there's the overlay issue of whether we should treat currencies as a separate and distinct asset class or not. And if we should see currencies as a equal to stocks, bonds, commodities, and real estate, should the currency beta be actively or passively managed?
Well, for now, let's recognize that it's devilishly hard to make money in a randomly chosen currency over the long haul by simply buying and holding it. The empirical record suggests that the long run return really is zero, as a general proposition. That doesn't mean you can't make money in trading currencies, or that forex-related strategies like the carry trade aren't productive, particularly in a multi-asset class portfolio.
Meantime, no one should be shocked, shocked to find that the euro isn't set to climb indefinitely, or that the dollar weakness of recent years, must run to zero. There's a lot of light and heat in forex, but when the dust clears, we're often right back where we started. Not always, but enough of the time to raise questions about the latest forecast du jour.
DURABLE GOODS ORDERS RISE FOR THIRD STRAIGHT MONTH
This morning’s update on new orders for durable goods reminds that the cyclical forces of recovery are bubbling. It’s still unclear how deeply and how soon the recovery will spill over into the labor market. As long as that uncertainty persists, there's some doubt about strength of the economic rebound overall. Meantime, it’s clear for the moment that the trend in the manufacturing sector continues to claw its way back from the steep losses of 2008.
New durable goods orders on a seasonally adjusted basis rose 0.5% in February, the government reports. That's well below January's 3.9% surge, but for the last three months this series has posted gains. Excluding the volatile transportation sector, new orders increased 0.9 percent in February; and if we ignore defense, the jump was even higher last month at 1.6%.
Three straight months of gain, along with substantially higher levels of new orders vs. a year ago, is an encouraging sign for the industrial corner of the economy. "Orders are generally believed to be a front runner for activity in the manufacturing sector because a manufacturer must have an order before contemplating an increase in production," explains Brian Kettell in Economics for Financial Markets .
Although the monthly reports for this series are notoriously volatile, the broad trend offers convincing clues for what lies ahead. By that standard, the ongoing rise over the past year suggests the rebound in manufacturing is more than a quirk. As our chart below shows, new orders for durable goods last month were nearly 11% higher compared with the level in February 2009. That's the biggest year-over-year gain in nearly four years (based on monthly data).
"Persistent strength in durable goods orders should be taken as a sign that both consumers and businesses are confident enough in the economy to engage in spending on big-ticket items," writes Pimco's Tony Crescenzi in The Strategic Bond Investor.
It's still debatable if durable goods orders are truly on a "persistent" uptrend, although the case for thinking optimistically is a bit stronger in light of today's report. "The business sector has been the strongest piece of the U.S. economic backdrop, an encouraging indication that the seeds of an organic growth dynamic are taking root and the recovery will continue," according to Julia Coronado, senior economist for BNP Paribas, via MarketWatch.com.
Business spending on new equipment, inventory restocking and a pickup in global demand mean companies from Boeing Co. to Owens-Illinois Inc. can look forward to sustained sales gains. A pickup in employment is needed to broaden the expansion as the economy heals from the worst recession since the 1930s.
"Businesses are ready to invest not just in inventories, but in equipment as well,” said Lindsey Piegza, an economist at FTN Financial in New York, who accurately anticipated the gain in orders. “These will be some of the key drivers of growth going forward."
But while the industrial sector continues to improve, it's still unclear how soon the recuperating process will spill over into the labor market. Either the recovery in manufacturing helps nurture an expansion in job creation, or the weak labor market puts a lid on the incipient mending in the industrial sector. Today's news on durable goods, along with other positive signs, indicate there's reason to stay optimistic in spite of the rough period of late in the labor market, as we discussed here and here, for instance.
The next installment of confirmation (or not) that the long-awaited rebound in the labor market is here arrives with tomorrow's news on initial jobless claims, followed by next week's update on nonfarm payrolls for March.
March 23, 2010
A RAINBOW OF RISK FACTORS
In the six decade-history of modern finance, the basic lesson is that risk matters. Managing risk, in other words, is more productive than chasing return. But what exactly is risk? Alas, there are no easy answers, but at least there’s a beginning.
Financial economics has been uncovering what risk means for decades, refining our understanding of financial hazard and, more importantly, how it’s priced and what it all implies for portfolio design. At the basic level, market risk—beta—is the elephant in the room. Unless you’re willing to hold extreme portfolios—a handful of securities, for instance—beta will cast a long shadow over risk and return.
Long but not absolute. Market beta can’t be dismissed, but neither does it tell the whole story. There are other risk factors under the sun, and several are worth considering for most investment strategies. It’s widely accepted that asset pricing is driven by multiple risk factors, albeit in varying degrees. But which ones should we consider? As a starting point, there’s a trio worthy of routine focus when it comes to designing and managing equity portfolios.
“Most investment practitioners believe that there are three factors that explain security returns and that these factors correspond to the Fama-French three-factor model,” writes Professor Craig Rennie in the Handbook of Probability. “This model suggests that beta, growth opportunities (usually measured by firms’ market-to-book ratios), and firm size determine most of the differences in expected returns of risk assets.”
In other words, a large if not dominant degree of how your stock portfolio performs over time is a function of the exposure to three risk factors: the equity market overall, small-cap stocks, and value stocks. By adjusting this mix, you can engineer higher expected returns relative to owning a conventional market-cap index fund. In other words, holding small cap stocks and/or value stocks in excess of their market-cap weights boosts expected return. In fact, if you analyze equity mutual funds that “beat the market,” you’ll find that most have done so by overweighting the small-cap and/or value factors. This isn't guaranteed, of course, but then again nothing else is either when it comes to risk factors. And even if the 3-factor risk model pays off over the long run, as history and a small library of research suggests, the associated risk payoff is likely to come in fits and starts.
There are other factors, of course. A popular fourth factor is momentum, or the tendency of stocks with gains in recent history to continue rising, and vice versa. “If you form portfolios on stocks that have gone up in the last year, this portfolio continues to do well in the next year, and vice versa,” notes Professor John Cochrane in the Handbook of the Equity Risk Premium. Mark Carhart was the first to extend the Fama-French 3-factor model with momentum, a.k.a. the 4-factor model.
In fact, momentum as a factor reached a milestone of sorts by way of formal targeting in publicly available index funds. AQR Capital Management launched a trio of momentum-based index funds last year. Reportedly, these are the first of their kind for the general investor.
Stepping back and considering the four factors, the implication is that there’s greater opportunity for managing risk on a more granular level. In turn, there’s more opportunity for generating a return above what’s offered by a conventional market-cap index funds. In fact, there are more factors to consider, such as volatility, dividend yield, etc. There’s also an expanding menu of products that zero in on specific risk factors.
In a world of multiple risk factors, the central challenge is managing the mix through time. For most investors, this is a challenge that threatens to overwhelm, depending on how many factors you target. In addition, there’s the possibility if not the inevitability of making serious errors in emphasizing this or that factor at the wrong time. In sum, the possibility of earning something less than the market portfolio’s return is matched by the chance for earning more for the average investor.
Yes, it’s still all about risk. Asset pricing research has turned up amazing insights over the years, offering investors a deeper understanding into the sources of risk premiums. But the fundamental lesson remains: the chance for earning a higher return comes linked with the chance of earning less than you would with a simple market-cap index fund.
What’s more, you’ll have to work harder at earning a bigger risk premium. As I explain in Dynamic Asset Allocation, there are lots of moving parts to managing money in a world of multiple risk factors. Relatively few who venture down this path will succeed on a net basis (i.e., after taxes, trading costs, etc. and adjusting for risk). The first question in the money game is asking yourself: Am I smarter than the average investor?
March 22, 2010
ECONOMISTS & HEALTHCARE REFORM: WHAT ARE THEY SAYING?
Here's a brief (very brief) sampling that caught your editor's eye, for one reason or another...
I like to think of the big tradeoff as being between community and liberty. From this perspective, the health reform bill offers more community (all Americans get health insurance, regulated by a centralized authority) and less liberty (insurance mandates, higher taxes). Once again, regardless of whether you are more communitarian or libertarian, a reasonable person should be able to understand the opposite vantagepoint.
In the end, while I understood the arguments in favor of the bill, I could not support it. In part, that is because I am generally more of a libertarian than a communitarian. In addition, I could not help but fear that the legislation will add to the fiscal burden we are leaving to future generations. Some economists (such as my Harvard colleague David Cutler) think there are great cost savings in the bill. I hope he is right, but I am skeptical…My judgment is that this health bill adds significantly to our long-term fiscal problems.
No piece of legislation as complex as the health care reform bill can avoid a whole variety of unintended consequences. Elsewhere, I and others have noted that a provision in the law appears to create strong incentives for businesses not to hire poorer, single mothers who will need subsidies to afford family-covering health insurance. Among the other unintended consequences of the health care reform legislation are its possible effects on small health insurance providers.
The support for the bill coming from the major insurers should be one piece of evidence that they expect it to be good for them, particularly due to the provision that requires Americans to buy health insurance. In addition, as is the case with almost all regulation, larger firms are better able to absorb the fixed cost of compliance than are smaller firms. Given that this bill authorizes the hiring of over 16,000 new IRS agents to enforce its tax code provisions, such compliance costs are sure to be high, which will have a higher relative burden for the smaller firms.
It has been a long slog, since those days in the early 1990s when right-wing policy analysts proposed an individual mandate to purchase health coverage as a respectable, market-oriented, responsibility-based alternative to either government-provided health care (the nanny state) or mandated employer-provided health care (the boss state). In November, 2004, Republican Governor Mitt Romney of Massachusetts followed through on that conservative proposal, and in April, 2006 he signed into Massachusetts law a health reform plan based on it.
Having conquered Massachusetts, RomneyCare is now the law of the land. But how did Republican RomneyCare become Democratic ObamaCare?
True, the copy is not exact. David Frum points out all the possible reasons--valid and invalid, important and unimportant--that conservatives might be unhappy with this Obama-Pelosi-Reid version of RomneyCare. He finds six:
1. it allows illegal aliens to buy health insurance with their own money; 2. the progressive taxes imposed to finance it will only become larger and more progressive as time passes; 3. a public option may be added to the bill at some point; 4. it imposes too many costs on small businesses; 5. it doesn't impose enough cost controls; 6. it expands the dysfunctional program that is Medicaid.
But these issues are minor compared to the big nut -- the essence of the reform -- which is that the insurance market has been restructured to remove those adverse-selection and moral-hazard problems that have broken our private insurance-based health-financing system. Americans are now being asked not to shirk their responsibilities but rather to act like adults: to take on the burden, to the extent they are financially able, of making sure that when they wind up at the hospital the cost of paying for their care is not loaded onto somebody else's shoulders.
Will the Obama Health legislation increase political opposition to immigration? I see an expansion of coverage for 30 million people in the United States. This must be an income transfer to this group and this means that taxpayers will cover this. Now, I do hope that preventative medicine will reduce this group's demand for costly emergency care but I do not know of a NBER quality health economics paper carefully documenting this optimistic claim.
Let's assume that the expansion of health care insurance coverage for the uninsured is an income transfer. If immigrants are over-represented in this group (or if this is even perceived to be true), will political opposition to immigration rise? The economics literature on the determinants of redistribution would say yes. Read the Alesina and Glaeser book. If you don't have time to read that, then read this . The ugly fact that emerges is that we are not generous when the recipients "look different" than us. Now, how big of a tax price will we collectively face because of this legislation? The CBO doesn't know the answer to this and I don't believe a word of the "scoring" that they do. Health economists will have plenty to do over the next couple of years.
HEALTH CARE REFORM & MARKET (IN)EFFICIENCY
One pundit notes that the lack of heavy selling today in equities (the S&P 500 was up about 0.5%) implies that the market "doesn't fear healthcare reform," via Andrew Leonard at Salon.com. Paul Krugman echoes the point on his blog: "if Obamacare is such a disaster for the economy, where’s the market reaction?"
Does this mean the market's efficient after all? Or, to take the opposite view: Is the market inefficient and therefore its muted reaction is a sign that healthcare reform is really bad news for the economy--bad news that the market doesn't perceive?
WILL HEALTH CARE "REFORM" REALLY LOWER THE DEFICIT?
The health care reform bill has passed the House and the only thing standing in its way from becoming law is the Senate. Although Republicans are expected to put up a fight, it’s unlikely that they’ll succeed in keeping the bill from the President’s desk, where Obama will sign it and proclaim victory.
Among the many questions that surround the health care legislation is cost. At a time when the U.S. budget is already saddled with hefty doses of red ink, there’s a growing debate about how the new health care bill will help, or hinder, the cause of fiscal probity.
Advocates of the legislation argue that the deficit will fall under with the arrival of health care reform as currently packaged. The bill is set to spend some $950 billion over the next decade, but it would also raise revenue. If you buy into the embedded assumptions in the legislation, the deficit outlook via the Congressional Budget Office will be lower, thanks to the various revenue-raising efforts.
"Could this really be true?" asks Douglas Holtz-Eakin, a former director of the Congressional Budget Office and currently the president of the American Action Forum, in a New York Times op-ed over the weekend. No, he warns. "The health care legislation would only increase this crushing debt," he predicts, offering several examples of why he thinks this is the future that awaits.
The Everyday Economist raises some doubts about whether the revenue raising assumptions in the bill will pan out. As one example, he considers the excise tax on “Cadillac” health care plans. But expecting this will generate revenue is premature because...
The tax is not implemented until 2013. This suggests that, in the near-term, firms that offer top-of-the-line insurance have an incentive to reduce the coverage extended to their employees to avoid the tax. This shift could potentially reduce health care spending as these individuals would then have to spend more in out-of-pocket costs – effectively raising the price and reducing the quantity demanded. Such a shift, however, would also imply lower tax revenue as these plans are eliminated.
Of course, even the analysis of the excise tax above makes important assumptions. For example, it was assumed that the tax was actually implemented and not repealed by subsequent legislation. In addition, the most vehement detractors of this provision have been labor unions as they tend to offer their members better benefits that could potentially be subject to the new tax. As a result, there has been discussion about creating an exemption to the excise tax for members of labor unions. Such an exemption, however, would result in lower tax revenue and a lesser reduction in health care spending.
But as a broad brush piece of legislation, supporters of the bill assert that net effect will be one of deficit reduction. "Americans think the bill is too expensive because they don't understand its cost controls," complains Ezra Klein of Newsweek. "The fact that the cost controls are complicated and numerous doesn't mean they're absent, or that they won't work." With that, he proceeds to offer a list of the bill's "best ideas" for controlling costs, including these two items:
Outlawing the bad kind of competition while enabling the good kind, which the bill does, is more than just a humanitarian measure. It's a cost control. The insurance "exchanges" imitate the market in which federal employees (including congressmen) purchase their health care insurance. Participating insurers can't discriminate based on pre-existing conditions, they have to answer to regulators if they attempt to jack up premiums, and consumers will be able to rate their insurers, a rating that everyone else will see when shopping for their insurance.
…The next cost control worth mentioning is an effort by Congress to solve the problem of, well, Congress. Medicare's cost problem is, in many ways, a political problem: Saving money means cutting someone's profits or someone's benefits, and politicians are afraid to do either.
Enter the Independent Medicare Advisory Board. Modeled off of the highly-respected (but totally toothless) Medicare Payment and Advisory Commission, IMAC is a 15-person board of independent experts chosen by the president, confirmed by the Senate, and empowered to cut through congressional gridlock. IMAC will write reforms that bring Medicare into like with certain spending targets. Congress can't modify these proposals, it can't filibuster these proposals, and if it wants to reject them, it needs to find another way to save the same amount of money. Making the process of passing tough reforms easier is the single most important thing you can do to make sure tough reforms actually happen.
None of this is swaying critics, including the Cato Institute's Michael Cannon, who argues that the new health care bill will boost the budget deficit by $59 billion.
In fact, no one really knows how the future will play out with the true cost of the health care. The legislation is so complicated, with so many moving parts, that it's virtually impossible to foresee how all its facets will interact and how this will change current estimates of revenues and costs.
Meanwhile, even if you don't fully understand the bill (and who does at this point?), one can maintain a healthy skepticism solely by recognizing that Congress has a poor record on matters of cost control. That's the nature of the beast. The optimistic view is that it's different this time.
March 21, 2010
IT'S ALL ABOUT HEALTH CARE LEGISLATION NOW
Here's something you don't see every day, via Bloomberg News:
"The bond market is saying that it’s safer to lend to Warren Buffett than Barack Obama."
What's the deal? As Bloomberg explains,
Two-year notes sold by the billionaire’s Berkshire Hathaway Inc. in February yield 3.5 basis points less than Treasuries of similar maturity, according to data compiled by Bloomberg. Procter & Gamble Co., Johnson & Johnson and Lowe’s Cos. debt also traded at lower yields in recent weeks, a situation former Lehman Brothers Holdings Inc. chief fixed-income strategist Jack Malvey calls an “exceedingly rare” event in the history of the bond market.
The $2.59 trillion of Treasury Department sales since the start of 2009 have created a glut as the budget deficit swelled to a post-World War II-record 10 percent of the economy and raised concerns whether the U.S. deserves its AAA credit rating. The increased borrowing may also undermine the first-quarter rally in Treasuries as the economy improves.
“It’s a slap upside the head of the government,” said Mitchell Stapley, the chief fixed-income officer in Grand Rapids, Michigan, at Fifth Third Asset Management, which oversees $22 billion. “It could be the moment where hopefully you realize that risk is beginning to creep into your credit profile and the costs associated with that can be pretty scary.”
This is more than just a strange quirk. Last week, Moody's warned that the U.S. may be in danger of losing it's triple-AAA credit status down the road. There's no imminent threat, but the clock is ticking. As Kansas City Star columnist Mark Davis advises, crunch time comes in 2013, when "the expected amount of interest will top 10 percent of tax revenues, by Moody’s forecast. And that’s the line in the sand. Beyond 10 percent, our AAA rating starts to wobble. It’s worth noting that Moody’s current forecast assumes interest rates don’t rise much."
Is this a serious risk? No, according to Treasury Secretary Geithner. It's simply a matter of reducing the deficit, he said last week. "This is completely within our capacity as a country to solve...it just requires that we find some political will to make those choices."
However the politics rolls out, it seems likely that all roads lead through health care spending, which is the crucial factor in deficits in the years ahead. On that note, one can be a pessimist or optimist, depending on how one views the health care bill that seems likely to pass the House this evening. Will this be a deficit-reducing piece of legislation, as supporters claim? Or is it just another factor that will drive red ink higher by expanding government's liabilities, as the skeptics predict? The true answer, we suspect, lies somewhere in the details of the byzantine health care bill that's now on its way to becoming law.
March 19, 2010
GREENSPAN'S BUBBLE REVIEW DU JOUR
"All bubbles burst when risk aversion reaches its irreducible minimum," former Fed chairman Alan Greenspan writes in a new paper—"The Crisis"—for the Brookings Institution. That minimum, he advises, arrives with "credit spreads approaching zero, though analysts’ ability to time the onset of deflation has proved illusive."
Is the maestro rethinking his long-held stance that central banks shouldn't try to address bubbles? Not necessarily, although he leaves room for debate. "Some bubbles burst without severe economic consequences, the dotcom boom and the rapid run-up of stock prices in the spring of 1987, for example," he advises, adding:
Others burst with severe deflationary consequences. That class of bubbles, as Reinhart and Rogoff data demonstrate appears to be a function of the degree of debt leverage in the financial sector, particularly when the maturity of debt is less than the maturity of the assets it funds.
I very much doubt that in September 2008, had financial assets been funded predominately by equity instead of debt, that the deflation of asset prices would have fostered a default contagion much beyond that of the dotcom boom. It is instructive in this regard that no hedge fund has defaulted on debt throughout the current crisis, despite very large losses that often forced fund liquidation.
Greenspan is now open to more financial regulation, according to his views in the paper, although he continues to argue that the unusually low interest rates that he engineered at the Fed in 2002-2004 weren't a mistake or a catalyst for the surge in markets. That's a debatable perspective, to say the least, as a number of economists argue, including:
• "The subprime crisis has its origin in Greenspan’s low interest rate policy."
"Subprime crisis: Greenspan’s Legacy," by Tito Boeri and Luigi Guiso
• "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."
"Origins of the Financial Market Crisis of 2008," by Anna J. Schwartz
Greenspan, however, doesn't accept such criticism. "Could the breakdown that so devastated global financial markets have been prevented?" he asks in his new paper. No, he argues…
Given inappropriately low financial intermediary capital (i.e. excessive leverage) and two decades of virtual unrelenting prosperity, low inflation, and low long-term interest rates, I very much doubt it.
Those economic conditions are the necessary, and likely the sufficient, conditions for the emergence of an income-producing asset bubble. To be sure, central banks have the capacity to break the back of any prospective cash flow that supports bubbly asset prices, but almost surely at the cost of a severe contraction of economic output, with indeterminate consequences. The downside of that tradeoff is open-ended.
But why not incremental tightening? There are no examples, to my knowledge, of a successful incremental defusing of a bubble that left prosperity in tact. Successful incremental tightening by central banks to gradually defuse a bubble requires a short-term feedback response.
But, policy impacts an economy with long and variable lags of as much as one to two years. How does the FOMC for example know in real time if its incremental ever greater tightening is impacting the economy at a pace the policy requires? How much in advance will it have to tighten to defuse the bubble without disabling the economy? But more relevantly, unless incremental Fed tightening significantly raises risk aversion (and long-term interest rates) or disables the economy enough to undercut the cash flow that supports the relevant asset prices, I see little prospect of success.
To be sure, there are no easy solutions when it comes to monetary policy in pre-crash periods. It's quite easy to inject liquidity after a market decline and claim some degree of results. It's far more of a gray area in the months and years before such events. Predicting the timing and magnitude of so-called bubbles, of course, is the problem. No one knows when, or if, such events are destiny until after the fact. That makes the idea of pre-emptive central banking policy challenging, to say the least.
Even so, that's not an excuse for dismissing the central bank's role in creating excess liquidity conditions that lead to economic imbalances. Central bankers are mortals, which means that their monetary prescriptions are less than perfect. Mistakes are inevitable. The question is whether we can learn from errors of the past? Maybe, although the first step is recognizing what went wrong.
Low interest rates alone weren't the cause of the upheaval in 2008. But arguing the opposite extreme is no less misguided.
March 18, 2010
IS UPSIDE ECONOMIC MOMENTUM SET TO BUBBLE?
The economy is struggling to regain positive economic momentum, according to recent readings of the Philly Fed’s ADS Business Conditions Index. Is it making any progress?
As the chart below shows, the ADS Index has been trending lower since late last year, suggesting that the headwinds to growth are building.
The index is “designed to track real business conditions” based on six indicators that are a blend of high and low frequency data, i.e., economic reports with frequent and relatively infrequent updates. The latest reading, however, shows an upturn, suggesting perhaps that the slump of late is about to turn.
One clue that the upturn may have legs comes by way the latest outlook for the Philly Fed's region, where the "manufacturing sector is continuing to show signs of growth," according to the current update.
In the wake of the Philly Fed manufacturing news, Bloomberg News advises:
Factories keep adding workers and increasing production to replenish depleted inventories and meet rising global demand. Gains in manufacturing may be the spark that ignites a broader economic expansion, leading to increases in payrolls and consumer spending.
“The manufacturing sector has been the one bright spot for the economy in recent months,” said Scott Brown, chief economist at Raymond James Associates Inc. in St. Petersburg, Florida. “Clearly a sustainable recovery will require an improvement in the jobs. We’re right on the cusp of new hiring.”
Meanwhile, the Conference Board today reported that its leading economic indicator (LEI) rose last month--the 11th consecutive increase. “The LEI for the U.S. has risen rapidly for almost a year now and it has reached its highest level," Ataman Ozyildirim, an economist at The Conference Board But, said in an accompanying press release. "The sharp pick up in the LEI appears to be stabilizing. As the economy moves from recovery into early phases of an expansion, the leading economic index points to moderately improving economic conditions in the near term. Correspondingly, the coincident economic index has been rising since July 2009, albeit slightly because of continued weakness in employment."
Another dismal scientist at The Conference Board said: “The indicators point to a slow recovery this summer." In the near term future, advised Ken Goldstein, "the big question remains the strength of demand. Without increased consumer demand, job growth will likely be minimal over the next few months."
The opportunity for fresh data supporting (or rejecting) optimism arrives next week with updates on durable goods orders (Wed), weekly jobless claims (Thursday) and the final estimate of 2009 Q4 GDP (Friday).
The clock is still ticking for a more convincing rebound, particularly with the labor market, which remains weak. But the clock is ticking slower than it otherwise would be if inflation was a threat, which it isn't, at least not based on the latest reading via today's CPI report, as we noted earlier.
"Tame inflation is the get-out-of-jail-free card for the Fed," opines Lou Brien, market strategist at DRW Trading via Reuters. Why does the bell toll for thee in slow motion? "Because as long as inflation stays low or trends lower as it's doing," he says, the Fed "can wait for the labor market to come back longer than they would if inflation was to start trending up." In short, the monetary liquidity flowing can roll on without worry of pricing pressures.
But the ticking may soon pick up the pace, as The Economist yesterday reported:
Dave Greenlaw of Morgan Stanley notes that one component explains all the decline in core inflation: housing. America’s Bureau of Labour Statistics measures the cost of home ownership by what someone would have to pay in order to rent the house he owns. Falling home prices and high vacancy rates are pushing rents down. Since rent and the estimated equivalent of rent for owners comprise more than 40% of the core index, this has a huge impact on the direction of core inflation. When housing costs are excluded, core inflation has actually risen, to 2.6% in February. Mr Greenlaw predicts that housing inflation will stop falling, spurring the Fed to raise rates later this year.
Maybe, although as Paul Ashworth of Capital Economics also tells The Economist, the weak labor market is the source of the feeble housing market. Unless you expect to see the labor market turn much stronger in the near term, the get-out-of-jail-free card will likely remain intact.
It's still all about jobs (politically and otherwise), and probably will be for many weeks and months to come.
IS IT GETTING BETTER? OR JUST NOT GETTING WORSE?
Sometimes the waiting game is the only game in town when it comes to evaluating the economic numbers du jour. That seems to apply to this morning’s updates in consumer inflation and weekly jobless claims. The news tends to be encouraging, but we’re still a long way from declaring victory.
The number of new filings for jobless benefits dropped last week by a modest 5,000 to 457,000, the Labor Department reports. That's a step in the right direction, given the recent concern that something more ominous was brewing. Yet jobless claims are still too high to offer comfort that the labor market's capacity for minting new positions is set to bubble. At least new claims aren't rising. Nonetheless, the threat of claims stuck in the 450,000 range continues to lurk, suggesting that the job creation process is still gummed up. Until we break below that level, it'll be hard to shrug off the risk.
Meanwhile, inflation remains subdued, based on today's inflation report. The consumer price index last month was unchanged from January, the Bureau of Labor Statistics advises. For the past 12 months, CPI inflation rose at a modest 2.1%.
Last month, the inflation report raised fresh concerns that deflation was again building a head of steam. In particular, core CPI (headline inflation less food and energy prices) slipped a bit in February. That was the first monthly decline in seasonally adjusted core CPI since 1982. A whiff of deflation, in other words, was in the air—again, as we wrote last month. In the wake of today's update, there's reason to think that last month's bout of deflation was an anomaly. Still, with prices overall edging up by the thinnest of margins, it's too soon to make definitive judgments one way or the other.
So it goes in evaluating current and future economic trends. With the great rebound from the abyss in late-2008 and early 2009 behind us, the heavy lifting of rebuilding the economy is upon us. Dramatic change, good or bad, seems unlikely for the foreseeable future. Instead, the back and forth of marginal adjustment may be with us for some time. The economy is struggling to pull free from a sea of debt on the balance sheets of government, businesses and consumers. On the plus side, monetary/fiscal stimulus, supported by the natural forces of cyclical recovery, is fighting the good fight.
We expect the forces of expansion to win, but the evidence of this triumph will come slowly, at times giving way to frustrating bouts of reversal. We've already seen this to some extent in jobless claims this year, as well as with consumer price. More of this backtracking is likely coming on various fronts.
Nonetheless, there are accumulating signs that the tipping point of expansion is near. It's going to be a struggle, to be sure. And much still depends on the labor market. Maybe the arrival of spring will be a catalyst. Heck, the economic cycle needs all the help it can get at this point.
A bit of good luck wouldn't hurt either. A surprisingly good report on the job front in the weeks and months ahead might just be the spark that gets us over the hump. Unfortunately, a negative surprise might bring the opposite. It's still precarious out there. Look out for falling shoes. But don't give up hope just yet.
March 17, 2010
REVIEWING THE EQUITY RISK PREMIUM
Estimating the equity risk premium is the holy grail of investing. That’s because the allocation to the stock market is, for most investors, the primary driver of risk in the portfolio. As a general proposition, one can say that the allocation to equities will (for good or ill) go a long way in determining the portfolio’s return in the long run, and perhaps over the short- and medium-term horizons as well.
No wonder, then, that here’s a lot riding on the outlook for equity returns above and beyond the risk-free rate, which we can define as short-term Treasury bills or, if you prefer, the 10-year Treasury Note. With that in mind, it’s always timely to take a fresh look at what financial economics tells us about projecting the equity risk premium. As a preview, there’s still precious little that’s new under the sun in strategic terms. Yet researchers keep chipping away at the nuances of asset pricing, and every now and then they turn up intriguing and perhaps useful clues for peeling away another layer of uncertainty in projecting risk premiums.
But the central challenge is unyielding. Professor Bradford Cornell sums it up this way in The Equity Risk Premium:
…the efficient market hypothesis is a kind of catch-22 of investing. Information that is predictable is worthless because it is already reflected in stock prices. The information that is valuable and can be used to make money is that information which cannot be predicted.
But investors require a risk premium to hold stocks, and history suggests the demand is sated. Not over every period in the short run, or in any given stock or even one stock market. The global equity risk premium, however, tends to be relatively durable, largely because global economic growth is reliably persistent over the long haul.
In fact, risk premia overall are linked the ebb and flow of economic conditions. As Professor John Cochrane explains in a chapter from the Handbook of the Equity Risk Premium:
Some assets offer higher average returns than other assets, or, equivalently, they attract lower prices. These “risk premia” should reflect aggregate, macroeconomic risks; they should reflect the tendency of assets to do badly in bad economic times.
In fact, lots of research tells us, backed up by the historical record, that the equity premium fluctuates. That’s not obvious by looking at the long-term record. Indeed, we know that the S&P 500 has generated a roughly 10% total return since 1926, according to Ibbotson Associates. (We can figure out the equity risk premium from this record by subtracting, say, the 3.7% annualized total return of 3-month T-bills over that span from the equity market gain.)
Yet looking at equity returns in smaller bites, such as 20-year periods, reflects a wider variety of annualized results, ranging from around 8% up to nearly 18%. Unsurprisingly, shorter time frames—five or 10 year rolling periods, for instance—harbor even more volatility in performance results.
Why does the equity risk premium vary? The basic answer is that investors require different risk premiums at different times depending on, well, lots of things. “When buyers demand increased compensation for risk, they pay lower prices, basically demanding that sellers compensate them for the increased risk that they see in owning stock,” writes Pimco’s market strategist Tony Crescenzi in his recent book Investing From the Top Down: A Macro Approach to Capital Markets. “By paying lower prices for stocks, buyers exact a 'premium' from the sellers of stock. Conversely,
when investors are risk-averse, they demand a smaller amount of compensation for the risks they see. This means that they become willing to pay higher prices, believing that equities carry relatively less risk than before. This happened in 1999 and 2000 when stock prices soared, with investors perceiving very little risk in owning stocks, a belief that was way off the mark.
The perennial challenge, of course, is developing some reasonable intuition about the period ahead. We can begin by considering the historical equity risk premium. This is naïve, of course, but it offers a reasonable benchmark as a starting point. But looking to the long-run past as the definitive guide to what’s in store over, say, the next 10 or even 20 years may be courting trouble.
How can we modify the historical risk premium to reflect something more realistic given the current conditions? There are no quick or fool-proof answers. In fact, we should look to a range of methodologies for some perspective. A full treatment is far beyond the scope here, but we might start by considering the Gordon growth model. Very briefly, quite a bit of academic study demonstrates that dividend yields and expected equity returns share a relationship, as our chart below shows. And if we consider current yield in context with its historical record of increase, we're beginning to scratch up some useful information.
If we take the current yield on the stock market (~1.7% at the end of Feb. 2010, according to Standard & Poor’s) and add that to the growth rate of dividends over the past 60 years—roughly 5%—we have an expected total return for U.S. stocks of 6.7%, or below the 9%-to-10% historical total return since 1926.
This is hardly the last word on looking ahead, but it’s a reasonable way to begin. But investors need to consider other factors as well. Academic research can be helpful in making forecasts. It’s no panacea, but the context is productive. But it's only the beginning. In fact, forecasting the equity risk premium is an ongoing chore, and one that requires continual reassessement, research and reflection.
With that in mind, here are some recent studies on the equity risk premium that are worth a look. Think of it as a taking a few more steps forward on the thousand-mile journey of prediction.
Out-of-Sample Equity Premium Prediction: Economic Fundamentals vs. Moving-Average Rules
by Christopher J. Neely, David E. Rapach, Jun Tu, and Guofu Zhou
This paper analyzes the ability of both economic variables and moving-average rules to forecast the monthly U.S. equity premium using out-of-sample tests for 1960–2008. Both approaches provide statistically and economically significant out-of-sample forecasting gains, which are concentrated in U.S. business-cycle recessions. Nevertheless, economic variables and moving-average rules capture different sources of equity premium fluctuations: moving average rules detect the decline in the average equity premium early in recessions, while economic variables more readily pick up the rise in the average equity premium later in recessions. When we simulate data with a habit-formation model characterized by time-varying return volatility and risk aversion relating to business-cycle fluctuations, we find that this model cannot fully account for the out-of-sample forecasting gains in the actual data evidenced by economic variables and moving-average rules.
Equity Risk Premiums (ERP): Determinants, Estimation and Implications—The 2010 Edition
By Aswath Damodaran
New York University - Department of Finance
Equity risk premiums are a central component of every risk and return model in finance and are a key input into estimating costs of equity and capital in both corporate finance and valuation. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. We begin this paper by looking at the economic determinants of equity risk premiums, including investor risk aversion, information uncertainty and perceptions of macroeconomic risk. In the standard approach to estimating equity risk premiums, historical returns are used, with the difference in annual returns on stocks versus bonds over a long time period comprising the expected risk premium. We note the limitations of this approach, even in markets like the United States, which have long periods of historical data available, and its complete failure in emerging markets, where the historical data tends to be limited and volatile. We look at two other approaches to estimating equity risk premiums – the survey approach, where investors and managers are asked to assess the risk premium and the implied approach, where a forward-looking estimate of the premium is estimated using either current equity prices or risk premiums in non-equity markets. We also look at the relationship between the equity risk premium and risk premiums in the bond market (default spreads) and in real estate (cap rates) and how that relationship can be mined to generated expected equity risk premiums. We close the paper by examining why different approaches yield different values for the equity risk premium, and how to choose the “right” number to use in analysis.
The Equity Premium in 150 Textbooks
By Pablo Fernández
I review 150 textbooks on corporate finance and valuation published between 1979 and 2009 by authors such as Brealey, Myers, Copeland, Damodaran, Merton, Ross, Bruner, Bodie, Penman, Arzac… and find that their recommendations regarding the equity premium range from 3% to 10%, and that 51 books use different equity premia in various pages. The 5-year moving average has declined from 8.4% in 1990 to 5.7% in 2008 and 2009. Some confusion arises from not distinguishing among the four concepts that the phrase equity premium designates: the Historical, the Expected, the Required and the Implied equity premium. 129 of the books identify Expected and Required equity premium and 82 identify Expected and Historical equity premium. Finance textbooks should clarify the equity premium by incorporating distinguishing definitions of the four different concepts and conveying a clearer message about their sensible magnitudes.
March 16, 2010
NO EASY ANSWERS IN THE AGE OF EASY MONEY
The key phrases in today’s FOMC statement from the Fed in reference to the outlook for interest rates: “exceptionally low” and “extended period.” Almost no one expected a change from the current zero-to-0.25% Fed funds target, although there was speculation that the wording might change. Not so. Bernanke and his crew want it understood that they’re going to keep rates low for quite a while, and they really do mean it.
The vote in favor of maintaining the status quo for the target Fed funds rate was nearly unanimous. There was one dissenting vote from Kansas City Fed president Thomas Hoenig. Although he voted against the FOMC’s let ‘er ride policy, the FOMC statement vaguely suggested that the dissent was over wording rather than the actual target rate. Maybe, maybe not. Here’s how the Fed release explained the matter: Hoenig “believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted because it could lead to the buildup of financial imbalances and increase risks to longer-run macroeconomic and financial stability.”
Does this mean that dissent on the FOMC has been reduced to debating rhetoric vs. rates? Maybe. In any case, it’s a moot point. Rates continue to hover just above zilch in the U.S. and look set to stay there for, well, an extended period.
Is that warranted? Hoenig seems to have his doubts. So does Joseph Carson, chief economist at AllianceBernstein, who says the Fed’s internal forecast anticipates 4% GDP growth this year and in 2011. “That growth expectation eventually has to follow through to their rate policy," Carson tells CNNMoney.com. "Hoenig's arguments are well founded; staying at a 0% funds rate while the economy is starting to grow will eventually lead to imbalances."
Perhaps, although it’s not top-line GDP growth that’s the problem so much as it is the ongoing weakness in the labor market. That doesn’t give the central bank a pass, of course. Unusually low rates left to roll on for an “extended period” may cause trouble down the road, even if job creation remains weak. In fact, we’d be surprised to find that the cheap money doesn’t come back to haunt the economy at some point. That doesn’t make raising rates any easier given the labor market; nor does it ease the anxiety about keeping the price of money at near zero. But it does remind that there are no easy decisions at the moment in the golden age of easy money.
ANOTHER FOMC DAY
Will they hike 'em today? Probably not. But the sight of a central bank raising interest rates is no longer unusual. Australia has been hiking the price of money recently and South Korea is reportedly set to begin its exit strategy. The Fed isn’t likely to join them today. The formal yeah or nay arrives this afternoon, when the FOMC releases a statement. But the aura of tightening hangs in the air.
But the aura isn't moving money at the moment. The futures market isn’t expecting any change. Fed funds contracts are currently priced for the status quo for the near term. The futures markets anticipates that rates will be higher in the second half of this year, but not by much.
But some intriguing clues are bubbling, according to Bloomberg News:
Money market interest rates at five-month highs show the Federal Reserve is laying the groundwork to siphon a record $1 trillion in excess cash from the banking system and sending a bearish signal on Treasuries.
Overnight federal funds rates rose to the highest since September and the cost to dealers to borrow and lend U.S. securities for one day more than doubled in the past month. Three-month Treasury bill rates rose last week to the highest since August.
The rise is a sign traders are preparing for tighter monetary policy as stimulus measures end. In the three months before the Fed started raising borrowing costs in June 2004, 10- year Treasury yields rose about 0.75 percentage point as bond prices fell. While higher rates mean increased borrowing costs for President Barack Obama, they also show growing confidence that the economic recovery is gaining traction.
“The Fed is definitely getting its ducks in a row,” said Mark MacQueen, a partner at Austin, Texas-based Sage Advisory Services Ltd., which oversees $7.5 billion. “There is no doubt that in the early phases of the Fed’s plan, the Treasury market could suffer.”
But for the moment the ducks are likely to stand pat. The only change will be the rhetoric in the FOMC statement, opines Greg Robb of MarketWatch.com. The "extended period" phrase in policy pronouncements of late that implied low rates as far as they eye could see, including this FOMC statement issued on January 27, may be retired, he writes. "Altering the wording would be a clear signal that the Fed is more sanguine about the economic outlook and believes ultra-low rates are no longer necessary -- and financial markets would react accordingly," Robb forecasts.
Sen. Dodd's new financial regulation package is out and about. What does it mean? What does it do? What will it change? Will it work? The analysis has only just begun. We can start by recognizing that the Dodd legislation aims to add "layers of oversight." It's already delivered layers of paper (the actual bill is 1,336 pages).
Here's how the NY Times profiled the new legislation: "The plan would create a nine-member council, led by the Treasury secretary, to watch for systemic risks, and direct the Federal Reserve to supervise the nation’s largest and most interconnected financial institutions, not just banks." That's a rather tall order, and it implies that the existing regulatory order, already a rather large and complex system, doesn't already address such issues, at least in theory. At least there's no claims to pursue world peace simultaneously.
In any case, we need to bit off this beast in small chunks. Let's take it slow, starting with this short Q&A from the Washington Post on the "6 key points of the financial regulation legislation."
March 15, 2010
IS A TRADE WAR BREWING?
Chinese Premier Wen Jiabao yesterday firmly rejected calls for a stronger yuan, which is widely credited for boosting the country's exports and maintaining its enormous trade surplus. “The Chinese currency is not undervalued,” he said on Sunday in Beijing. "We oppose all countries engaging in mutual finger-pointing or taking strong measures to force other nations to appreciate their currencies."
The Chinese have been asserting for some time that revaluing the currency was a non-starter. Earlier this month, China's central bank chief said as much, as we discussed here. Wen's comments yesterday only strengthen his country's resolve.
"I understand that some countries want to increase their exports," Wen said, "but I don't understand the practice of depreciating their currency and forcing others to appreciate theirs in order to accomplish this. I think this is a type of trade protectionism."
Paul Krugman didn't use the P word in his New York Times column today in "Taking On China" over its "policy of keeping its currency, the renminbi, undervalued." He didn't need to. It was hard to ignore the protectionist implications in Krugman's recommendation of imposing a temporary surcharge of 25% on Chinese imports coming into the U.S. "I don’t propose this turn to policy hardball lightly. But Chinese currency policy is adding materially to the world’s economic problems at a time when those problems are already very severe. It’s time to take a stand."
Perhaps, but protectionism, whether you call it that or not, comes with a fair amount of economic risk. Nonetheless, "Despite the economic arguments against it, protectionism has an undeniable political allure," write William Baumol and Alan Blinder in their textbook Macroeconomics: Principles and Policy. "It seems, superficially, to 'save American jobs,' and it conveniently shifts the blame for our trade problems onto foreigners."
For good or ill, noises from both Republicans and Democrats these days seem to favor some form of retaliation for China's artificially weak currency. According to BusinessWeek:
U.S. lawmakers, including Senator Charles Schumer, are proposing that China be hit with stiffer tariffs to compensate for the unfair export advantage they say comes from an undervalued currency. Economist Paul Krugman estimates that global growth would be about 1.5 percentage points higher if China stopped restraining the value of the yuan, and after Wen’s comments said the U.S. should consider putting a 25 percent surcharge on Chinese goods.
“Chinese officials are alone in their refusal to acknowledge that the yuan is undervalued,” Senator Charles Grassley, an Iowa Republican, said in a statement responding to Wen’s remarks. “If they choose to stick their heads in the sand, we’ll have to find another way to address this problem because it’s been going on for far too long.”
Expect more of this tough talk on trade policy in the U.S. as mid-term elections in November draw near at a time when the U.S. continues to suffer from a weak labor market and a risk of sluggish economic growth. "There's nothing off limits when election-time comes around, and China makes themselves an easy target," Ralph Cossa, president of the Pacific Forum at the Center for Strategic and International Studies, told AP.
But launching a trade war runs the risk of a conflict spinning out of control. Nations can retaliate, which can spur more action on the other side. Given the high degree of political anxiety in the world these days over economic affairs, the hazards of protectionism seem higher than usual. History certainly offers little support for thinking that a nation can launch a trade war and contain the blowback while reaping the lion's share of the game. It's also a myth that trade wars can be fought on a limited scale, by targeting a particular ill or country. Surgical strikes simply don't exist with protectionism, even on a small scale, in a globalized economy.
"Although a trade war may not be as destructive as a military warn," writes Randy Epping in The 21st Century Economy, "in both cases many suffer--often the very people the war was meant to protect."
In any case, it's misleading to think that a stronger yuan is the cure-all for what ails the U.S. A tempting idea, but one with limited mileage. China's export machine draws on more than a weak currency. Much more, as James Fallows explains in Postcards from Tomorrow Square: Reports from China.
Nonetheless, don't underestimate the potential fallout from a trade war, or its apparent solutions. Yes, the Chinese currency is a problem for the global economy. Launching a new round of protectionism almost certainly isn't the answer. The real challenge is coming up with policy responses that a) have a reasonable chance of success; and b) don't end up causing more damage than the original problem. There are no easy answers, of course, which is what makes protectionism's simplicity so appealing...and dangerous these days.
March 12, 2010
A TAXING EXPERIMENT
Supply side economics guru Arthur Laffer co-authored a book recently whose title is anything but subtle: The End of Prosperity: How Higher Taxes Will Doom the Economy--If We Let It Happen. This provocative title came to mind after perusing some freshly minted numbers from the Tax Foundation, which estimates what it would take to close the U.S. government’s fiscal 2010 budget deficit by adjusting federal income tax rates for individuals. That's not going to happen, of course. Not even close. But it's an interesting way to consider what we owe and what it would take to pay off the debt solely on the backs of individual tax payers--in one year. In this make-believe world, the adjustment, of course, would be an increase in tax rates, and by more than a trifling amount. So it goes when liabilities exceed revenue by something approaching biblical proportions.
One can debate the Tax Foundation’s assumptions, of course. And in the real world there are other means of closing the budget deficit. In fact, there’s no legal pressure to close it this year, or any time soon, for that matter. Economic reality imposes its own restrictions and limits, but that’s another matter. Meantime, here’s how the Tax Foundation summarizes its theoretical experiment:
Assuming deductions, exemptions and credits were kept the same as they are now, Congress would have to raise each personal income tax rate by a factor of almost two and a half to erase the 2010 deficit. Even in later years when the President's Budget predicts that the deficit will be "only" in the $700-to-$800 billion range, the rates necessary to close the deficit are untenable.
The CBO projects a budget deficit for fiscal 2010 of $1.3 trillion. According to the Tax Foundation, blotting out that red ink by way of higher personal income taxes—all in one year—would require more than doubling the current tax rates. For the upper income levels, a near tripling of the tax burden would be required, as the table below shows.
The chances of Congress raising tax rates to close the deficit in one year, much less having the President sign off on the idea, is about as likely as waking up on Saturn tomorrow morning. The Beltway boys and girls don’t usually favor politically self-destructive legislation. If anything, they’re partial to the opposite spectrum of legislative activity, which is part of what got us into this deficit trouble in the first place.
Yes, higher tax rates are coming, and may already be bubbling before they're formally announced, as we discussed last week. But higher rates are likely to come quietly in the night, as opposed to dropping out of the blue on Monday morning with a formal press conference announcing the change on the front steps of the Capitol. No doubt there'll be other changes, too, including cutting back on certain spending projects that lack a large and influential constituency, i.e., something other than Medicare, Social Security, etc.
In any case, the Tax Foundation’s quantitative “what if” review is a reminder of just how deep a hole that’s been dug and what it would take to climb out. Assuming we even try. History suggests that printing money is the political path of least resistance. And for good reason: it works, at least until the next election. And even then, there are limits, which is to say that it works until it doesn’t.
For the moment, the bond market has a high level of tolerance for fiscal impropriety. That’s largely a function of the political cover that flows from the deflation/disinflation blowback generated by the Great Recession. But tomorrow, as Scarlett once said, is another day. So too is what passes for tolerance.
A BIT MORE CONSUMPTION IN FEBRUARY
Retails sales last month rose 0.3%, the Census Bureau reported this morning. That’s an upside surprise compared to the consensus outlook, which predicted a 0.3% fall. So much for the idea that snow can keep consumers away from the malls, even if the weather was blamed for pinching the labor market last month.
In matters of consumption, February’s gain marks the second month of modest gain. Over the past 12 months, retail sales are up a respectable 3.9%. The recovery in consumption, it seems, is humming along nicely. And so it is, as long as you don’t search for too much perspective.
Much depends on how we crunch the numbers. If we look at the trend in actual retail dollars spent on a monthly basis (seasonally adjusted), the trend looks clear. As our first chart below shows, Joe Sixpack is spending considerably more than he was a year ago.
But if we’re looking for big-picture trends as it relates to the economic cycle, we need to look at more than just month-by-month dollar comparisons. Monthly percentage change is one option, although there’s quite a bit of statistical noise here. Looking at rolling 12-month percentage change helps filter out some of the noise and focus on the broad trend, many economists advise. This is no silver bullet, nor is any other lone piece of data. But as economist Joseph Ellis outlines in Ahead of the Curve: A Commonsense Guide to Forecasting Business and Market Cycles, it’s all about finding context. Looking at key economic variables with some perspective helps. With that in mind, consider our second chart below, which graphs retail sales on a year-over-year basis.
Clearly, retail sales have recovered on a percentage basis from the Great Recession. That’s not surprising, given the enormous monetary and fiscal stimulus over the past year. The challenge will be one of keeping the rebound intact. On that note, the modest slippage in the 12-month pace of change in recent months may be simply random behavior. But given the economic context of late, perhaps there’s something more ominous lurking in the trend. We simply don’t know. It all depends on how consumers act in the months ahead, and to some extent that will depend on the labor market.
"While we are not expecting the consumer to come roaring back in the near-term, improvements have been quicker than expected considering the still-distressed state of the labor market," according to Adam York, an economist for Wells Fargo Securities, via MarketWatch.com.
It’s still all about jobs, jobs, jobs, even if today’s it’s about conspicuous consumption.
OBAMA WILL NOMINATE JANET YELLEN AS FED VICE CHAIRMAN
The Wall Street Journal this morning is reporting that Janet Yellen is on the fast track to become the central bank's second-in-command replacement for the retiring Don Kohn.
Here's an excerpt from the Journal:
Ms. Yellen, president of the Federal Reserve Bank of San Francisco since 2004, has been a strong supporter of Fed Chairman Ben Bernanke's policies to fight the deep economic downturn.
Ms. Yellen, 63 years old, was chair of the Council of Economic Advisers from 1997 to 1999 under President Clinton, after serving as a member of the Fed's Washington-based Board of Governors for three years.
One of the more dovish policy makers among the Fed's 12 regional bank presidents, Ms. Yellen has been a key advocate of the Fed's policy of near-zero interest rates and a massive expansion of the central bank's balance sheet, even as some regional Fed officials advocate for pulling back the monetary stimulus more quickly.
Reacting to the news, Yoshio Takahashi, a fixed-income strategist at Barclays Capital in Tokyo, tells Reuters: "Given the fact Yellen is seen as most dovish among FOMC members, the market is likely to think that the Fed may take more time until it decides to raise interest rates."
Meantime, it looks like Paul Krugman will continue writing for the NY Times after all.
March 11, 2010
NO, WE'RE NOT MAKING THIS UP...
Greece has economic troubles, and the extent and breadth of those troubles only seems to worsen the more the outside world learns of what makes this country tick.
But enough pre-game show. This particular story speaks for itself. You're either drinking the Kool-Aid or you're not. Every economist (and armchair analyst) is his own for this one. Without further adieu, this from the NY Times...
Vasia Veremi may be only 28, but as a hairdresser in Athens, she is keenly aware that, under a current law that treats her job as hazardous to her health, she has the right to retire with a full pension at age 50.
“People should be able to retire at a decent age,” Ms. Veremi added. “We are not made to live 150 years.”
Perhaps not, but it is still difficult to explain to outsiders why the Greek government has identified at least 580 job categories deemed to be hazardous enough to merit retiring early — at age 50 for women and 55 for men.
Greece’s patchwork system of early retirement has contributed to the out-of-control state spending that has led to Europe’s sovereign debt crisis. Its pension promises will grow sharply in coming years, and investors can see the country has not set aside enough to cover those costs, making it harder for Greece to borrow at a reasonable rate.
As a consequence of decades of bargains struck between strong unions and weak governments, Greece has promised early retirement to about 700,000 employees, or 14 percent of its work force, giving it an average retirement age of 61, one of the lowest in Europe.
The law includes some dangerous jobs like coal mining and bomb disposal. But it also covers radio and television presenters, who are thought to be at risk from the bacteria on their microphones, and musicians playing wind instruments, who must contend with gastric reflux as they puff and blow.
And Greece may be an early indicator of troubles to come. Bigger countries like Germany, France, Spain and Italy have relied for decades on a munificent state financed by a range of stiff taxes to keep the political peace. Now, governments are being pressed to re-examine their commitments to generous pensions over extended retirements because the downturn has suddenly pushed at least part of these hidden costs to the surface.
WAITING (HOPING) FOR THE FLOOR TO GIVE WAY
The jury’s still out on the path of least resistance in the trend for initial jobless claims. Today’s weekly update is certainly a step in the right direction, although last week’s meager drop in new filings for jobless benefits falls far short of stellar, or convincing. The sluggish behavior of late in this series has kept us anxious for more than a month, and the number du jour doesn't change much.
Initial claims were 462,000 (seasonally adjusted) for the week through March 6, the Labor Department reported this morning. That’s down slightly from the previous week’s 468,000. But as our chart below reminds, it’s unclear if the broader decline that’s been in place for a year has stalled. In the dark art of reading recent history as a guide to divining the future, one can argue that the risk of a new surge in claims has diminished. If so, that’s encouraging, but we now must confront the more pressing question: When will the decline will resume?
This is no trivial matter, considering the value of initial jobless claims as one of several leading indicators for the economic cycle. (For some background, see our previous posts here and here. In addition, you can find some examples of the formal research on the subject here.) The best we can say at this point is that the jury’s still out on the big picture trend. Jobless claims are a volatile series on a weekly basis, and even over longer stretches, as the chart above reminds. But the time is running short when we can look at a sideways-moving trend in claims and dismiss it as statistical noise. All the more so at a time when the labor market's capacity for creating new jobs remains, at best, questionable, as the latest update in nonfarm payrolls shows.
Meanwhile, we take no encouragement from the trend in continuing claims, which tracks the population of folks who’ve been collecting jobless benefits for more than a week. This number is reported with a lag relative to initial claims, but the latest figure reported today supports the case for thinking that we may be moving sideways for some period of time in the job market overall. For the week through February 27, continuing claims rose by 37,000 to 4.558 million (seasonally adjusted). And as our second chart below shows, this series has been going nowhere fast so far this year.
But all’s not lost yet, advises James O’Sullivan, global chief economist at MF Global in New York. "The net rise in the last two months was because of temporary factors, notably weather effects," he tells BusinessWeek today. "Claims will likely have to resume a downward trend if payrolls are to improve, which we think will happen."
Hope springs eternal, or at least until next week's report.
March 10, 2010
A BROADER ARRAY OF RISKS & OPPORTUNITIES IN GLOBAL EQUITIES
The global equity market has cast a long influence on regional stock markets in recent years. Whether it was a bull market on steroids or the opposite effect, the gravitational pull of a broad-minded definition of the world’s equity market has been a major force in moving narrower slices of stocks. Is the long shadow of equity beta now in the process of transition? It’s a little easier to answer “yes” if we consider year-to-date total returns for the primary equity regions around the world.
As our chart below shows, performance so far in 2010 is a mixed bag. The developed markets in Asia and the U.S. are leading the performance race through March 9 with gains of roughly 3.5% each. At the losing end is Europe with a 3.5% loss.
It’s too soon to draw final conclusions, but so far at least there’s reason to wonder if a broader array of risk and return profiles are coming in stock markets across the globe. Such a future isn’t hard to rationalize if consider what appears to be shaping up as relatively divergent economic and financial futures depending on the corner of the world under discussion.
As the IMF recently reported in its latest economic outlook for the global economy, “growth performance is expected to vary considerably across countries and regions, reflecting different initial conditions, external shocks, and policy responses.” The report goes on to explain,
For instance, key emerging economies in Asia are leading the global recovery. A few advanced European economies and a number of economies in central and eastern Europe and the Commonwealth of Independent States are lagging behind. The rebound of commodity prices is helping support growth in commodity producers in all regions. Many developing countries in sub-Saharan Africa that experienced only a mild slowdown in 2009 are well placed to recover in 2010. Growth paths are diverse for advanced economies as well.
Is this something different from the usual variation? Indeed, there’s always a rainbow of results. It’s a big world, after all, and everything from central bank policy to tax rates to managing and regulating the marketplace differs. But those factors, and more, are arguably in overdrive these days and will remain so in the years ahead. One reason is that the policy responses to the global recession will vary to a wider degree over time. That’s not obvious based on the recent past, when the common theme has been a relatively coordinated policy response of rapidly lowering interest rates over a short period.
But while everyone was doing something similar in 2008 and 2009, it’s not unreasonable to wonder if a more varied mix of exit policies awaits. Economic conditions are likely to evolve in dramatically different ways for the foreseeable future. Divergence is already beginning to emerge. In Australia, for instance, the central bank has been raising interest rates since mid-2009 as the economy recovers at a relatively rapid pace compared with other industrialized nations. By comparison, U.S. monetary policy is expected to remain unchanged deep into 2010.
Meanwhile, there’s a substantial degree of difference in the debt structure around the world. Almost every country borrowed money to fund the liquidity injections, but the blowback from the red ink hasn’t been far from uniform. Britain, for instance, has will have an estimated fiscal deficit that’s more than twice as large (measured in relative terms against GDP) compared to Germany this year, according to a recently study published by Bank for International Settlements. Meanwhile, China’s fiscal red ink is expected to be just one-fifth of India’s for 2010.
One implication from all this is that if the global equity market delivers modest results in the years ahead, as some strategists predict, that relatively calm and mediocre exterior may hide a comparatively wider array of returns and risks bubbling on a regional and national basis. In turn, that means that there are greater opportunities for dynamically managing asset allocation. It also means that volatility and hazards are higher.
A more diverse world of equity results may be coming, but there’s still no free lunch on the menu.
March 9, 2010
A FED HEAD'S SOBERING ANALYSIS OF THE LABOR MARKET
We've heard this before but we need to hear it again. Today the message comes from Charles Evans, president of the Chicago Federal Reserve Bank. "A number of labor market issues… lead me to think this accommodation will likely be appropriate for some time," he said in prepared remarks delivered at a speech in Washington. In other words, the central bank will keep interest rates low for the foreseeable future. The lack of job growth is the main catalyst. How long will the easy money last? "I think six months is a good time period to say I think we'll have accommodative policy like we have today."
If this is what passes for optimism, and arguably it is, there's a case for thinking that the crowd needs to recalibrate its expectations. Indeed, there's more at stake than speculating on when the price of money will rise. Low rates this time are a reflection of structural problems in the economy, and even looking out six months doesn't necessarily change all that much, even if rates start to move higher by that point. Evans laid out the ugly details in his talk today:
The rise in long-term unemployment may have ramifications for the economy going forward. The likelihood of finding a job tends to decline as an individual remains out of work for a longer period. Partly this reflects the fact that those who typically have a difficult time finding work will tend to be unemployed longer. In this case, longer spells are a symptom rather than the source of an underlying problem. However, a long unemployment spell could itself cause deterioration in a worker’s skills, leaving some of the long-term unemployed with less bright job prospects even as the economy begins to revive. This could contribute to high average unemployment duration for some time.
One of the smoking guns for thinking this is the future that awaits comes by way of the duration of unemployment. "In February," Evans explains, "over 40% of the unemployed were in the midst of a spell lasting more than six months, by far the highest proportion in the post-World War II era."
The trend of rising duration this time around was graphically shown in a chart Evans used in his talk, which is reproduced below. The graph plots the jobless rate (horizontal bar) vs. the average length, or duration, of unemployment since 1947. The basic trend is that duration rises as the unemployment rate increases. When the Great Recession began, the jobless rate was roughly 5% and duration was around 17 weeks. In other words, we began the current contraction in a weakened state that was substantially worse than usual. And it's deteriorated ever since.
Indeed, the red dots in the chart above show the monthly statistics for 2008 and 2009. The bottom line: the jobless rate and the average length of unemployment are at the highest in more than 60 years. This is disturbing for obvious reasons, along with some not-so obvious ones. As Evans said, "The likelihood of finding a job tends to decline as an individual remains out of work for a longer period." The not-so-astonishing implication:
…long-term unemployment tends to lead to permanent earnings losses, particularly for those who have previously invested heavily in job- or industry-specific skills. So, high unemployment durations could have long-lasting effects on consumer confidence and demand.
In other words, there's a heightened risk "that the recovery in labor markets could be slow even as output returns to a well-established growth path," he said.
You didn't necessarily hear it here first, but rarely has the warning been so loud and clear from the central bank's upper ranks.
There is a long history in financial economics of documenting some degree of predictability in asset returns. So why aren't investors doing a better job of earning a risk premium? Is it because the prediction variables aren't so useful after all? Or maybe the evidence showing support of earning higher risk premiums requires looking at longer periods than is the norm. Another possibility is that investors overall are incapable of mustering the emotional discipline required for exploiting forecasting opportunities.
Of all the possibilities—and there are many—the weakest seems to be dismissing the prediction factors as irrelevant. As one example, an inverted yield curve has a long history of preceding downturns in the economy. This is widely documented and recognized. As economist Bernard Baumohl advises in his book The Secrets of Economic Indicators,
…once the [yield] curve is inverted, the odds greatly increase that a recession is unavoidable. Just how certain can we be a recession will occur? Let history be a guide. Since 1960, all six U.S. recession have been preceded by an inverted yield curve months in advance. No other indicator has shown such consistency, not even the stock market.
Many other variables have shown varying degrees of usefulness in predicting returns. Indeed, a deep and broad array of published empirical literature since the 1980s in particular demonstrates that a range of predictors offer robust forecasting ability. There is an ongoing debate over the source of the predictability and the extent that the predictability translates into real-world profit opportunities. In the short term, for instance, there are few robust predictors. Meantime, there's also an ongoing discussion about whether the predictability is evidence of a rational world where expected returns vary vs. seeing the predictability as evidence of irrational behavior. There is wide recognition, however, that expected returns vary with some degree of predictability. That's no silver bullet, but it opens the door for thinking that we can enhance the equilibrium returns dispensed by the market portfolio.
A small sampling of the literature that supports the case for return predictability includes:
* Research on stock market dividend yield and other accounting-based metrics for equities
* Return-based volatility trends
* Correlation trends among asset classes
* Short-term return persistence (momentum)
* Relative return among asset classes
And, as we noted, the term structure of interest rates (i.e., the yield curve) is among the many predictors that have been productively analyzed through the years.
Critics argue that individual variables that perform well in historical tests often fail to deliver comparable results in out-of-sample tests, i.e., in periods outside the testing dates. For example, a recent academic study reports that individual predictors don’t outperform simple forecasts drawn from historical averages (“A Comprehensive Look at the Empirical Performance of Equity Premium Prediction,” by Amit Goyal and Ivo Welch, Review of Financial Studies, 2008).
On the surface, this looks fata for thinking that forecasting factors are useful in the real world. But the evidence that any one predictor fails at times is unsurprising. Even if a flawless predictor was able to deliver a constant stream of accurate return forecasts (a virtual impossibility, of course), its value would soon be arbitraged away. News of this predictor’s incessant forecasting strength in the past would quickly attract new investors, who would then embrace the predictor, thereby rendering its practical value nil by bidding up the relevant assets to prices that reduce expected return to zero or less. In addition, fluctuating economic conditions are likely to provide varying degrees of predictability power to any one predictor at different points in the business cycle.
The challenge for investors is interpreting the literature on predictors and deciding how to utilize the research while recognizing that the forecasts will be less than perfect at all times. A possible solution is combining predictors to minimize the potential for failure in any one predictor at times. In other words, by diversifying the set of predictors used to forecast returns, the reliability of the prediction may be enhanced, if only marginally.
The economic rationale for combining individual predictions as a means of raising the success rate of forecasts dates to research published more than 40 years ago ("The Combination of Forecasts," by J.M. Bates and C.W.J. Granger, Operational Research Quarterly, 1969). This paper is widely cited as establishing the basis for showing that multiple forecasts are superior to individual forecasts.
Subsequent research over the years has strengthened the case for expecting pooled forecasts to outperform its components in isolation. A 1983 paper, for instance, observes that combined forecasts "can be quite accurate" ("The Combination of Forecasts," by Robert Winkler and Spyros Makridakis, Journal of the Royal Statistical Society, 1983). And a 2004 study shows that combining forecasts of economic growth has a habit of outperforming individual predictions (“Combination Forecasts of Output Growth in a Seven-Country Data Set,” by James Stock and Mark Watson, Journal of Forecasting, 2004).
Applying the concept of combination forecasts to predicting the equity risk premium, a paper published this year demonstrates so-called out-of-sample predictive power for 15 economic variables when used in concert for predicting the excess return for stocks. Diversifying the set of predictors, in other words, minimizes forecast errors, according to "Out-of-Sample Equity Premium Prediction: Combination Forecasts and Links to the Real Economy," by David Rapach, et al. (Review of Financial Studies, 2010).
Using multiple predictors to forecast risk premiums is a relatively recent line of research for financial economics, even though the underlying concept has been formally recognized for decades. Is this a short cut to big gains? Of course not. But as researchers continue to peel away the onion skin, the mysteries of asset pricing continue to be revealed, albeit slowly and unevenly.
The lessons from the evolving research with combination forecasts are intriguing. One of the implications is that forecasting risk premia requires a broad set of predictors. In effect, investors should diversify the sources of their forecasts. This reasoning is that each predictor's value rises and falls through a business cycle. Different predictors harbor different information about what's coming at different times. As such, drawing predictions from predictors whose information is highly correlated is subject to a higher failure rate compared to a more diverse and carefully chosen mix of predictors.
This may be a revelation to some, but it's actually more of the same in financial research. “The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk,” Peter Bernstein explained in Against the Gods: The Remarkable Story of Risk. This revolution is in fact a continuum of ideas and insights. That includes the growing evidence that we can't blindly assume that one, or even a handful of randomly chosen predictors will suffice. Investing is hard work, and it's destined to get harder. So it goes for investors as they continue to eat under the tree of financial knowledge.
March 8, 2010
A DEEPER SHADE OF RED FROM THE CBO
It's all about deficits these days. The challenge is figuring out what it all means for the markets, the economy, the man on the street and for politics in Washington. What's crystal clear at the moment is that there's a bull market in red ink. That's hardly a surprise, although the debt estimates continue to creep higher. That latest example comes from the Congressional Budget Office, which published a new analysis on Friday of President Obama's budget outlook. The CBO concludes that the projected deficit for the decade ahead will be $1.2 trillion more than the White House predicts.
The reaction from the Republicans is predictable. "The news today from CBO is clear: The president’s budget will continue to lead our nation into a fiscal catastrophe—an ever worse one than the president’s own numbers suggest," says Paul Ryan (R-Wisconsin), a Republican on the House Budget Committee, via BusinessWeek.
The White House begs to differ, of course, arguing that it's making the best of a bad situation. "That is why even as we increased our short-term deficit to rescue the economy, we have refused to go along with business as usual, taking responsibility for every dollar we spend, eliminating what we don’t need, and making the programs we do need more efficient," the administration's Office of Management and Budget asserted when it released its forecast last month.
Perhaps the question is whether the budget plans are too heavily focused on spending, or weak on raising sufficient revenue to pay for the plans. The answer depends on your perspective. Consider this excerpt from CNNMoney.com:
The CBO cited two big contributors to the jump in debt.
One is the president's proposal to extend the 2001 and 2003 tax cuts for the majority of Americans. The other is the proposal to protect middle- and upper-middle-income families from having to pay the Alternative Minimum Tax (AMT).
Together those proposals would cost $3 trillion between 2011 and 2020.
"It points out the unwillingness of the administration to raise the revenues to pay for the size of government being proposed," said Robert Bixby, executive director of the Concord Coalition, a deficit watchdog group.
Is the Obama administration a victim of its own optimism? Not necessarily, says Jim Horney of the Center on Budget and Policy Priorities. "It's not that the administration has a rosy scenario, but the CBO is a little less optimistic about income growth," he tells The Hill.
Regardless of one's political views, the rising level of debt is affecting the public's attitude. "More than twice as many U.S. adults (58%) say that debt owed to China is a more serious threat to the long-term security and well-being of the U.S than is terrorism from radical Islamic terrorists (27%)," according to a new a new Zogby poll. What's more, there was little variation by political affiliation. Democrats, Republicans and independents were in agreement by a wide margin that debt was the number-one threat.
The big question is when (if) the bond market's views will change. The benchmark 10-year Treasury remains in the upper 3% range, where it's been since last summer.
The muted outlook on economic recovery is one reason. But the real issue is deciding how long the fixed-income set will stay calm and give the government the benefit of the doubt. There's a compelling argument for thinking that the price of money should stay low in a time of diminished expectations. Unfortunately, that's just an assumption and it's not clear that it's written in stone.
March 7, 2010
IS A NEW ERA DAWNING FOR CHINA'S CURRENCY POLICY?
Is China's undervalued currency set to rise? That depends on how you interpret yesterday's comments from the governor of China's central bank.
"The chief of China's central bank reportedly suggested Saturday that the nation may decide to let its currency rise vs. the dollar, but he gave no clues as to when that might happen," TheStreet.com reported. Meantime, The New York Times tells us: "China’s Bank Chief Says Currency Is Unlikely to Rise."
No matter how you interpret Zhou Xiaochuan's comments yesterday, there was enough innuendo and implication to support almost any forecast. Consider this tantalizing remark via The Telegraph: “If we are to exit from irregular policies and return to ordinary economic policies, we must be extremely prudent about our choice of timing,” Zhou said. “This also includes the [yuan] exchange rate policy.”
Such oblique observations will keep the rumor mills rolling and the forex traders trading. In any case, the stakes could hardly be much bigger for the global economy, and the U.S. in particular. The Middle Kingdom’s GDP (at purchasing power parity) is second only to the U.S., or third if you consider the European Union a single country, according to the CIA World Factbook. And while large economies tend to expand at relatively low rates compared with smaller nations, that doesn’t yet apply to China, which is estimated to have grown at a real rate of 8.4% last year, according to the CIA—exceeded only by four other countries, all of which are tiny by comparison.
“A country’s exchange rate cannot be a concern for it alone, since it must also affect its trading partners,” the FT’s Martin Wolf recently argued. “But this is particularly true for big economies. So, whether China likes it or not, its heavily managed exchange rate regime is a legitimate concern of its trading partners. Its exports are now larger than those of any other country. The liberty of insignificance has vanished.”
That’s a diplomatic interpretation of how America views China and its currency. Robert Lawrence Kuhn, an international investment banker and longtime adviser to the Chinese government, summarizes the American perspective in somewhat harsher tones. "China is seen as a mercantile predator which keeps its currency artificially low to boost exports and steal jobs…", he writes in his new book How China's Leaders Think: The Inside Story of China's Reform and What This Means for the Future. Beijing begs to differ, Kuhn acknowledges. "China's leaders, of course, do not deny that their policies benefit their own people. But they assert that, in an integrated global economy, China's stability and development is essential for world peace and prosperity."
For good or ill, the global ramifications are huge. Keeping the yuan undervalued boosts China's exports, a major reason for America's trade deficit, which in turn creates an incentive for China to buy U.S. Treasuries as a tool for keeping its currency cheap relative to prices implied by trade flows. One result of this policy is that U.S. interest rates have been lower, perhaps a lot lower than they otherwise would have been. Economist Robert Barbera, writing in The Cost of Capitalism, explains the linkage in recent years:
Low mortgage rates, booming housing refinance, and strong consumer spending defined 2002-2005. Much of the spending was on products made in China. Incredibly, over the first five years of the new decade, China's exports to the United States rose from 4 to 11 percent of nonauto U.S. retail spending. China's excitement about this export boom led directly to its strategy for conducting monetary policy. Central bank authorities were willing buyers of the U.S. dollar in order to make sure that there was very little change in the dollar/Chinese yuan exchange rate.
Accordingly, they bought the U.S. dollars that Chinese manufacturers collected for their exports. They bought the dollars that U.S. multinational corporations spent as they built factories in China. They bought the dollars U.S. investors funneled into Chinese real estate. In total, these purchases led to China's accumulating trillions of dollars' worth of U.S. Treasuries in a remarkably short period. If we accept the assertion that China's bond buying kept mortgage rates low in the United States, we come to an interesting conclusion. China kept U.S. long rates low by lending trillions to the United States. Low mortgage rates allowed Americas to borrow against their homes and use the proceeds to spend. And, increasingly, they bought products that were made in China—vendor financial on a trillion-dollar scale.
The benefits, and repercussions, from the low rates are, of course, well known at this point. But while most of the world we knew under the regime of the Great Moderation is gone, one of its basic building blocks remains intact. But is China's undervalued currency finally living on borrowed time?
The yuan is essentially unchanged in dollar terms since mid-2008. Almost everything else in the global economy has changed, been repriced or reassessed. Will the status quo as it relates to China's currency roll on?
"It is encouraging that Gov. Zhou's statement suggests that the move to a managed float of the renminbi will be resumed once the global recovery firms up," Eswar Prasad, a professor of trade policy at Cornell University, told The Wall Street Journal yesterday. "Maintaining an undervalued exchange rate certainly benefits China, but at the expense of other countries that lose their relative competitiveness in foreign trade."
As complicated as all this is, the reality is even more Byzantine. Trade policy is but one slice of the U.S.-China relationship. The challenge is deciding how one corner influences another. Washington's stance on Taiwan, for instance, and China's reaction (including the latest announcement from Beijing), is one of many reminders that the game's is three-dimensional chess.
"Just as the nineteenth century belonged to England the twentieth century to America, so the twenty-first century will be China's turn to set the agenda and rule the roost," Jim Rogers advised in A Bull in China. Figuring out what that means in geopolitical and macroeconomic terms has only just begun.
March 5, 2010
FAMA, MARKET EFFICIENCY, AND THE LATEST RECAP
Debate about market efficiency is forever. That includes the ocassional commentary from the man who started it all, or at least played a pivotal role in bringing the idea to the financial fore, starting in the 1960s. What's it all about? You could spend the better part of a year reviewing the academic literature, and the remainder of the decade catching up on the various threads of discussion--pro, con and everything in between. For the short, short, short recap, a line from Peter Bernstein's classic Capital Ideas sums up Eugene Fama's research as well as anyone, particularly the early work: "Fama's point is that, on the average, information moves so fast that the market as a whole knows more than any individual investor can know."
But within that reasonable, but far from universally accepted notion lies a universe of nuance and just as much argument over the details. That includes our own view on synthesizing a whole from the disparate parts via Dynamic Asset Allocation. Meantime, Fama's latest effort to opine on market efficiency comes by way of a request from the Annual Review of Financial Economics for a professional autobiography. Fama's response can be read here. As for the excerpt that caught our eye, read on...
Vindicating Mandelbrot, my thesis (Fama 1965a) shows (in nauseating detail) that distributions of stock returns are fat-tailed: there are far more outliers than would be expected from normal distributions--a fact reconfirmed in subsequent market episodes, including the most recent. Given the accusations of ignorance on this score recently thrown our way in the popular media, it is worth emphasizing that academics in finance have been aware of the fat tails phenomenon in asset returns for about 50 years.
My thesis and the earlier work of others on the time-series properties of returns falls under what came to be called tests of market efficiency. I coined the terms "market efficiency" and "efficient markets," but they do not appear in my thesis. They first appear in "Random Walks in Stock Market Prices," paper number 16 in the series of Selected Papers of the Graduate School of Business, University of Chicago, reprinted in the Financial Analysts Journal (Fama 1965b).
From the inception of research on the time-series properties of stock returns, economists speculated about how prices and returns behave if markets work, that is, if prices fully reflect all available information. The initial theory was the random walk model. In two important papers, Samuelson (1965) and Mandelbrot (1966) show that the random walk prediction (price changes are iid) is too strong. The proposition that prices fully reflect available information implies only that prices are sub-martingales. Formally, the deviations of price changes or returns from the values required to compensate investors for time and risk-bearing have expected value equal to zero conditional on past information.
During the early years, in addition to my thesis, I wrote several papers on market efficiency (Fama 1963, 1965c, Fama and Blume 1966), now mostly forgotten. My main contribution to the theory of efficient markets is the 1970 review (Fama 1970). The paper emphasizes the joint hypothesis problem hidden in the sub-martingales of Mandelbrot (1966) and Samuelson (1965). Specifically, market efficiency can only be tested in the context of an asset pricing model that specifies equilibrium expected returns. In other words, to test whether prices fully reflect available information, we must specify how the market is trying to compensate investors when it sets prices. My cleanest statement of the theory of efficient markets is in chapter 5 of Fama (1976b), reiterated in my second review "Efficient Markets II" (Fama 1991a).
The joint hypothesis problem is obvious, but only on hindsight. For example, much of the early work on market efficiency focuses on the autocorrelations of stock returns. It was not recognized that market efficiency implies zero autocorrelation only if the expected returns that investors require to hold stocks are constant through time or at least serially uncorrelated, and both conditions are unlikely.
The joint hypothesis problem is generally acknowledged in work on market efficiency after Fama (1970), and it is understood that, as a result, market efficiency per se is not testable. The flip side of the joint hypothesis problem is less often acknowledged. Specifically, almost all asset pricing models assume asset markets are efficient, so tests of these models are joint tests of the models and market efficiency. Asset pricing and market efficiency are forever joined at the hip.
INCLEMENT WEATHER FOR JOBS
It’s the weather, they say. The loss of 36,000 jobs in last month’s nonfarm payroll count may have been a victim of the snow, the Labor Department advises with this morning’s release of the February employment report. The unemployment rate, at least, was unchanged last month, albeit at a high 9.7%.
What's the holdup on the recovery? "Severe winter weather in parts of the country may have affected payroll employment and hours," the government's press release advised. But lest anyone get the wrong idea, we're also told that "it is not possible to quantify precisely the net impact of the winter storms on these measures."
The weather-is-to-blame view is persuasive for some economists. “Without the weather in February this would have been a month for jobs growth,” Ellen Zentner, a senior economist at Bank of Tokyo-Mitsubishi UFJ, told Bloomberg Television. “We’ve got positive jobs growth in there, we just can’t see it” because of the “weather effects,” she asserts.
Maybe we've been snow blinded, but The Economist's Free Exchange blogger this morning isn't quite so upbeat in reaction to today's employment report: "…a sideways movement in labour markets is a setback at this point. The economy must create over 100,000 jobs per month just to keep up with population growth, and it should be averaging monthly payroll increases of over 250,000 to reduce the unemployment rate at the same pace as in the first year of the 1983 recovery."
Upbeat or not, all of this leaves just one choice: Hoping for a spring thaw with the March numbers. Meanwhile, if we take the February report at face value, we're looking at a familiar trend in the employment picture: low-level losses and the tantalizing possibility that gains are near. But not yet. Damn those winter storms.
Save for last November's 64,000 rise in nonfarm payrolls, 25 of the last 26 months have shed jobs. The red ink for nonfarm payrolls now stands at 8.4 million lost jobs, according to the Labor Department.
As for February, the losses were relatively light, compared with the carnage in the first half of 2009, but that's increasingly a thin reed for those trying to rationalize the numbers du jour as the moment of rebound slips ever forward.
At best, it was a mixed bag for last month's employment changes among the various subgroups that comprise the total nonfarm payroll number. Construction suffered the biggest hit, unsurprisingly, given the weather, losing 64,000 positions. The services sector almost but not quite picked up the slack, posting a 42,000 rise. But that masked the negative trend within the services sector last month, with one dubious exception. Indeed, the big winner among services firms in February came in temporary help services, which added nearly 48,000 jobs last month. Every bit of gain helps, of course, but that's not exactly the corner of the economy where expansion breeds bullish sentiment at this point.
Overall, there's a growing risk that the labor market will languish for an extended period. The big losses, perhaps any loss in nonfarm payrolls is behind us. But that's not good enough to begin the hard work of laying the foundation for even modest economic growth in the near term. More than two years after the Great Recession began, the labor market is still suffering, albeit suffering due to a lack of job creation. It's not obvious that this risk is factored into the crowd's sentiment, but another month or two of moving sideways in the labor market and there may be hell to pay.
Meantime, we'll be watching the weather forecasts. March has come in like a lamb and so the month may go out with a meteorological panthera leo.
March 4, 2010
THE CHINA SYNDROME
Big deficits and rising mountains of public debt. Is it a nightmare? No, it’s the fiscal profile du jour of these United States. Or is it both? In any case, assuming Congress keeps current laws and policies intact, the federal budget deficit, as a share of the economy, is on track for fiscal 2010 to be the second highest since World War Two, the CBO projects.
“Under current laws and policies, CBO’s projections show that level climbing to 67 percent by 2020,” the government’s budget watchdog reports. “As a result, interest payments on the debt are poised to skyrocket; the government’s spending on net interest will triple between 2010 and 2020, increasing from $207 billion to $723 billion.” What’s the solution? Everyone knows what’s required, although the details of implementation will be messy, which in Washington means politics, in massive super-sized doses.
Here’s the set-up, once more by way of CBO: “To keep federal deficits and debt from reaching levels that would substantially harm the economy, lawmakers would have to significantly increase revenues, decrease projected spending, or enact some combination of the two.”
Meanwhile, Democratic leader Steny Hoyer in the House of Representatives earlier this week dropped some clues about how the majority is thinking on such matters. “"It seems to me that the only solution that can win the support of both parties is a balanced approach: one that cuts some spending and raises some revenue while avoiding extremes in either direction," he said via Reuters. Easy to say, tough to do, especiall in a mid-term election year.
Spending cuts and taxes on one side vs. rising deficits and the potential blowback for the bond market on the other. Red ink beyond a certain level will go over with the fixed-income set like a lead balloon. But for the moment, all’s calm with bond yields. The benchmark 10-year Treasury yield remains in the 3.6% range, or more or less unchanged this year. Can it last in the face of some ugly choices? The basic alternatives: Raise taxes, cut spending, both, or risk letting the federal deficit surge into uncharted and potential destabilizing territory for the economy and the markets.
As problematic as all this is, it’s even worse in the current economic climate for the simple reason that the outlook for growth is modest, at best. Meanwhile, the demand is exploding for spending on a range of fronts, from Medicare and Social Security to the war on terror to fighting the recession to the pet project du jour. The toxic combination of high spending and low growth threatens to complicate an already sour political atmosphere in Washington. You think you've got gridlock now? Brother, you haven't seen anything yet. History suggests as much. As the book The Presidency and Economic Policy reminds, “When revenues grow at a slower rate than the rate of increase for federal spending, the resulting deficits make it more difficult for politicians to divide up the fiscal pie among competing programs, let alone promise the voters new benefits.”
How does all this factor into the relationship with America’s two largest creditors? Japan and China together hold about 12% of U.S. Treasuries outstanding, according to economist Michael Cosgrove. Writing in an op-ed piece today for Investor’s Business Daily, he advises:
The Chinese can lecture the administration about excessive federal outlays, but nothing would be more effective than dumping Treasuries, even for a short time. Such action would panic investors, and as a result the administration may well agree to constrain spending to placate the Chinese.
No one wants havoc in the capital markets, but the Chinese can do U.S. taxpayers a major favor by dumping Treasuries just as soon as the Chinese can buy their put options on U.S. equities. U.S. equities will quickly recover their lost ground and much more if the administration would agree to constrain federal outlays. Excessive federal spending and regulatory involvement in the economy are holding back equity gains.
The sooner the Chinese dump Treasuries, the better. It is a message that all members of Congress, as well as the Obama administration, need to hear. The Chinese needed to take such action during the Bush years, but that is water under the bridge.
The Chinese can see how the Japanese ruined their economy by growing public debt outstanding to over 225% of GDP in 2010 from 68% in 1991, according to IMF data. The U.S. outstanding public debt to GDP ratio was also 68% in 1991. In 2008 it was 70%. At the end of this year it will be about 94%.
The current Congress and administration seem intent on repeating the mistakes of Japan that in the end will also ruin the U.S. economy.
In fact, the latest numbers show that China’s appetite for Treasuries retreated a bit in December. “"In the current climate, China's move to reduce its U.S. government debt creates a large propensity for misunderstanding," said Shi Lei, an analyst with the Bank of China's Global Financial Markets Department via MarketWatch.com. "Even though China didn't buy [bonds]," Shi said, "there were still many other countries willing to purchase U.S. Treasury securities."
If that’s supposed to soothe tortured political souls in Washington, it’s not doing the trick for Eric Anderson, author of China Restored: The Middle Kingdom Looks to 2020 and Beyond. Writing yesterday for The Huffington Post, he explains:
Contrary to popular opinion, Beijing could sell that [U.S. Treasury] debt with few long-term consequences for China's economy...and likely her political reputation. Such a move would cost you and I a fortune the next time we considered shopping for a car or a house...and would further expand an already outrageous national debt. Controversy can breed confusion, but in this case it should simply generate consternation...in every American household and at 1600 Pennsylvania Avenue.
THE PLOT THICKENS IN THE LABOR MARKET
Today’s weekly update on new jobless claims offers a reprieve on the darker visions conjured on these pages in recent weeks, including here. New filings for unemployment benefits dropped last week to by 29,000 to 469,000. Whew, that was a close one! But the risk for this series that we’ve been discussing lately is still with us, even if the latest report offers some breathing room for thinking positively.
The good news is that there was no follow-through on the recent rise in new jobless claims, at least not yet, as our chart below shows. The charitable interpretation, bolstered by today’s number, is that it was all a statistical quirk; a February fluke caused by the heavy snows last month. Or maybe it was the normal short-term volatility that tends to plague this dataset. But while there’s a slightly stronger case for arguing that jobless claims aren’t set to rise, there remains the more pressing question of when this series will resume falling?
It’s going to take weeks to answer that question. In the meantime, we’re left to wonder if jobless claims have hit a floor, temporary or otherwise. If that proves to be the case, that’s almost as troubling as watching claims rise because it would suggest that the labor market’s recovery, already weak if not feeble, may be facing more stress than previously realized.
Watching jobless claims, while hardly a silver bullet, is among the early warning signs of things to come. Recent history appears to back up the idea that initial claims offer a clue of what’s coming for the business cycle and the labor market. The fact that jobless claims were falling for much of last year was a sign that job destruction in nonfarm payrolls was slowing and that the GDP contraction had ended. That's hardly unique to the present cycle, as we've discussed. The forward-looking ability in jobless claims is well understood in the dismal science, as noted, for instance, in a St. Louis Fed report from a few years ago. Meanwhile, economics professor Todd Knoop explains in Recessions and Depressions,
Initial unemployment claims are more sensitive to changes in the business cycle than total unemployment. Unlike total unemployment, which lags peaks and troughs because of lags in the hiring process, initial unemployment claims are a leading indicator because firms anticipate changes in economic conditions and increase layoffs before production and decrease layoffs before conditions improve.
Where does that leave us with the latest numbers? Watching, waiting and worrying. Initial jobless claims appear to be at a crossroads. "Firing activity has largely tapered off, but new hiring has yet to pick up, Zach Pandl, an economist at Nomura Securities International, tells Reuters. That's not inherently troubling, except when you consider the current context: an unusually long stretch of non-recovery in the labor market, i.e., job growth.
Ethan Harris, head of economics for North America at Bank of America/Merrill Lynch, opines in a Bloomberg TV interview that “we are in this limbo state where it is not clear if job growth has started yet.” But he's hopeful and predicts that the limbo will give way to expansion, explaining: “Many companies say they over-reacted and fired a lot of people, more than they needed to, with the news of the recession. So, we’re expecting broad-based re-hiring.”
But the future is one thing, and the here and now is something else. At the moment, the labor market seems to be betwixt and between, neither contracting nor growing. The expectation is that expansion is near. We'll learn in tomorrow's jobs report for February if near is now.
March 3, 2010
MORE OF THE SAME: A SLOWDOWN IN JOB LOSSES
Two new private-sector reviews of last month’s labor market show that the economy is still shedding jobs. The only good news is that the rate of loss continues to slow. But a loss is still a loss at this late date in the economic cycle, and today’s numbers suggest that Friday’s monthly update on jobs from the government may suffer another round of red ink, albeit in relatively mild form.
The ADP National Employment Report advises that nonfarm private payrolls in the U.S. slipped by 20,000 last month. "The February employment decline was the smallest since employment began falling in February of 2008," according to the accompanying press release.
Was winter weather to blame? Perhaps, although ADP minimizes that gremlin. Again quoting from the company's press release:
Two large blizzards smothered parts of the east coast during the reference period for the BLS establishment survey. The adverse weather had only a very small effect on today’s ADP Report due to the methodology used to construct it. However, the adverse weather is widely expected to depress the BLS estimate of the monthly change in employment for February, but boost it for March. Therefore, it would not be unreasonable to expect the BLS estimate for February (due out this Friday) to be less than today’s ADP Report even though the BLS estimate will include the hiring of temporary Census workers not captured in the ADP Report.
It's come to this: hoping for salvation from the Census Department. So it goes at a time when any scrap of good news, temporary or otherwise, is pounced upon as a pinpoint of light in the dark tunnel of job creation.
Meanwhile, another report from employment services firm Challenger, Gray & Christmas reports more than 40,000 jobs were eliminated last month. That's comfortably below January's 70,000-plus cuts, the firm notes via CNNMoney.com. Nonetheless, it's hard not to notice that two independent reports today indicate the same general trend: another round of job losses for February.
If the Labor Department's update on Friday makes it three, February's retreat will mark nonfarm payrolls' net decline in 25 of the previous 26 months, according to the official government tally. Yes, it's getting better, which is to say the losses are diminishing, but the question still remains: When is net job growth coming? As we wrote last month, "the longer this drags on, the higher the odds that we're facing an even weaker post-recession job recovery than previously anticipated."
With each passing month of loss, the stakes are higher for the necessity of minting jobs. The real challenge isn't one of simply seeing a net gain on the payrolls ledger. That's coming, and perhaps soon. But what's needed is more than a statistical change, i.e., a lengthy stretch of large gains on the order of 200,000, 300,000, and more a month. Unfortunately, almost no one expects that's imminent. Yes, seeing 10,000, 50,000 or even 100,000 net new jobs will be refreshing (when it actually arrives), but that thimble of repair is no match for the tidal wave of 8 million-plus lost jobs since the Great Recession began in December 2007.
As troubling as this is, it's all the more problematic in a world that's just coming to terms with the debt and deleveraging that's weighing on the global economy. Greece and, increasingly, Britain are only the beginning of new world order. The U.S. is part of this infamous club too. And let's not forget the veteran of debt and deleveraging: Japan.
What are the implications for all this red ink? History suggests remaining humble in forecasting a quick and easy solution.
March 2, 2010
THE REALLY BIG PICTURE
Some events are legitimately macro, or MACRO, such as the shifting of the Earth's axis in the wake of the Chilean earthquake. The Feb. 27 earthquake "may have shortened the length of each Earth day," according to the Jet Propulsion Laboratory.
Measured in dollar terms, the quake's impact is easier to spot. One estimate puts the damage as high as $8 billion.
The human loss, of course, is beyond calculation. How can we help? No shortage of options, including the Red Cross and the International Medical Corps, to name but two of the many organizations that need financial support, for Chile as well as for the victims of Haiti's recent quake.
THE ENDLESS SEARCH FOR MACRO POLICY SOLUTIONS
Everyone has a prescription for managing the business cycle these days, but no one has a solution. That’s because there are none, at least nothing that passes the smell test of a workable system that can deliver nirvana: maintaining capitalism’s power to drive economic growth while eliminating its tendency for stumbling from time to time.
Bridging these two facets, which are inextricably linked, is at the center of the debate. Obvious solutions, however, are elusive, and probably always will be. The fact that a range of policies have been tried over the decades, and delivered mixed results, is testament to the idea that there's always a cost to every "solution."
No less a critic of unfettered capitalism than Hyman Minsky recognized the limits of pushing too far on one end without biting too deeply into the benefits on the other side. “We need to embark on a program of serious change even as we need to be aware that a once-and-for-all resolution of the flaws in capitalism cannot be achieved,” Minsky wrote in Stabilizing an Unstable Economy. "Even if a program of reform is successful, the success will be transitory. Innovations, particularly in finance, assure that problems of instability will continue to crop up; the result will be equivalent but not identical bouts of instability to those that are so evident in history."
Finding the middle ground won't be easy this time, but it should be tried, argues economist Bob Barbera in last year's The Cost of Capitalism. He wisely notes that "one cannot forget that the essential driver in free market capitalism is the risk-taking entrepreneur, bankrolled by the world of finance. Enlightened societies, therefore, need to embrace free market capitalism, coupled with policies aimed at increasing margins of safety and tempering flights of fancy."
The challenge is figuring out exactly where productive policy prescriptions end and self-defeating market regulation begins. In fact, much of the political and economic debate since the 1930s in the U.S. has been focused on that question, and the results to date are still mixed.
Keynesian intervention of one sort or another is widely embraced as the general framework for finding this sweet spot these days, but past missteps and excesses in applying the principles outlined in The General Theory of Employment, Interest and Money should give one pause for expecting too much. In the 1970s, an active fiscal policy intent on maintaining full employment backfired with stagflation.
Some say the errors in the '70s was less about Keynesian failure vs. an oil price shock and loose monetary policy. In any case, defenders of aggressively managing the business cycle fell out of favor. In the wake of the downfall rose the neo-classical economists led by Milton Friedman. Although Friedman's insights and opinions ranged far and wide, his basic prescription was one of favoring markets and recognizing the power of monetary policy for good or ill. As he and Anna Schwartz argued so persuasively in A Monetary History of the United States, 1867-1960, the central bank's printing presses are a critical and often overlooked factor in the ebb and flow of economic fluctuations.
But there's a case to make that the Fed ignored the lessons of history and kept monetary policy too loose for too long for much of the first decade of the new century. Are we doomed to repeat history? Even when the lessons are clear?
Now the pendulum is swinging back toward a Keynesian view of the world, or perhaps a Keynesian/Minsky interpretation, and not without cause. Certainly there's a case for seeing the banking sector as something unique in the economic sphere. There's a limit to letting free market forces have their way with banks, which is part of the reasoning for central banking. The lender of last resort is a concept that arose out of necessity. Letting banks fail runs the risk of allowing a bank run to terrorize the economy.
At the same time, there's a limit to how much government can do to minimize the risk of financial failure. As Jean-Charles Rochet explains in Why Are There So Many Banking Crises? The Politics and Policy of Bank Regulation, "supervision [of banks] and market discipline are more complements than substitutes: one cannot work efficiently without the other."
Government management of economic cycles is arguably necessary to some degree but also dangerous if it goes too far and costs too much. It's too early to say what's excessive in the current climate, but some early clues suggest that countries that have boldly embraced Keynesian policies are setting themselves up for failure, as a recent Bloomberg article suggests:
The U.K. has produced notable economists over the years, but John Maynard Keynes, the guru of government intervention, was one of truly global significance.
So it may be fitting that the U.K. will also become the deathbed of Keynesian economics.
Britain has been following the mainstream prescriptions of his followers more than any developed nation. It has cut interest rates, pumped up government spending, printed money like crazy, and nationalized almost half the banking industry.
Short of digging Karl Marx out of his London grave, and putting him in charge, it is hard to see how the state could get more involved in the economy.
The results will be dire. The economy is flat on its back, unemployment is rising, the pound is sinking, and the bond markets are bracketing the country with Greece and Portugal in the category marked “bankruptcy imminent.” At some point soon, even the most loyal disciples of Keynes will have to admit defeat, and accept that a radical change of direction is needed.
Finding the balance between enlightened regulation that maximizes the benefits of free market capitalism is akin to searching for the optimal balance between democracy and sidestepping the tyranny of the majority. The definitions, standards and results are forever in flux, which means that there are no true solutions. The idea that a market economy can be "tamed" is naïve, but so too is the expectation that an uncritical embrace of free markets will be politically acceptable and economically viable. Somewhere between those two extremes lies a reasonable balance. Exactly where, and on what terms, is debatable, now and forever.
The great challenge is coming to terms with two halves of the same economic coin: The business cycle can't be tamed, but neither can it be left untended. If this sounds like a paradox wrapped in a contradiction, you're right--it is. Welcome to macroeconomics.
March 1, 2010
IS THE TAX BITE THE NEW HEADWIND?
Today’s personal income and spending update for January looks like a warning of things to come, but not for the obvious reasons. The weasel in the henhouse is all the more troubling at the moment since it’s masked by the all-important topic of consumer spending, which rose substantially last month. Beneath this rosy surface, however, is a potentially troubling trend.
But first the good news, such as it is. Personal consumption expenditures rose a strong 0.5% last month, the best pace since October. That’s above average by the standard of the past decade. Worries that Joe Sixpack is set to close up shop and save, save, save are on hold again, or so the latest government numbers suggest. But there's a slight glitch. As our first chart below shows, consumer spending rose last month (red line), but the jump coincides with a rather sharp fall in disposable personal income (black line). What’s going on here?
The drop in income reflected an increase in various tax deductions. Indeed, wages overall were up last month, but the BEA reports that a relatively larger bite in domestic “contributions for government social insurance” and “current personal taxes” turned a gain into a retreat for monthly disposable personal income. By recent standards, the rise in taxes looks unthreatening, in both absolute and relative terms. But recent standards are almost certainly misleading, thanks to fiscal stimulus of late and the government's recession-era policy of helping smooth over the rough edges of the Great Recession by putting more money in taxpayer’s pockets.
The outlook for red ink of unprecedented proportions on the government’s balance sheet suggests that Washington will have to dip its hand ever deeper into the taxpayer till in the years ahead. Did the uptick in government deductions last month signal the start of this trend?
Consider two charts that track the last three years of the relative tax bite on personal income. The chart below shows the percentage of personal current taxes relative to personal income on a monthly basis. “Personal current taxes consist of taxes on income, including realized net capital gains, taxes on personal property, payments for motor vehicle licenses, and several miscellaneous taxes, licenses, and fees,” according to the BEA.
The next chart shows the ratio of so-called social insurance deductions to personal income. These taxes fund a number of programs, including Medicare and Social Security, BEA advises.
In both cases, the change in trend is obvious, or so it seems. One month is hardly definitive evidence of a secular shift, but given what we know about government finances, last month's uptick may be more than just statistical noise. Indeed, the trough of December has given way to a rebound in the relative share of tax deductions in January. Given the mounting liabilities facing the government, one doesn't need a wild imagination to expect that the path of least resistance is up for Uncle Sam's relative cut of wages in the year's ahead. Think of it as the new headwind--and one we need like a hole in the head at this point in this business cycle.
For all the troubles of the last two years, one favorable trend has been the general decline in the relative tax burden on wages. All the better since it came when wages overall have tumbled from the lofty peaks of 2007 and early 2008. But for reasons of fiscal integrity, it's getting harder to keep the government's tax burden at the low levels that have prevailed over the last 24 months without cutting spending by more than trivial amounts. And if that isn't enough of a headache, all of this comes at a time of heightened risk that overall economic growth may be substandard for the foreseeable future.
Even if we ignore tax rates, reasonable minds might wonder about the momentum in the broader rebound for spending and income over the past year. As our fourth and final chart below indicates, the annual pace of change in personal income and spending has peaked, at least for the moment. It's unclear what comes next, thanks to a number of rather large unknowns lurking, starting with the labor market.
But we know the key question: What will keep the spending and income recovery alive? The big-picture answer, of course, is economic growth. Will we see any? And how much? The details that deliver an answer are likely to be messy for the year ahead.
ASSET CLASS RETURNS FOR FEBRUARY
The trend in February was again one of posting a wide range of results and a shifting pattern of winners and losers on a monthly basis. This isn’t a shock, but more of it is probably coming, meaning that a new set of challenges await for managing asset allocation relative to the trend for much of the past 12 months.
Last October, we considered a future with a wider divergence of returns: red as well as black ink sprinkled liberally across our monthly performance summaries. At the time, the trend du jour was one of handsome if not stellar gains in virtually everything on a monthly basis. That was all but certain to end at some point, and perhaps sooner rather than later. The great reflation of 2009 in asset prices, while reasonable and somewhat expected, was destined to run its course as the more challenging economic and financial era of the post-Great Recession period arrived.
This new era has been arriving now for several months, courtesy of the market’s efforts to digest a volatile array of news and trends that are often as confusing as they are potent. Indeed, as our table below shows, monthly total returns for the major asset classes were fairly wide last month, ranging from a strong 5.6% gain for REITs down to a 1.2% loss for inflation-indexed Treasuries. That’s almost a mirror reversal of January’s performance results at the extremes, with TIPS in the lead and REITs suffering a hefty tumble in this year's first month.
Expect more of this back and forth, with asset classes shifting positions in the monthly updates. This looks set to continue until a higher level of clarity on the future arrives. That's going to take time as the macroeconomic details of the new world order unfold, for good or ill. Indeed, there are numerous uncertainties lurking, some of which may pose substantial hazards to the cause of sustained economic growth. More often than not, debt is attached to these concerns, one way or another.
Governments the world over are pulling every trick they know out of their monetary and fiscal hats in an effort to combat the hazards that confront the global economy, primarily in the developed world of the U.S., Europe/Britain and Japan. For the near term, the prevailing winds in this epic battle will determine winners and losers on a monthly basis. Depending on the news cycle of the day, progress may appear to have the upper hand, only to give way to the forces of darkness. Lots of suprises are coming. Get used to it, and be patient.
It may be some time before the major asset classes again enjoy a bout of smooth sailing with easy gains in almost everything. Without the powerful tailwind of deep discounts that prevailed in betas a year ago, markets are likely to face a rough sea of volatility and trendless meandering in the months and quarters ahead.