May 29, 2010
SATURDAY LINK LIST: 5.29.2010
Consumer spending was flat last month, even though income was up in April. A sign of things to come? A sampling of reaction from the punditocracy…
"The good news is that households are making more money; the bad news is that they are not spending it," said Joel Naroff, president of Naroff Economic Advisers.
"Income growth outpaces spending in April"
Over the last several decades, personal spending has been bolstered mostly by borrowing, [according to Guy LeBas, the chief fixed-income strategist for Janney Montgomery ScottGuy LeBas]. "If we take out that borrowing, the trajectory has to be much lower," he said. "I think what we are looking at here is a cultural trend that is going to play out over years."
"U.S. Consumer Spending Was Stagnant in April"
The New York Times
Ian Shepherdson, chief economist for High Frequency Economics, said that retail sales account for only two-fifths of total spending. The data released Friday showed that purchases of nondurable goods such as food and fuel dipped 0.1 percent, adjusted for inflation. Spending on services rose 0.1 percent. "These numbers get the second quarter off to a soft start," Shepherdson said. "The lesson here is that relatively strong retail sales numbers do not guarantee robust consumption." Consumer spending is a key component of the economic recovery, but the high unemployment rate has kept demand in check. Store traffic and sales this month have tapered off, according to the International Council of Shopping Centers, a trade group. The ICSC this week lowered its forecast for May sales from a gain of 3.5 percent compared with the previous year to between 2 and 2.5 percent. However, some retailers say that the late Memorial Day weekend will push purchases into June.
"Personal incomes up, but consumer spending flat in April"
The Washington Post
Consumption remained flat in April, the Commerce Department said Friday, despite an increase in incomes fueled by the job market's improvement last month. It was the first time in six months that consumer spending didn't increase, and follows gains of 0.5% and 0.6% in February and March, respectively. "I just think we saw some really outsized gains in February and March," said Michelle Girard, an RBS Securities Inc. analyst, adding that the outlook for consumer spending remains strong thanks to the labor-market rebound.
"Consumers Save More, Hold Spending Steady"
The Wall Street Journal
However, even the higher savings rate will likely serve as a point of contention between the bulls and bears. Most economists generally view the nation's higher savings rate as a constructive development after a decade of over-consumption, in many cases paid for with credit. But if the savings rate rises too high, consumer spending will decline, lowering GDP growth. What would resolve the bull/bear tug-of-war regarding tepid consumer sentiment? Sustained job growth. The economy has added an average of 260,000 jobs in March and April, and if it adds more than 200,000 jobs in May, that would signal to Americans that the U.S. economy is creating jobs in a sustained way, something that historically has triggered an uptrend in consumer sentiment.
"Consumers Holding Steady in May"
Richard DeKaser, president of Woodley Park Research, is not too surprised by the drop in consumer spending in April. "Spending had been outstripping income for some months...to a degree that was simply unsustainable," explained DeKaser. From October 2009 to March 2010, personal spending grew at least 0.2 percent and as high as 0.7 percent. In that same period, it outpaced income 5 out of 6 months and by as much as 0.5 percentage points.
"'Unsustainable' growth in consumer spending cools in April"
International Business Times
May 28, 2010
APRIL INCOME RISES WHILE CONSUMER SPENDING IS FLAT
This morning’s update on personal spending and income for April raises as many questions as it answers.
First the good news. Disposable personal income rose strongly last month, posting a 0.5% gain in April, the fastest pace since last December. The rise was equal in real as well as nominal terms. A healthy rise in wages was a critical factor, courtesy of expanding payrolls in April. But if you thought that a strong month of income growth would juice spending, last month’s numbers were a disappointment.
Income jumped in April, but spending was virtually unchanged, in nominal and real terms. That’s a sharp drop from the trend of late, when higher consumption has been the monthly story. Since October, personal consumption expenditures have risen every month in nominal terms at a monthly average of roughly 0.5%. Last month, however, the spending all but dried up. Yes, consumers spent more in services, albeit mildly, while purchases of goods (the cyclical sensitive portion of consumption) retreated by a substantial 0.4% in April.
Is this a sign that consumers are beginning to save more by delaying if not forgoing unecessary spending? Probably. Is it a trend with legs? If so, does it imperil the prospects for the economic recovery? A single month’s numbers are hardly a trend, and so we should be careful in reading too much into April’s report. Another reason for reserving judgment comes by looking at the recent history in the various components of personal consumption expenditures. For starters, upward momentum looks healthy, as the chart below shows. Also, keep in mind that nondurable goods spending--the biggest loser last month--looked ripe for a slowdown, given its leadership in recent history.
Yet spending ultimately requires income, and so one must be considered in context with the other. That inspires looking at the broader trend for this pair over time. Consider the chart below, which shows the rolling 12-month percentage change in spending and disposable income in nominal terms. The pace of spending (red line) has obviously rebounded sharply over the past year. So too has income (black line), although the trend hit a patch of turbulence in April.
It’s premature to say that the rebound in disposable income—a critical factor for expecting the nascent economic recovery to roll on—is in trouble. But the downshift in the income trend in the chart above merits watching. If nothing else, it serves as a reminder that it’s still all about jobs. Private-sector wages represent roughly half of personal disposable income. Only a rebound in the labor market can keep income levels rising, which is turn is necessary to keep consumption bubbling--the primary driver of GDP.
"The recovery has been impressive, but there are significant headwinds facing it," Adrian Cronje, chief financial officer of investment firm Balentine, tells CNNMoney.com. "And in the last few weeks and months, there's been a lot that's caused people to sit back and take a breath."
Nigel Gault, chief U.S. economist at IHS Global Insight, advises via Bloomberg BusinessWeek: "The consumer is going along for the ride but isn’t really leading the recovery." On the other hand, “because employment is growing, we’re starting to create some labor income and that is positive for future consumer spending."
The transition from the deepest recession since the 1930s to economic recovery was always destined to face bumps and setbacks, raising questions anew about the strength and durability of the rebound. Today's numbers are merely a preview of things to come. The Great Recession is over, and the Great Transition is here. In theory, distinguishing between the two is a piece of cake. In practice, reading the tea leaves is going to get complicated at times.
SHOULD WE WORRY ABOUT A 90% DEBT/GDP RATIO?
Paul Krugman questions the central finding in a new Reinhart-Rogoff research paper that focuses on the apparent linkage between government debt and economic growth. The study ("Growth in a Time of Debt") has been cited in the discussions in Washington re: the budget deficit, as The Hill reported here. The central point in the paper: when debt rises to 90% of GDP, growth "deteriorates markedly," according to Carmen Reinhart, an economist at the University of Maryland and co-author of the paper. Krugman isn't so sure. "It’s based on a crude correlation," he charges, "and as soon as you look at specific examples, it starts to look all wrong."
Krugman argues that high debt doesn't cause slow growth; rather, it's the other way around. In the case of Japan, he writes: "surely we believe that Japan’s financial crisis is what both slowed growth and increased debt." Something similar applies to Europe, he adds.
As for the U.S., the country is now just under the 90% debt/GDP ratio threshold. Is this something to worry about? No, Krugman suggests, although he doesn't say that directly. But his comments suggest as much. Drawing lessons from history for the U.S. is complicated by the fact that the previous instance of a 90% debt/GDP ratio was just after World War Two, which did in fact witness slow growth. This is a bad example, Krugman advises, mainly because the country was winding down from a war stance.
The Reinhart and Rogoff study acknowledges that war tends to boost debt, explaining,
In principle, the manner in which debt builds up can be important. For example, war debts are arguably less problematic for future growth and inflation than large debts that are accumulated in peace time. Postwar growth tends to be high as war-time allocation of manpower and resources funnels to the civilian economy. Moreover, high war-time government spending, typically the cause of the debt buildup, comes to a natural close as peace returns. In contrast, a peacetime debt explosion often reflects unstable underlying political economy dynamics that can persist for very long periods.
It's hard to prove anything definitive in economics, and so there's always reason to doubt a given relationship. Consider the fierce debate over the business cycle and the stock market. The S&P 500 has a tendency to peak ahead of recessions. Some say this is evidence that the stock market anticipates a downturn in the economy. The implication: the market's pricing in a perceived threat of a future shock. But another school of thought charges that a falling stock market—the proverbial popping of "the bubble"—triggers the subsequent economic downturn, or at least is a contributing factor of some consequence.
Krugman and others worry that the debt/GDP ratio argument of Reinhart and Rogoff will give deficit hawks additional political influence in Washington. The possibility is a two-way street, however. If embracing Reinhart and Rogoff means letting the hawks have more say over fiscal policy, the opposite is true if the debt/GDP concept is minimized.
It's almost certainly wrong to say that reaching a 90% debt/GDP ratio always and forever guarantees slower growth. There are always exceptions, and perhaps the U.S. will beat the odds, as it so often has in its economic history. But we shouldn't be too quick about dismissing the relationship identified in the Reinhart and Rogoff paper. The study crunches the numbers on 44 countries going back 200 years. Clearly, there's a risk when debt rises. How much of a risk, and the exact relationship is debatable, but it's surely more than negligible.
Krugman's right that closer study is required to figure out if slow growth causes high debt vs. the other way around. But it's hard to imagine that relatively elevated levels of debt are immaterial to the prospects for growth.
Correlation isn't causation. But that doesn't mean that we should ignore correlation when it seems to make sense. The U.S. faces what may be a turning point of critical economic significance. The stakes are high, in part because the red ink is rising and the prospects for growth are questionable. Debt may not be fate when it comes to future growth, but it's a risk factor, and one that may be rising as we write.
The real challenge at the moment is finding the right balance between avoiding the mistakes of the Great Depression while doing all that's reasonable to ensure that the economic recovery continues. This is mostly a monetary policy issue. As Scott Sumner argues (persuasively, in my view), the Fed could be doing more to juice the economy.
Meantime, one has to ask if we're threatening growth prospects with higher levels of debt? Maybe. History seems to suggest as much. And since we haven't yet explored the full possibilities of monetary policy techniques, a la Sumner and others, maybe we ought to try before allowing the fiscal deficits to rise further on the assumption that Keynesian stimulus is the only lever left to pull.
May 27, 2010
MORE CHATTER ABOUT DEFLATION...
The pundits are buzzing about the rapid decline in the money supply of late. The latest catalyst for the chatter is a story yesterday in the Telegraph, which ran this provocative headline: “US money supply plunges at 1930s pace as Obama eyes fresh stimulus.”
The story goes on to report:
The M3 money supply in the United States is contracting at an accelerating rate that now matches the average decline seen from 1929 to 1933, despite near zero interest rates and the biggest fiscal blitz in history.
Monetary economist Tim Congdon from International Monetary Research tells the Telegraph that the descent in the money supply is "frightening." He says that "the plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly."
The Federal Reserve no longer publishes M3, although the underlying components are still available and so the series can be calculated by anyone inclined to do so. Unsurprisingly, other measures of money supply are falling too. The annual percentage change in M2, for instance, has been dropping like a rock for months, as the chart below shows.
The trend is more than a little worrisome, given the recent rise in deflation risk, albeit a mild rise and therefore one that may yet turn out to be a false alarm. The markets are constantly forecasting the future, but the forecasts aren't 100% accurate. Figuring out when they're wrong is the trick. That said, the Treasury market's 10-year inflation forecast has dipped under 2% over the past week or so for the first time since last October. So far, the market's inflation outlook is holding steady at around 1.9%, as the second chart below shows.
Did the Treasury market overreact? Is the threat of deflation overstated? Maybe, although the steep fall in the money supply is one reason for wondering. Another is looking around the world and seeing that the D risk is on the rise in Britain and Japan. Deflation in the U.S. and U.K. "cannot be ruled out," warned Adam Posen (external member of the Monetary Policy Committee and senior fellow at the Peterson Institute for International Economics) in a speech earlier this week.
Economist Carmen Reinhart, co-author of This Time Is Different: Eight Centuries of Financial Folly, made a similar observation yesterday. As the The Hill reported…
The level of U.S. debt has reached a point at which economic growth traditionally begins to slow, a bipartisan fiscal commission making recommendations to the White House and Congress was told Wednesday.
The gross U.S. debt is approaching a level equivalent to 90 percent of the country's gross domestic product, the level at which growth has historically declined, said Carmen Reinhart, a University of Maryland economist.
When gross debt hits 90 percent of GDP, Reinhart told the commission during a hearing in the Capitol, growth "deteriorates markedly." Median growth rates fall by 1 percent, and average growth rates fall "considerably more," she said.
Reinhart said the commission shouldn't wait to put in place a plan to rein in deficits.
"I have no positive news to give," she said. "Fiscal austerity is something nobody wants, but it is a fact.
Gross debt is at 89 percent and will reach 90 percent by the end of the year, said Sen. Kent Conrad (D-N.D.), a member of the commission.
The warning signs are mounting. Much depends on how the Fed conducts monetary policy from here on out. Nominal interest rates are low, virtually zero in fact. But as Scott Sumner, an economist who blogs at The Money Illusion, has repeatedly counseled, it's still possible to have tight money and low nominal rates. As such, deflation may still be a risk at this point in the economic cycle. The solution? Growth. In particular, growth in a number of key economic metrics in May and beyond. But collecting and publishing the relevant data will take time. It'll be a while before we definitively figure out if all the deflation talk is really just talk.
May 26, 2010
IS THE REBOUND IN DURABLE GOODS STILL DURABLE?
Today’s update on new orders for durable goods is just the thing to blow away the deflation blues that have been poisoning the party over the past few weeks. Spending was up in April for this leading indicator. Actually, that’s no surprise. We already knew that last month was loaded with encouraging reports. Industrial production and retail sales, for instance, jumped last month. And job growth in April was the strongest in four years. But it’s May that suffered a change in sentiment in the markets. Figuring out if it’s just a temporary blip, or something more ominous that will show up in the economic indicators will take time. Unfortunately, April numbers won’t help figure out what's what, even if they look good.
Relevant or not, the 2.9% rise in new durable goods orders last month is a handsome gain. It’s the strongest monthly advance since January, and the fourth increase in the last five months. As our chart below shows, the overall trend in new orders remains firmly on an upswing through last month.
As always, the broad picture has a few warts when we look closer. Notably, new orders less transporation slipped 1% in April. Why should we review new orders without transportation? Economist Bernard Baumohl of The Economic Outlook Group explains in The Secrets of Economic Indicators: Hidden Clues to Future Economic Trends and Investment Opportunities…
Orders for civilian aircraft occur in periodic bursts and are hugely expensive. When a large order is received, it swells the total value of new orders for a brief period, greatly exaggerating the underlying pace of demand for durable goods, only to plummet the next month when it returns to a more normal level. To eliminate these erratic movements, it’s better to study the behavior of durable goods orders without transportation.
A similar caveat applies with defense-related orders, Baumohl advises. All of which inspires looking at new orders over longer periods of time to smooth out the rough edges that can mislead on a monthly basis. Fortunately, the trend looks good on this front. As our second chart below shows, the rolling 12-month % change in new orders for durable goods has been showing signs of recovery for some time.
Or so the numbers through last month reveal. Will it continue in May and through the summer? The latest deflationary scare offers fresh reason for wondering, as we’ve been discussing, including here and here.
No one really knows, of course, but that never slows the guessing, informed or otherwise. What are the pundits saying? Here’s a few samples to consider…
“Look, a double-dip recession is a genuine risk — I’d place it at 20 percent as opposed to 5 percent a few weeks ago. We have some chronic problems in Europe, but I don’t see it leading us to a Lehman-style contagion. At some point, you revert to a focus on our fundamentals, and those are decidedly better than conventional wisdom has it.”
Robert J. Barbera, chief economist, ITG
New York Times
“Durable orders in general are holding up pretty solidly. That speaks to both consumer and business demand and I think orders are going to hold up for a while longer.”
Carl Riccadonna, senior U.S. economist, Deutsche Bank Securities
The big rise in overall orders was further evidence that manufacturing is helping to drive the rebound. U.S. companies are benefiting from rising demand both at home and in major export markets. However, there are concerns that a debt crisis in Europe could derail the global recovery. Financial markets have been roiled in recent weeks by fears that the problems facing Greece could spread to other heavily indebted European countries, such as Spain and Portugal.
Martin Crutsinger, economics writer
"We now have five quarters of increases, and that's a good sign of transitioning from a recovery to sustainable growth. It's too early to gauge the impact of the European crisis ... probably have to wait until May or even July to see an impact."
John Canally, investment strategist/economist, LPL Financial
May 25, 2010
WHAT'S IN A NAME?
The Great Recession is over, but the Great Recovery isn't quite here. That's no surprise. We've been expecting a rather lengthy transition that's betwixt and between for some time. A year ago we opined that "the recovery period, whenever it commences, will be unusually slow and sluggish." We've reiterated the forecast a number of times. Perhaps future economic data will prove otherwise, although for the moment there's no shortage of like-minded thinkers.
As the folks at Yardeni.com, an independent financial consultancy, advise in today's note to clients:
Everyone is capitulating. Investors usually do that at the bottom of a bear market, not this close to the top of a bull market. It seems to me that everyone I talk to in our business is depressed. That’s not surprising given all the downbeat chatter suggesting that the end is near. For the past year, as stocks soared, the widespread view among institutional investors was that “this will end badly.” Nevertheless, they were mostly fully invested bears. They felt compelled to participate in the bull market. Now they are worrying that the end is finally in sight for the global economic recovery, the bull market in stocks, and (of course) the euro.
But Yardeni and company aren't necessarily bearish. As the note continues:
I see the beginning of the end of the deficit-financed social welfare state. But that won’t necessarily lead to a bad ending. It could be the beginning of greater fiscal discipline among governments around the world. That would be a happy outcome. Just imagine a world where governments freeze their spending, retirement ages are tied to average life expectancy, and homebuyers are required to put 30% down to buy a house.
Even so, it's almost certain that big, quick and easy gains in all the major asset classes a la 2009 are history. The future will be tougher, on a number of levels. But what to call the new era? Sy Harding, president of Asset Management Research Corp., has a suggestion today via an essay titled: From Great Recovery to Great Austerity!
PONDERING A FUTURE OF DEBT
Everyone knows that the U.S., and most of the mature economies around the world, are swimming in a sea of red ink. The great unknown is the degree and form of the blowback. The optimistic view is that the pain will be relatively mild and that the recovery in the world economy will help nations grow their way out of the problem. But what if growth isn't sufficiently strong or durable? In that case, the future may be quite a bit less rosy than the optimists predict.
The bond market recently has been pricing in a somewhat darker outlook, as we discussed last week. Stock and commodities markets are now joining the party, as the selling bias of late suggests. The only thing worse than a load of debt weighing on the economy is a load of debt that triggers a general decline in prices. To the extent that a hefty debt load is a contributing catalyst, we can't yet rule out that possibility. As the sobering assessment of the Committee for a Responsible Federal Budget asserts,
The current fiscal path of the United States government is unsustainable. For the past forty years, our debt-to-GDP ratio has averaged around 40 percent. This year, it is projected to exceed 60 percent, the highest point since the early 1950s. Under the President’s budget proposals, the fiscal situation will continue to deteriorate even as the economy recovers. By the end of the decade, debt is projected to be 90 percent of GDP, approaching our record high of around 110 percent after World War II. Things will deteriorate further as the Baby Boom retirement accelerates. Ten years later, the debt is expected to be well over 150 percent of GDP. By 2050, it is projected to be over 300 percent and still heading upward.
But history reminds too that recoveries after unusually deep recessions are a precarious beast. Focusing on budget austerity at this juncture may be self defeating if deflationary risks are again percolating, as the Treasury market appears to be telling us. Yes, inflation is a long-run risk, but not now, not today. What's required now, more than ever, is growth. But as Robert Kuttner reminds, "Austerity does not produce prosperity." At least not at this point in the economic cycle, even if fiscal rectitude is necessary and essential for the years ahead.
Some analysts warn that we shouldn't rule out a double-dip recession. In fact, avoiding another leg down in the broad economy is priority one, two and three. The risk also looms for Britain and the eurozone.
Welcome to the proverbial rock and the hard place. A double-dip recession isn't fate, at least not yet. As we wrote yesterday, we still expect the economy to muddle through, although that may not suffice to keep the big risks at bay. In short, a sustainable economic recovery isn't guaranteed. Much depends on how governments and investors react in the weeks and months ahead.
The biggest test in the post-Great Recession era is... now. Forget the past 12 months. That was in many ways a misleading signal of what awaits. As we've argued many times on these pages and in The Beta Investment Report, bouncing off of end-of-the-world prices is a one-time affair. That's over and the real economic challenge is upon us. Exactly what that means has yet to be determined. The details are inextricably bound up with debt, and how much pressure it puts on the global economy.
There will be many twists and turns on the road ahead, rife with lots of questions that lack obvious and compelling answers in the here and now. The one that currently looms: Will the European fiscal crisis trigger a global retrenchment in economic activity? No, according to Treasury Secretary Timothy Geithner. But the markets aren't yet inclined to agree and prefer instead to discount the risk a bit more these days.
May 24, 2010
GROWTH? PROBABLY, BUT IT WON'T BE EASY
The 12-month-old U.S. economic recovery is in "good shape," a new survey of economists advises. The National Association for Business Economists reports that 46 panelists of macroeconomic forecasters "marked up their predictions for economic growth in 2010 and expect performance to exceed its long-term trend this year and next," according to a press release published by NABE today. The upbeat view comes at a time when the deflationary risks appear to be rising, if only slightly, as we discussed last week (here and here). The great struggle between growth vs. contraction in the post-recession period has begun. Expansion still has the upper hand, but the minions of decline aren't going to fade away quietly.
Reading NABE's full report certainly stiffens one's resolve for thinking that the future is still modestly bright. Consider a few highlights from the survey, which we quote verbatim:
* The NABE forecast panel has boosted its expectations for growth in 2010 to 3.2 percent for real GDP from 3.1% in its February forecast.
* Many of the forecasters believe that the traditional cyclical forces of pent-up demand and inventory building are becoming more important. Although financial headwinds will temper the pace of growth, concerns about credit conditions have eased somewhat compared to February’s survey. Inflationary pressures are expected to gradually build, but a “stagflation” scenario—a combination of slow growth and high inflation—is considered highly unlikely.
* The biggest boost to the outlook comes from households, as forecasters have marked up their outlook for spending. Real consumer spending is still expected to lag behind the overall economy but should see sizable growth. Part of this mark-up reflects reduced expectations of thrift. The saving rate for 2010 is currently expected to average a modest 3.4 percent—down from the 4.6 percent rate predicted just three months ago.
* Job growth is now on a steady footing. Except for a third-quarter slowdown related to a reversal of Census related hiring, job gains are expected to remain robust throughout the forecast horizon, as output gains remain steady but productivity gains progressively slow. The jobless rate is forecast to steadily decline to 9.4 percent by yearend 2010 and 8.5 percent by year-end 2011, though it remains high by historical standards and is ranked by panelists as their second greatest “concern.” Additionally, NABE panelists increased their estimate of the unemployment rate consistent with full employment to 5.5 percent from 5.0 percent previously.
The survey also notes that business investment will "be an engine of growth." How so? NABE explains that "the massive inventory liquidation of 2008-2009 is over, with restocking slated for the next two years. Second, business spending on equipment and software will be strong, likely buoyed by a combination of higher operating rates and rising corporate profits." Also, the survey panelists predict that corporate profits will rise by a robust 20% this year, followed by a 7% gain in 2011. And with low interest rates extending out as far as the forecasting eye can tolerate, it all looks like smooth and easy sailing for the second half of 2010.
Count us among those who think the economy will continue to improve, but we draw the line in thinking that it's all a bed of roses from here on out. If we could somehow fast forward to 12 months hence, our expectation for looking back on the year would be one where the majority of economic indicators post positive change. But getting from here to there is likely to be rocky, which is to say a recovery marred by an unusual degree of volatility in both the usual data suspects and the interim prices changes for capital and commodity markets.
Last week's wild ride in the stock market is a sign of things to come. There's a recovery bubbling, but the easy part is behind us. Bouncing off of apocalypse lows in late-2008 and early 2009 has been replaced by the hand-to-hand combat of street battles, in which the forces of growth have to work harder to keep deflation at bay. Given the nature of the Great Recession, and the magnitude of the losses and the resulting debt load on the global economy, there will be setbacks at times that unsettle the crowd and raise doubts anew. Last week's deflationary signals are an example.
A fresh reason for doubt is always in season, of course, but the risks are higher this time around because the recovery is quite a bit more precarious. How could it be otherwise when governments the world over have moved heaven and earth to engineer a reflation to match the deflation of 2008/2009? So far the efforts have succeeded in keeping the economy from going down the sinkhole, but it's going to take even greater exertions to keep the nascent and vulnerable rebound on track. Meantime, the payback will likely diminish.
Recovery? Yes. But it's not going to be easy, and at times it's going to be downright difficult. This is actually good news for strategic-minded investors, assuming they keep some cash on hand and have the discipline to engage in some buying when the world is selling. There will be no shortage of opportunities in the months ahead. Alas, discipline of this type is rare. Therein lies a key reason why some risk premiums among the major asset classes are still positive, depending on the day.
May 23, 2010
A LITTLE MACRO PERSPECTIVE...
Economist Scott Sumner explains why a free-market bias isn't easily dismissed in analyzing cause and effect in economic history since 1980. He offers some data in support of his hypothesis "that neoliberal reforms lead to faster growth in real income, relative to the unreformed alternative."
You can't really "prove" anything in economics, of course. Meantime, you can hardly swing a cat without hitting a pundit who thinks that moving toward "neoliberal reforms" over the past generation was a mistake. The Great Recession is one reason for the recent surge of doubt, even though recessions have been arriving on a semi-regular basis since the beginning of economic time. Changing the economic paradigm doesn't change this fact. Over the centuries, virtually everything has been tried. And still the contractions keep coming. On the other hand, adjusting incentives that promote capitalism seems to boost output during periods of expansion, at least when measured over long stretches of time.
The burden of proof is one those who argue that less capitalism and more government regulation is a net plus over the long term. Where's the evidence? There isn't any, as Sumner's analysis suggests.
SUNDAY EXCERPTS: 5.23.2010
Dissecting the clues for the world economy: Japanese bond yields, declining prices for equities and commodities, a divergence of opinion about local finances, the influence of American finance regulation (for good or ill), and rethinking "too big to fail" vs. "too small to diversify" in banking regulation...
Japan’s 20-year bonds rose the most in 17 months as concern Europe’s fiscal crisis is worsening boosted demand for the relative safety of government debt. Benchmark 10-year yields touched the lowest level since December before Treasury Secretary Timothy F. Geithner visits Germany and the U.K. next week to discuss the European debt situation. Five-year yields touched levels unseen since 2005 as stocks slid and the Bank of Japan kept interest rates near zero yesterday. The BOJ conducted its third same-day operation this month to boost liquidity and said it would provide one-year loans to banks to encourage lending and defeat deflation.
"Japan’s 20-Year Bonds Rise Most in 17 Months on European Crisis," Bloomberg BusinessWeek
...the declines in stock market values and commodity prices since April have only served to reverse the gains in March. So perhaps it's most accurate to describe developments so far not as a conviction that we're on the verge of replaying events of 2008, but simply as a realization that the global economic recovery is not as strong as it appeared to be just a month ago. But the news coming next out of Europe and China will be watched with great interest by the rest of the world.
"Europe and the world economy," Econobrowser
So one part of the sovereign debt concerns which are currently so preoccupying the financial markets is associated with the containability of state debt in the context of ageing societies, and this issue is further complicated by the fact that different developed societies are ageing at different rates. This underlying uneveness is leading some people to draw some surprising conclusions. For example, according to a Financial Times/Harris opinion poll published this morning, the French turn out to be the most nervous of developed economy citizens when it comes to thinking about the sustainability of their country’s public finances.
Some 53 per cent of those polled in France thought it was likely that their government would be unable to meet its financial commitments within 10 years, while only 27 per cent thought this outcome was unlikely. Americans were only slightly less worried, with 46 per cent saying default was likely, against 33 per cent who saw it as unlikely. Curiously, only a third of the British people polled thought a government default was likely in the next 10 years, and I say curiously since on many counts the UK economic position is far more critical than the French one is... On the other hand, the Spanish respondents were remarkably more positive about their situation, with only about 35 per cent of Spaniards questioned saying they considered default to be a likely eventuality over the next decade. Which is strange, not because I have any special insight into whether or not Spain will default, but Spain’s problems are clearly worse than any of the other three aforementioned countries...
"Much Ado About (Some Of) The Wrong Things," A Fistful of Euros
Given the mess that the U.S. has made of financial regulation throughout its history, it is a wonder that authorities in other countries continue to look to us as a model in this area. In the 19th and early 20th century, limits on U.S. bank branching produced as many as 30,000 tiny, mostly unit, banks with waves of failures on numerous occasions. These failures led to persistent attempts to put a financial safety net under the banking system, an effort that failed in Congress 150 times (based on the ample evidence from the failures of states’ deposit insurance systems) before succeeding in the Great Depression. That calamity also saw the separation of commercial and investment banking despite what we now know — namely that the securities underwritten by bank affiliates declined in price by less than others (Kroszner-Rajan), and that commercial banks with investment banking affiliates were more stable, not less (White).
"U.S. Financial Reform: Don’t do as we say, or do," Finance: Facts and Follies
Many commentators have called for regulation to prevent banks from becoming “too big to fail”. This column adds a cautionary note. A world with only small and domestic banks is no safer. The key benefit of multinational banks – being able to mobilise funds across countries – could still be extremely useful for maintaining stability in times of distress.
Giacomo Calzolari, et al.
"Multinational banks: They did not run away during the crisis," VOX
May 22, 2010
Online MBA, a website dedicated to business education and related resources, is giving away a limited number of books on its recommended list. Among the titles offered: Dynamic Asset Allocation. Instructions on how to request a copy of my book, or some of the other titles offered, are posted here (at the bottom of the page). What's the catch? Supplies are limited...first come, first serve.
May 21, 2010
A NEW SEASON OF RISK AVERSION...AGAIN
Earlier this week we pondered the potential for higher deflation in the months ahead. One of the suggestive clues was the falling inflation forecast as implied by the shrinking spread between the yields on the nominal and inflation-indexed 10-year Treasuries. At the time, the market was priced for inflation at 2.13% for the decade ahead (as of May 18). A mere 48 hours later, the market-based forecast dropped sharply: Treasuries yesterday anticipated inflation at 1.89%--the first reading under 2% since last October.
The Treasury market is subject to all the usual imperfections when it comes to implied forecasts and so we should be cautious in reading too much into any one day's numbers. But this much is clear: the market's perceived risk of deflation is running higher these days. Given the magnitude of the change, we should think twice before dismissing the message. Indeed, as our chart below shows, there's been a sharp deterioration in sentiment this month in the market's inflation outlook. At the end of April, Treasuries expected 10-year inflation on the order of roughly 2.4%, or some 50 basis points higher vs. yesterday's numbers.
A new round of deflationary risk is unwelcome, of course. Although we're still a long way from a sustained decline in prices across the board, it's not too early to consider the hazard anew, as the latest rush into Treasuries suggests. That's a change for the worse relative to recent history. For six months or so, it looked like the deflation threat had been vanquished. It may yet prove to be so. But there are more than trivial doubts arising today.
Ironically, last month witnessed a long-awaited rise in new business loans. For the first time since October 2008, the monthly tally of commercial & industrial loans approved at commercial banks was higher, according to the Federal Reserve. Although the rise was slight, it was a step in the right direction for thinking that the central bank was finally inducing higher levels of lending again in the corporate sector—a necessary step for thinking that the economic expansion was taking root. Indeed, C&I loans were the last major holdout in the recovery over the past year in terms of showing positive change.
But suddenly there's a fresh wave of doubt. The apparent catalyst is Greece and the debt woes of Europe. But these concerns aren't new. In early February, for instance, we observed that the anxiety over debt and deflation was very much in the air. What's changed? Nothing, really, other than the market has reassessed the red ink challenge and decided the fallout may be worse than previously thought. Pricing risk for the threat du jour is invariably an imperfect science, and one subject to revision. That's been working to our advantage over the past year; now it's swinging the other way. Divining the future is a risky business, with the estimates forever in flux.
Meantime, the world awaits more economic data. The numbers that have been supporting the case for growth so far this year are suddenly ancient. The labor market's apparent return to minting new jobs on a net basis now requires a fresh batch of supporting data to fend off deflationary fears. Ditto for thinking that C&I loans are headed higher. In fact, everything may be reassessed in the days and weeks ahead. What's needed to stabilize sentiment and convince the crowd that the glass is half full rather than half empty? New numbers that show that the recent signs of economic growth were more than a statistical blip; more than a dead-cat bounce.
It was always the case that the apparent recovery was going to be tested. The massive slump that was the Great Recession was never going to fade away quickly and seamlessly. Instead, the restoration of growth was going to come in fits and starts, and keep everyone guessing at times. Back in January, considering the year ahead, we asked: "Will the economic rebound build a head of steam that's self sustaining?" Our forecast at the time: "It's going to a close call." That still looks like a reasonable prediction at the moment. Wiping away doubts born of the deepest recession since the 1930s was destined to take time. But as mere mortals, we're all subject to thinking positively when the recent data looks encouraging. We're not likely to make that mistake again any time soon.
The cause of recovery has taken a hit. It's not fatal, but it's not trivial either. For the moment, it's all about sentiment. And, perhaps, the sentiment is wrong. But for now, it takes a card-carrying contrarian to make the case that the optimism of recent months wasn't misplaced.
"The risk is skewed towards deflation right now," Dimitri Delis, fixed income strategist at BMO Capital Markets, warns. Until—and if—we see economic reports to the contrary, risk aversion is the new new thing…again.
May 20, 2010
NEW JOBLESS CLAIMS RISE
Today’s update on last week’s new jobless claims is discouraging, and not only because filings jumped by a hefty 25,000 for the week through May 15.
As the chart below shows, new claims for unemployment turned up last week to 471,000, the highest since early April and in the upper range that’s prevailed so far this year. That raises the risks for the economic recovery, if only slightly. As we wrote last week, the job market has been struggling in 2010 and initial claims offer no reason to think otherwise. True for much of this year, true today.
A rise of any significance in jobless claims is obviously bearish for the simple reason that more folks are joining the unemployment line. As a robust leading indicator, this metric provides some glimpse of what's coming. Last year it signaled recovery, which is exactly what arrived. Today, however, it's warning of a round of sluggish economic activity. That’s always bad news, of course, although it’s particularly problematic at this stage, when the recovery should be on solid legs. Then again, weekly numbers are subject to a high degree of volatility and so we need to look at the trend. Unfortunately, the trend so far this year, at best, is one of treading water. Troubling as that is, given the enormous need for net job creation, the challenge is compounded by the possibility that jobless claims are set to rise at a time when it’s already late in the cycle for a labor market recovery that has yet to deliver convincingly encouraging numbers.
And if that wasn’t enough, all this arrives at a time when the risk of deflation may be inching higher, as we discussed yesterday.
The recent economic evidence, combined with the stock market’s decline of late, is signaling that the economic recovery is facing a new round of headwinds. The proof is still tentative and subject to revision in the coming weeks. But the stakes are high and the hour is late. Unless we see some compelling evidence to the contrary in the near future, we may be looking at a long, sluggish summer of second guessing and rethinking about the state of the economic rebound.
But first we need to see the data. Next week brings updates on existing home sales (Monday), consumer confidence (Tuesday), new orders for durable goods (Wednesday), another weekly update on jobless claims (Thursday) and personal income and spending for April (Friday).
The optimistic view is that the still-meager but mounting case for thinking that the recovery has stalled is really a head fake by way of statistical noise. If so, we’ll know soon if that’s reality or wishful thinking. But judging by the stock market’s sharp slide early today, the case for optimism has few takers at the moment.
May 19, 2010
IS THE RISK OF DEFLATION RISING AGAIN?
Last week, I advised that the unusual rallies in the dollar and gold this year may be a warning sign that deflationary winds are starting to blow harder. Historically, one falls as the other rises. The fact that both are climbing suggests the markets are worried about deflation...again. Today's report on April consumer prices only strengthens the case for thinking that the "D" risk is climbing once more. It may be a false warning, but it's getting harder to ignore.
The seasonally adjusted consumer price index (CPI) dropped 0.1% last month, the Bureau of Labor Statistics reported today. That's the first monthly fall in headline consumer prices in more than a year. The sharp drop in energy prices last month was a driving factor, but core CPI (which strips out food and energy prices) was flat in April, suggesting that there's more than a weak energy market to blame.
It's still too early to declare that deflation is again a broad and imminent threat, as it was in late-2008. But the "D" risk is higher, if only marginally. The primary catalyst: debt. The debt crisis in Greece has soured sentiment on the outlook for the eurozone and throughout the developed world. The world's attention has been refocused anew on the perils of debt and deficits in the new world financial order. As the mature economies struggle with rising levels of red ink, combined with less-than-robust forecasts for growth, the markets are turning cautious. That's inspired a new (and so far mini) flight to safety, which still means moving into dollars and, to a lesser extent, gold.
In a world where anxiety is once again on the march, if only slightly, it's no wonder that prices generally are weakening again. One month is hardly definitive proof of anything, of course, and so we can't draw hard and fast conclusions from a single monthly report on consumer prices. Rather, it's the trend that's important. Unfortunately, the trend offers little reason to think that disinflation (or its evil cousin deflation) is completely dead.
Consider the chart below, which shows the 12-month percentage change in core CPI. For the first time since 1966, the annual pace of core CPI last month dipped below 1%. More ominously, the 12-month change in core CPI has been falling sharply since December.
Headline inflation, which includes energy and food, offers a more reassuring trend, as the second chart below shows. Nonetheless, it's obvious that the reflation efforts have stalled of late. Headline CPI on a 12-month basis has rebounded sharply from last year's brief flirtation with outright deflation. The question before the house: Has it stabilized in the mid-2% range? Or is it poised to fall once again, dragged down by the deflationary winds that appear to be blowing?
The Treasury market seems inclined to expect more deflationary risk in the near future. The inflation forecast based on the yield spread for the nominal and inflation-indexed 10-year Notes was 2.13% yesterday—down from 2.45% on April 29, as the third chart below shows. Yes, that may be nothing more than the usual volatility in the Treasury market. But given the clues bubbling elsewhere in the global economy, we're not yet prepared to dismiss this forecast of falling inflation as statistical noise.
The next several weeks may prove crucial in confirming or rejecting the new deflationary worries. Indeed, it's still too early to dismiss the continuing liquidity creation by the world's central banks. In the long run, higher inflation is a virtual certainty. In fact, the risk of opening the door to overly high inflation for the generation ahead remains a concern. But not now. The path from here to there may yet be defined by fighting a new round of deflationary pressures.
Considering the hazards that outright deflation can impose on the prospects for economic recovery, it's obvious that keeping the "D" risk at bay is a battle that the central banks can't afford to lose. Growth is the only real hope of making progress in repairing the damage from the Great Recession. Everything from job creation to keeping the red ink from overwhelming national budgets is at stake. Even before the recent uptick in the deflationary threat, the outlook for economic growth was middling, at best, in the developed world. That somewhat uninspiring outlook now appears a bit more vulnerable. Exactly how vulernable depends on what we learn in the economic reports in the weeks ahead.
For the moment, inflation is tame to nonexistent. Deciding if that's also a prelude to deflation is a live debate…again.
Even so, don't assume that the global economy can be summed up with one perspective. The hazards that lurk in the mature economies aren't always reflected in the developing world. "Chinese inflation might be out of control," warns Fortune.com today.
It's a complicated world. The common denominator: risk. There's still plenty to go around. Same old, same old. It just comes in a wider array of flavors these days.
May 18, 2010
FINANCIAL REGULATION AND HISTORICAL RHYMES
Every financial crisis brings cries of more regulation. True in centuries past, true today. But more regulation isn’t always better regulation. And sometimes the knee-jerk reaction to do something, anything (if only to look politically astute) is a step backward.
"Governments know that the public believes that ‘something must be done’ after a crisis, but all too often through history governments have done the wrong thing," argue the authors of the recently published The Road from Ruin: How to Revive Capitalism and Put America Back on Top. In making their point, Michael Bishop and Michael Green recount a bit of 18th century financial history...
In the same year as Britain’s South Sea Bubble, France had its own financial crisis, following the newfangled financial innovation of paper money. France responded to the Law Panic of 1720— named after the Scotsman John Law, who was behind the new economic plan— by abandoning paper money entirely, which stalled its economic development. Similarly, strict regulation of the financial sector was a central plank of President Roosevelt’s New Deal reforms to tackle the Great Depression, yet many of these regulations proved to be wide of the mark. Some reforms, such as trying to stabilize the banks by forcing them to hold much more capital, made the Depression worse; others, such as splitting up the banking sector into separate investment and retail banks, imposing arbitrary caps on interest rates, and tightly regulating the stock market, hobbled the U.S. economy for nearly half a century.
It would be a mistake to argue against rethinking some, if not most of the existing financial regulation in the wake of the 2008 crisis and the Great Recession. The challenge is figuring out what to fix, what to leave alone, and generally what’s required to promote stability and entrepreneurship without creating new hazards in the process. Considering the mounting efforts in Congress to introduce a maze of new financial regulations, Andrew Lo, a finance professor at the Massachusetts Institute of Technology warned earlier this month: "Until we understand what the causes were, we may be implementing ineffective and even counterproductive reforms. I understand the need for action. I understand the need for something to be done. But what I expect from political leaders is for them to demonstrate leadership in telling the public that we need to proceed about this in a much more deliberate and rational and thoughtful way."
Nonetheless, it’s fair to say that the general demand for more regulation runs hot these days. That includes the residential real estate market, which in many ways was ground zero for the economic ills of recent vintage. In his 2009 book A Failure of Capitalism, Richard Posner speaks for many when he writes: "The housing bubble and the risky lending practices could have been prevented by more aggressive regulation and the elimination of tax benefits for homeowners."
Perhaps, although the messy details of minting new regulations are upon us as the end game for financial reform legislation unfolds in the Senate. As usual, you can find a rainbow of views on what’s shaping up to be a rather large bill, and one that’s reportedly likely to pass, for good or ill.
As we ponder a new chapter of financial reform in American history we might want to pause a moment and consider if any of the recent troubles were caused by previous reform efforts gone awry. A new study published by the Philadelphia Fed offers some evidence for thinking that such worries are more than political provocation. "The U.S. bankruptcy reform of 2005 played an important role in the mortgage crisis and the current recession," according to the new research study: Did Bankruptcy Reform Cause Mortgage Default Rates to Rise? The paper’s abstract answers in the affirmative, explaining...
When debtors file for bankruptcy, credit card debt and other types of debt are discharged — thus loosening debtors’ budget constraints. Homeowners in financial distress can therefore use bankruptcy to avoid losing their homes, since filing allows them to shift funds from paying other debts to paying their mortgages. But a major reform of U.S. bankruptcy law in 2005 raised the cost of filing and reduced the amount of debt that is discharged. We argue that an unintended consequence of the reform was to cause mortgage default rates to rise. Using a large dataset of individual mortgages, we estimate a hazard model to test whether the 2005 bankruptcy reform caused mortgage default rates to rise. Our major result is that prime and subprime mortgage default rates rose by 14% and 16%, respectively, after bankruptcy reform. We also use difference-in-difference to examine the effects of three provisions of bankruptcy reform that particularly harmed homeowners with high incomes and/or high assets and find that the default rates of affected homeowners rose even more. Overall, we calculate that bankruptcy reform caused the number of mortgage defaults to increase by around 200,000 per year even before the start of the financial crisis, suggesting that the reform increased the severity of the crisis when it came.
To be sure, mortgage defaults were but one piece of a very large calamity. Nonetheless, the paper brings to mind a couple of famous quotes. The first, from Santayana, is the ever pertinent gem about how those who ignore history are doomed to repeat it. Finally, there’s the dean of American letters, Mark Twain, who wisely observed that while history doesn’t repeat, it does rhyme.
HOUSING STARTS RISE, BUT NEW BUILDING PERMITS FALL
The housing market has stabilized. In fact, it's safe to say that it's rebounding. After being hammered for three consecutive years through early 2009, the trend is again friendly in housing construction. But the number of new building permits issued fell sharply last month. Is the nascent recovery in housing starts destined to follow?
If we focus on housing starts alone, the trend is certainly clear. Privately-owned housing starts rose nearly 6% last month to a seasonally adjusted annual rate of 672,000. That’s more than 40% higher than the year-ago level. As business and accounting professor Esme Faerber wrote in All About Bonds, Bond Mutual Funds, and Bond ETFs, "strength in housing starts shows consumer confidence in the economy." And so it does in 2010. As we reported last week, retail sales rose in April for the seventh consecutive month.
What, then, are we to make of the steep drop in new permits issued? Is it merely statistical noise? Or is it an early warning sign that the recovery in housing construction of late poised to slow, or even reverse? In that case, the wider economic recovery may face a growing risk of stalling. Ongoing weakness in building permits would surely raise that specter. Indeed, the trend in permits is considered to lead housing starts, according to Professor Mark Hirschey in his textbook Fundamentals of Managerial Economics .
That relationship has remained intact over the past 12 months or so. For the year through March, permits jumped by 31%, well above housing start’s 22% climb. But permits tumbled nearly 12% last month, the biggest monthly drop since the darkness that was December 2008. As a result, last month’s tally of new building permits issued was the lowest since October 2009.
Is there a crack forming in the budding housing recovery’s foundation? Too soon to say, although the trend in permits in the months ahead deserves close attention. As with so much of the economic rebound over the past year, the stress test of endurance is the year ahead, rather than the year that's just passed. Bouncing off the bottoms of economic cycles is one thing; sustaining the bounce is something else. At least one pair of dismal scientists is wary of what comes next:
"The increase in demand prompted by the tax credit has lifted [housing] construction, but the expiration of the credit on April 30 has made home builders wary about continuing to add new homes during the summer," wrote economist Ian Shepherdson at High Frequency Economics, according to Marketwatch.com.
“We think the pace of the housing recovery will be modest at best,” Jonathan Basile, an economist at Credit Suisse, told Bloomberg BusinessWeek. “It’s encouraging to see starts gain some traction but the decline in permits takes some of the luster off.”
May 17, 2010
MID-MONTH PORTFOLIO REVIEW
May’s shaping up to be a rough month for most of the major asset classes. The primary catalyst: debt worries. As investors become increasingly anxious over the ramifications of mounting deficit spending in Europe and throughout the developed world, risk aversion is the new new thing…again.
The riskier corners of the global asset markets are taking it on the chin so far this month through May 14, as our table below shows. Stocks the world over are down by roughly 4% to 8% this month as of last Friday. Equities in mature markets outside the U.S. have been hit hardest. The MSCI EAFE index has shed more than 8% in the first two weeks of May.
The markets are becoming ever more sensitive to red ink, and the message is starting to reverberate in political circles. "This week has started with the news that the German government will press other eurozone countries to follow its example in setting rules for balancing budgets within its regions," Jane Foley, research director at Forex.com, told AP today. "However, this is unlikely to fundamentally alter sentiment with respect to the euro given broad based skepticism about the ability of Greece to stomach the budget reform already on the table."
The fact that mounting debts are starting to take a toll on market sentiment should come as no surprise. It’s been obvious for some time that this was a hazard that couldn’t be ignored. “It's all about debt from here on out, and probably will be for many years,” we wrote last month.
The potential for trouble was compounded given the strong rallies in almost everything in the first quarter and during the 12 months or so through the end of April. It seems that investors were focused on momentum rather than economics. But that's changing, as it inevitably would, given the magnitude of the fiscal challenge that awaits.
We’ve been advising in The Beta Investment Report for some time now that the stellar rebound in assets since early 2009 was misleading. In the January 2010 issue of the newsletter, for example, we wrote: “Today, it’s easier to argue that the future is bright, or at least brighter. Expected risk premiums are therefore lower. How much lower is the great unknown. But having witnessed across-the-board gains in everything, and at historically high levels as 12-month returns go, we’re inclined to be cautious.”
At the time, relatively few ears were open to such talk. Presumably there are a few more listeners today. Does that mean it’s time to sell everything and go to cash? No, although navigating the world that awaits will be quite a different challenge than what we’ve seen over the past year or so. Big, easy gains in everything is almost certainly history. The new world order of complication is upon us. The details of designing and managing asset allocation looks set to be relevant once more.
May 15, 2010
SATURDAY LINK LIST: 5.15.2010
Red-ink roundup: Here, there and everywhere…
Navigating the Fiscal Challenges Ahead
Fiscal risks have risen, especially in advanced economies, for three reasons: underlying fiscal trends have further deteriorated…financial markets have increased their focus on fiscal weaknesses; and progress in defining fiscal exit strategies has been slow.
Deutsche Bank boss doubts Greece will repay loans
The head of Germany's biggest bank has cast doubt on whether debt-wracked Greece will be able to repay billions of euros (dollars) in loans, prompting Berlin to ride to Athens' defence on Friday.
The second debt storm: Who will bail out the countries that bailed out the world's corporations?
The debt mountain that brought down some of the world's biggest banks and dragged the international financial system to the brink of disaster has simply shifted to governments. Now it's threatening countries around the globe -- and, if left unchecked, could rip the very fabric of Europe's economic system and wreck economic recoveries in the U.S., China and Latin America.
US Problems Similar to Greek, Says Bank of England CEO
Today the governor of the Bank of England Mervyn King raised an alarm that the United States is facing the same problems that Greece does.
The Eurozone Bailout—Are We Still Standing?
As we are about move into the fourth day of the week where EU policy makers together with the IMF and the ECB launched an unprecendented series of aid tools to combat the mounting risk of a collapse in Greece and elsewhere in the European periphery I am finally ready to move in with some comments. First of all, there has been no shortage of comments, opinions and market calls on the back of the bailout package and while risky assets have indeed rallied, it is if the underlying reality of the situation looms ever more prescient underneath the surface than what one would have expected from such a collosal dose of stimulating policy.
Fiscal crisis, contagion, and the future of euro
The Eurozone has been swept up in turmoil that has ranged from stock and bond markets to exchange rates, government spending and tax rates. Marco Pagano, Professor at the University of Naples Federico II and CEPR Research Fellow, explains events, how they hang together, and what needs to be done. This challenge facing Europe could be a historical turning point.
Greece and the Euro: Recession With No Exit
Pity the poor Greeks and beware of getting what you wish for.
The Eurozone lender of last resort?
OK. Let's simplify this whole Eurozone mess.
The Greek Myth of Profligacy: The Fiscal Crisis in Greece Isn’t About Spending
It’s not the spending. The Greek fiscal situation is a mess, a big dangerous mess. But they didn’t spend their way into that mess and they won’t be able to cut their way out of it.
May 14, 2010
INDUSTRIAL PRODUCTION & RETAIL SALES RISE IN APRIL
Retail sales rose in April—the seventh consecutive monthly increase, the government reported. Meanwhile, industrial production also rose last month—the third straight rise and the strongest since January. On a year-over-year basis, both measures are up sharply, suggesting that the broad trend in the economic recovery rolls on.
Looking futher out, there’s still debate about the sustainability of recent economic growth, engineered to some extent by fiscal and monetary stimulus over the past year. In particular, some analysts wonder if current growth is merely borrowing expansion from the future. If so, the second half of the year may suffer as payback kicks in. But no one really knows. The next several months may prove to be a crucial period for deciding what lies ahead. In essence, the snapback period of growth after the recession will be stress tested for durability through the coming weeks and months. One burden that awaits is the “herculean task in digesting mounting piles of debt in the U.S. and around the world while keep growing bubbling and inflation contained. As economic juggling acts go, this one promises to be more than a little challenging. Perhaps that’s one reason why the stock market swooned this morning despite the rise in retail sales and industrial production.
Meantime, here’s a sampling of the commentary from this morning’s chattering classes on the numbers du jour…
“Production is barely keeping pace with demand,” Aaron Smith, a senior economist at Moody’s Economy.com in West Chester, Pennsylvania, said before the report. Lean inventories relative to sales “supports the outlook for solid manufacturing growth.” Bloomberg BusinessWeek
"We're starting the second quarter on a very positive note. The manufacturing recovery is getting more diffuse with 17 of 19 major sectors increasing production," said David Huether, chief economist at the National Association of Manufacturers. "It looks more durable and deeper." Associated Press
"The industrial sector is benefiting from increased domestic demand, a strong export expansion, and to an important extent from a cyclical inventory swing," said Dan Meckstroth, chief economist for the Manufacturers Alliance. MarketWatch.com
Official US figures showed a 0.4% rise in retail sales last month, compared to expectations of a 0.2% increase. At the same time the March figure has been revised upwards from 1.9% to 2.1%. James Knightley at ING Bank said:
The April US retail sales report is a little better than the market was expecting with headline sales up 0.4% month on month. The details offer a very mixed picture with a 6.9% jump in building/garden equipment offsetting falls in furniture, clothing and sporting goods. Indeed, if we exclude the building group, sales would have fallen 0.3% month on month. Consequently the detail shows retail sales growth isn't as healthy as the headline suggests. Moreover, consumer spending continues to grow more strongly than the relationship with consumer confidence suggests would historically be the case. We therefore do have doubts about the sustainability of the strength in retail sales and would not be surprised to see softer figures in the next few months.
“It looks like a very solid recovery," said Bob Mellman, senior economist at JP Morgan in New York. ABC News
"DYNAMIC ASSET ALLOCATION" ON THE RECOMMENDED LIST
Several of the books on the list will be familiar to business/finance readers, such as When Giants Fall: An Economic Roadmap for the End of the American Era and 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. There are also several lesser-known titles that are intriguing. On that caught our eye:
How We Decide...a fascinating review of how neuroscience can help us make better decisions.
May 13, 2010
STILL NO SIGN OF DOWNWARD MOMENTUM IN JOBLESS CLAIMS
Jobless claims dipped last week by a meager 4,000 to a seasonally adjusted 444,000, the Labor Department reported this morning. But even that spare decline is less than it seems. The previous week’s claims were revised up by 4,000, making the last two weeks more or less a wash, depending on whether you’re feeling statistically generous or not.
Stepping back and looking at the broader trend reveals that jobless claims continue to bounce around at the low end of the range for the year to date: roughly 450,000, give or take. That's a substantial improvement from a year ago, but such observations are rapidly becoming the stuff of ancient history. In short, analysts are asking this data series: What have you done for me lately? Not much, it turns out. Indeed, it’s still unclear if claims will break through this floor any time soon. Clearly, the job market has been struggling in 2010, and based on this set of numbers, more of the same may be coming.
Optimists counter that there’s fresh hope for renewed progress in the wake of two encouraging months of robust gains in nonfarm payrolls (April’s rise was the best in four years). "The labor market is moving in the right direction," says Ryan Sweet, a senior economist at Moody’s Economy.com, via Bloomberg BusinessWeek. "Claims haven’t fallen as quickly as would be suggested by the non-farm payrolls." The implication: new filings for jobless benefits are set to fall significantly in the weeks ahead.
Either that or the broad rebound in nonfarm payrolls will stall. The consensus view seems to favor progress, although it’s also clear that dismal scientists are having a tough time feeling confident about what comes next. Andrew Gledhill, also of Economy.com, tells AFP: "The labor market is gradually recovering as businesses are growing more confident and slowing the pace of payroll reduction. That said, current values for initial claims remain high and we would like to see them come lower to be more comfortable with the sustainability of recent net job gains." He advises that April’s gains in nonfarm payrolls suggest that initial claims deserve to be under 400,000, or about 44,000 claims lower than the latest tally.
That's going to be tough in the near term, another analyst warns. "There are more jobs being created, but the general trend is that businesses are still reluctant to hire," notes Gary Shilling of A. Gary Shilling & Co. in a Reuters piece today. "The data show that the issue is more a lack of hiring and not people getting laid off." And, he adds, "That's why the unemployment rate [currently at 9.9%, or near the high point for the recession] remains where it is."
May 12, 2010
THE DOLLAR’S UP, AND SO IS GOLD. A WARNING SIGN?
Gold is trading at a record high today—roughly $1240/oz as we write this morning. The standard interpretation is that the metal is pricing in higher inflation in the years ahead. That’s an accurate reading of gold’s message, but the analysis is more complicated than usual once you consider the metal’s trend of late in context with other markets and the global economic climate. In the short term, the rising demand for gold is also telling us that the risk is rising (again) for a new wave of deflation in the months ahead.
One sign that the higher gold price is less about inflation in the near term is the concurrent increase in the dollar. That's unusual. Over the last several decades (the modern age of fiat currencies), the greenback and gold have generally shared a negative correlation. When one rises, the other falls. Not every day, week or even month, but in the grand cycle of global economics the dollar and gold are competitors as a monetary store of value.
For good or ill, the dollar is the world’s reserve currency in practice. That's a role once held by gold. But while the metal is no longer official legal tender, old habits die hard. As such, gold is still widely considered money, and to an extent it represents an alternative to the dollar, at least on the margins.
Meanwhile, the greenback's fluctuations aren't always a straight reflection of the economic outlook of the U.S. Given its role as the world's reserve currency, the dollar’s rise is also a sign of rising risk aversion around the world. In that case, the dollar’s value may climb against foreign currencies even when gold’s price is ascending. That certainly sums up the current climate.
For the year so far, the dollar is higher by about 9%, based on the U.S. Dollar Index. Meanwhile, gold is up about 13% year to date. Simultaneous, ongoing rallies in both is fairly rare. What does it mean? Call it the flight-to-safety trade, which is benefiting gold and the dollar.
Investors around the world shifted assets back into the dollar, not because the U.S. is in a substantially stronger fiscal position than Europe or Japan. Although you can make the case on the margin that the U.S. economic is brighter, there’s no getting around the fact that America’s fiscal position in absolute terms is deteriorating--in sync with the rest of the developed world. In short, rising deficits and liabilities without (so far) the political will to raise taxes or cut spending in a meaningful way. The pressure valve, as a result, is higher inflation by way of printing money to solve the country’s fiscal troubles.
That scenario is obviously a plus for gold’s price. Presumably no one needs a primer on why gold is an inflation hedge. In a world that’s continually bailing out struggling companies and countries, and at the same time keeping keeping interest rates at rock bottom nominal rates, the potential for higher inflation is obvious. Indeed, the reason that so much of the developed world is engaged in providing emergency loans and the like is that demand for money exceeds supply sans government intervention. But the government is intervening. Where are the governments getting the money? They’re not raising taxes. They're not cutting services. That leaves the third choice: printing money. The mix may change in the future, but in the present that's more or less the reality.
Meantime, the risk of higher inflation isn’t imminent. In fact, we may not see prices rise in a material and sustained way for several years. Indeed, the market’s outlook for inflation has recently turned lower, based on the spread between nominal and inflation-indexed 10-year Treasuries. This market-based inflation forecast, while hardly the last word on the topic, does at least give us a sense of how the crowd is pricing future inflation risk. For the moment, that risk has fallen, as our chart below shows.
Lower inflation expectations are a good thing generally, although at the moment that’s a debatable point. As the chart above shows, the reflation efforts of central bankers has succeeded in printing away the deflation risk, which was a clear and present danger in late-2008 and early 2009. Higher inflation generally was required to keep the global economic system from imploding. It worked. The question is whether the deflationary winds are again blowing?
It’s too soon to say, although this risk bears watching once more. We already have some warning signs that alert us that risk aversion is rising--simultaneous increases in the price of gold and the dollar’s value. A falling inflation forecast in the Treasury market is another. If these trends continue, aided and abetted by falling equity prices and a new downturn in housing, we may be looking at another battle with the forces of deflation.
The critical factor will be the broad trend in economic growth. We can sum up this issue with one strategic question: How much of the fiscal and monetary efforts at ending the recession in the recent past has merely borrowed future growth? At some point, juicing the economy today diminishes the potential for growth tomorrow. You can’t get blood out of a stone, nor more growth out of an economy simply by printing money. At least not in the long run. In the short run, there’s a case for government intervention, at least in the darkest days of late-2008. But now we’re betwixt and between, juggling the risk of higher longer term inflation with the hazards of short term deflation (again), or so it seems.
The ultimate manifestation of deflation, of course, is a fall in the value of a nation’s GDP, a.k.a. recession. It’s premature to say that another recession looms. The economy, fortunately, has shown some ability to grow at a faster rate recently, as indicated by the accelerating pace of net job growth in the last two months. But this leads us back to the question of how much of the recent economic growth is simply borrowing future growth? No one really knows, of course, although it’s a safe assumption that some degree of borrowing is all but inevitable.
The risk of recession is still quite low, but the gold, forex and inflation markets are telling us that the risk is no longer falling and perhaps it’s even starting to rise.
May 11, 2010
INFLATION WILL "SAVE" THE EURO
Fiat currencies ultimately succumb to the follies of government largess, but the denouement rarely comes quickly. So it goes that the rumors of the euro’s death have been premature.
No government will sit idle as its currency struggles with survival. The template for life-giving resuscitation is, in the 21st century, widely recognized and practiced, albeit in various forms with various results. But in the grand scheme of monetary policy, there are two basic paths available when a currency comes to the strategic fork in the road. One is to let the natural market forces have their way in times of economic contraction. This choice allows prices to settle on the point of equilibrium, which is to say fall. But letting supply and demand take control is political suicide at some point. Deflation, in short, is unacceptable to the citizenry, and understandably so in a world of debt. Did anyone really believe that the European Central Bank and the various governments on the Continent would allow Greece, a tiny sliver of the eurozone’s economy, bring down of the world’s leading currencies?
The solution, as any student of financial and economic history knows, is the time-tested device known as inflation. Fiat currencies are, by definition, a flexible beast. They exist solely by government decree. If the state has the power to create a currency, it also retains the power to revive it when economic turbulence arrives. Indeed, the raison d'etre of fiat currencies is to elevate inflation when the alternative is unacceptable. Reflation, in short, is every currency’s savior in times of turmoil.
The last time central bankers and governments attempted the alternative in any meaningful way was the early 1930s, when a variant of the gold standard was in force. Suffice to say, that policy path had its problems. As Barry Eichengreen writes in astute book Golden Fetters: The Gold Standard and the Great Depression, 1919-1939, “the gold standard itself was the principal threat to financial stability and economic prosperity between the wars.”
The gold standard is a potent tool for keeping a lid on inflation, but it’s not much use otherwise. No wonder, then, that when a currency (or an economy) needs inflation (or less of deflation), the gold standard can be downright lethal. The gold standard is the antithesis to a flexible monetary policy. That can be a net plus at times, perhaps most of the time. But it threatens heavy economic pain every so often, and every economy ultimately cries uncle at some point. In that sense, the gold standard is impractical since it's politically unacceptable at certain points in the business cycle.
The euro isn’t linked to gold, of course, but below every fiat currency is the potential to step closer to a de facto gold standard. The governments of Europe have been facing such a decision in recent months amid the collapsing fortunes of Greece. Tethered to the euro, the Greek economy is effectively chained to a gold standard, albeit one imposed by the folks in Brussels rather by the barbaric metal. Devaluation of the currency (a.k.a. inflation) is impossible for Greece, just as it was for the U.S. in the early 1930s pre FDR. That shifts the pressure elsewhere. Economic adjustment is inevitable in times of crisis. If not with reflation, then where? In the 1930s in the U.S., under a gold standard, there was only one way out, as economics professor Randall Parker explains in The Economics of the Great Depression. In essence,
…economic agents should be forced to re-arrange their spending proclivities and alter their alleged profligate use of resources. If it took mass bankruptcies to produce this result and wipe the slate clean so that everyone could have a fresh start, then so be it. The liquidationists viewed the events of the Depression as an economic penance for the speculative excesses of the 1920s. Thus, the Depression was the price that was being paid for the misdeeds of the previous decade. This is perhaps best exemplified in the well-known quotation of Treasury Secretary Andrew Mellon, who advised President Hoover to “Liquidate labor, liquidate stocks, liquidate the farms, liquidate real estate.” Mellon continued, “It will purge the rottenness out of the system. High costs of living and high living will come down.”
Something similar awaits Greece, assuming it remains in the euro. The governments of Europe recognize the pressure and so they seek to ease Greece’s burden by offering reflationary support to ease the pain of the de facto gold standard. Nearly $1 trillion of reflationary spending is reportedly on its way.
In some respects this is a grand experiment. Can Europe maintain the euro, and its gold standard-like pressures on Greece and at the same time direct reflationary help to the ailing economy? To the extent that Greece represents a threat to the survival of the euro, it’s all but certain that European governments and the ECB will contain the threat. But at what cost? Greece will either be forced out of the euro (an unlikely scenario) or reflationary efforts will ease the pain by devaluing the euro vis a vis the dollar. Then again, the dollar has its own inflationary baggage if we look forward into the medium- and long-term future. Is one more burdensome than the other? The market has its work cut out for making a distinction.
The details will be messy, as they always are. But if the choice is inflation or deflation, we know how this story ends. Governments don’t willingly embrace deflation in the wake of the Great Depression, the last time that policy was embraced. Inflation is an easier pill to swallow…in the short term. There are long-term consequences, of course.
Inflation is always the preference since the Great Depression. There are some compelling reasons why that’s so. But it’s hardly a free lunch, even if it appears to be at the moment.
May 10, 2010
RATIONAL ASSET PRICING COMPLICATIONS
Is momentum investing irrational? Momentum here is defined as the persistence of recent pricing trends to continue in the short-term future. It’s not a trick question, but it’s complicated. As financial economics continues to identify “factors” (or alternative betas, if you prefer), the new insight both helps and hinders the effort to clarify the truth about asset pricing. One the one hand, documenting the case that securities prices are driven by more than the “market” beta represents an attack against modern portfolio theory and the efficient market hypothesis. Yet the same smoking guns can also be used to defend EMH. The momentum factor offers an intriguing example.
Let’s step back a bit first and lay out the broader debate about EMH, which is a theory that says all known information is reflected in market prices and so it’s hard to beat the market by picking securities. EMH is crucial piece of MPT, which in its basic form is a body of theories that tells us that the market portfolio—broadly defined—is the “optimal” portfolio. As such, the market portfolio will generate the highest return for a given level of risk over time. The original interpretation of MPT was simply to buy and hold the market portfolio. To the extent you wanted to customize the strategy, you also held some degree of cash. In that case, the only question for managing the total portfolio was how to allocate assets between cash and the market portfolio.
This looked like a prudent strategy for many years, in part because financial research tested MPT and found that the real world results more or less fell in line with what the theory predicted. But starting in the 1980s, economists began turning up so-called anomalies in asset pricing. These anomalies couldn’t be explained by standard finance theory. Among the more widely analyzed examples: the small cap and value factors, which earn higher returns than conventional asset pricing theory allows.
Fast forward to 2010 and it’s clear that financial economics recognizes an array of betas bubbling in the strategic sauce. There are multiple factors determining asset prices instead of just one. That doesn’t mean that the old finance is wrong per se; rather, the new finance is a more detailed, flexible worldview of how capital markets operate. Taken to its logical conclusion, the new interpretation of finance opens up a rainbow of opportunity for designing and managing asset allocation. Investors are no longer limited to deciding on simply allocating between cash and the market portfolio. As financial research has continued to analyze the nuances of markets, it’s uncovered an expanding array of possibilities for customizing investment strategy.
On its face, multiple betas look like a death sentence for MPT and EMH, at least if we’re looking at the original interpretations of these theories. But even then, it’s premature to plan the funeral.
Consider momentum. There’s a small library of research telling us that the momentum effect is durable and worthy of consideration as a separate and distinct beta. In fact, there’s even a trio of momentum index funds from AQR Capital Management that attempt to formally isolate and exploit this factor. But here’s the conundrum:
On the one hand, the presence of momentum confounds and harasses EMH and MPT because this factor isn’t easily explained (if at all) by conventional asset pricing theory. But some of the anti-EMH folks also recommend that momentum is a worthy strategy. In effect, attempting to exploit momentum is rational, or at least reasonable, or so their advice suggests. After all, as alternative betas go, momentum looks compelling. It’s been formally identified in the academic literature for two decades (and pursued by active managers for a lot longer). But while the cat's out of the bag, momentum still manages to generate alpha, or so we're told. In fact, momentum is a key source of the enduring success of managed futures-based strategies, which have been around since the 1970s.
The trouble is that exploiting momentum requires a short-term focus, typically no more than a year or two, and more typically less than 12 months. Let’s say that your momentum model is effectively telling you to buy equities because the stock market has been rising sharply in the last 6 months. If we look at investing through momentum-colored glasses, buying equities looks reasonable (rational) under this premise. But let’s also imagine that fundamental market measures, such as dividend yield and price-earnings ratio, are also suggesting that equities are overbought, perhaps to the point that the stock market has reached a point of Irrational Exuberance. Indeed, it’s not unusual to see buy signals based on momentum arise when fundamental valuation measures suggest its time to sell.
Who’s right? The momentum folks? Or the strategists who say that buying stocks at points when valuation is stretched thin is irrational behavior? Both sides are effectively in the anti-EMH camp. And yet each can at times be at odds with one another. What’s a supporter of irrational behavior to do? Who defines irrational decisions?
The problem is that trying to neatly define markets as irrational or rational is a game of semantics. Reality is far more nuanced. Rather than trying to explain asset pricing as a function of rationality or irrationality, it’s more compelling to see markets are driven by an array of betas. Perhaps we can focus on some to develop a strategy to beat the broad market beta. It’s not easy, and if we’re wrong we’ll fall short of the market portfolio, which costs virtually nothing to replicate and requires no skill or talent.
Deciding whether to build portfolios based on multiple betas is a choice. It may or may not be a productive choice. In fact, relatively few who play this game will win, which is why owning the market portfolio still makes sense for many investors. But this much is clear: trying to fit an updated view of asset pricing into yesteryear’s labels only confuses the pursuit of clarity in the capital markets. The old finance isn't perfect, but it still works pretty good. Unless you aspire to something more.
May 9, 2010
SUNDAY EXCERPTS: 5.9.2010
Greece, the risks and ramifications…
The U.S. is a long way from being where Greece is, but the developed world has been living beyond its means and is now being called to account.
Byron Wien, vice chairman, Blackstone Advisory Partners.
“Greek Debt Woes Ripple Outward, From Asia to U.S,” The New York Times
A major write-down of Greece’s $400 billion sovereign debt would deal a serious blow to an already enfeebled European banking system, which holds the majority of that debt. Indeed, if Greece’s debt does need to be written down by anywhere near the Standard and Poor’s estimate, one could see the IMF having to revise up by at least 20 percent its present estimate of the European banks’ likely loan losses from the 2008–2009 global economic crisis.
Desmond Lachman, resident fellow, American Enterprise Institute
“Greek Tragedy Could Have Multiple Acts,” The American
At some stage, the euro area would have had to come to a fork in the decision-making road. This may be that fork. The euro area needs to decide whether it wants political union. The nations which accept a political union will have to go down one route – and those that don't will have to leave the euro.
History shows that monetary unions of large sovereign nations cannot survive unless they become a political union. Monetary union requires labour mobility and fiscal flexibility in the form of a single treasury. Rich regions need to bail out poor areas when needed. This is easier to implement if they are part of the same country and much harder to justify across a monetary union.
The basic problem with the euro was that one interest rate does not suit all the countries. In economic jargon, the euro is not an "optimal currency area". In other terms, the economies are so different they need their own interest rates. One size does not fit all."
Gerard Lyons, chief economist, Standard Chartered
“Europe's future in the balance as eurozone faces its toughest test,” The Observer
Greek lawmakers voted 172 to 121 to approve the austerity measures -- worth about $38.18 billion through 2012 -- which will reduce pensions and civil servants' pay and raise taxes. Opposition parties lambasted the government for imposing measures that they deemed too harsh.
"The dose of the medicine you are administering is in danger of killing the patient," conservative opposition leader Antonis Samaras said.
“Greece agrees to austerity plan to secure European Union, IMF rescue loans,” Associated Press
May 8, 2010
SATURDAY LINK LIST: 5.8.2010
Healthcare deficits, muni bubbles, PIGS, the problem with Europe's currency, and thinking about interest rates as a mechanism for reflecting market information...
David Gratzer, Forbes.com
President Obama insists that his health reform legislation is "the most significant effort to reduce deficits since the Balanced Budget Act of 1993."
Beware the Muni-Bond Bubble
Nicole Gelinas, City Journal
The financial crisis has exploded plenty of long-held beliefs, including the idea that mortgage debt is a risk-free investment.
The PIGS’ external debt problem
Ricardo Cabral, VoxEU.org
Financial markets are focused on the public finances of Portugal, Ireland, Greece, and Spain (the “PIGS”).
Does a common currency area need a centralized fiscal authority?
Greg Mankiw, Greg Mankiw's Blog
Paul Krugman has a thoughtful and thought-provoking column on Greece today.
Interest rates as a market price
Bill Woolsey, Monetary Freedom
Last March, Charles Schwab had an op-ed in the Wall Street Journal criticizing low interest rates.
May 7, 2010
APRIL'S JOB GROWTH IS THE HIGHEST IN 4 YEARS
The news arrived just in the nick of time. Nonfarm payrolls surged by 290,000 last month (seasonally adjusted), the biggest rise in four years. This is good news—great news, in fact, as it suggests that the labor market is in fact recovering with substantial momentum. Given yesterday’s wave of market selling around the globe, the news comes at a crucial moment in the business cycle. Indeed, the outlook would indeed appear bleak if today's employment numbers were low or (gasp!) negative.
Rest assured, the road ahead remains challenging. But the April employment report is a down payment on thinking that progress, if not yet inevitable, is a good deal more likely than it was yesterday. It's clear that the trend in net job growth is quite real. Macro trends on this level don't turn on a dime. That was working against us over the last two years; now it seems to be a net positive.
As our chart below shows, the economy is now creating jobs on a level that’s unmistakably robust. It’s taken longer than usual to reach this point, and there’s still some doubt if the trend is sustainable in terms of hefty monthly gains. But for the moment, the labor market turned a corner for the better and it would take a rather large negative shock to turn this ship off course.
A month ago, there was a clue that better times were coming for job growth. When the March employment report was released, we wrote that "Job Growth Worthy Of The Name Arrives…Finally." In fact, today's report revised upward the 162,000 rise in March nonfarm payrolls to 230,000. But we also wondered at the time if the March employment news was a quirk. We now have an answer.
Of course, there are always caveats and contingencies, and today's update is no different. That starts by recognizing that the government is engaging in a fair amount of hiring these days, including the addition of 66,000 temporary Census workers last month. Yet even after ignoring the government, private sector payrolls still rose by a strong 231,000 in April. And the gains were broad based. Except for losses in transportation/warehousing and information industries, employment rose throughout the economy last month.
Tempering the good news, however, was a rise in the unemployment rate in April to 9.9% from the 9.7% rate that prevailed in each of the three previous months. "The unemployment rate is up as discouraged workers are returning to the job market to look for employment," Stuart Hoffman, chief economist at PNC Financial Services Group, tells Bloomberg BusinessWeek.
More troubling is the tally of the long-term unemployed (jobless for 27 weeks or more): this measure continues to rise. There were 6.716 million long-term unemployed workers last month, up from 6.547 million the month before and 80% higher than a year earlier.
Therein lies the core of the main challenge that continues to hang over the economy: repairing the damage born of the massive job losses of the past two years. Job creation in the private sector is the ultimate answer. Today's numbers are encouraging, more so than we've seen in any employment report since the Great Recession began. But let's recognize that we need many more months of April's good news to see significant progress on the broad economic front. What's more, with the Greek debt crisis threatening to migrate across borders in Europe and around the world, the markets aren't likely to tolerate any setback on the economic front.
Despite today's good news, doubt lingers. "The economy is turning; unfortunately it is not improving as much as one would hope given the downturn," Dan Greenhaus, chief economic strategist for Miller Tabak and Company, tells The New York Times today. "As companies come out of the downturn they are going to be somewhat reluctant to at least immediately increase their work force."
The trend, at least, now appears to be our friend when it comes to net job creation. But even if job growth turns out to be sustainable and robust, there's no quick cure for another problem weighing on economic recovery: debt. As we wrote last month, "It's all about debt from here on out, and probably will be for many years." For those who disagree, yesterday's global selloff is a reminder that there are still some rather large and dangerous skeletons in the closet.
Ultimately, job growth is the only way out, in part because it both reflects and stimulates broad economic expansion. Ground zero in attacking the threats that bedevil the U.S. is the labor market, and today, at least, the army of growth won.
May 6, 2010
JOBLESS CLAIMS DIP AGAIN. WILL TOMORROW'S LABOR MARKET UPDATE CONFIRM THE TREND?
Today’s weekly update on jobless claims offers a glimmer of hope that there’s enough growth momentum in the economy to push new filings lower in the weeks ahead. But after reading yesterday’s disappointing ADP employment report, we’re not expected any sudden bursts of good news. Tomorrow's jobs report from the Labor Department may suggest otherwise, of course. But for the moment, it's still touch and go with payrolls.
The good news is that new filings for unemployment benefits dipped last week by 7,000 to 444,000. Save for two weeks earlier this year, that's the lowest in nearly two years. So why aren't we enthused? After all, this isn't the first time that jobless claims have moved sideways for an extended period in the wake of a recession. But the previous downturn in the economy was an extraordinary reversal of fortunes, and the blowback continues to reverberate around the world. Yes, there's a broad economic recovery underway in the U.S. and in much of the world. But it's a recovery that's still vulnerable and prone to setback. Recognizing as much makes it difficult for distinguishing between a normal but temporary slowdown in new claims vs. an ominous sign of another round of economic weakness.
The story's the same with continuing claims, which tracks people who are already collecting jobless benefits. As our second chart below shows, there's been a sharp fall in continuing claims over the past year, echoing the drop in initial claims and the broad rebound in the economy, albeit from recession lows. But the fall in continuing claims has stalled recently.
There's a lot riding on tomorrow's payrolls update for April. The consensus forecast calls for a rise of 187,000 in nonfarm payrolls for last month, Briefing.com reports. That's hardly a stellar gain at this stage, but if it proves accurate it would probably buy time for keeping investor sentiment safely in positive territory. Anything materially below that estimate, however, may trigger a wholesale re-evaluation of the economic recovery's health.
But don't dismiss the forces of positive momentum just yet. Gallup reports today that its Job Creation Index rose to its highest level last month since November 2008. Gallup explains that its index "suggests that layoffs were down across the U.S. in April" and there was "a modest improvement in hiring."
The only mystery now is whether the Labor Department has confirming data…or not.
May 5, 2010
ADP'S REPORTS JOB GROWTH FOR APRIL...JUST BARELY
Let’s hope today’s ADP National Employment Report is wrong. Nonfarm private employment increased by a meager 32,000 last month, according to this report. The general trend is fine, but that’s far below the consensus forecast by economists for this Friday’s government update on April payrolls. More importantly, a net rise of 32,000 is hopelessly insignificant given the extent of the 8-million-plus job losses in the Great Recession. But what the economy needs, and what it ultimately gets, may be two different things.
The crowd, however, is expecting that the Labor Department will report net job creation in the private sector of nearly 190,000 for April, according to Briefing.com. That a world above ADP’s 32,000 estimate for last month’s change in the labor market. Why the disparity? ADP’s accompanying press release offers a clue:
Unlike the estimate of total establishment employment to be released on Friday by the Bureau of Labor Statistics (BLS), today’s ADP Report does not include any federal hiring in April for the 2010 Census. For this reason it is reasonable to expect that Friday’s figure for nonfarm total employment reported by the BLS will be stronger than today’s estimate for nonfarm private employment in the ADP Report.
ADP’s estimates of the labor market shows that April created jobs for the third straight month. The trend itself, thin though it is, is a step in the right direction. If the government reports an April gain on Friday, as it almost surely will, that’ll make two months in a row for a rise in the official payrolls report. Job destruction is over. But it’s still unclear if job creation of substance and persistence has arrived. Without a significant follow-through on March's widely hailed bout of job creation, the market may start to have second thoughts about the recovery. Indeed, the labor market is still a gray area in terms of the post-recession era. Recovery is alive in kicking in a number of economic metrics, but job creation has yet to offer convincing evidence that it's joined the party.
“Today’s report is very encouraging,” Gary Butler, President & CEO, ADP, said in a statement. “The challenging economic environment appears to have stabilized.”
Perhaps, although it’s not yet obvious that the labor market’s revival will suffice. “Private employment will add jobs, but slowly,” opines Aaron Smith, a senior economist at Moody’s Economy.com, via Bloomberg BusinessWeek. “Private hiring needs to accelerate to prevent a substantial softening in the labor market when census hiring ends this summer.”
May 4, 2010
WHAT'S THE DEAL WITH MOMENTUM INVESTING?
Your trusty editor reviews the strategy, including a trio of new momentum index funds in the new issue of Financial Advisor magazine. "Momentum investing has long been a thorn in the side of conventional market theories," the article begins. "That doesn’t dim its power as a strategic investment tool, but it can still be an awkward beast." For the details, read on...
May 3, 2010
CONSUMER SPENDING & INCOME RISE IN MARCH
Today’s update on consumer spending and income confirms what was already clear in Friday’s Q1 GDP report: the economy is rebounding. It’s debatable if the rebound has the wherewithal to roll on at a pace that’s sufficient to keep the economic engine humming. But for the moment, the numbers speak loud and clear.
Disposable personal income (DPI) rose 0.3% in March, the Bureau of Economic Analysis reported this morning. That’s up from February’s flat performance and is the best monthly gain since last December. DPI is up 3.4% for the past 12 months. Spending fared even better. Personal consumption expenditures (PCE) jumped 0.6% in March, at the top of the trend in recent months and raising PCE by 4.5% over the year-earlier level.
In short, the snapback in spending and income was alive and well in March. As our chart below of rolling 12-month percentage changes in DPI and PCE illustrate, the trend has been friendly of late. Short of an outright meltdown in the economy, the rebound was all but destined to arrive. After the extraordinary dive in consumer spending in 2008, it was virtually assured that some degree of climbing out of the hole was highly likely. After delaying purchases for months, the natural forces of cyclical recovery were augmented with monetary and fiscal stimulus. We’re now seeing the fruits of the resulting recovery.
Deciding what comes next is less clear. The good news is that short of a new shock to the economy, the mending will likely continue. Confidence is returning and interest rates remain low. Meanwhile, government stimulus is still coursing through the economy in various forms. But there are a number of headwinds in the future that raise questions about how strong the recovery will be in the months and quarters ahead. As stimulus fades and interest rates rise, spending by businesses and consumers must pick up the slack.
On that note, it’s unclear if Joe Sixpack’s recent revival to form in spending is temporary or something more. One reason for staying cautious comes from looking at our second chart, which compares spending and income since the Great Recession’s official start in December 2007. Indexing this pair shows that income, which has received a relatively large degree of government support in the past two years, is rising well above the increase in spending.
The gap in income growth over spending growth is closing, however. Will it continue to close? Or will a new-found propensity to save keep a lid on spending growth? No one knows, of course, although a new survey economists suggests keeping expectations contained. According to a new AP survey of dismal scientists, two-thirds of "44 leading economists" said that the recession has created a "new frugality" among consumers.
One of the critical variables for determining if the frugality is temporary or the new habit of the age will come from the labor market. On that front too there’s much speculation. The next data point arrives on Friday, when the April report on nonfarm payrolls is released.
Payrolls in March rose by 162,000, the best month since the recession began but still well below what’s needed to make headway in recovering the 8-million-plus jobs lost in the downturn. But more important than absolute levels at this point is the need for continuity in the economy’s ability to create jobs on a net basis.
By that standard, the crowd is hopeful that Friday will dispense another favorable report. The consensus forecast for nonfarm payrolls calls for a rise of 187,000 for April, according to Briefing.com. That’s slightly better than March’s gain, but still well below what’s needed.
The trend overall is favorable these days, but the details are starting to matter too. One of those details is the trend in wages. While income (DPI) and spending (PCE) are higher over the past year by 3.4% and 4.5%, respectively, private sector wages are up by a relatively light 0.8% through March. One more reason that the stakes are high for Friday's job report (and the ones that follow). Spending, after all, has to be financed (eventually), and government largess has its limits in a new era of red ink.
REITS CONTINUE TO SOAR
April was relatively uneventful for the major asset classes in terms of total returns—with one exception. REITs scored another outsized gain last month, posting a strong 7.7% total return, based on the MSCI REIT Index. Real estate securities are also far ahead of the pack for 2010 after advancing by nearly 18%, or about twice as much compared to the next-best performance for U.S. stocks in the year-to-date ranking. But with REIT valuations stretched thin, it’s getting harder to expect the real estate surge to roll on at this pace.
In the wake of the price surge in real estate recently, the yield on equity REITs fell to 3.49% as of April 29, according to data from the National Association of Real Estate Investment Trusts. That’s slightly below the 10-year Treasury’s 3.76%. Is that a sure sign that REITs are set to correct? No, although it raises the risk in the asset class.
It’s worth noting that in the past, when the equity REIT yield overall dipped below the 10-year Treasury yield, it’s signaled rough times for real estate stocks. During 2006 and 2007, the yield on the 10 year exceeded the REIT yield. After REIT prices were crushed in 2008, the yield premium over Treasuries soared, reaching more than 7 percentage points over the 10 year in early 2009.
Today, the premium has evaporated to the point that owning a risk-free Treasury produces more dividend income vs. the equity REIT market. For an asset class that’s widely embraced for income, that’s a tough nut to swallow when it comes to real estate securities. Considering that REITs are also the first-place return leader among the major asset classes over the past 12 months only adds to the risk.
That doesn’t mean REITs won’t continue to be the return leader in the months (years?) ahead. But REITs are no longer the stellar bargains they were a year ago. If your allocation to REITs is bursting on the high side relative to where it was a year ago, taking a bit of money off the real estate table looks compelling.