July 26, 2010
THE CAPITAL SPECTATOR ON VACATION...
Postings will be light to nonexistent for the rest of the week as I indulge in some mid-summer R&R. The usual editorial tricks resume on Monday, August 2. Meantime, stay cool, be well and watch out for falling economic numbers.
CORPORATE EARNINGS: HIGH STANDARDS & RECENT HISTORY
As rebounds in corporate profits go, recent history is probably about as good as it gets. That's no surprise, considering that the hammering of corporate America just prior to the rebound was no less extraordinary. The implication: the best days are behind us. That doesn't mean that corporate profits are destined for trouble, but recent history delivered a backdrop of nirvana for the stock market. If something less, and perhaps considerably less is coming, so too are attitude adjustments. The question is whether the crowd's expectatiions are fully and fairly adjusted?
In 2008's fourth quarter, after-tax corporate profits (seasonally adjusted, annualized) dropped by a crushing 34% vs. the previous quarter, according to data from the St. Louis Fed. Fast forward to this year's first quarter and corporate profits posted a rebound of 70% of that cyclical low. As the chart below suggests, that's the gold standard for bull markets for the bottom line.
And if we compare quarterly corporate profits on a year-over-year percentage-change basis, the trend of late also looks spectacular relative to history.
But now what? Optimism isn't dead on the corporate-profits front, according to some analysts. "As long as we don't fall into another recession, it's a good time to make money," Larry Hatheway, an economist at UBS, tells the Washington Post. "We're able to squeeze more profits out of sales than we were twenty or thirty years ago."
Maybe, but the market's not quite sure if the best of times have passed. "Second-quarter corporate profits have gotten off to a robust start, but the stock market has moved lower and shown little pep," writes Dave Kansas in The Wall Street Journal. "On top of that, various sentiment indicators, ranging from consumer confidence to investors' view of the stock market, have slid sharply." He goes on to note:
According to the American Association of Individual Investors, bearish sentiment is at its highest level since 1987, when such record-keeping began.
So, why such a sharp disconnect between profits and performance? There are two things in play. One is an old Wall Street saw: Buy on the Rumor, Sell on the News. In simple terms, this means that traders will buy in anticipation of an event, such as quarterly-profit news, and then sell when that news comes out. The fundamental underpinning of this truism is that markets anticipate and look ahead more than they react to events when they occur.
That leads nicely into the second issue: Quarterly reports are indeed about the past. They are a reflection of what took place over a three-month period that ended some weeks before the report comes out.
This year's second-quarter earnings results so far have delivered better-than-expected results, reports Don Miller of Money Morning, but it hasn't spurred much new equity investing overall. He continues:
Some 10% of S&P 500 companies reported earnings last week, and results were actually a good deal better than the market reaction would lead you to believe. Companies beat earnings per share estimates by nearly 11% on average.
With the recent volatility, the commentary coming out of talking heads has been that investors are focusing on revenue rather than bottom-line earnings, perhaps because of the link between companies' sales and the economy. If revenue is down because consumers aren't spending, that's a sign that the economy will remain weak.
But the "weak revenue" argument is misguided, as 73% of companies this earnings season have beaten revenue estimates, which is at the top end of the historical range and well above the long-term average of 62%, according to [Bespoke Investment Group].
The S&P 500 has advanced a slim 1.5% since the first second-quarter earnings report hit the Street, advises Kelly Evans of The Wall Street Journal. Why? One possibility is the Fed's emphasis on the economic uncertainty of late. "For every upside surprise in corporate earnings, it seems there's a disappointing piece of economic data."
It doesn't help that earnings comparisons are destined to moderate. Maybe not in this quarter, but soon. That's not a death sentence. The mother of all earnings rebounds must return to normal and so the earnings party is headed for calmer, gentler days. That's not a problem in and of itself. But until there's more optimism on the economic front, the macro-adjusted reality for corporate earnings growth isn't likely to inspire the crowd.
WHO KNEW? ZEROES CAME OUT ON TOP
Zero-coupon Treasuries with maturities of 20-plus years are reportedly the top-performing investment this year through July 22, posting a 21% return so far. Ok, so what's going to dominate for the second half? A repeat performance with zeroes? Naw, it couldn't be. Well, it's not likely, right? On the other hand...
It's more complicated than it appears. From today's Wall Street Journal: "After studying more than a decade of deflation in Japan, economists have slowly realized they have no idea how it works."
July 24, 2010
WEEKEND READING: 7.24.2010
►VIX, volatility and ETFs/ETNs:
Vix and More blog: "While I was out of pocket for a few days, Barclays had the temerity to launch a new VIX ETN. Not only that, but this new volatility product is the first inverse VIX ETN to hit the market. It goes by the formal name of Barclays ETN+ Inverse S&P 500 VIX Short-Term Futures ETN and has a ticker of XXV."
► Tail Risk Talk (HT: Mebane Faber):
Pimco Sells Black Swan Protection as Wall Street Markets Fear and Is it possible to hedge tail risk?
Economic Security at Risk—Findings From the Economic Security Index:
"Even before the current recession, economic security was a major concern of most Americans. This concern has only grown amid the deepest downturn in decades."
►What Can The Fed Do?
Bruce Bartlett: "This week, Federal Reserve Board chairman Ben Bernanke testified before Congress that the Fed is prepared to take additional actions to stimulate the economy in the event that growth falters. Unfortunately, the Fed does not yet appear to be considering an end to its ill-advised policy of paying interest on excess reserves at banks, which is in effect a subsidy to them for not lending."
►Revisiting Global Small Caps
MSCIBarra: "Global small-cap-stock investing gained significant attention after the bursting of the technology bubble in early 2000. After a considerable run-up in the early and mid 2000s, global small caps underwent severe stress during the recent financial crisis. Since the easing of credit markets, the small-cap segment has rebounded. More importantly, relative to international large- and mid-cap stocks, small caps still exhibit distinct characteristics that may provide opportunities for portfolio diversification and active management. Passive investors looking to track small-cap indices can employ optimization techniques to build tracking portfolios, with reasonable tracking error and transaction costs, that overcome the challenge of the high number of index constituents."
►A toxic toolkit
Greg Ip (The Economist/Free Exchange blog): "Asked Wednesday what he’d do if the economy needed more stimulus, Ben Bernanke was noncommittal: 'We are going to continue to monitor the economy closely and continue to evaluate the alternatives that we have.'"
The Battle: How the Fight between Free Enterprise and Big Government Will Shape America's Future
The Rational Optimist: How Prosperity Evolves
The Great Reflation: How Investors Can Profit From the New World of Money
July 23, 2010
'YA JUST CAN'T MAKE THIS STUFF UP FILE...
Today's New York Times has a story about Italian automaker Fiat and its efforts to "make its workers more productive." What's priceless is one of the accompanying photos (see below), which shows a Fiat employee wearing a T-shirt that may inspire something less than optimism when it comes to expectations about boosting productivity, a decidedly capitalistic notion. Namely, the worker is wearing a shirt with a hammer and sickle, the international symbol of communism. The story also quotes a factory worker who worries that the push to improve productivity will "impose American-style standards" on the workforce. Oh, no--not that! The worker concludes that "“too much work is going to kill our workers.” Yes, folks, things are tough all over.
JOBLESS CLAIMS & HISTORY
Yesterday's post about the trendless trend in new jobless claims inspired one reader to complain that I wasn't paying sufficient attention to the history for this data series and therefore drawing unnecessarily dark conclusions.
The charge is that I ignored the historical tendency for new filings for unemployment benefits to meander a bit in the wake of recessions past before turning down in earnest. After economic contractions end (as defined by the National Bureau of Economic Research), new weekly filings have been known to move sideways or even rise a bit for a time, providing false signals that the rebound is in trouble. The implication: the sluggish activity in filings this year should be viewed in the context of history. In other words, the trendless trend in 2010 isn't a troubling sign after all; rather, it's merely a repeat performance of the normal ebb and flow in post-recession periods.
That's a comforting thought, but how relevant is it for the here and now? Surely it would be foolish to dismiss history outright. And for the record, I'm no stranger to looking at the economic record and drawing inferences…up to a point. For example, in a March 2009 post, I looked at the history of initial jobless claims as an early signal for estimating when recessions will end. I've also noted at times that jobless claims don't always fall quickly after recessions (in an article from this past May, for instance). Do I point out all the caveats and possibilities in each and every post on initial jobless claims, or any other subject? Of course not--life (and attention spans) are short.
But I digress. Fo some context on the long-run history of claims, consider the chart below, which shows the seasonally adjusted four-week moving average of weekly new filings since the mid-1960s in comparison with recessions, as indicated by the gray bars. (Click on the chart to open a larger version.) Note that initial claims dropped once an economic downturn ended. No surprise there. But it's also true that the pace and magnitude of the drop varied considerably. This is economics, not physics.
After the short recession in 1980, for instance, the four-week moving average peaked in early June of that year; six months later, it had fallen to just above 400,000. That was a stellar performance in terms of change: jobless claims that year fell rapidly and substantially. Of course, it didn't mean much that time--a new and deeper recession arrived the following year. By contrast, new claims fell sluggishly after the 1990-91 downturn. But the uninspiring decline didn't change the fact that the nineties would bring some of the strongest economic growth in U.S. history.
Every recession is different and so it's folly to expect history will repeat like clockwork when it comes to broad economic trends. Indeed, economic "rules" are in constant flux. One example can be found in the historical trend with job creation. In the wake of recessions over the past several decades, the net pace of job growth has been weakening after economic downturns. The fear is that this trend remains intact today. Given the deep losses in jobs, that trend threatens to bite deeper this time.
The past, in other words, isn't irrelevant for analyzing economic trends, but neither is it fate, depending on what we're looking at and when. Par for the course in the dismal science, which is also partly a dismal art.
The focus on these pages when it comes to initial jobless claims is trying to bring some perspective in real time to the numbers du jour. That's a difficult task, to say the least, and one that's prone to a fair amount of error, even under the best of circumstances. The future is still uncertain, no matter how many spreadsheets of data we review.
As to the optimistic view that the trendless trend so far this year with initial claims is typical and therefore nothing to worry about, we're skeptical. As the chart above reminds, claims rose to an unusually high level in the Great Recession and remains elevated. Even after more than a year of decline, claims are at heights that more or less represented peaks in the previous two recessions. History, it seems, cuts two ways when it comes to analyzing jobless claims. Pick your poison.
Granted, the last two downturns were mild compared to the recent troubles. But that only makes the prospect of a sluggish decline in this data series all the more troubling. It's reasonable to wonder if new jobless claims could move sideways for an unusually lengthy stretch of time, as they did after the 1990-91 contraction. Unless you're expecting a repeat of the late-1990s boom in the near-term future (we're not), the early nineties precedent for initial claims suggests a rocky road ahead.
Yes, there's a precedent for jobless claims staying relatively high, but that's hardly a reason for optimism given the current conditions, which are well short of inspirational. Dismissing the tendency for new claims to tread water this year based on looking to the past seems dangerously short-sighted at the moment. Perhaps our anxiety is misplaced; maybe salvation is coming after all. Surely there's good news in the economic numbers too, as we pointed out recently. But a mixed bag at this stage is problematic, as we've been discussing on various fronts all year.
Economic analysis is always enlightened until the next report changes the crowd's view. Meantime, the future is unclear and the case for staying cautious still has merit. History provides some incentive for keeping the faith, but it's just as easy to read the numbers from the past and draw darker visions.
July 22, 2010
MORE WORRIES WITH NEW JOBLESS CLAIMS
Well, that didn’t last long. Today’s weekly update on new jobless claims dashed hopes for the moment that the previous downturn in this series was the start of something new in the way of positive momentum for the labor market. Indeed, the numbers were sufficiently encouraging a week ago to inspire asking: Is the dip real? We now have the first installement on an answer. It's not necessarily the last word, but so far the response is discouraging.
New filings for unemployment benefits surged by 37,000 last week on a seasonally adjusted basis. That's the biggest weekly rise since February's 40,000 pop. ""It's very disappointing to have this leading indicator of economic conditions jump higher," John Lonski, chief economist at Moody's Economy.com, told CNNMoney.com today. "This is the latest reminder of a weak labor market, and the jump preserves worries regarding the adequacy of economic growth."
Of course, there's always a case for thinking that the latest number for any economic report is less (or more) than it seems. And so it is with today's jobless claims. Tony Crescenzi, a portfolio manager at bond giant PIMCO, offers one possibility for reserving judgment, writing (via Marketwatch.com): "Elevated levels of claims remain consistent with a relatively subdued pace of job growth, but it is important to keep in mind that many individuals are filing for benefits and hoping to capitalize on the many extensions of benefits that have been approved."
But even if today's rise in jobless benefits doesn't mean much, there's still the bigger problem that's plagued this metric all year: it's going nowhere fast. As the weeks and months roll by without a material decline in new filings for unemployment insurance, it's getting tougher to argue that the labor market's salvation is just around the corner.
Meantime, today's numbers only remind that the stakes are that much higher for the next phase of monetary policy. As we discussed in our previous post today, it's not yet obvious that the Fed is prepared to go to the next level with monetary stimulus, even if the case for acting grows with each new number.
Adding to the list of worries is yesterday's mixed news in housing for June: a small annualized rise in new housing permits issued last month (+2.1%) that was tempered by a bigger fall in new housing starts (-5.0%).
Perhaps it's prudent to wait a bit longer for more economic reports to come in before rolling out the big guns of quantitative easing; perhaps not. But the burden of waiting increasingly falls on those who argue for staying the central bank's hand. The Fed's balance sheet has already ballooned dramatically over the past two years, and so the exit strategy challenge is already a big question mark for the future. But not today. If Bernanke and company do nothing at this stage of the game, that's not going to make future policy choices any easier, or the risks any smaller. But doing nothing on the monetary front might bring big problems for the economic cycle in the near term. Choices, choices.
This much is obvious now: the broad trend isn't improving. The real worry is that it may actually be getting worse. Tick tock, tick tock…
BERNANKE'S TEPID TESTIMONY
Fed Chairman Bernanke's Senate testimony yesterday offered little reason to expect that the central bank was about to embark on a bold, new plan of monetary stimulus to offset the recent signs that deflationary pressures were bubbling anew. As Bloomberg News reported, "the Fed chief devoted a bigger portion of his prepared testimony to how the Fed would eventually withdraw its unprecedented credit expansion."
Soft pedaling the deflationary risks and de-emphasizing what the Fed could do with additional monetary stimulus left several dismal scientists discouraged, including Scott Sumner and Paul Krugman, who wrote the Fed head's commentary "lack all sense of urgency" about battling apparent increase in the D risk lately.
Meanwhile, the market's outlook for inflation continues to bounce around at the 1.7% level, based on the yield spread between the 10-year nominal and inflation-indexed Treasuries. That's down sharply from the 2.45% range of late-April and sign that the crowd sees the D risk as more than a trivial threat.
Indeed, the appetite for a safe haven continues to rise. The benchmark 10-year Treasury yield is now 2.90%, as of yesterday. It's been steadily falling from 4% in early April. For reasons that presumably need no explanation these days, a material jump in the demand for liquidity is a distinctly unhealthy sign at this late date, as it implies that the crowd's anxious about the economy.
One of the critical measures for deciding if the Fed is letting deflation build a new head of steam is the annual pace of change in the nation's money supply. Various gauges of the money stock were recently dropping at the steepest rates since the Great Depression, suggesting that the demons of contraction were overtaking Bernanke and company's efforts to keep the expansion going. The trend inspired our question last month: Is it time to crank up the printing presses…again?
The latest reading on money supply suggests that the aggregates are no longer in freefall. For instance, the currency stock of M1 money supply has recently stabilized at just under a 4% annual pace. That's down from the 10%-plus rate of a year ago, but it appears that M1's rate of change is moving sideways in positive territory.
But the broadest measure of U.S. money supply (M2), while also treading water these days, is advancing at less than a 2% annual pace…
And the MZM definition of money (basically the liquid components of M2) is in outright retreat on an annual basis, as it has been since April…
Overall, the recent trend for the monetary aggregates is a mixed bag. For the moment, that's worrisome because the outlook for the economy isn't any better.
July 20, 2010
MID-MONTH PERFORMANCE UPDATE FOR THE MAJOR ASSET CLASSES
Misery loves company, but returns for the major asset classes show no sign of wear this month from the economic worries of late. If anything, the chatter about deflation and the potential for a double-dip recession has emboldened the bulls in July. Save for TIPS, prices are higher across the board, and by more than trivial amounts for most broadly defined asset classes
Indeed, it's been a strong month for gains through July 19. There's no assurance that the advances will hold up through the end of the month, when we publish our strategic monthly recap (the last one was published here). In fact, there's a good case for expecting a tactical retreat, or at least a downshift in the buying. Meantime, the year-to-date tallies look impressive. Perhaps it's fair to say that the crowd has been willing and able to climb a wall of worry.
Foreign stocks are the big winners so far in July--equity markets in developed market nations in particular. Vanguard Europe Pacific ETF (VEA) closed yesterday with a gain of more than 7% for the month so far, the clear leader among our ETF proxies for the major asset classes. The rest of the world's stock markets aren't doing so bad either. In the U.S., equities have climbed nearly 4%, based on Vanguard Total Stock Market ETF (VTI).
Overall, July has been a powerful month for returns, as shown by the 3.9% price gain so far in July for the Global Market Index, a passive mix of all the major asset classes weighted by market value. As returns for this benchmark go, that's an impressive run over such a short period. The pace won't last, of course. But for the time being, there's a strong tailwind blowing all the major betas higher.
The issue is one of deciding whether a) the markets correctly sense a better-than-expected future in the months ahead; or b) the speculators have gone off the deep end in recent weeks. It's clear why bond prices might run higher. If investors are worried about economic weakness and deflation, rushing into the safe haven of fixed income has obvious appeal. But why the simultaneous surge in demand for risky assets in recent weeks? Is the economic future a good deal brighter than it appears? Or have the optimists run ahead of reality once again?
Perhaps we'll have the answer when we publish our strategic update of the markets early next month. Stay tuned.
July 19, 2010
TREASURIES ARE HOT...STILL
The Treasury market's 10-year inflation forecast slipped last week, and more of the same looks likely for today. The yield spread between the conventional and inflation-indexed 10-year Treasuries dropped to 1.71% on Friday, down 10 basis points from the week before and well below late-April's 2.45%--the previous peak. The debate about deflation—is the risk rising?—is likely to be front and center this week. That's likely to fuel more buying in Treasuries.
“U.S. Treasuries are still attractive,” Sungjin Park in the fixed-income department at Samsung Investment Trust Management in Seoul told Bloomberg News. “A double- dip recession is inevitable” in the U.S.
Inevitable? That's a bit strong. But the risk surely isn't fading. And there's no denying that the public demand for Treasuries is rising. Adding to the momentum to chase government bonds is last week's news that headline consumer price inflation retreated by 0.1% last month—the third straight month of decline. "The latest string of reductions of the CPI is significant and raises questions about the probability of a deflationary situation," advises Asha Bangalore of Northern Trust in a research note.
But before we concluded that even lower rates are fate for an extended period, consider the recent dip in foreign demand for U.S. assets. AP reports:
China reduced its holdings of U.S. Treasury debt in May as total foreign holdings of government debt posted a slight increase.
China's holdings fell by $32.5 billion to $867.7 billion, the Treasury reported Friday.
The report said that total holdings of Treasury securities edged up $5.8 billion to $3.96 trillion in May, a slight increase of 0.1 percent compared to April.
The Treasury said that net purchases of long-term securities, a category that covers not only U.S. government debt but also debt of U.S. companies, increased by $35.4 billion in May. That followed bigger gains of $81.5 billion in April and $141.4 billion in March.
The deflationary pressures may be mounting, but offshore demand for Treasuries is likely weakening, at least at the margins. It's unlikely that China and other large holders of U.S. government debt are going to start selling their massive holdings of Treasuries. But it's also unlikely that there's a growing appetite for buying huge quantities of additional Treasuries going forward. Yes, the dollar's still the world's reserve currency, and that's not going to change anytime soon. More flows in the greenback are destiny for the time being. But...
According to Dow Jones: "China should reduce the amount of U.S. dollar-denominated assets in its foreign exchange reserves in favor of those denominated in other currencies or other types of assets, former People's Bank of China adviser Yu Yongding wrote in an article published in the state-run China Securities Journal on Monday."
Nonetheless, last week was a good one for going long Treasuries. The iShares Barclays 20+ Year Treasury Bond ETF (TLT), for instance, was up about 1.6% on Friday vs. the weak-earlier close. And for the year so far, TLT has climbed more than 12% vs. a 4% loss for the S&P 500 Spider ETF (SPY). Treasuries are hot, and stocks are not. Deciding if that holds will depend on how the deflationary game plays out. As usual, it all looks clear…until it's not.
A few months ago, the notion that deflation was again lurking was widely dismissed. Today, it's on everyone's mind. The only thing for sure is that betting the farm on one outcome is a short cut to big gains…or big losses. For everyone else, a bit of hedging is in order.
There are lots of moving parts for deciding what comes next. That starts with wondering: Will the Fed roll out a new round of monetary stimulus in an effort to slay the D risk? What are the odds that Bernanke & company will sit on their central banking hands and watch the market's 10-year inflation forecast fall even lower in the days and weeks ahead? Will they really do nothing if the inflation outlook drops to 1.6%, 1.5%, or lower?
July 18, 2010
FUNNY PAPER & THE FUNNY PAPERS...
MONETARY POLICY GETS NO RESPECT
The cover story in Time's current issue summarizes what everyone already knows. The economic rebound has lost strength recently. The story goes on to report that the policy responses at this late date aren't encouraging, largely because political support for more fiscal stimulus is weakening faster than the economy. Strangely, the article makes no reference to the possibilities for additional monetary stimulus. The not-so-subtle suggestion is that if the economy needs additional help, new government spending programs are the only game in town and this door is closing fast because of political considerations.
The chief problem, as the Time article presents it, is one of fading public support for more spending by Washington:
Polls show that voters either don't understand — or don't buy — the long-established economic theory of John Maynard Keynes, which calls for more government spending (even if it means running up deficits) to help the economy through hard times. Instead, the public is in the mood to smack big Washington spenders hard this November...A new Time poll reveals just how hard the task is: Two-thirds of respondents say they oppose a second government stimulus package.
But as many economists have been explaining recently, monetary policy options may not be a dead end at this point--despite the fact that nominal interest rates are at or near zero. Yet the so-called zero-bound problem inspires some economic pundits to conclude that fiscal stimulus is all that's left, or so Time's cover story this week counsels. But this is shortsighted, according to a number of dismal scientists. What's more, the possibilities for additional monetary policy at the zero bound have been circulating for quite some time.
Late last year, the Peterson Institute for International Economics, for example, published a research report that reviewed some of the monetary policy options with very low short-term rates. And a recent working paper by economists at the New York Fed and Princeton University models the possibilities and finds that the impact of "non-standard monetary policy can be large at zero nominal interest rates." Even Paul Krugman, the high priest of Keynesian fiscal stimulus, doesn't ignore the potential of monetary policy at the zero bound (even though he tends to be skeptical of it), as he discusses in his blog post of July 14. And in another post on the same day, Krugman argues that the Fed isn't targeting a sufficiently high level of inflation. In other words, the central bank needs to be more aggressive in its monetary policy now--even at the zero bound!
I'd be remiss if I didn't mention Scott Sumner, an economist who arguably has done more than any one blogger over the past year to remind, reflect and otherwise explain how monetary policy is far from dead during the infamous liquidity traps. Spend some time reading his blog and you'll be hard pressed to ignore monetary policy options at the zero bound. You may find reason to disagree, but Sumner's detailed analysis over the last year or so remind that the topic of monetary policy at the zero bound is (or at least should be) a topic of discussion.
Yes, we can debate how effective the Fed and other central bankers will be when rates are this low. Expectations, for instance, are a key issue at this point. Simply targeting higher inflation might not work if the crowd thinks it's temporary. Of course, some financial commentators (including this one) aren't persuaded at all that printing more money at this stage, regardless of the details, will work.
Perhaps, but given the state of the economy at the moment it's not clear that we still have the luxury of ignoring the case for an additional round of unorthodox monetary stimulus. Or perhaps the better way to put it is that we don't have all that much to lose if the Fed goes the extra mile in the summer of 2010. The stakes are all the higher if, as Time tells us, that the political outlook for more fiscal stimulus is dead.
July 16, 2010
STILL WONDERING ABOUT DEFLATION
John Makin, a visiting scholar at the American Enterprise Institute, recommends in today's Financial Times that the Federal Reserve and other major central banks "announce firm price level targets that imply rapid money creation through more aggressive asset purchases." The counsel follows his essay published earlier this month that warns of the "rising threat of deflation."
Targeting higher inflation is controversial at this stage, although that's largely because outright deflation hasn't set in, at least not yet. But the sentiment for inflation targeting could change if the general price trend shifts from the current disinflation to deflation proper. That's a possibility, or so the market tells us. The outlook for inflation has been trending lower recently, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries. As the chart below shows, this measure of inflation expectations was 1.82% for the decade ahead, as of yesterday—a sharp drop from around 2.45% in late-April. Normally, disinflation of this degree might be welcomed. But given the weak economy of late--the anemic job growth in particular--falling inflation expectations are a problem.
The good news is that inflation expectations aren't getting any worse at the moment. And yesterday's modestly bullish news on initial jobless claims provides some incentive for thinking that the risk of deflation may wane in the weeks and months ahead. But it's still too early to say for sure. Meanwhile, the data overall is still mixed. Yesterday's news of a sharp drop in manufacturing activity in New York state and another decline in wholesale prices last month (the third consecutive retreat) certainly don't boost confidence that the D risk has passed.
July 15, 2010
GLOBAL INFLATION EXPECTATIONS
IS THE DIP REAL?
Today’s weekly update on initial jobless claims suggests that the labor market is finally turning (or will soon turn) for the better. Maybe. For the first time in nearly two years, seasonally adjusted new filings for jobless benefits totaled less than 430,000. We've seen this movie before only to end up with disappointment, as we've been discussing (such as here, for instance). Will it be any different this time? For today, at least, it's easier to answer "yes."
As the chart below suggests, the momentum now looks set to shift to the side of growth. Can we believe it? There’s reason to wonder, given the recent history. New jobless claims have been moving sideways this year, raising worries that the labor market’s rebound was fizzling. Today’s report provides fresh hope that job creation may stronger than it appeared.
"We've been waiting for the day that this number creeps toward 400,000, and it looks like that's finally where we're headed," Craig Thomas, senior economist at PNC Financial Services, tells CNNMoney.com today.
But there are caveats (as always) for reading too much into any one number. As the AP reports:
Normally, such a sharp drop in jobless claims would be seen as a positive sign that the job market is improving. But economists will need to see the downward trend continue for several more weeks before drawing conclusions.
Another concern is that the latest drop may be the result of temporary seasonal factors. A Labor Department analyst said manufacturing companies reported fewer temporary layoffs than usual this time of year. General Motors said last month that it would forgo its customary two-week summer factory closings, which it uses to retool plants for new car models.
That usually causes a spike in temporary layoffs and jobless claims in early July. Other manufacturers also reported fewer temporary layoffs than expected, the analyst added.
Last week's drop "is very encouraging," Jennifer Lee, an economist at BMO Capital Markets, said in a note to clients. "But it likely won't last" because much of it was due to seasonal factors.
It doesn't help expectations to learn that unadjusted weekly claims jumped by nearly 49,000 to more than 513,000 last week. Seasonal factors are an issue, perhaps more so than usual these days. The trick is deciding if the fine print is bullish or bearish.
THE PARADOX OF DISMISSING MARKET EFFICIENCY
The efficient market hypothesis (EMH) is one of the most contentious topics in all of financial economics. You could spend years reviewing the mountain of literature, both pro and con, that dissects the subject into ever finer slices without reading the same paper twice. As a practical matter, EMH has been helpful for investors, namely, making the case for indexing. Indexing isn't perfect and some investors can do better, but passive investing has a history of more or less working as advertised: delivering middling performance over time relative to a wide range of actively managed results, and at low cost.
But even the posted results don't convince some critics, who argue that the success of indexing is due to factors beyond what the theory allows. This is an endless debate, in part because of the so-called joint hypothesis problem. For example, let’s say you set out to prove or disprove EMH. You run the numbers through a model and come to a conclusion. But no matter the result, you’re never quite sure if your model is flawed or the markets are inefficient. How would you know which story applies? Well, you’d need corroborating evidence, i.e., a third model, and one that’s flawless. Otherwise, you'll need to make a decision based partly on gut instinct. So much for definitive answers in deconstructing Mr. Market's rules for asset pricing.
That leaves us with the thankless task of using one or more flawed models, reviewing financial history and reading the research for figuring out what seems to work best. I did some of that in my book Dynamic Asset Allocation. Poring over decades of financial theory and empirical research, I argue that markets tend to be mostly efficient over the medium- to long-term horizons, but with the caveat that there’s enough non-random pricing evidence to support some amount of active asset allocation.
None of this persuades EMH critics. But what’s puzzling is that some (all?) opponents of efficiency assume that market prices are more or less correct as the basis for arguing the opposite. For instance, consider the debate over dividends, which goes back to the early 1980s, when Professor Robert Shiller published his widely quoted paper "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?" The idea here is that the market is inefficient because stock prices move too much relative to the comparatively smooth changes in dividends. In other words, the stock market prices dividends in a haphazard manner that's of questionable efficiency.
That view can't be dismissed, but 30 years of thinking through the problem has spawned a rainbow of interpretations. That includes the possibility that fluctuating dividend yields (i.e., prices bounce around a lot while actual dividends are fairly tame) can offer some value in forecasting equity market return without indicting EMH. An important paper emphasizing this perspective is Professor John Cochrane's 2008's "The Dog That Did Not Bark: A Defense of Return Predictability." Summarizing his analysis, Cochrane writes:
If returns are not predictable, dividend growth must be predictable, to generate the observed variation in divided yields. I find that the absence of dividend growth predictability gives stronger evidence than does the presence of return predictability.
And if you graph the data, Cochrane's point looks plausible. Consider, for instance, the chart below, which compares the trailing 12-month dividend yield on the S&P 500 and its predecessors over the decades vs. the subsequent 10-year value of $1 invested in the S&P at a given dividend yield. For instance, the trailing stock market yield in March 2000 was roughly 1.2%. A $1 investment in the S&P at that point would be worth about 80 cents a decade later.
Overall, there's chart shows a fairly strong relationship between current yield and subsequent return. Higher yields tend to be linked with higher returns in future years, and vice versa. It's not perfect but it'd be foolish to ignore the strategic connection between valuation and performance. Is dividend yield a silver bullet? No, of course not, but neither is anything else. You need to look at a mix of data to generate productive estimates of the expected return for stocks. But surely dividend yield deserves to be one of the variables.
Is the yield/return relationship evidence that the market is inefficient? Not necessarily. The fact that stock prices are less than perfectly random doesn't invalidate EMH. In other words, EMH's legitimacy doesn't rely on the random walk theory, even though many academics used to argue just that. But financial economics no longer sees markets in those terms. Expected risk premiums can bounce around in an efficient market, as explained in A Non-Random Walk Down Wall Street. Yes, EMH may still be flawed (or irrelevant), but you can't prove it by showing that market prices aren't perfectly random.
At the same time, some critics of EMH use the fluctuating dividend yield (and other wandering metrics of "fundamental" value) to argue that the market's irrational. When dividend yield rises or falls to some level (invariably a subjectively defined level), some investors are inspired to claim that stocks are overpriced or underpriced. That may or may not be true, although the choice of words can be misleading.
It's widely accepted that expected returns on assets change, reflecting the prevailing conditions. EMH never argued that expected return would remain constant. Rather, it only says that market prices reflect known information about companies, the economy, etc. Accordingly, the market also reflects an assumption about expected return and risk. Sometimes the market prices the future at a high or low discount rate. Is it correct? Sometimes, sometimes not. Par for the course in divining the future.
Here's the key question: Is it proper to use the market's prices (and by extension dividend yield) to claim irrational pricing? Perhaps not, since that assumes that the underlying prices are rational--somethng that EMH critics are loathe to accept. Simply put, it's a stretch to claim that market prices are irrational and then use the same prices to make a rational analysis of expected return.
As an example, let's say a stock market index is priced at 100 and it's paid $1 in dividends over the past 12 months. That is, the dividend yield is 1%. After poring over the index's history, you discover that 1% is low—the lowest in 50 years, in fact. In turn, you declare that the market's irrational. Prices are too high (or, if you prefer, yields are too low). The market's gone off the deep end, ergo, EMH is irrelevant. Maybe, but it's hard to make the case based on this analysis.
If market prices are useful and providing some degree of insight, how can we use those same prices to conclude that the market's irrationally overvalued? If you really believed that market prices are worthless, you'd pay no attention to dividend yield because that would be irrelevant too.
And there's another problem. If you think the market's undervalued because market prices are irrational, buying stocks and hoping to sell at future irrational prices sounds like gambling rather than investing.
In fact, the anti-EMH crowd respects market prices, even if they don't come out and say so. Some strategists hedge their bets in the terminology. For example, Andrew Smithers is no fan of EMH. Yet in his book Wall Street Revalued: Imperfect Markets and Inept Central Bankers he writes of a "moderately efficient market" and the "imperfectly Efficient Market Hypothesis." He argues that "the case against the EMH leads naturally to the idea that the markets rotate around value rather than remain perfectly tied to it."
Yet an updated interpretation of EMH and modern portfolio theory (MPT) sounds similar, as I outline in my own book. In fact, supporters and detractors of the current reading of EMH and MPT are generally in agreement, even if the rhetoric suggests otherwise. Market prices are relevant in some degree, which means that related measurements like dividend yield, book value, price-to-earnings ratio, etc. provide valuable information for estimating expected return.
Where the consensus breaks apart is deciding why expected return fluctuates. The anti-EMH group says it's due to irrational pricing in the market. Of course, if you really believed that, you'd question the associated dividend yield and p/e ratio and therefore avoid stocks entirely. But the anti-EMH folks don’t go that far, which suggests that they may not be thoroughly and irrevocably opposed to EMH after all.
July 14, 2010
RETAIL SALES & THE ECONOMIC TREND
Today’s update of retail sales for June doesn’t look good, but it’s still not so bad in terms of the broader trend. That doesn’t mean that there’s nothing to worry about, but for the moment the annual pace of retail sales is still comfortably in positive territory. But given the current climate, more downshifting may be coming. At what point does a return to trend signal something worse? It’d be foolish to underestimate the hazards these days, but the economy’s fate is not yet doomed, or so the trend in retail sales imply.
On a monthly basis, the news is less encouraging. Seasonally adjusted retail sales dropped last month by 0.5%, the second straight monthly decline. But that’s hardly the end of the world, considering that retail sales rose in each of the first four months of this year. On a monthly basis, this is a noisy number and so it's not yet clear that sustained losses are destiny.
On a rolling 12-month basis, retail sales are still up sharply, as the chart below shows. For the year through June, total sales are higher by 5%. That’s at the top range of the glory days in the years ahead of the Great Recession. What this chart tells us is that the annual pace of retail sales can still drop in the months ahead without turning bearishly fatal.
Even so, there are still plenty of reasons to stay cautious on what comes next. If we review retail sales in terms of seasonally adjusted dollars spent, for instance, the trend looks quite a bit more intimidating. In our second chart below, it’s hard to miss the hefty decline in consumer spending of late. Although retail sales are up sharply in absolute dollars from a year ago, it looks like the rebound peaked in April 2010. For the moment, we’re nowhere near the previous top, nor are we likely to return to those heights anytime soon. In that sense, the chart below is a graphic symbol of the times--diminished expectations and deflated economic activity.
Retails sales, of course, are but one measure in a sea of economic numbers. In an effort to bring some clarity to the broader economic trend, I publish an equally weighted index of 18 economic statistics in The Beta Investment Report, as listed in the table below, which is republished courtesy of the July issue of the newsletter.
Unsurprisingly, the BIR Economic indices have been falling recently, reflecting the rise in deflationary risks lately, as we discussed here and here, for example. But economic news arrives with a lag, of course, and so forecasting the broad trend is that much more difficult. For instance, the last full month with all the 18 economic reports published was May. Meantime, June data continues to roll in, including today’s retail sales report. So far, eight of the 18 data points for June have arrived. Unfortunately, five of the eight posted declines last month vs. May; one is unchanged; and one is higher. It’s not yet clear that the economic weakness of late is set to end.
The lone gain so far for the June data, however, is encouraging. Commercial & Industrial loans turned up last month—the first increase since October 2008, according to the latest round of revised data from the Federal Reserve. The news that lending is moving higher is good news, of course. New loans are essential in the grand scheme of the business cycle for planting the seeds of growth. Lending in the private sector by itself is hardly a silver bullet, but it’s a fundamental part of every recovery.
Alas, the uptick in June, welcome as it is, is slight. As increases in C&I loans go on a monthly basis, the 0.02% rise could hardly be much smaller. But for the moment, that’s all we’ve got. The question is whether we’ll see anything better anytime soon?
July 13, 2010
CHOOSING INDEX FUNDS: PRICE IS ONLY PART OF THE ANALYSIS
Indexing offers many advantages for investing, but not all index funds are created equal. For the leading index products, low cost is a big attraction. But in a world where indexing choices have exploded, caveat emptor applies. "Most investors assume, however, that indexing automatically means getting a cheap fund and certainly one that's cheaper than an actively managed fund, Morningstar's John Coumarianos advises. "However, this isn't necessarily the case."
Quite true. Some index funds are grossly overpriced. Of the nearly 2,000 index products (ETFs, ETNs and open-end products) in the June edition of Morningstar's Principia software, more than 600 have a net expense ratio of 1% or higher and nearly 200 charge 2% or more.
But while you should never overpay for indexing, it's also true that you can go to extremes in seeking out the absolute lowest price at all times in exclusion to other factors. It's tempting to think that picking the lowest-cost index fund always brings you the best choice. That's true sometimes, perhaps often, and it certainly making indexing investing easier. But relying on it as a hard-and-fast rule that never fails is asking for trouble. That's especially true when you're analyzing funds that focus on a particular slice of a broadly defined asset class.
One example is the world of small-cap value (SCV) funds. There are a number of choices, but picking a fund is tricky in this corner of equities, and expense ratios are just the tip of this iceberg. The next issue of The Beta Investment Report analyzes the possibilities by first zeroing in on the short list of conventional SCV index funds. Among the ETFs, one stands out for its low cost. But it's not obvious that this is the best choice.
Why? The answer starts by running factor analysis on the monthly returns for the funds on the short list. In particular, analyzing a fund's return via multiple regression against the value, small-cap and broad market factors reveals a fuller profile of what's driving each portfolio. This analysis of SCV index funds shows that one ETF stands out as providing a deeper, richer exposure to the small-cap value beta—an exposure that's not exactly conspicuous simply by looking at raw returns or reading the usual suspects for fund summaries.
Meantime, this SCV fund isn't the lowest-cost choice. Is it the best choice? Perhaps, although much depends on what the investor is looking for. For instance, if you're trying to boost the expected return of your overall equity allocation by overweighting small-cap value, the fund with the stronger exposure to the SCV beta is compelling. Of course, SCV has a history of beating the broad market (and most other equity styles) over time for a reason: higher risk, as implied by some interpretations of the Fama-French three-factor model.
True, SCV over the long term doesn't always register higher return volatility, the traditional definition of risk. But in the short term, SCV has been known to lose more than the broad market in bear markets, which tends to be compensated with higher returns of some magnitude when the market recovers. But not every investor wants SCV in the extreme. For those who have a lower risk tolerance, a tamer version of SCV indexing may be appropriate.
Yes, the price of entry is a key benefit of indexing, but it's not always the only variable to consider.
July 12, 2010
IS THERE ANY THERE THERE IN HEDGE FUND BETA?
Hedge funds are supposed to be the ultimate diversification tool. The idea is that the returns post low/negative correlation with broad measures of conventional investing strategies and yet somehow manage to deliver positive returns when the standard strategies tumble. That’s certainly true some of the time for some of the managers. But expecting hedge funds writ large to deliver satisfaction is too often dashed on the rocks of reality. The notion of a hedge fund beta, in other words, isn’t all that attractive.
The latest bit of evidence comes from news reports today that "hedge funds had their fourth-worst first half since industry performance-tracking began," according to a story from MarketWatch.com. The article goes on to report:
An index of hedge funds run by Hennessee climbed 0.2% in the first half of 2010. The only years with worse performance in the first six months of the year were 2008, 2002, and 1994, the firm noted. Hennessee has been tracking performance in the industry since 1987.
Those three previous calendar years, by the way, just happened to be losing years for stocks, in case you were wondering. Shocking, isn't it? Yes, there's a hedge fund beta, but in broad terms it has a fairly high correlation with the stock market.
What's the problem now? Jason Bonanca, who runs strategy and research for hedge fund MKP Capital Management, offered an opinion via Reuters today: "The noise quotient in the market has been very high this year, and it is hard to make money when there is that amount of underlying volatility."
Really? That's strange, considering that many fans of hedge funds advise that this "nimble" corner of managed money excels in taking advantage of volatility. If you can't prove yourself (and your high fees) when markets are volatile, when is the right time to own hedge funds? When markets are relatively calm? But isn't that when conventional plain-vanilla indexing strategies tend to do best? Hmmm.
The problem is that aggregating hedge fund returns into a single benchmark is something akin to herding people off the street onto a stage and expecting to find lots of talent. Sure, you'll find it, but it's likely to be rare.
Consider the 12-month trailing returns for long-short mutual funds, according to Morningstar Principia software. For the year through the end of May 2010, returns for the 100-plus funds in this category ranged from a high of nearly 47% down to a loss of more than 20%. For perspective, the S&P 500 was up about 20% over that stretch. For the past 3 years, the top annualized performance for long-short mutual funds was in excess of 12%; the worst roughly -15%. The S&P's gain during that period was a slight 0.3% annualized return.
The variation is even greater in privately managed hedge funds. But that performance in excess, presumably, is the attraction. Hedge fund strategies reportedly benefit from the fact that managers can do almost anything, in contrast to the highly regulated world of mutual funds and ETFs. But the dark side of that equation is that returns can be all over the map with lightly regulated hedge funds, for good or ill. As such, the risk in pursuing hedge fund beta is that you end up with mush—and that's before deducting all the hefty fees.
Yes, some hedge funds live up to the hype, but many (most?) don't. In the end, we're all swimming in the same waters, trading the same securities and looking at the same data. A few talented managers will be able to beat the odds, but most will deliver mediocrity, or worse. Ditto for conventional investing.
That inspires picking and choosing hedge fund managers as opposed to buying them in the aggregate (or owning the growing array of publicly traded funds that attempt to capture the hedge fund beta). There's certainly a case for focusing on the best hedge funds .But that opens a new can of worms. Even if you can identify talent, it's not obvious that the crème de la creme is going to let you into the club.
Meanwhile, even the truly talented managers face more competition over time. "Hedge funds, when they were new, did make a lot of money," reports MoneyLife.com.
According to Chicago-based data provider Hedge Fund Research between 1990 and 2000 hedge funds were able to achieve an astonishing annual return of 18.74%. They did this by exploiting opportunities in markets. Of course the great thing about competitive markets is that success breeds competition subsequently driving down prices. Over the more recent past, between 2000 and 2007, hedge fund returns have been far more modest, just an 8.61%.
In the end, everything becomes a commodity eventually. The only question is how much you pay for it. Alas, bargains in the land of hedge funds are the exception.
MONDAY MORNING CHATTER: 7.12.10
The economic news this week focuses on retail sales (Wednesday), wholesale inflation, new jobless claims and industrial production (Thursday), and consumer price inflation and consumer sentiment (Friday). For a bit of context, here are some links that caught our attention...
July 9, 2010
TALKING UP DEFLATION
The market's falling inflation forecast over the last two months took a breather yesterday, but the subject of monetary policy and the heightened risk of deflation is hotter than ever, as we've been discussing (here and here, for example). It wasn't obvious that the central bank was prepared to act, but now it appears that the Fed is starting to recognize the problem, or so recent news reports suggest.
The current outlook for inflation, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries, rose slightly to 1.79% yesterday--the highest since June 30. But since late April, the market's expectation for inflation over the next 10 years is still down sharply from around 2.45% in late-April. Debate rages about whether the trend is a warning sign for the economy or merely statistical noise.
The central bank, however, seems to be taking the threat a bit more seriously these days. As the Washington Post reported yesterday, the "Federal Reserve weighs steps to offset slowdown in economic recovery." According to the article:
Top Fed officials still say that the economic recovery is likely to continue into next year and that the policy moves being discussed are not imminent. But weak economic reports, the debt crisis in Europe and faltering financial markets have led them to conclude that the risks of the recovery losing steam have increased. After months of focusing on how to exit from extreme efforts to support the economy, they are looking at tools that might strengthen growth.
"If the economic situation changes, policy should react," James Bullard, president of the Federal Reserve Bank of St. Louis, said in an interview Wednesday. "You shouldn't sit on your hands. . . . I think there's plenty more we could do if we had to."
With the Fed funds target rate at zero-0.25%, conventional monetary policy seems to be at a dead end, a.k.a. the problem of the zero bound, as it's known. But as the WaPo story advises, unconventional tactics include talking up the outlook for low interest rates for an extended period, cutting the rate to zero for bank reserves held at the Fed, and buying more mortgage securities to add to the Fed's balance sheet.
Economist Mark Thoma thinks the Fed should try another round of unconventional monetary policy stimulants, but warns against expecting too much. As he explains,
I think the economy needs more help, particularly labor markets. But where will that help come from? Additional fiscal policy seems to be off the table due to worries about the deficit, worries I think are baseless, but I don’t control the fiscal policy levers. That’s the best thing to do right now, but it’s not going to happen.
That leaves monetary policy… one thing they could do is to purchase long-term securities in an attempt to lower long-term interest rates. Or they could set a higher inflation target to try to lower long-term rates. The idea is that this will spur investment spending by businesses and new spending on durables by households.
The Fed should use these tools, "but we shouldn’t expect miracles," warns Thoma.
Paul Krugman is also skeptical, although he advises: "What would really be effective would be a credible commitment to a higher inflation target, which would reduce real interest rates. But that’s not on the menu, at least not yet." In any case, he's dubious about what it all means. "It’s good to see the Fed getting worried; but don’t get too excited," he writes on his blog.
But economist Scott Sumner thinks unconventional monetary policy still has quite a bit of punch left, if the Fed is willing to use it. "The real 'big guns' would be a higher price level target," he opines. "I want the Fed to raise interest rates by setting a much higher price level or [nominal GDP] target," he asserts. "But alas, the Fed seems horribly confused about this issue. Only if the period of zero rates was linked to economic conditions in such a way as to increase inflation expectations, would the policy have any stimulative effect."
When the IMF's top economist proposed a higher inflation target for central banks earlier this year in a research paper, the punditocracy slapped him down. Bloomberg columnist Caroline Baum, for instance, dismissed higher inflation targeting as a "lousy cure" back in February in a response to the IMF study.
Of course, it's easy to dismiss higher inflation targeting if outright deflation is only a threat, as it is at the moment. Indeed, Baum suggests that a little deflation can be a good thing. And Daniel Gross at Slate.com writes that "a pleasant surprise when prices of many items fall." He notes that there's good and bad deflation. The bad kind is a byproduct of falling output and the dark side of the business cycle a la the Great Depression vs. the good kind that's driven by rising productivity and technological innovation.
Unfortunately, much if not all of the deflationary winds blowing these days come from the dark side. To be fair, outright deflation isn't here yet, nor is it certain (or even likely) that it'll turn up. But the risk is rising. And with the outlook for a jobless recovery looming, this is no time to soft pedal the D risk. Yes, the Fed overestimated the potential for deflation in 2002-2005, keeping interest rates too low for too long. But that was then; this is now.
Sure, a little deflation is a good thing. Everyone likes to pay less (except when it comes to investing, but that's another issue). The problem is that keeping the monster in the box is quite a bit tougher once he's escaped. Figuring out when he's escaped vs. merely peeking out and blowing raspberries is as much art as it is science, which makes the near-term future that much more hazardous for policy choices.
Is a lot of deflation a bad thing? Absolutely. Ignoring the danger is simply ignoring economic history. But the issue isn't whether pundits understand the challenge. It's all about central bankers, and at the moment the jury's still out.
July 8, 2010
STATISTICAL REFRESHMENT...FOR NOW
The case for deflation retreated a bit today with this morning’s update of weekly jobless claims. New filings for unemployment benefits slumped by a tidy 21,000 last week to 454,000, the government reported. That's the biggest weekly drop since mid-April and the decline represents a tactical victory for the bulls. But until and if the trend rolls on it’s only marginally encouraging. The strategic outlook, in other words, is still up for grabs.
For reasons that need no explanation at this late date, a drop in new jobless claims is as welcome these days as a rainstorm in a desert. But the same old problem remains: Been there, done that. As the chart below reminds, new filings have been bouncing around in a range all year. A sustained dip below the 450,000 would signal a change for the better. As of last week, new claims are at the lower end of recent history. Salvation, it seems, could be just around the corner.
But we've been hoodwinked before and it'd be foolish to think that the numbers can't jump higher again. Further complicating the analysis is the anticipated summer shutdowns of auto plants to retool equipment for new models—a glitch that may render jobless claims data unreliable in coming weeks.
As Ian Shepherdson of High Frequency Economics advises MarketWatch.com: The latest drop in weekly jobless claims "is welcome news and we'd love to be able to say with confidence that it marks the start of a renewed downward trend, but we cannot. The next clean claims data won't appear until early August, so until then we are inclined to ignore the numbers."
Meantime, we'll have to look to other metrics to read the economy's tea leaves. Next week brings updates on monthly retail sales and consumer price inflation. Unfortunately, the consensus forecast calls for a decline in consumer spending for June and flat prices in headline CPI for the month, according to Briefing.com. The debate about the economy, in short, is still alive and kicking.
THE MAIN EVENT
Yesterday's sharp rally in the stock market takes the edge off of deflation concerns…for the moment. But let's not forget that the Treasury market's implied 10-year inflation forecast is still bouncing around at the lowest levels since last October. In other words, yesterday's revival of bullish spirits in equities didn't pare deflationary anxiety, at least not yet.
The inflation forecast is a thin 1.70%, based on yesterday's yield spread for the nominal 10-year Treasury Note less its inflation-indexed equivalent. The jury's still out on whether this dip has legs, although the downside momentum seems to be picking up strength. As for what comes next, much depends on whether the risk-aversion trade still has a head of steam. Yesterday's action in stocks offers some evidence for thinking the tide has turned and that the renewed rush into Treasuries in recent months run its course. Maybe, but one day a trend does not make.
This much is clear: the days and weeks ahead are likely to be a crucial turning point, for good or ill, in the renewed battle against the forces of deflation. The crunch time has arrived. It's just not yet obvious which side will get crunched.
Yesterday's skirmish seemed to favor the cause of reflation. The S&P 500 soared over 3%. But while the daily change is impressive, the broader trend of selling risk has yet to break. The S&P is still well below its 200-day moving average. As market technicians have been pointing out, the 50-day moving average recently fell below the 200-day counterpart—the so-called death cross, which is considered by some to be bearish signal of some import. But nothing's foolproof in forecasting the future, and so the crowd watches and waits for the next data point.
On that note, the Treasury is scheduled to sell a whopping $12 billion of inflation-protected bonds today. As a measure of how the crowd's thinking about pricing trends, we'll get a pretty good sentiment reading with this auction.
Meantime, the IMF raised its outlook for global economic growth:
Balancing the strong growth numbers for the first half of 2010 and the adverse impact of increased financial turbulence, the IMF forecasts world growth to rise to 4 ½ percent this year, before falling somewhat to 4 ¼ percent in 2011—with the world average masking large differences around the globe.
But despite the stronger than expected first half recovery, the IMF warned that uncertainties surrounding sovereign and financial sector risks in parts of the euro area could spread more widely, posing difficulties for both financial stability and the economic outlook.
The disinflation/deflation minions are still pressing hard, but the cause for growth isn't yet lost, as the IMF forecast reminds. But it's still too soon to say which side will win. The case against outright deflation still looks stronger, but the defences are slowly giving way. The battle rages on.
July 7, 2010
DOUBLE DIP TALK: 7.7.2010
Beauty is in the eye of the beholder, and so is the risk (or lack thereof) for recession. Almost everyone agrees that the threat of a new economic contraction is higher today than it was a few months back, but the consensus ends there. What looks like a fait accompli to one dismal scientist appears as a minor hazard to another. For some perspective on the debate, and a bit of context for monitoring the risk of a new recession, read on…
The economy is still in the gravitational pull of the Great Recession and all the booster rockets for getting us beyond it are failing. The odds of a double dip are increasing.
--Robert Reich, professor of public policy at the University of California, Berkeley
Christian Science Monitor
A week ago, we accumulated enough evidence to conclude that the U.S. economy is most probably headed into a second leg of recession. It is unclear whether this will be identified as a second recession or a continuation of an existing downturn. In either case, I've repeatedly noted that the apparent strength in the U.S. economy over the past year has been driven almost exclusively by an almost inconceivably large burst of fiscal and monetary "stimulus" last year, whereas intrinsic economic activity has stagnated.
--John Hussman, Hussman Funds
From a theoretical point of view, another recession is what we should expect right now. This is because both GDP and employment are driven by private business investment, and huge tax increases on both business income and capital investment are now only six months away.
--Louis Woodhill, an engineer and software entrepreneur, is on the Leadership Council of the Club for Growth
Real Clear Markets
The economy is headed for a period of very weak growth, it really doesn't matter to anyone other than econ nerds and bad reporters whether the growth rate is actually negative in any given quarter [a double dip].
--Dean Baker, co-director of the Center for Economic and Policy Research
We don’t expect a double-dip recession in the global economy. The market is over pessimistic.
--Fan Cheuk Wan, head of Asia Pacific research at Credit Suisse Private Banking
I still think it’s very unlikely that the economy will fall into a double-dip. Double-dip fears are quite prevalent right now and have been. But, I find the situation very similar to the last two so-called jobless recoveries where feelings of double-dip constantly bubbled up to the surface but never materialized.
--John Ryding, RDQ Economics
Seer Press News
Pointing to strong U.S. consumer spending data and modest income growth, Scotiabank economists Derek Holt and Gorica Djeric wrote in a note that fears over an imminent descent into a new recession are overblown…"You don't get a double-dip recession while the U.S. consumer is still spending," Holt said. "We have half a million [new] jobs in the private sector — that's not something to shake a stick at."
The U.S. economy doesn’t show signs that it will relapse into another recession, said Christina Romer, President Barack Obama’s chief economist. “We certainly do not see any sign of that in the data,” said Romer, who chairs the White House’s Council of Economic Advisers, in an interview on Bloomberg Television today. “We’re anticipating moderate growth.”
8 Problems That Could Trigger a Double-Dip Recession
U.S. News & World Report
10 factors that could lead U.S. economy into 'double-dip' recession
So what exactly is a 'double-dip' recession?
July 6, 2010
DEFLATION RISK IS STILL RISING
When we last left the Treasury market on Friday, the market’s forecast of inflation for the 10 years ahead had fallen at the steepest pace in a year.
As our chart below shows, the inflation outlook slumped to 1.73% on Friday, based on the yield spread between nominal and inflation-indexed 10-year Treasuries. That’s the lowest since early October 2009, and sharply below the previous high of 2.45% set back in late April 2010, according to the government’s interest rate data.
There’s always some doubt about the market’s forecast. Divining the future is a hazardous game, and so the collective bets of the crowd aren’t foolproof. But as the inflation outlook continues to retreat, it’s getting tougher to dismiss the trend as market noise. The solution? Arresting and reversing the rapid decline in the annual pace of the money stock is arguably at the top of the list, as we discussed last week.
Otherwise, economic news will decide the direction of the inflation forecast in the weeks and months ahead. Unfortunately, updates this week are light. Later today comes word of the ISM services industry index. Meanwhile, Thursday’s update of initial jobless claims will provide additional context to last week’s mixed news for the June payrolls report.
If there’s any clarity at the moment, it comes from the labor market. The sure-fire economic solution to the mounting deflationary risk is a strong and sustained rebound in job growth. Unfortunately, the odds look high for a jobless recovery at the moment, thus the market’s outlook for a new round of disinflation, perhaps outright deflation.
Until and if the economic trend intervenes by way of a surprisingly strong burst of growth, the deflationary bias is likely to persist. Not every day, of course. But for two months now, the Treasury market has been telling us to prepare for another round of falling inflation expectations. The good news is that the decline isn’t yet as steep or persistent as it was in late-2008. On the other hand, it’s not yet obvious that a repeat performance will be avoided...unless the Fed comes riding to the rescue by cranking up the money stock. So far, there signs aren't encouraging.
July 2, 2010
MODEST PRIVATE SECTOR JOB GROWTH IN JUNE
The decline of 125,000 in nonfarm payrolls for June isn’t a surprise. Most economists were forecasting a decline of 100,000 or so. Nor is the tumble necessarily an omen for the economy. A big factor in the retreat in the headline number is the termination of temporary Census workers. And if we strip out the government's influence, there's good news: private-sector employment added 83,000 new jobs last month, a rebound from May’s tepid 33,000 gain. But the modest rebound in private sector employment isn’t a revelation either, based on the consensus forecast among dismal scientists. Overall, the debate about whether the labor market is on a sustainable path of recovery is still alive and kicking.
The nation’s unemployment rate fell a bit, dropping to 9.5% in June, down from 9.7% in the previous month. That’s the lowest since last July’s 9.4%. But it's still high, and it's not yet obvious that it's set to decline dramatically any time soon. On a strict numbers basis, however, it’s fair to say that the labor market showed some improvement in the critical areas last month, namely, private-sector job creation and the overall jobless rate. If we left it there, we could claim that the mending process is bubbling, albeit modestly. Of course, no one's likely to look at those numbers in isolation.
As our chart below shows, private-sector job growth has been positive for each and every month this year through June. The average monthly gain in the first half of 2010: roughly 99,000 jobs. That’s obviously a world of improvement from shedding hundreds of thousands of jobs per month, as was the case at this time a year ago. But the problem remains the same challenge and uncertainty that we’ve been writing about for some time: the labor market has yet to show a robust rebound that matches the depth of the previous losses. There are still substantial headwinds blowing against the forces of growth, and it remains to be seen if the labor market can make progress against the forces of deflation.
Today’s employment report surely dodges a bullet in the sense that it’s hard to argue that the private sector isn’t hiring. It is. The economy has created nearly 600,000 new private sector jobs over the past six months. That’s obviously a step in the right direction, and to the casual observer it sounds impressive. But let’s not sugarcoat the results: They’re tepid, given what’s required to a) made substantial headway in repairing the damage from the Great Recession; and b) keeping the so-far vulnerable economic recovery from fading. More than 8 million jobs were lost in the previous contraction, and only a token amount of those positions have returned.
At the same time, today’s numbers minimize the case for seeing a new recession on the near-term horizon. That doesn't mean that a double-dip recession isn't possible. It is, but the odds still look low (and perhaps a little lower in the wake of today's employment report). Yet the same numbers provide only the thinnest support for thinking that the labor market rebound is gaining strength. As the trendless trend in initial jobless claims numbers suggest, we’re still stuck in something that looks dangerously close to neutral. And that, to be frank, isn't good enough, although it may be destiny for the foreseeable future.
The debate about what comes next in the economy, as a result, is set to roll on. There’s something for everyone in the labor market report, which means that nothing has changed all that much. It’s still going to be a long summer.
Nigel Gault, chief U.S. economist at IHS Global Insight, summed up today's labor market news rather well when he told AP: "It could have been worse, but it wasn't good."
July 1, 2010
MORE RISK AVERSION IN JUNE
June was another rough month for risky assets, although the losses were considerably deeper with U.S. stocks from a dollar-based return perspective. REITs also took a hit: for the first time since the opening months of 2009, real estate securities dropped by more than 5% for the second month running. Bonds, on the other hand, did quite well in June. With the threat of deflation taking a toll on investor sentiment, the safety of fixed-income (even at unusually low yields) attracted capital flows last month like moths to a flame. And commodities overall, as per the Dow Jones-UBS Commodity Index, managed to eke out a fraction gain.
As our table below shows, the worst of the red ink was largely contained in REITs and domestic equities. That helped keep losses in the Global Market Index to a relatively light decline of 1.2% in June.
But don't let June mask the broader trend. Stepping back and considering the first half of 2010, there are more losses, and deeper ones among the major asset classes. Commodities, for instance, are down by nearly 10% and foreign developed stocks have retreated by more than 13% in dollar terms—the steepest decline for the major asset classes on a year-to-date basis through June’s close. The global flight into the dollar via Treasuries has helped push the greenback higher so far this year. In turn, that exacerbates any losses in foreign assets when priced in dollars.
Unsurprisingly, the proprietary benchmark for The Beta Investment Report posted middling results relative to the major asset classes during this year’s first six months. The Global Market Index has shed 4.2% this year through June 30.
What's convincing the crowd to run for cover? Deflation worries, which may show up in any number of ways in the weeks and months ahead. The leading concern is that the value of GDP will fall. In other words, renewed concern about recession is again at the top of the worry list.
The sentiment shift was evident in May, when the markets demanded a new and lower price for risk. That's another way of saying that investors demanded a higher expected return, a preference that may have legs. Midway in May, we noted that there were warning signs to consider, including the simultaneous rise of gold and the dollar. The two usually move in opposite directions, unless risk aversion is on the rise. Until the economic data offers compelling evidence to the contrary, the markets aren't likely to reconsider the bearish outlook that's prevailed for the last two months.
This morning's update on initial jobless claims certainly doesn't provide an incentive to think positively. New filings for unemployment benefits jumped 13,000 last week to a total of 472,000. As we've been arguing for some time, the trendless trend in jobless claims is a sore point in the economic recovery and one that threatens to do serious damage to sentiment the longer it rolls on. For the moment, it's rolling on, as the second chart below reminds.
Tomorrow brings word of the broad employment picture for June. Unfortunately, the outlook isn't rosy. The consensus forecast calls for a retreat of 100,000 in last month's nonfarm payrolls, according to Briefing.com.
In fact, the markets have been pricing in a fresh round of bad news for the better part of the last two months. As we opined in January, the odds looked pretty good that 2010 would be a much more challenging year compared with 2009--a contrarian view at the time. Indeed, saving the economy from collapse was relatively easy, and markets reacted according in 2009 by repricing risk higher (and expected return lower). Keeping the reflation going, however, is something else. Macroeconomics has learned much over the decades about how to sidestep a full-blown meltdown. Figuring out what needs to be done to keep the rebound going in the wake of a deep financial crisis is on much more tenuous intellectual ground.
For what it's worth, we're still not convinced that a new recession is imminent. Nonetheless, the odds of stagnation, or worse, are rising. Much depends on how the Fed reacts in the coming weeks. Yesterday we argued that the central bank needs to keep the pace of money supply rising at a healthy clip, at least for the time being. Instead, the Fed has let the annual pace of change in the money supply drop like a rock. Unless that changes, and soon, the economic outlook may continue to deteriorate further.