October 29, 2010
MORE OF THE SAME IN Q3 GDP: SLUGGISH GROWTH
The U.S. economy expanded at an annualized 2% in the third quarter, the Bureau of Economic Analysis reports. The rate of GDP increase for July through September is up slightly from Q2’s 1.7% pace, but still well below the 3.7% logged in this year’s first quarter or the robust 5.0% reading from last year’s final three-month stretch. In other words, the economy’s continuing to muddle along with enough forward momentum to keep another recession at bay. At the same time, today’s GDP report isn’t likely to inspire confidence that economic growth is sufficient to cure the sluggish trend in the labor market—the primary macro challenge these days.
Notably, personal consumption expenditures (PCE)—which account for around 70% of GDP—grew in Q3. In fact, consumer spending’s pace accelerated, advancing at an annualized 2.6% rate, up from 2.2% in Q2. The rate of increase in consumer spending has climbed in each of the past three quarters. Within PCE, however, the bulk of the higher spending has come from services, which includes a range of consumption arenas—everything from transportation to healthcare. By contrast, the rate of spending slowed modestly for durable and nondurable goods—the cyclically sensitive slices of PCE.
Nonetheless, the much-feared retreat of the American consumer wasn’t evident in today’s update. That’s no assurance that spending won’t slip in the quarters ahead. Certainly there’s no shortage of incentives for saving more and spending less. Yet overall consumption continues to rise for the moment.
One reason for caution arises from the slowing trend in the private investment column of the GDP report. This measure of economic spending “comprises purchases by domestic businesses of new capital goods, such as factories and machinery,” notes economist Robert Barro in Macroeconomics: A Modern Approach. “These capital goods are durables, which serve as inputs to production for many years.” Business spending is second only to the consumer as a driver of the macro trend. But in what may be a warning sign, private domestic investment’s rate of increase slowed by roughly half in Q3, rising at just under 13% on an annualized basis—the slowest this year.
Inflation also decelerated in Q3. The price index for personal consumption expenditures rose by an annualized 0.8% during the three months through September, down from 1.0% in the previous quarter.
Overall, today’s GDP report keeps hope alive, but without softening the concerns that have triggered so much anxiety this year about the strength of the expansion. The weak rebound in job creation is still a pressing issue, and today’s macro update doesn’t offer reason to think otherwise. Still, it’s clear that the economy dodged a bullet in Q3. More of the same is probably in store for the near term.
That’s not great, but it could be worse. The real problem is that slow growth is vulnerable to unexpected shocks. The economic expansion rolls on, but it remains a precarious recovery with no immediate solution on the horizon.
"We're just muddling along," Ken Mayland, president of ClearView Economics, tells AP. "I think it is going to be hard to break out of this sluggish-growth rut."
October 28, 2010
CAN WE BELIEVE THE DIP IN JOBLESS CLAIMS THIS TIME?
Today’s update on weekly jobless claims delivered a wallop—in the right direction for a change. It may be another head fake, but on its face this morning’s report is the best news in months for this measure of the job market. It’s only one number, of course, and so all the usual caveats apply. All the more so given the volatility in this data series and the fact that we’ve been hoodwinked many times before in thinking that the stat du jour on this front was a sign of improvement in the labor market only to find that, well, it wasn’t. But for the moment, there’s a new talking point on Wall Street and it’s a refreshing change of pace from the usual gloomy news.
New filings for jobless benefits surprised economists by dropping a robust 21,000 to 434,000 on a seasonally adjusted basis for the week through October 23. That’s the lowest level since mid-July. As our chart below suggests, the drop may be the start of a new phase in—dare we say it?—job creation. Actually, that's too strong until we see more numbers in the weeks ahead. Let's say this morning's number suggests a potentially new round of lesser job losses. One day at a time in macro in the new normal. In any case, the general change in direction is encouraging, at least relative to the trendless trend that’s prevailed.
Even if jobless claims continue to dip, it’s unlikely that the labor market is about to explode on the upside. Modest growth...continued growth? Sure, that's still our baseline scenario, albeit with caveats. There’s still too much fundamental negativity in the economy to expect deep and wide job creation. But that doesn’t preclude some relatively good news for the near term. Just don’t forget: There’s still a long way to go in repairing and righting the number-one problem in macro: weak job growth. And no matter what today’s jobless claims imply, or don’t imply, there’s still no silver bullet out there. If you think otherwise, read a few reports about residential real estate, for instance. The healing will take time and suffer setbacks, and there's no way to change that reality any time soon. Marginal improvement, however, is possible, maybe even likely and (if we're truly an optimist) it'll roll on for an extended period. But, hey, let's not overdo it--it's only one report.
All that aside, it's a bit easier to argue today that it’s not going to get any worse and maybe, just maybe, it may start to get a little better. “Job growth is modest right now, but it should improve,” Joel Naroff, president of Naroff Economic Advisors, told Bloomberg ahead of today’s report. “People will be surprised at how much better the labor market looks like in six months.”
Is today’s update a downpayment on that surprise? Stay tuned…
THE STRANGE WORLD OF MONETARY ECONOMICS IN 2010
GMO's Jeremy Grantham, surely one of the finest investment strategists of our time, is no fan of the Federal Reserve's track record over the past decade or so. In fact, he's gone on record with sharp criticisms of the central bank. This is an institution, after all, that's made mistakes, to say the least. But how to proceed? In his latest quarterly missive, Grantham remains skeptical that the Fed has a silver bullet solution up its sleeve for the various problems that ail the economy at the moment. He did, however, suggest in so many words that Bernanke and company should adopt an inflation target. A reasonable idea, but one that comes with some assumptions on the mechanics--assumptions that complicate the analysis at the moment on what the Fed should, and shouldn't do, for those of a particular world view.
To be precise, Grantham advises that "if I were a benevolent dictator, I would strip the Fed of its obligation to worry about the economy and ask it to limit its meddling to attempting to manage inflation." But here's the problem: After reading the remaining 15 pages of Grantham's analysis and commentary (along with his long-running views from the past), it's easy to come away with the idea that he's no fan of another round quantitative easing (QE2), a.k.a. a new effort to buy up Treasuries in order to lower medium- and long-term interest rates. But if the Fed is expected to target inflation, isn't the case for QE2 compelling these days? Perhaps. But arguing in favor of QE2—an activist role for the Fed—is an awkward position for Grantham, and many other strategists.
But the numbers, if we accept them at face value, suggest that QE2 may be required. Inflation, after all, is falling. Last month, the annual pace of headline consumer inflation has been falling steadily this year, and other measures of inflation have been following suit. Letting it continue to fall risks making a huge mistake, perhaps on par with the Fed's ignominous record in the 1930s.
The argument, then, that the Fed should work to stop inflation from dropping further looks persuasive, at least if you believe that inflation should be relatively stable and contained over time. That means that if inflation is falling, and it's falling at unusually low levels at a time when the outlook for economic growth is weak, the argument for quantitative easing to reflate is stronger.
Suddenly, however, it's not clear we're going to get QE2 after all, or perhaps not enough to make a difference. "Doubts about the wisdom and efficacy of the policy among economists and some of the Fed's own decision makers," The Wall Street Journal reports, have recently raised questions about what to expect at the Fed's FOMC meeting next week.
The renewed debate about what's coming has boosted the dollar, at least temporarily interrupting its decline of late. But that's not necessarily good news for the near term if—if—inflation is set to continue falling. A rising dollar and falling inflation is a problem, even if it's not obvious when focusing on each side of this equation separately. For some of the details, read David Wessel's article today in the Journal, which argues that the-late Milton Friedman would have argued in favor of QE2, a point I made last week.
The question, of course, is whether inflation really is going to continue declining. As always, the future's debtable. But yesterday's news that capital spending fell last month is a sign that there's still plenty of doubts about the economic trend to keep worries alive for now. Add to the mix the questions about how effective QE2 can be, if at all, and we have the foundation for a potent debate.
But this much is clear: arguing on behalf of stabilizing inflation makes for strange bedfellows these days. So it goes as the Great Experiment in righting economy rolls on.
October 27, 2010
LET A THOUSAND INDEXES BLOOM
Choosing an index to represent a particular beta is almost as difficult these days as deciding how to design and manage asset allocation. It wasn't that long ago when there was generally one choice: capitalization weighted indices. Now there's a growing mix of so-called alternative weighted benchmarks, and more are on the way.
As a new review of "alternative" equity indexing strategies advises, the possibilities now include some familiar and not-so-familiar choices, including, equal weighting, minimum-variance weighting, diversity weighting, fundamental weighting, and risk efficient indexing, to name a few.
Each vendor argues that it offers a superior indexing methodology, but it's unlikely that all the claims are accurate. Every strategy can't be above average. Nonetheless, it's not always obvious which strategy is likely to work best and under what conditions. In fact, analyzing competing indexing methodologies is in its infancy as a research focus, suggesting that we all have much to learn in the years ahead as new benchmarks go live and sink or swim with the ultimate empirical test: real world investing with actual assets under management paying real-world fees and suffering real-world surprises and mistakes.
Meantime, what do we know so far? One is that if you compare all the various efforts (including actively managed funds) at beating a cap-weighted index over time, there's likely to be a wide array of results with cap weighting more or less in the middle, perhaps slightly above average. That's partly a function of cap-weighting's inherently low transaction costs, which usually translate into a potent advantage over time vs. strategies designed to excel, which inevitably results in higher costs. Indeed, you can buy a simple cap-weighted U.S. equity index ETF for as low as six basis points these days in the retail market. It stands to reason that if your alternative indexing strategy charges 50 or 100 basis points, you've got a lot of ground to make up from the start.
Another reason cap weighting probably does about average to slightly above average is that market prices capture important information. The market's not perfectly efficient, but neither is it hopelessly irrational, particularly over the long run. Accordingly, beating "the market" isn't easy, which can be translated as: beating a cap-weighted index over time may be tougher than it appears in back tests.
That principle seems to apply to asset allocation strategies too. In a recent issue of The Beta Investment Report, I compared more than 900 multi-asset class mutual funds against the newsletter's benchmark, the Global Market Index (GMI), which holds all the world's major asset classes and weights them passively, i.e., by market value. For the 10 years through this past August, GMI earned a 3.4% annualized total return. That performance beat about 70% of the 900-plus multi-asset class funds that are more or less in competition with GMI, according to some number crunching using Morningstar Principia software.
Another fairly established empirical fact is that some (most?) of what appears to be investment intelligence in equity land is related to investment style. The small-cap and value factors in particular have a history of beating the broad indices over time and these sources of additional risk premia are the likely sources for a fair amount of what's considered superior investment skills. In fact, the new paper cited above ("A Survey of Alternative Equity Index Strategies," by Tzee-man Chow, et al.) says as much:
In any case, the details matter. In a world where you can buy small-cap and value betas directly, and at a low cost, investors must decide if it's worthwhile to pay more for owning small-cap and value factors indirectly via alternative indexing strategies. Given the expanding menu of possibilities on this front, which aren't always intuitive, informed choices require some homework.
Indexing, in short, is getting more complicated. This arena was once the epitome of simplicity. No more. The bigger question is whether the increasing complication will translate into superior risk-adjusted returns for most investors. Stay tuned…
October 26, 2010
ECON BLOGGERS ARE GLOOMY
The Kauffman Foundation yesterday published its Fourth Quarter Economics Bloggers Survey. The report summarizes the views of the "top economics bloggers," a label that generously includes The Capital Spectator, or so the Kaufmann Foundation opines. In any case, the overall view is rather dark, a bit darker than the current outlook on these pages. In fact, the survey's general tone is the darkest yet, relative to previous responses in this poll. The accompanying press release for the report notes that the "respondents' outlook on the U.S. economy is more pessimistic than in any previous quarterly survey in 2010, with 99 percent saying that conditions are mixed, facing recession or in recession. When asked about the probability of a double-dip recession in the United States, the average response is a 41 percent probability; two-fifths see a 20 percent probability, and opinion declines toward higher probabilities."
A few highlights from the survey...
October 25, 2010
ANOTHER SIGN THAT THE MARKET IS NOW EXPECTING HIGHER INFLATION
Expectations about inflation/deflation are a critical factor for handicapping the future in terms of broad price trends, as we discussed in the previous post. Hold that thought as you consider that 5-year inflation-indexed Treasuries sold at a negative yield for the first time, according to Bloomberg.
What does it mean? "It signals people’s expectation of the Fed being able to create some inflation with the QE program," according to Alex Li, an interest-rate strategist at Deutsche Bank. "With nominal rates so low, in order have high TIPS breakevens you’ve got to have negative real yields on the five-year."
The Bloomberg article reports that "the securities drew a yield of negative 0.55 percent." That inspires Keith Blackwell at the Royal Bank of Canada in New York to advise: “With more quantitative easing the likelihood of a deflation scare over the short term has decreased significantly, as the Fed is committed to upping inflation expectations." In other words, "TIPS look much more attractive."
THINKING ABOUT DEFLATION
It’s important to distinguish between “good” and “bad” deflation, the former being a byproduct of improved technology, higher productivity, and other factors that can generally be lumped under the heading of “progress.” Bad deflation, by contrast, is the blowback from a shock of one form or another that produces a financial crisis, such as the one that occurred in 2008.
In those cases when deflation threatens, it's almost always a problem when it's triggered by a financial crisis. Several centuries of history speak loud and clear on this point. But is the threat from deflation limited to those instances when broad measures of prices are currently falling? Not necessarily. The fear of future deflation, even when prices are stable or still rising, can be harmful too. Expectations in economics, after all, can become a self-fulfilling prophecy, particularly when it comes to broad trends in prices.
No less is true for inflation/deflation expectations. In fact, this is where the monetary rubber meets the road. As a recent New York Fed monograph reminds, “monetary economists have emphasized the importance of longer term inflation expectations, and recent literature suggests that the containment of long term inflation expectations is the most important objective in conducting monetary policy.” No less is true if worries about deflation lurk.
The challenge is measuring expectations. At best, it's a difficult task. One tool is looking at the yield spread between nominal and inflation-indexed Treasuries, a proxy for inflation expectations. It's an imperfect gauge, but it does capture some degree of how the crowd's thinking about the inflation/deflation outlook. By this standard, there's reason to think that the outlook for prices has stabilized recently, as the chart below shows. The market's forecast for inflation on Friday was roughly 2.1%--up from the recent low of around 1.5% in late-August. The general view, in other words, appears to be that the Federal Reserve's talk of a new round of quantitative easing (QE2) has short-circuited falling inflation expectations. Yes, that's premature. We'll need to see the Treasury's inflation forecast remain steady for some length of time. But for the moment, a bit of optimism is in order.
Will the crowd's prediction turn out to be accurate? There's reason to think so, given what researchers have told us about the connection between inflation expectations and actual price changes. But there are caveats. One is that there's a lag between the market's inflation prediction and the actual reported rate of consumer inflation. The current update on consumer prices runs through last month, and the latest number advises that inflation's pace was still falling through September. Deciding the efficacy of monetary policy on battling deflation anxiety in terms of actual price changes will take time.
There's also the issue of the Fed's tough talk on rolling out QE2. When will it arrive exactly? How potent will it be? How long will it last? Will it really have an impact on the actual level of inflation?
Deflation may or may not persist, but that’s largely a function of the policy response. As economists Richard Burdekin and Pierre Siklos point out in Deflation: Current and Historical Perspectives, “sustained deflation is only possible when the rate of money growth falls behind the rate of growth of output and money demand.”
For the moment, there's reason for thinking that the deflation threat isn't as strong as it appeared in August and September. Does that mean that the Fed has achieved its goal and will now minimize QE2? If so, will the disinflation/deflationary march resume?
Lots of questions these days with relatively few answers in real time. The Treasury market's inflation outlook is one exception, but it's far from the last word on where inflation's headed. But the fact that commodity prices have been rising lately, including gold, suggests that the Treasury market's inflation forecast is more than noise.
READING ROOM FOR MONDAY: 10.25.2010
►Wall Street focuses on the 'three Es.'
Julianne Pepitone/CNNMoney/Oct 24
Investors are bracing for an onslaught of news this week: The earnings avalanche continues, midterm elections are approaching and economic data are due in a bunch of sectors. Those "three Es" are a lot for investors to digest individually, and this week's triple-whammy could bring volatility to a market that's been behaving somewhat normally.
►Dollar sell-off resumes after G20, eyes on Fed
By Anirban Nag/Reuters/Oct 25
The dollar dropped broadly on Monday, hitting a 15-year low versus the yen, as a Group of 20 agreement to shun competitive currency devaluations was taken as a green light to resume dollar selling by investors..."The G-20 was seen as a hurdle by some and now that is over, investors are back to do what they are most comfortable with -- dollar selling," said Ankita Dudani, G-10 currency strategist at RBS.
►Gold Gains on Dollar's Drop; Palladium Soars to Highest Level Since 2001
By Nicholas Larkin and Sungwoo Park/Bloomberg/Oct 25
Gold climbed in London as a weaker dollar boosted demand for the precious metal as an alternative investment. Palladium advanced to a nine-year high...“We have an anti-dollar sentiment in place as long as uncertainty about the next Fed steps exists,” said Bayram Dincer, an analyst at LGT Capital Management in Switzerland. “Thus, people prefer to direct investments towards gold.”
►Markets Seem to Be Taking Fed Seriously
Karl Smith/Modeled Behavior/Oct 24
The 10 year breakeven rate seems to be moving higher indicating that the market is expecting inflation.
►New NABE Survey Shows Business Recovery Gaining Momentum, with More Jobs Ahead
NABE Industry Survey October 2010/National Assoc. for Business Economists/Oct 25
“NABE’s October 2010 Industry Survey confirms that the U.S. recovery from the Great Recession continues, with business conditions improving,” said William Strauss, Federal Reserve Bank of Chicago. “Industry demand, profits, costs, employment and capital spending strengthened compared to results in the July 2010 report. Outside of skilled labor, no significant amount of shortages was reported. Inflation appears to remain contained, with more firms reporting falling prices than increasing prices for their products. An improved outlook for hiring over the next six months was reported, with the best reading this year. While regulatory policy and federal taxes are expected to have a negative impact on respondents’ companies’ performance over the coming year, monetary policy is forecast to have a positive impact.”
►The Central Banker's Case for Doing More
Adam S. Posen/Peterson Institute for International Economics/Oct 24
Posen argues that monetary policy should continue to be aggressive about promoting recovery, and further quantitative easing should be undertaken. Policymakers face a clear and sustained uphill battle, in which monetary ease has an ongoing role to play, even if it may not deliver the desired sustained recovery on its own. In every major economy, actual output has fallen so much versus where trend growth would have put them, and trend growth has not been above potential for long enough as yet, that there remains a significant gap between what the economy could be producing at full employment and what it currently produces. Thus, policymakers should not settle for weak growth out of misplaced fear of inflation. If price stability is at risk over the medium term, it is on the downside.
►The Effects of Fiscal Stimulus: Evidence from the 2009 ‘Cash for Clunkers’ Program
By Atif Mian and Amir Sufi/Stanford University/Sep 2010
A key rationale for fiscal stimulus is to boost consumption when aggregate demand is perceived to be inefficiently low. We examine the ability of the government to increase consumption by evaluating the impact of the 2009 “Cash for Clunkers” program on short and medium run auto purchases...We find that the program induced the purchase of an additional 360,000 cars in July and August of 2009. However, almost all of the additional purchases under the program were pulled forward from the very near future; the effect of the program on auto purchases is almost completely reversed by as early as March 2010 – only seven months after the program ended. The effect of the program on auto purchases was significantly more short-lived than previously suggested. We also find no evidence of an effect on employment, house prices, or household default rates in cities with higher exposure to the program.
October 23, 2010
BOOK BITS FOR SATURDAY: 10.23.2010
● Shock of Gray: The Aging of the World's Population and How it Pits Young Against Old, Child Against Parent, Worker Against Boss, Company Against Rival, and Nation Against Nation
By Ted Fishman
Radio interview with author via NPR
By the year 2030, one billion people on the planet will be over the age of 65. Plus, for the first time in history, the number of those who are older than 50 will be greater than those under 17. Ted Fishman has traveled around the world to find out what effects this aging trend will have on families and communities, nations and economies. Host Liane Hansen speaks with Fishman about his new book Shock of Gray.
● Globalization at Risk: Challenges to Finance and Trade
By Gary Clyde Hufbauer and Kati Suominen
Summary by Yale University Press
International economists Gary Clyde Hufbauer and Kati Suominen argue that globalization has been a force of great good, one that needs to be actively advanced and honed. Drawing on the latest economic analyses, they reveal the drivers and effects of global finance and trade, lay out the key risks to globalization, and offer a practical policy roadmap for managing the challenges while increasing the gains. Vital reading for anyone in business, finance, foreign affairs, or economics, Globalization at Risk is sure to advance public debate on this defining issue of the 21st century.
● Running Money: Professional Portfolio Management
By Scott Stewart, Christopher Piros, and Jeffrey Heisler
Video of author (Stewart) discussing the book
Designed to be First Comprehensive Textbook for Advanced Portfolio Management Courses...Boston University School of Management’s Scott Stewart, research associate professor in the Finance Department and faculty director of the MSIM Program, has co-authored a new textbook on investment strategy called Running Money: Professional Portfolio Management. The work delves into asset allocation, security selection, and the investment business at large.
● The Last of the Imperious Rich: Lehman Brothers, 1844-2008
By Peter Chapman
Review via Blogcritics.org
Chapman presents a telling narrative of the financial history of America by focusing on one player in its banking world. One of the things that becomes clear as a result of this narrative is that it is not the common people who are in charge, but the blessed people: the moneymakers and the bankers high among them. Chapman reveals just how interconnected high business and Washington behind-the-scenes politics were at the height of Lehman glory. And this makes the Lehman story deeply ironic: those who fled the oppressive rule of the kings of Europe, kings who claimed their right to rule came from a magical quality of their character, become royalty themselves, thanks to the fact that they had the inimitable talent for making money.
● Economic Lives: How Culture Shapes the Economy
By Viviana A. Zelizer
Excerpt via Princeton University Press
In my opinion, economics has paid a stiff price for its current scope and precision. It has, on the whole, located its central causes in the decisions of largely autonomous individuals who operate within constraints set by well-defined resources and institutions. Even game theory, after all, generally features individuals who make choices individually with no more than anticipation of how other parties will make their own autonomous choices. Such an approach has the virtue of parsimony. But it almost entirely neglects the incremental negotiation of shared understandings and interpersonal relations that lies at the center of alternative, more sociological, analyses of economic processes...
By no means does the book before you synthesize contemporary thinking in economics and economic sociology. Far from it: the book’s chapters trace an itinerary into and through economic sociology with only side glances at parallel developments within economics. But they do, I think, raise issues about which economists could benefit from studying more extensively. Most centrally, the book examines how connected people incorporate available culture and interpersonal relations into their daily negotiation of economic activity. In doing so, all of us incessantly reshape the economy at the small scale and the large. That is why I have called this book Economic Lives.
October 22, 2010
QE2 AND HISTORY
In my previous post, I wrote that the case for a second round of quantitative easing (QE2) is warranted, given the current economic climate. Why should we expect QE2 to help more than it hurts? The answer is based in part on interpreting recommendations by Milton Friedman in the late-1990s regarding Japan’s struggle with deflation as it relates to current conditions. Of course, Japan never really conquered its deflationary problems, but that’s due in no small degree to the fact that Japan never really embraced Friedman’s advice wholeheartedly. Without going into detail here, let's just say that Japan’s focus was on price stability rather than engineering a dose of inflation to correct for the deflationary bite. The distinction was and remains a critical factor for assessing what's happened in the Japanese economy, and why, ever since.
We can also look to the history of U.S. policy in the 1930s for additional support for thinking that QE2 is warranted in the here and now. Let's start by noting that there was a dramatic change in the fortunes of the U.S. economy in March 1933. A fair amount of analysis by economic historians over the years offers compelling evidence for identifying the catalyst for the economic rebound starting in March 1933 to what might now be called quantitative easing.
Consider the chart below, which shows the trend in U.S. industrial production in the early 1930s. For nearly three years in the thirties, the Great Depression squeezed the economy, as indicated by a virtually non-stop drop in industrial production, which was cut roughly in half between between early 1930 and mid-1932. Although the trend stabilized in the second half of 1932 and early 1933, there was no rebound of significance...until the spring of 1933.
As the chart above illustrates, there was a dramatic rise in industrial production starting in March 1933. In fact, the sharp increase in industrial activity was tied to the U.S. government’s abandonment of the gold standard. Why is that relevant? The short answer, as economist Barry Eichengreen explains in Golden Fetters: The Gold Standard and the Great Depression, 1919-1939, is that the gold standard, contrary to popular perception, “was the principal threat to financial stability and economic prosperity between the wars [World Wars I and II].” How so? The gold standard effectively forced tight money on the economy at a time when the opposite was needed.
Eichengreen doesn’t reach that conclusion casually. Indeed, he spends the better part of his 1992 book (along with a number of additional research studies and commentaries in subsequent years) reviewing the evidence in support of his thesis.
Eichengreen is in good company. Milton Friedman and Anna Schwartz offer a similar view in their monumental A Monetary History of the United States, 1867-1960 (or in the condensed version: The Great Contraction, 1929-1933).
Economist Scott Sumner has also written extensively on the causes and consequences of the Great Depression. On his blog from earlier this year he writes:When FDR took office in early March 1933 we were in the midst of the worst banking panic in American history. Some states had already shutdown their entire banking system and FDR was about to close all of America’s banks. Yes, the contraction ended in March 1933, but only because FDR made it end with the most expansionary monetary policy in American history—which caused both prices and output to rise rapidly in the months immediately after March 1933.
Sumner is no idle observer making outlandish claims. Rather, here is an economist who for years has studied the finer points of what happened in the thirties. Among his more detailed essays on this point in history are those here and here, for instance. Sumner’s basic point: there was a strong case for quantitative easing then, and now.
Okay, but if quantitative easing is so compelling, why did the rebound in industrial production after March 1933 falter later that year? Eichengreen explains in Golden Fetters: “The recovery of American output was not more sustained because the stimulus lent by policy was so limited. While authorizing the Treasury to intervene with purchases of gold on the international market, Roosevelt could not compel the Fed to support his action with extensive purchases of government securities designed to increase the money supply.”
In other words, there wasn’t a sufficiently strong and sustained application of quantitative easing in the second half of 1933 and beyond. Yes, that sounds a lot like what’s happening these days re: the arguments against QE2.
The attacks on QE2 may be misguided, but they’re not surprising. Liquat Ahamed, writing in Lords of Finance: The Bankers Who Broke the World, a popular economic history of the events that created the Great Depression, observes:Roosevelt’s decision to take the dollar off gold rocked the financial world. Most people could not understand why a country with the largest gold reserves in the world should have to devalue. It seemed so perverse. Indignant bankers lamented the loss of the one anchor that could keep the government honest...But in the days after the Roosevelt decision, as the dollar fell against gold, the stock market soared by 15 percent. Financial markets gave the move an overwhelming vote of confidence. Even the Morgan bankers, historically among the most staunch defenders of the gold standard, could not resist cheering. “Your action in going off gold saved the country from complete collapse,” wrote Russell Leffingwell to the president.
The situation in 2010 is different from 1933, of course. Different, but with parallels. Every economic crisis is different, but history can teach us a few things…if we listen. But the danger of making the same mistakes is always lurking.
Yes, QE2 carries many risks. But we have to deal with the pressing threats as they arrive, and worrying about runaway inflation today is premature, and perhaps more than a little dangerous. The day for fighting that battle will come. But not now.
REVISITING FRIEDMAN'S ADVICE
Economist Scott Sumner makes a good point: "For decades the Fed has steered the economy along a path of two to three percent inflation. The policy has not been controversial. Sometimes they ease, and sometimes they tighten." But the policy has become controversial these days. What's changed? Again quoting Sumner: "Recently inflation has run closer to 1%, and Bernanke has suggested pushing the rate back up to 2%." Those are fighting words in some circles.
Bernanke's policy prescription has triggered an outcry that the central bank should effectively stand back and let nature take its course. What is that course? Allow inflation to continue falling. This seems utterly misguided, but there's a growing chorus of pundits who argue for no less. And let's be clear: We're really talking about the nominal change in the economic growth. In the current climate, it's unlikely that we'll see nominal GDP rise until the inflation rate stops falling if not rises a bit.
How can we achieve that goal? The policy at issue is a second round of so-called quantitative easing (QE2), or the Fed's purchase of government bonds. Is this some radical idea cooked up by crackpots who are oblivious to economic realities? No, not at all. The challenge facing the U.S., while far from common, is hardly unprecedented. The recent experience in Japan is one example, and the Great Depression in the 1930s is another. Indeed, Milton Friedman delivered what many economists see as the definitive prescription for what a central bank should, and shouldn't, do in the face of low and falling inflation, high unemployment and forecasts of lower aggregate spending. As explained in detail in A Monetary History of the United States, 1867-1960, it's a mistake to maintain tight monetary policy under those conditions.
Ah-hah! counter the critics. Fed policy is loose, very loose these days, as indicated by the zero-to-25-basis point Fed funds target rate. Actually, that's a misreading of current conditions. Indeed, as one example, the Taylor Rule implies that Fed funds should be at negative 5% or so. The Fed's not going to engage in negative policy rates, but it still has options, namely QE2. For some background on why that's reasonable and arguably necessary, allow Milton Friedman to explain, albeit as it related to Japan in the 1990s. Analyzing the Japanese economic ills in 1998, Friedman dismissed the idea that low interest rates were a sign of easy money and that there was nothing else the Bank of Japan could do.
Although Friedman's point is misunderstood in the current climate, if not ignored entirely, some economists are attempting to set the record straight. For instance, David Beckworth and William Ruger provide a basic overview in Wednesday's op-ed "What Would Milton Friedman Say About Fed Policy Under Bernanke?
Yes, there are risks with QE2. But the risks of not engaging in QE2 appear to be substantially greater. Unless you expect a material change for the better in the economy in the near term, calling on the Fed to stand pat risks repeating the mistakes of monetary history.
October 21, 2010
SUPERBOWL OF INDEXING CONFERENCE
I’ll be speaking at the 15th annual Superbowl of Indexing conference in Phoenix on Monday, Dec. 6. In particular, I’ll be one of several panelists on the asset allocation seminar at 2:30pm. If you’re also attending, please drop by and say hello. For more information about the conference, which runs Dec. 5-8, you can find all the details here.
THE TRENDLESS TREND IN JOBLESS CLAIMS ROLLS ON
If you’re feeling the sting of statistical whiplash from watching the trendless trend for weekly jobless claims, you’re not alone. Whenever this crucial measure of the labor market show signs of progress, it doesn’t take long to reverse the good news with a fresh round of discouraging numbers. But just when you’re set to throw in the towel and accept a darker fate on this measure, it surprises on the upside. That frustrating state of affairs summarizes what’s been unfolding with initial jobless claims in 2010, and there’s no reason to think anything’s changed with this morning’s news that new filings for jobless benefits dipped last week.
There were 23,000 fewer new claims for unemployment insurance for the week through October 16 on a seasonally adjusted basis, the Labor Department reports. That’s the good news, although the shortened week due to the Columbus holiday on October 11 may have skewed the numbers. In any case, the bad news is that last week’s decline to 452,000 new filings looks familiar. We’ve been here before, only to watch the downtrend evaporate…many times. As the chart below reminds, this gauge of joblessness has been moved through the 450,000 mark, up and down, with a fair degree of frequency this year.
Is there any reason to think that last week’s decline has legs? Answering “yes” requires a sign that the economy is capable of creating jobs at a pace that’s mildly encouraging. Unfortunately, even by that modest standard there’s little reason for optimism, as the latest employment report suggests. Yes, there’s a bit of good news in the fact that the economy has been minting new private sector jobs on a net positive basis. That’s preferable to the alternative on the other side of zero, and arguably it's enough to keep the double-dip recession risk at bay. But until and if we see a stronger upside in nonfarm payrolls, initial jobless claims are likely to continue their blazingly fast trip to nowhere. Simply put, the economy remains stuck in a precarious recovery that's subject to any number of hazards.
Ellen Beeson Zenter, senior U.S. macroeconomist at Bank of Tokyo-Mitsubishi, speaks for many in a research note issued this morning (via Reuters) when she writes:The larger-than-expected drop is welcome, but we're left wondering whether the drop represents underlying improvement in the labor market or whether it is simply a function of the Columbus Day holiday in which many unemployment offices were closed. While jobless claims do seem to be on a downward trend, it can hardly be classified as pronounced and claims hovering around the 450,000 mark implies that little or no job growth exists.
That leaves the crowd looking to the next data point. Other than jobless claims reports (released every Thursday), the next big number that will shed light on where the labor market may be headed arrives on November 1, with the release of consumer spending and income numbers for September. The update for October nonfarm payrolls comes a few days later, on November 5.
It’s still all about jobs, but we’re not likely to learn anything new until early next month. And even then, the odds appear slim for a material change in the trend of late, for good or ill. In sum, the good news and the bad news is rolled up in one maddening fact when it comes to the big picture on employment: Nothing much is changing.
BUFFETT RECOMMENDS INDEXING...AGAIN
He said it again. Yes, Warren Buffett, one of the greatest active investors of all time, thinks indexing is a good idea for most folks. The Oracle of Omaha gave index funds a plug in a new article in Fortune.
The story's writer, the estimable Ben Stein, recounts a recent conversation with Buffett:"What should a typical upper-middle-class person in the U.S. buy to prepare for retirement?""Equities," Buffett answers without a moment's hesitation."The VTI?" I ask."That's good enough. Maybe a selection of high-dividend-paying stocks that are likely to raise their dividends. Maybe the top 100 dividend payers of the S&P 500."Then, after a second's thought, he adds, "Well, maybe not that, but equities."
VTI is the ticker for the Vanguard Total Stock Market ETF, a large cap fund that tracks the MSCI U.S. Broad Market Index. It's not the first time that Buffett has recommended indexing. In 2007, for instance, he advised that "a very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money." Buffett has made similar recommendations at least twice in the annual reports of his firm, Berkshire Hathaway.
Why would one of the world's great investing minds advocate that investors employ a strategy that's the antithesis of Buffett's extraordinarily successful investment process? Simple, really. Although the CEO of Berkshire Hathaway Inc. is too modest to say so in so many words, he's effectively telling us that there's only one Warren Buffett.
Yes, a relative handful of investors will beat the indices by a wide margin. But the overwhelming majority will earn average returns, perhaps below average after factoring in taxes, trading costs, and all the usual hazards that bedevil investing decisions in real time. The key question, then, is: How much will you pay for average returns? Using the best index funds ensures that you'll pay rock bottom prices. VTI, for instance, charges a mere 7 basis points, or seven-hundredths of one percent. That compares with around 100 basis points, or 1% of assets, for the average actively managed U.S. stock fund. That doesn't sound like much, but it adds up over time, and it's a performance drag that's difficult for most active funds to overcome in the long run.
Of course, it's misleading to think that simply buying and holding one U.S. equity fund is all there is to enlightened money management. That basic strategy may work, of course, but it might not. In a world where the future's always uncertain, diversifying across multiple asset classes is the only game in town short of embracing an unusually high level of risk by betting the farm on one stock, one fund, or one asset class.
The good news is that there's a rainbow of index funds for all the major asset classes and most of their various subcategories. There's also an expanding list of so-called alternative betas. Ours is a golden age for low-cost beta products and it allows the average investor to focus on the critical investing issue: designing and managing a portfolio of betas, a.k.a., asset allocation. You can, in short, engineer a rainbow of risk levels using a mix of betas, and at a very low cost.
Successfully managing asset allocation over time isn't easy, but there are some simple things we can do to juice return while keeping a lid on risk. A rules-based rebalancing strategy, for instance, can help. Yes, there's a lot more we can do, but we should be cautious in attempting to do too much. After all, few of us have the smarts of Warren Buffett.
Update: In the original version of this post, we erroneously used the term "seven-tenths of one percent" when we should have written "seven-hundredths of one percent." The text has since been corrected above and the revised sentence now reads: "VTI, for instance, charges a mere 7 basis points, or seven-hundredths of one percent." Sorry for any confusion.
October 20, 2010
READING ROUNDUP FOR WEDNESDAY: 10.20.2010
►Britain to slash welfare in austerity gamble
Sumeet Desai/Reuters/Oct 20
Britain will on Wednesday take an axe to its welfare state as part of an 80 billion-pound cut in public spending that could seal the fate of both the economy and the coalition government…Economists are split between those who say the drastic action is needed and those who argue it will tip Britain back into recession. Almost all agree, however, that growth will slow and the Bank of England will have to keep monetary policy super-loose for the foreseeable future.
►Mervyn King warns of 'sober' decade ahead
The UK is facing an unpleasant, "sober" decade, Bank of England governor Mervyn King has warned…Mr King also raised hopes that the Bank may inject more money into the economy through its process of quantitative easing (QE). He said that at present the amount of money in the economy was still "barely growing at all". He added that it was a "key role" for the Bank to provide stimulus when the economy was in need.
►China Rates Must Rise to Cool ‘Serious Inflation,’ Chen Says
China’s deposit rates must rise by at least another 1.5 percentage points to contain the nation’s “serious inflation,” Yale University finance professor Chen Zhiwu said.
The 25-basis-point increase in China’s one-year lending rate announced by the central bank yesterday should have taken place about four to six months ago, Chen said in a telephone interview from Hong Kong.
►Difficult Policy Choices Await Europe As Recovery Gets Under Way
Christoph Klingen/IMF/Oct 20
Policymakers face difficult choices as they tackle vulnerabilities while nursing a fledgling economic recovery. Fiscal policy needs to strike a delicate balance between supporting demand through deficits on the one hand, and addressing unsustainable debt dynamics and eroding market acceptance on the other.
►Deflation Still The More Probable Outcome In The U.S.
Editors/BCA Research/Oct 19
With oil prices firming and breakeven rates moving higher, it makes sense to ask if U.S. inflation protection is beginning to be warranted. The answer is a definitive no… The overall picture is one of very weak pricing power and a period of outright deflation in 2011 should not be ruled out.
►Rangers, Yankees and Federal Open Market Committee: One Game at a Time
Richard Fisher/Dallas Fed/Oct 19
…the outcome of the next FOMC is yet to be determined…But until the committee meets, nothing is decided. You should bear this in mind given the recent speculation about the prospect for further quantitative easing or the shape and nature of forward policy guidance: No decisions have been made on these fronts and will not be made until the committee concludes its deliberations at its next meeting on Nov. 3.
►How to Prevent a Currency War
Barry Eichengreen/Project Syndicate/Oct 12
Today, the United States is in the position of the gold-standard countries in the 1930’s. It can’t unilaterally adjust the level of the dollar against the Chinese renminbi. Employment growth continues to disappoint, and fears of deflation will not go away. Lacking other instruments with which to address these problems, the pressure for a protectionist response is growing.
So what can be done to address the situation without getting into a beggar-thy-neighbor, retaliatory free-for-all? In the deflationary 1930’s, the most important way that countries could subdue protectionist pressure was to use monetary policy actively to push up the price level and stimulate economic recovery. The same is true today. If fears of deflation were to recede, and if output and employment were to grow more vigorously, the pressure for a protectionist response would dissipate.
The villain of the piece, then, is not China, but the US Federal Reserve Board, which has been reluctant to use all the tools at its disposal to vanquish deflation and jump-start employment growth. Doing so would help to relieve the pressure in Congress to blame someone, anyone – in this case China – for America’s jobless recovery. Where the Bank of Japan has now led, the Fed should follow.
Of course, with China pegging the renminbi to the dollar, the Fed would, in effect, be reflating not just the US but also the Chinese economy. But this is within its capacity. China’s economy is still only a fraction of the size of America’s, and the Fed’s ability to expand its balance sheet is effectively unlimited.
China might not be happy with the result. Inflation there is already too high for comfort. Fortunately, the Chinese government has a ready solution to this problem: that’s right, it can let its currency appreciate.
►Chinese Discomfort With Aggressive Monetary Stimulus Highlights Its Virtues
Matt Yglesias/Yglesias/Oct 18
The Chinese government’s discomfort with monetary stimulus is understandable. Monetary stimulus plus Chinese currency policy will equal an undesirably large amount of inflation in China. That means that in order to avoid an undesirably large amount of inflation, Chinese leaders will need to engage in a more rapid currency readjustment than they want to. That, however, merely underscores that unilateral monetary action is the right way for the US government to handle our concerns about China’s currency policy. We don’t need to threaten them, or bribe them, or cajole them, or go to “currency war” or anything. What we need to do is to adopt monetary policies that are appropriate for our economic situation. The Chinese will learn to deal with it, and in the longer term we’ll all be better off.
►12th Federal Reserve District Fed Views
Editors/San Francisco Fed/Oct 14
THE MONETARY ROCK & THE HARD PLACE
China's central bank raised its benchmark interest rate by 25 basis points yesterday in a bid to slow inflation's momentum. The country's inflation rate in August was reported at 3.5%, higher than the government's 3% target, and the September update is likely to report a rise. Meanwhile, the Chinese economy is reportedly growing at 9%-plus.
China's economy is clearly an integral part of the global economy, and has been for some time. What are the ramifications for economies around the world and asset markets now that China is tightening its monetary policy? One is that it sets up an increasingly stark dichotomy with economic conditions in the developed world, where growth is weak, debt is high and inflation is falling, and China, which is growing robustly.
It all suggests a new era of risks. That's partly because of pressures building in currency exchange rates. China's currency is controlled by the government and so the natural inflow of liquidity into the yuan after a rate hike will be limited. That's no accident, since the Chinese government has long been intent on keeping its currency undervalued.
Is it any wonder, then, that the Federal Reserve is set to engage in second round of quantitative easing (QE2)? No, not really. Last week's consumer price inflation report for September reminded that U.S. inflation is still slipping. Core CPI rose at a scant 0.8% for the past 12 months last month, the lowest pace since the early 1960s.
If left to the marketplace, China's currency would strengthen and the dollar would weaken. But that natural realignment is stymied because of China's capital controls. That raises inflation risks for China and disinflation/deflation risks for the U.S. As a result, the Fed's hand is, to some degree, forced—forced to embrace QE2. China's hand is also being forced—forced to raise interest rates. But if the yuan's rise is curtailed, the pressures shift to China's economy, forcing up inflation that much more. Accordingly, more rate hikes in China are assured. Given China's strong economic growth, a 25 basis point rate hike in the face of mounting inflation worries is, by itself, virtually insignificant. That implies that additional rate hikes will be needed.
Meanwhile, the Fed's pre-game show for QE2 appears to be gaining traction with the markets. Inflation expectations (as determined by yield spread between the nominal and inflation-indexed 10-year Treasuries) is still above 2%, the highest since the spring. If inflation expectations continue to rise, it may be appropriate to modify QE2 plans. But not yet.
QE2 carries risks, of course, but so too does allowing inflation to fall further. The U.S. economy is caught between the rock and the hard place. But this much is clear: U.S. monetary stimulus, appears to be aggressive and appropriate, based on the Fed's zero-to-0.25% nominal Fed funds target. In fact, monetary policy is still tight, according to the Taylor rule, which implies that Fed funds should be negative 5%. That's not going to happen, of course, which is why Bernanke and company are set to embrace QE2.
October 19, 2010
UP & DOWN WITH HOUSING STARTS & PERMITS IN SEPTEMBER
Waiting for the housing recovery is like waiting for paint to dry. It’ll happen, but not any time soon. The best we can say is that the market appears to be stabilizing, although it's a stability at a greatly diminished level from the glory days, a.k.a., the years before 2007.
Today’s update on new housing starts and building permits issued for September doesn’t change anything. The market’s still depressed, but it’s getting easier to argue that the correction phase is over. And with each month of uninspiring data, the closer we come to something worthy of a recovery. When will that happen? First we'll need to see signs of life in the labor market, but that looks far off at the moment too, or so the last employment report suggests.
Patience, the French essayist Vauvenargues counseled, is the art of hoping.
Meantime, that leaves us with the meandering we’re-not-going-anywhere phase in housing. Indeed, the latest numbers are split between a decline in September for the seasonally adjusted annual rate of new housing building permits (-5.6% vs. the August pace) and a slight rise in housing starts last month (+0.3%). Unimpressive, to say the least, but looking at the longer-term trend suggests that these leading measures of the housing industry are still poised for treading water, as the chart below implies.
Yes, housing starts last month rose a bit to an annual rate of 610,000, the highest since April. But new building permits—a measure of future housing construction—inched down to a rate of 539,000, the lowest since the spring of last year.
No matter how you slice it, the housing industry is still reeling from the devastating implosion of recent years. The worst is over, but the recovery is nowhere in sight. That leaves us with an industry stuck in neutral, or so one can assume based on the prevailing definition of optimism for this sector.
“The worst of the housing market downturn may be behind us, but the path to recovery is likely to be long and slow,” Russell Price, a senior economist at Ameriprise Financial Inc., told Bloomberg News before today’s report was released. Price’s view is no less reasonable now that we’ve had the benefit of looking over the actual housing numbers for September.
That’s one reason for keeping our expectations for the broad economy muted. As economist Evelina Tainer notes in her book Using Economic Indicators to Improve Investment Analysis, “[Housing] permits are considered to be a leading indicator of [housing] starts and the economy in general…”
By that standard, permits and starts are reinforcing the view that the economy’s bumping along with a small growth bias that's just enough to sidestep a new recession (probably), but not much more. And even that thin reed of of optimism is subject to revision if we run into unexpected trouble.
But hope springs eternal in some circles, or at least what passes for hope these days when it comes to residential real estate. “I have been puzzling over why this is so bad in that sector; I keep thinking it has got to turn around, and hopefully this is the turnaround,” advises Kurt Karl, chief economist at Swiss Re in New York, via Reuters. “Basically, rates are very low and typically when rates are this low and housing prices aren't collapsing you would have a real surge in housing activity. Some parts of the market are blocked up with foreclosures and a lot of people are underwater. Even so, when you look at the starts and the low level of existing home sales, it is way below what you would expect.”
ALPHAS, BETAS & ASSET ALLOCATION
Morningstar yesterday advised that "deciding whether to buy or keep a fund that was once a top performer can be tricky." In fact, that's understating the challenge if you consider that managing a portfolio of active managers requires two skills: predicting when market-beating returns are likely to prevail and deciding when the bloom has fallen from the rose.
The primary reason for using active managers is the pursuit of market-beating results, or alpha. Of course, alpha can be negative or positive, meaning that while it's easy to be an active manager, it's a lot tougher to routinely deliver positive alpha. Yes, it can be done, but it's not easy, as the historical record tells us in no uncertain terms. And just as it's hard for active managers to excel, there's little reason to expect that the average investor is any better at picking top managers (and avoiding the dogs) on a consistent basis over time.
Indeed, choosing the top active managers is akin to selecting the best securities. It's not surprising to find that most efforts on this front end up with mediocre results, at best. The damage from taxes and trading costs is one reason. Another is that the future's uncertain. There's also the necessary challenge of forecasting betas. Focusing on active management doesn't give you a pass from developing intuition about the outlook for beta, or the trend in the underlying market. It would hardly be productive to identify a stellar small-cap value equity manager, for instance, without making a forecast about the general outlook for small-cap value stocks.
The dirty little secret of using active managers is that you'll still need to run the analysis on betas. That means that managing a multi-asset class portfolio with active managers requires twice the work, at least. For most investors, the challenge is likely to be insurmountable.
Even for professionals overall, the track record for publicly traded funds that engage in some form of multi-asset class investing is just what you'd expect overall: average. I crunched the numbers on 900-plus funds in Morningstar Principia's database with at least 10 years of history that are labeled conservative allocation, moderate allocation and world allocation. I excluded portfolios that employ short positions or leverage. This takes in a lot of territory, but the common denominator is that most if not all of these portfolios engage in some form of managing a multi-asset class strategy. It's an imperfect proxy for multi-asset class portfolios, but it offers a rough estimate of real-world track records in this niche.
The best performer in this group for the decade through August 31, 2010 posted a stunning 17% annualized total return. There was almost as much drama in the bottom performer, albeit in reverse: an annualized 11%-a-year loss! Those are extreme outliers, and so they mask the returns posted for the bulk of these funds. For instance, 95% of the portfolios reported a gain of 6% or less.
In fact, a passive, unmanaged approach to buying all the major asset classes, weighted by market values, outperformed about 70% of the 900-plus funds. The Global Market Index (GMI), a proprietary benchmark I use on the pages of The Beta Investment Report, generated a 3.4% annualized total return for the 10 years through this past August. Mindlessly rebalancing GMI every December 31 boosted GMI's return to 4.4%. Not bad for a know-nothing strategy that buys and holds all the major asset classes in an asset allocation chassis that simply accepts Mr. Market's weighing scheme.
Is GMI's modestly above-average performance surprising relative to the 900-plus actively managed funds holding multiple asset classes? No, not really. Alpha, after all, is a zero-sum game. Positive alpha is financed by negative alpha. In other words, winners exist because of losers. Beta is usually in the middle, or perhaps slightly above average, thanks to higher taxes and trading costs that continually harass the pursuit of alpha. True for individual markets, true for a broad mix of asset classes.
This isn't necessarily an argument for avoiding active managers. Depending on the market, your strategy, your skill and a host of other factors, you may decide to pursue alpha. Indeed, the overwhelming majority of investors do so. But there are practical limits to boosting return using actively managed funds as your asset allocation broadens. It's one thing to say that you're going to own only, say, U.S. stocks and spend all of your research efforts focused on choosing a top manager in that corner. It's quite another challenge to own five, 10 or 20 asset classes and attempt to maintain exposure to the leading active managers in each bucket while also managing the overall mix with a deft hand.
Even if you decide to target betas exclusively—i.e., use ETFs, ETNs and index mutual funds—your task will be quite difficult if you plan on engaging in some degree of active asset allocation. In fact, if you own active managers you'll still have to do all the heavy lifting when it comes to analyzing betas. The only difference with choosing actively managed funds is that you'll need to be correct on forecasting betas and alphas to warrant the additional effort. That sounds like a full-time job, which means that the odds look slim for winning the money game with so many moving parts if you're crunching the numbers in your spare time.
For most investors with a broad asset allocation strategy, a better strategy is using mostly index funds and ETFs and reserving active managers to a handful of funds where you're confident that the manager can add value over time. When in doubt, index. One of the benefits of using betas is that you have a high degree of confidence that you'll capture the lion's share of the risk/reward profile of the target market and that you'll pay a low cost in the process. That's a strong hand to play to tip the odds of success in your favor.
Meanwhile, owning too many actively managed funds eventually runs the risk of delivering what you're desperately trying to avoid with that strategy: earning beta. In that case, you'll be paying actively managed prices for average performance. The only thing worse than beta is high-priced beta. That's what most investors end up with in the long run, despite all the frantic efforts to engineer superior results. Fortunately, that's one risk in money management that's easily avoided.
October 18, 2010
READING ROUNDUP FOR MONDAY: 10.18.2010
►Bernanke caution gives markets pause, as US dollar rebounds
Michael Hewson/ShareCast/Oct 18
For the last six weeks the US dollar has slid lower relentlessly on speculation that the Federal Reserve will embark on a further stimulus program to shore up the flagging US economy. Bernanke’s comments on Friday more or less confirmed the inevitability of such a move, and yet the US dollar index despite making new 8 month lows actually finished the day higher than when it started, which perfectly illustrates the dichotomy that can exist in currency markets between expectation and reality.
The fact is the Fed chairman’s comments about the difficulties in determining the pace, size and costs of any purchases are weighing on the FOMC committee with respect to how aggressive they should be at their November meeting. This has given the markets pause for thought and may give the US dollar some respite. Bernanke’s views on the prospects of the US economy are likely to be further analysed when he gives another speech on Tuesday night.
►Gold Declines for Second Day as Dollar's Increase Curbs Investment Demand
Nicholas Larkin and Wendy Pugh/Bloomberg/Oct 18
Gold declined for a second day in London as a stronger dollar curbed demand for the precious metal as an alternative investment…
“The dollar looks set to provide further direction in the coming sessions as players speculate over the Fed’s quantitative easing measures,” said James Moore, an analyst at TheBullionDesk.com in London. Precious metals “would benefit from a period of consolidation, however gold should remain underpinned by dip-buying interest from the physical and investment sector.”
►When the weak are strong
Scott Sumner/The Money Illusion/Oct 17
How can we explain these perverse cases—weak economies and strong currencies? Perhaps the usual direction of causation was reversed. Perhaps the strong currency caused the weak economy, by causing deflation. Indeed, it’s now almost conventional wisdom that money was too tight in the US during 1929-33…
So it seems to me that the profession does have an answer to the mystery of strong currencies in weak economies. When this phenomenon occurs, the strong currency is itself the cause of the problem. It seems that deflation can severely damage a formerly quite productive economic machine…
Didn’t the US economy go down the toilet between July and November 2008? And didn’t the dollar not collapse, but rather soar in value against the euro during that 4 month period? So why do almost no economists consider tight money to have been the problem during that period? Why isn’t that like the US in the early 1930s, Argentina in the early 2000s, and Japan in the 1990s?
►China Uneasy with Quantitative Easing Prospect
Andrew Batson/WSJ Real Time Economics/Oct 18
Chinese commentators are starting to show unease at the increasingly likely prospect that the U.S. Federal Reserve will relaunch a program of buying bonds to push down interest rates. And no wonder: Even before it has actually started, such so-called quantitative easing is complicating the nation’s continued effort to manage its currency.
►Monetary Policy in a Low-Inflation Environment: Developing a State-Contingent Price-Level Target
Charles Evans/Chicago Fed/Oct 16
In my opinion, much more policy accommodation is appropriate today. In a speech two weeks ago, I stated that I believe the U.S. economy is best described as being in a bona fide liquidity trap. This belief is not a new development for me; instead, it is a dawning realization. Risk-free short-term interest rates are essentially zero. Both households and businesses have an excess of savings relative to the new investment demands for these funds. With nominal interest rates at zero, market clearing at lower real interest rates is stymied.
In this setting, even a moderate expansion without a double dip will not lead to appropriate labor market improvement. Accordingly, highly plausible projections are 1 percent for core Personal Consumption Expenditure Price Index (PCE) inflation at the end of 2012 and 8 percent for the unemployment rate. For me, the Fed’s dual mandate misses are too large to shrug off, and there is currently no policy conflict between improving employment and inflation outcomes. The economic theories that central bankers rely on for evaluating appropriate monetary policy suggest to me that we need lower short-term real interest rates than the current real federal funds rate of –1 percent. Indeed, if the federal funds rate were positive, I would advocate substantial nominal reductions. But we are effectively at zero...
If the Federal Reserve decided to increase the degree of policy accommodation today, two avenues could be: 1) additional large-scale asset purchases, and 2) a communication that policy rates will remain at zero for longer than “an extended period.”
A third and complementary policy tool would be to announce that, given the current liquidity trap conditions, monetary policy would seek to target a path for the price level. Simply stated, a price-level target is a path for the price level that the central bank should strive to hit within a reasonable period of time.
►Why Worry About Low Inflation?
Daniel Indiviglio/The Atlantic/Oct 16
On Friday, Federal Reserve Chairman Ben Bernanke all but promised that another round of monetary expansion is imminent. He emphasized that to take such a drastic measure, both aspects of the Fed's mandate would have to be invoked. Obviously unemployment is too high, and lately inflation has also been lower than U.S. central bankers would prefer. It's easy to understand why high unemployment is awful, but what's so bad about low inflation?
In fact, a 1% inflation rate isn't necessarily worse than a 2% inflation rate -- it's more about expectations. Since the market understands that the Fed targets an inflation rate of around 2%, when it sinks well below that, as it has recently, then the market may begin to change its expectation of the Fed's ability and desire to hit that target. This risk becomes even greater when interest rates are already near zero, as the Fed would have to rely on alternative means to raise prices. So the market's expectation could potentially lead to deflation -- particularly in a time when the economy is very slow and firms might already be cutting prices to conjure up more consumer demand.
So the problem is more one of instability. The fear is that deflation could eventually result if inflation is allowed to decline below its target. Deflation is a particularly dangerous problem, because central banks don't have strong tools to fight a deflationary spiral.
October 16, 2010
BOOK BITS FOR SATURDAY: 10.16.2010
● Seeds of Destruction: Why the Path to Economic Ruin Runs Through Washington, and How to Reclaim American Prosperity
By Glenn Hubbard and Peter Navarro
Interview with co-author (Hubbard) via Reuters
In their must-read policy manifesto, “Seeds of Destruction,” Glenn Hubbard and Peter Navarro outline the biggest economic problems facing America and what can be done about them. Hubbard is the former head of the Council of Economic Advisers under George W. Bush and is now dean of Columbia Business School. Navarro, a Democrat, is a business professor at the University of California, Irvine and author of The Coming China Wars.
● Ruthless: How Enraged Investors Reclaimed Their Investments and Beat Wall Street
By Phil Trupp
Video interview with author on Fox.
It's being called a book for everyone who's invested in Wall Street…The book came about after Trupp's life and plans for retirement were turned upside down after he was told a large portion of his investments were frozen. But Trupp fought back and won!
● American Colossus: The Triumph of Capitalism, 1865-1900
By H.W. Brands
Review via The Wall Street Journal
The nature of both ruin and success is the subject of "American Colossus," H.W. Brands's account of, as the subtitle has it, "The Triumph of Capitalism" during the period 1865-1900. Mr. Brands paints a vivid portrait of both this understudied age and those industrialists still introduced by high-school teachers as "robber barons"—Vanderbilt, Andrew Carnegie, John D. Rockefeller and J.P. Morgan. Together these men of the 19th century laid the foundations that would allow the use of innovations that we think of as modern, such as trains and automobiles, on a massive scale in the 20th century.
● The Hellhound of Wall Street: How Ferdinand Pecora's Investigation of the Great Crash Forever Changed American Finance
By Michael Perino
Podcast interview with author via NPR.
Ferdinand Pecora was little known outside New York until 1933. The former New York prosecutor was called to Washington to become chief counsel of Senate hearings looking into Wall Street's wrongdoings that led to the Crash of 1929. Pecora is a surprising hero of the time -- he was a poor Italian immigrant who earned his legal education at night school. And over a ten-day period, he grilled some of the titans of Wall Street, toppling one of them -- multimillionaire Charles Mitchell, aka Sunshine Charley -- who was chairman of National City Bank, the predecessor of the current-day Citibank. NPR's Robert Siegel talks to Michael Perino, a law professor and former Wall Street litigator, about his new book, The Hellhound of Wall Street: How Ferdinand Pecora's Investigation of the Great Crash Forever Changed American Finance.
● The Quant Investor's Almanac 2011: A Roadmap to Investing
By Irene Aldridge, Steven Krawciw
Summary via press release.
For years, quantitative investing was regarded as the domain of a select few institutional traders that employed teams of highly educated mathematicians and physicists. Yet many principles behind quantitative investing do not require mathematical prowess, computer knowledge, or economic education to understand. In The Quant Investor's Almanac 2011: A Roadmap to Investing, Irene Aldridge, quantitative portfolio manager at a boutique investment firm, and Steven Krawciw, executive at a global private bank, offer investors the latest quantitative investing strategies digested down to their essentials.
October 15, 2010
IS IT REALLY THAT EASY?
Will eliminating “financing constraints” create 850,000 jobs? Perhaps, or so a new study advises. "According to our estimates, eliminating financial constraints of small firms could add up to 850,000 jobs to the economy," asserts a recent paper from the Boston Fed: "Financing Constraints and Unemployment: Evidence from the Great Recession." This much is clear: the longer the labor market struggles to mint new jobs on a net basis, the stronger the incentive to try almost anything to boost employment creation. Surely there are no silver bullets, but maybe there’s an array of bronze buckshots that add up to something more than a rounding error. Maybe. If so, that suggests that policy makers look for possible solutions in the usual and not-so-usual places. As such, the new Boston Fed research is food for thought.
As the study observes,Lending to small businesses in the United States has fallen dramatically since the onset of the Great Recession. According to the most recent data, small business loans made by commercial banks declined by over $40 billion between the second quarter of 2008 and the second quarter of 2010 (Table 1). Similarly, the responses to the Federal Reserve’s Senior Loan Officer Opinion Survey on Bank Lending Practices indicate that banks have significantly tightened credit standards on Commercial and Industrial loans to small firms in thirteen consecutive quarters (2007:Q1 to 2010:Q1)
Why’s that relevant?Unlike larger firms, which have broader access to capital markets, small businesses are highly dependent on bank financing for their initial establishment and subsequent growth. Accordingly, smaller firms are likely to have been impacted disproportionately when banks restricted credit following the shocks to their balance sheets.
So, what’s the solution? Or the implied solution, or (more realistically) the partial solution?We suggest that policies aimed at making credit available to small business, such as the recent $30 billion Small Business Bill or the loans guaranteed by the Small Business Administration, would help stabilize the labor markets and economic activity in general. According to our estimates, eliminating financial constraints of small firms could add up to 850,000 jobs to the economy.
Such ideas are hardly novel these days. Indeed, if you type in "small business loans" on Google's News section, you'll get enough reportage citing fresh credit extensions to wile away a month's worth of reading. Nor is there a shortage of pundits calling for more loans. For instance, Scott Shane (professor of entrepreneurial studies at Case Western Reserve University) writes today for Bloomberg BusinessWeek: “As long as we face declining home prices, uncertainty about the effects of the new health-care law and business regulation, and high and rising marginal income tax rates, the small business sector is unlikely to show the positive owner outlook, job growth, investment levels, and business formation rates common in economic expansions.”
As he explains in more detail,The weak housing market is weighing down many small businesses. The construction and real estate industries that have been hard-hit by the collapse in home prices are made up largely of small companies. Estimates by Small Business Administration economists indicate that more than 99.6 percent of companies in real estate and construction are small businesses. And unemployment in the construction industry is 17.2 percent.In addition, small business owners were among the most frequent users of home equity loans during the real estate boom, tapping equity in their homes to fund their businesses. Data from Barlow Research's quarterly survey of roughly 900 small business owners show that 25.4 percent of respondents used their homes as collateral for their businesses or to obtain a personal loan where the proceeds were used to finance a small business. These loans have largely evaporated as housing prices have fallen 28 percent from their peak in March 2006, taking with them much of the home equity that small business owners were using to fund their companies. Combined with tightening loan standards at banks with many nonperforming real estate loans, declining home values have choked off a major source of small business finance, making it difficult for many small businesses to expand.
Will easing the path to credit for small businesses help? It certainly can’t hurt. Of course, we should be careful when it comes to extending loans blindly, which is part of why the economy's hobbled in the first place. In any case, creating lots of new loans isn't a quick fix by any means. But given the current climate, it’s hard to imagine we’re doing too much of it these days. Still, there are some encouraging signs to be found around the country.
But there’s still a long way to go for the overall economy. As St. Louis Fed senior VP Julie Stackhouse explains, “Businesses across the country report that credit conditions remain very difficult. In fact, the data on small loans made by banks show that outstanding loans have dropped from almost $700 billion in the second quarter of 2008 to approximately $660 billion in the first quarter of 2010.”
There are no easy-solution levers left to pull. That leaves only hard work and a complicated, multi-solution path out of this mess. In turn, that implies that we’ll need one additional resource for weathering the “recovery” in the post-Great Recession era: patience.
TALKING ABOUT GOLD...
American Public Media's "Marketplace" radio show called today to discuss my article on gold in the November issue of The Atlantic. I'm told that my spot airs today, this evening, although the exact time varies based on the local station affiliate. In the New York City region, for instance, the show runs from 6:30-7:00pm tonight on WNYC (FM 93.9/AM 820). When and where will the show air in your neck of the woods? As terrestrial radio folk have advised from time immemorial: Please check your local listings.
THE PACE OF CONSUMER PRICE INFLATION IS STILL SLIPPING
Today’s update on September consumer price inflation suggests that the worries about deflation in recent months weren’t misguided. Although consumer prices overall are still rising, the increase is slight. More worrisome is the trend. The annual pace of consumer inflation continues to fade. It’s not a rapid decline, although it's fairly persistent. Given the macroeconomic backdrop these days (lots of debt and sluggish growth hobbling the economy and labor market), the disinflation trend can’t be dismissed. Until and unless it's stopped, we know how this movie ends, and it's not going to be pretty. Fortunately, the central bank still has the power to alter the outcome, but the clock is ticking.
Last month, the consumer price index (CPI) rose a bare 0.1%, the U.S. Labor Department reported—down from 0.3% in August. This could be statistical noise, of course, which inspires looking at the longer-term trend in terms of rolling 12-month percentage changes. By that measure, a picture of what's been happening speaks for itself. As the chart below illustrates, the rate of increase in headline consumer inflation has been slipping for most of this year. Through September, CPI rose 1.1% vs. a year earlier, down from a 2.7% annual pace in January.
The Federal Reserve and many economists prefer to look at consumer inflation on a “core” basis, which means stripping out food and energy prices. Those two factors can distort the numbers in the short term for various reasons. In fact, a number of studies have shown that over time, core CPI is a better indicator of where inflation overall is headed. At the very least, the trend in core CPI is worth watching, if only for additional perspective. On that front, however, the news isn’t any better relative to headline CPI. In fact, one can argue that the trend in core CPI is quite a bit worse when it comes to worrying about the risk of future deflation.
Consider the second chart below, which graphs the annual 12-month percentage change in core CPI. Last month, core CPI rose by 0.8% on a year-over-year basis. That’s the lowest rate so far this year. In fact, it’s the lowest 12-month percentage change since the early 1960s. If you're looking for reasons to worry that inflation is an imminent threat, you won't find it here.
The issue isn’t whether low inflation is inherently bad. It’s not. But the risk isn’t that inflation stays low, which would be a good thing. Rather, the worry is that the disinflationary trend rolls on, eventually turning into deflation.
Some critics of the Fed’s apparent willingness to embrace a new round of quantitative easing complain that the central bank is fostering the seeds of higher inflation. If so, there’s little if any evidence in support of that fear in today’s CPI report. Don’t misunderstand: the methodology behind the CPI calculation is flawed. But it’s not so flawed that the general trend it depicts is erroneous.
In fact, independent measures of broad inflation from various economic shops more or less corroborate the broad trend that’s apparent in CPI. There’s plenty of room for debating the details, but on the fundamental issue of whether inflation is rising, remaining stable, or decelerating, the evidence looks fairly convincing that the latter condition prevails these days.
What’s the solution? Ultimately, the Fed must stabilize the disinflation trend, in large part by stabilizing inflation expectations. That requires convincing the crowd that the central bank is serious about raising inflation’s pace. As I discussed earlier this week, there’s been some recent evidence in the markets for thinking that the Fed has made some progress with that goal. But today’s CPI report reminds that the battle to beat the D risk out of the system isn’t quite over. In fact, it's unclear if the real war is just beginning.
Yes, inflation will one day return as the priority in monetary policy, and the Fed must act accordingly when that turning point arrives. But first things first.
READING ROUNDUP FOR FRIDAY: 10.15.2010
►Emerging-Market Currencies Soar
David Wessel/Wall Street Journal
Currency markets, seeing few signs global financial officials made progress in defusing tensions in last weekend's talks in Washington, Thursday resumed their seemingly relentless determination to push down the U.S. dollar, particularly against currencies of emerging markets.
►Dollar Weakens Near 15-Year Low Against Yen Before Bernanke Policy Speech
Keith Jenkins and Candice Zachariahs/Bloomberg
The dollar traded near its weakest level in 15 years against the yen before a speech by Federal Reserve Chairman Ben S. Bernanke that may indicate whether the central bank will ease monetary policy further…Bernanke will speak later today at the Boston Fed conference.
►QE is working: gold up, euro up, EU politicians up in arms
The deliberate attempt by the Federal Reserve to create more inflation is beginning to have a big impact on financial markets. Yesterday the dollar came under selling, and commodity prices increased after the release of the Fed’s minutes suggested that QE is now virtually a certainty.
►Emerging Markets: Investment Opportunities in the New Normal
Curtis A. Mewbourne/Pimco
For investors looking for government exposure as opposed to private companies, there are two alternatives, namely local currency and dollar-denominated government bonds. The regionally diversified J.P. Morgan GBI index was yielding around 6.25% at the end of September, which is about three times the yield of similar maturity government bonds from developed markets. And while historically higher interest rates in EM countries were thought to be compensation for currency weakening, given current conditions we think the highest probability is that EM currencies will appreciate vs. the U.S. dollar. Thus, investors may benefit from both higher interest rates and currency appreciation. Interestingly, in the aftermath of the global financial crisis, local government bonds as represented by the JPM GBI index have behaved more like developed country interest rates, posting more than 16% returns this year through September, while global equity markets overall (as represented by the MSCI World Index) have gained 3.5%. Of course, all investments involve some degree of risk, and for EM investors those risks would include political risk, policy risks and, in some cases, liquidity risks. But on balance we think the balance of potential risks and returns looks compelling.
►Only the Weak Survive
Nouriel Roubini/Project Syndicate
The risk of global currency and trade wars is rising, with most economies now engaged in competitive devaluations. All are playing a game that some must lose.
►China still stockpiling foreign currency
In the latest sign that the Chinese could be keeping the yuan artificially undervalued, China's currency reserves jumped in the third quarter, to one of the highest levels on record…
Mark Williams, Senior China Economist for Capital Economics, said the Chinese report Wednesday of a $194 billion rise in the value of Chinese foreign currency holdings during the third quarter is one of the biggest on record and a sign that intervention by the People's Bank of China is far from over.
Part of that rise is due to the decline in the value of the dollar versus other freely traded currencies, such as the yen and the euro, during the quarter. But Williams estimates China made purchases of about $108 billion. He said it's proof that the Chinese are going to keep intervening in the markets to keep the yuan in check.
►Two visions of macro
Scott Sumner/The Money Illusion
There seem to be two approaches to macro policy, once interest rates hit the zero bound:
1. The pessimistic view: In this view, monetary policy can do no more. Trade balances become a zero sum game. The US gains from some (not all) contractionary policies adopted by other countries, such as currency revaluation. If China sharply revalues its currency, it may cost millions of jobs in China, and hurt countries that export materials and machines to China, but it will boost jobs here. It might not be accurate to claim this is a zero sum game view of the world, but it comes pretty close. (By the way, I used the term ’sharply revalue’, as I think a gradual revaluation is in China’s own interest.)
2. The optimistic view: Even at the zero bound monetary policy is still the most important factor driving [nominal GDP] growth. It’s not a zero sum game. A sharp Chinese revaluation might reduce world [aggregate demand]. A dramatic easing by the Fed would not just depreciate the dollar against goods and services, it would sharply raise world [aggregate demand], and world [real GDP] if there is slack in labor markets. This could easily help overseas firms, even in countries whose currencies might rise a bit against the dollar. In this view, you don’t look for jobs by trying to take them away from other countries, even countries that might be “misbehaving” according to some sort of arbitrary “rules of the game” that never did and never will exist, but rather you try to generate jobs in your own country by boosting your own [aggregate demand].
October 14, 2010
ETF FUND OF FUNDS: CHOOSE CAREFULLY
The explosion in ETFs enhances investment strategy options on a number of levels. One is that ETFs that hold a mix of other ETFs is now a growth industry. Indeed, as the population of strategy-specific ETFs rises, so too do the possibilties with ETF fund of funds. But as with any other ETF decision, picking a fund of fund ETF requires attention to detail. There's already quite a few of these products trading, and more are coming. The strategies range from the exotic to the simple. Predictably, some are worthwhile, some aren't. The first question for all of these funds: Is there any possibility for value-added management alpha? If the answer is "yes," then the second question: Is the fee reasonable?
As one simple example of how you might consider these questions, consider the recently launched OneFund ETF (ONEF). There are many other ETF fund of funds to consider, but since this product's strategy is quite basic, it lends itself to a quick test. According to the fund's website, One Fund "is a simple and easy way to own a globally diversified, professionally managed stock portfolio in a single fund." The website also explains,By investing in One Fund, you have the potential to gain exposure to over 5,000 different companies in the U.S. and around the world. This underlying diversity in the Fund's composition may reduce volatility and increase the return potential for investors.So while you are buying a single fund – One Fund – you are really buying a globally diversified stock portfolio in a single investment.
One Fund is effectively a core holding for capturing the global equity market beta. Conceptually, the strategy has merit. Indeed, a core global equity fund can be used as an anchor around which investors can customize a global stock market allocation strategy. You could, for instance, use the fund in a core-satellite approach, owning One Fund as the core plus some mix of additional funds targeting specific pieces of the global equity market and, perhaps, managing the satellite allocation dynamically.
But while One Fund's focus on providing a core global equity product is sound, there are other choices to consider. One is the Vanguard Total World Stock Index ETF (VT). Another is iShares MSCI ACWI Index (ACWI). Both VT and ACWI invest globally, owning stocks from the U.S. and foreign developed and emerging markets, weighting shares by market cap. The goal in both VT and ACWI is to be comprehensive, tapping the market value-weighted portfolio of all the planet's stocks. If that sounds like One Fund's strategy, you're right—the three funds are more or less equivalent.
One clue is that the three funds move with a high degree of similarity. Although One Fund has a short history (it was launched this past May), comparing the product with the older VT and ACWI since then suggests that this trio share a relatively high correlation, as a graphical history of fund prices suggests.
Another clue that that the three funds are similar comes from examining One Fund's portfolio, which is listed on its web site. As of October 14, One Fund held five ETFs: four Vanguard ETFs and one iShares fund. This brings us to the key question: Is it worth paying One Fund an additional fee to hold ETFs you can buy yourself? One Fund charges a management fee of 35 basis points for this service. You'll also pay the expense ratios charged by the five ETFs held in One Fund's portfolio. Overall, One Fund's total expense ratio is 51 basis points. But if you replicated One Fund's portfolio yourself, the weighted expense ratio of holding the same five ETFs would come to a bit more than 15 basis points—a rather large discount vs. the 51 basis points you'll pay to One Fund. Even if you wanted a one-stop fund for owning all the world's stocks, VT's expense ratio of 30 basis points and ACWI's 35 basis points offer less expensive choices.
What's more, One Fund's literature explains that its strategy is buy and hold. Accordingly, the opportunity to add value through rebalancing or tactical asset allocation is nil.
Even if you agree that buy and hold is superior, there's another problem. Holding a portfolio of multiple funds in one product prevents you from engaging in tax-loss harvesting strategies, which could add 50 to 100 basis points on an after-tax basis without taking on additional risk.
The bottom line: It's not obvious why you would pay an additional fee to One Fund for a simple buy-and-hold strategy comprised of five ETFs that you buy and manage on your own. Replicating this strategy, in other words, is quite easy and doing so offers the potential for significant cost savings/tax reductions over time. In sum, a good idea that's too expensive. It's not egregiously expensive, but there's no compelling reason to pay more for this strategy.
Yes, some fund of fund ETFs may be worth the price of entry, but you have to choose carefully. But the analysis won't always be so simple. This is a growth industry and many of the new products coming out have a lot of moving parts. Caveat emptor.
October 13, 2010
THE GREAT EXPERIMENT ROLLS ON
The Treasury market's inflation expectations have bounced higher since the end of August, reversing the summer downturn that was driven by worries that deflationary pressures were on the march. Given the precarious nature of the economic rebound, it's premature to declare the deflationary scare over. But the evidence is certainly looking stronger (or less discouraging) for arguing that the Federal Reserve is ahead of the curve these days rather than behind it.
Exhibit A is the yield spread between the nominal and inflation-indexed 10-year Treasuries, a proxy for the market's inflation outlook. It's imperfect and subject to error, of course, just like every other metric that's used to forecast the unknowable future. But as a measure of market sentiment, it's worth watching. As of yesterday, this spread was 1.95%, up from around 1.5% in late August, as the chart below shows. Is that the all-clear sign? No, but it's obviously a move in the right direction.
The bounce in the Treasury market's inflation forecast is strengthened by the fact that commodities prices have been rising lately too. As one example, consider the recent increase in the iPath Dow Jones-UBS Commodity ETN (DJP), a broad measure of futures prices for raw materials. Since the end of August, this exchange-traded fund is up more than 10%. No sign of deflation here.
Another sign that the crowd thinks that the risk of deflation has been retreating recently: higher stock prices. The S&P 500 has been climbing almost non-stop since early September, returning to levels previously reached in May. That's a significant rebound because May was the month when deflation worries emerged anew and prices started to tumble.
Another reason for downgrading deflation fears a notch: money supply is no longer contracting on an annual basis. Weekly readings of seasonally adjusted MZM money stock, for instance, rose slightly on a year-over-year basis for much of September. That's still close enough to zero to wonder what the future holds, but the outright contraction in the annual change from the summer is clearly history, at least for now.
In fact, the central bank is reportedly set to expand its war on deflationary anxiety by formally raising its target rate for inflation. As Bloomberg News reports today:Federal Reserve policy makers may want Americans to expect inflation to accelerate in the future so they spend more of their money now.Central bankers, seeking ways to boost flagging growth after lowering interest rates almost to zero and buying $1.7 trillion of securities, are weighing strategies for raising inflation expectations as well as expanding the balance sheet by purchasing Treasuries, according to minutes of the Fed’s Sept. 21 meeting released yesterday.Some Fed officials are concerned that expectations of lower inflation will become self-fulfilling, damping demand by increasing borrowing costs in real terms, the minutes said. By encouraging Americans to believe prices will start rising at a faster pace, the Fed would reduce inflation-adjusted interest rates and stimulate the economy. Chairman Ben S. Bernanke said in 2003 that Japan could beat deflation by using a “publicly announced, gradually rising price-level target.”“The Fed is on the verge of actively targeting a higher inflation rate,” said Dan Greenhaus, chief economic strategist at Miller Tabak & Co. in New York. U.S. stocks advanced, sending benchmark indexes to five-month highs, the dollar fell and gold declined for the first time in three days after the minutes were released.
Clearly, expectations that the Fed can and will do more to stimulate the economy—despite the fact that nominal interest rates are virtually zero—has changed the sentiment lately. For the moment, the idea that the central bank is out of bullets at the zero bound is on the defensive. Is quantitative easing (QE), in all its various forms, a silver bullet? No, but it can help, and perhaps more than the critics acknowledge. Yet there's also a danger of assuming too much. Still, QE isn't chopped liver, or so recent market actions suggest. In any case, the Fed seems inclined to continue with QE for the near term, as implied in yesterday's release of the minutes for the Sep. 21 FOMC meeting. Reviewing last month's discussions among the monetary mavens inspires expectations that the Fed will announce a new semi-bold round of QE at the next FOMC meeting on Nov. 2-3.
The true test, of course, is whether the Fed's ability to move market sentiment, on the margins or otherwise, will translate into real change in the economy, i.e., enhance job creation. Given the normal lag in the employment picture, definitive answers are going to take time. Meanwhile, the connection between QE and the labor market is an open debate, and one that elicits a fair amount of skepticism, and rightly so. Attempting to fend off deflation with monetary policy is one thing; creating jobs with QE is another. But for the moment, there's a bit more optimism that Bernanke and company can at least make a change for the better on the margins. The Great Experiment rolls on.
As always, there are risks, however. There are no free lunches in monetary economics. Many strategists (and some Fed members) warn that elevating inflation expectations is a dangerous game if—if—the Fed loses control of the momentum. In a world awash in debt and deficits, higher inflation comes prepackaged with some obvious hazards down the road. But at the moment, the debt and deficits are still creating a bias toward deflation, or at least disinflation. Arguably, the only reason we don't have outright deflation is that the central bank has kept the beast at bay.
Rest assured, at some point the inflationary threat will return...eventually. In the long run, the main challenge is navigating the transition from fighting deflation to keeping a lid on higher inflation. But not yet. Soon, perhaps sooner than we think, but not yet. The real problem is that deciding when the deflation risk is truly dead is as much art as it is science, perhaps more of the former. Monetary policy has come a long way since the errors of the Great Depression, but subjectivity is still alive and kicking.
October 12, 2010
WHAT'S UP WITH AMERICA'S GOLD?
Inquiring minds want to know. Gold is certainly topical these days. A roaring bull market tends to have that effect. What does the Federal government plan on doing with its stash? Official U.S. reserves are by far the world's largest. The combination of record prices and a massive 8,000-ton national nest egg inspire a number of questions, some of which I explore in a new article published in the November issue of The Atlantic magazine. Here's the online version of Uncle Sam’s Mysterious Hoard.
THE NOBEL PRIZE IN ECONOMICS & A FED NOMINEE
It's not often that an economist is nominated to the Fed, with Senate confirmation still up in the air, and the nominee becomes the co-recipient of the Nobel Prize for Economics. In fact, it's never happened. It remains to be seen whether winning the Nobel helps or hurts in terms of joining the Fed. But there it is: MIT professor Peter Diamond is awaiting the Senate's yea or nay. While he's wondering if the government will be his next employer, he's picked up what would appear to be a career-boosting prize. Diamond, along with Dale Mortensen (Northwestern University) and Christopher Pissarides (London School of Economics), yesterday were awarded the Nobel in economics for their research on the labor market.
The Nobel committee explained that the three economists were recognized for their analysis of so-called frictions in the job market. This trio's work focuses on trying to bring perspective, if not answers, to a number of key questions, including: Why are there so many unemployed workers at times with relatively high amount of job openings? And, of course, the macro issue is pertinent as well, namely: How does economic policy alter the unemployment rate?
As the Nobel announcement's press release explains,This year’s Laureates have developed a theory which can be used to answer these questions. This theory is also applicable to markets other than the labor market. On many markets, buyers and sellers do not always make contact with one another immediately. This concerns, for example, employers who are looking for employees and workers who are trying to find jobs. Since the search process requires time and resources, it creates frictions in the market. On such search markets, the demands of some buyers will not be met, while some sellers cannot sell as much as they would wish. Simultaneously, there are both job vacancies and unemployment on the labor market. This year’s three Laureates have formulated a theoretical framework for search markets. Peter Diamond has analyzed the foundations of search markets. Dale Mortensen and Christopher Pissarides have expanded the theory and have applied it to the labor market. The Laureates’ models help us understand the ways in which unemployment, job vacancies, and wages are affected by regulation and economic policy. This may refer to benefit levels in unemployment insurance or rules in regard to hiring and firing. One conclusion is that more generous unemployment benefits give rise to higher unemployment and longer search times.
Additional background from the Nobel committee on the trio's line of research advises:According to a classical view of the market, buyers and sellers find one another immediately, without cost,and have perfect information about the prices of all goods and services. Prices are determined so that supply equals demand; there are no supply or demand surpluses and all resources are fully utilized. But this is not what happens in the real world. High costs are often associated with buyers’ difficulties in finding sellers, and vice versa. Even after they have located one another, the goods in question might not correspond to the buyers’ requirements. A buyer might regard a seller’s price as too high, or a seller might consider a buyer’s bid to be too low. Then no transaction will take place and both parties will continue to search elsewhere. In other words, the process of finding the right outcome is not without frictions. Such is the case, for example, on the labor market and the housing market, where searching and finding are essential features and where trade is characterized by pairwise matching of buyers and sellers.
As a graphical representation of one of the key issues studied by the three economists, consider the chart below, which is known as the Beveridge curve. It compares the jobless rate with the job vacancy rate. As the Nobel committee background report notes, "It has been known for a long time that the labor market fluctuates between situations of either high unemployment and few vacancies or low unemployment and many vacancies."
Why does the relationship in the chart above hold? One of the models created by this year's Nobel winners in economics offers an explanation. Again quoting the background literature from the Nobel committee:If unemployment and vacancies move in opposite directions, then changes can be regarded as reflecting variations in the demand for labor which occur over a business cycle. However, if unemployment and vacancies increase simultaneously, it is instead more natural to pursue an explanation in terms of changes in the performance of the labor market. One reason could be weaker matching efficiency, i.e., longer durations of unemployment in a given market situation. Another explanation could be more rapid structural changes that increase the rate at which firms lay off workers. Such developments on the labor market could be a sign that long-term unemployment will increase.
The labor market, of course, is front and center in the global economy at the moment, particularly in the mature economies of the U.S., Europe and Japan. In particular, the sluggish pace of job creation has sparked a fierce economic and political debate about what to do, if anything. Diamond says the U.S. needs a second stimulus package.
As for the theories of Diamond, et al., Alex Tabarrok of the Marginal Revolution blog says yesterday's Nobel award "can be thought of as a prize for unemployment theory." He continues: "A key breakthrough was to realize that the problem was not how to explain unemployment per se but rather how to explain hiring, firing, quits, vacancies and job search and to think of unemployment as the result of all of this underlying microeconomic behavior."
It's all quite topical at the moment, considering that the current U.S. unemployment rate of 9.6% has rarely been higher. And with few economists predicting a sharp drop anytime soon, the subject of the labor market could hardly be any more timely.
One might wonder if Diamond's new claim to fame will help him win approval to the Fed. The stumbling block has been certain Senate Republicans, who argue that Diamond doesn't have enough macro policy experience to warrant confirmation to the Fed. Leading the charge against Diamond is the senior Republican on the Banking Committee, Alabama Senator Richard Shelby. In late July, Shelby said that "Professor Diamond is a skilled economist and certainly an expert on tax policy and on the Social Security system. However, I do not believe he’s ready to be a member of the Federal Reserve Board. I do not believe that the current environment of uncertainty would benefit from monetary policy decisions made by board members who are learning on the job."
Has Shelby changed his mind now that the nominee in question is a Nobel Prize winner? Not necessarily, or so the Senator's comments yesterday suggest: "While the Nobel Prize for Economics is a significant recognition, the Royal Swedish Academy of Sciences does not determine who is qualified to serve on the board of governors of the Federal Reserve system."
Diamond, it seems, is not only studying employment frictions, he may end up as the victim of the disease, albeit a particularly rare form a la Senate politics.
October 11, 2010
Yesterday's New York Times story about a huge Minneapolis Ponzi scheme involving currency trading provides some familiar lessons about investing and the finer points of protecting yourself against scams:
● Plots to separate investors from their money are a constant. Bernie Madoff, the head of the largest investment swindle in history, is cooling his heels in prison, but there are countless imitators lining up to take his place and that will never change. For every Madoff who's fingered, prosecuted, and jailed, a large number of Bernie wannabes are running around raising capital.
● If you're assuming that government regulation will save you, you're dreaming. Most financial frauds are shut down long after they've fleeced millions from naïve investors. Sometimes that's due to incompetence by the regulators, as it was with the Madoff debacle. Yet sometimes a fraud is allowed to fester in order to gather information to aid in the prosecution. That may be legally prudent, but it leaves gullible investors at risk. The Times article about the Minneapolis fraud notes that the FBI was investigating the Ponzi scheme for months and it was all but certain that the operation was a sham. But during the FBI's investigation, millions of dollars in new capital flowed into the fund…money that eventually "disappeared." As a general rule, by the time the authorities enter the picture, most of the money's gone. Some of the cash is returned, but it's almost always a small fraction of the invested proceeds.
● There are almost always warning signs that a swindle is underway. The details of a Ponzi scheme can be convoluted, but you don't usually need a Ph.D. in finance to smell something funky going on. Rely on your own gut instinct as a start. If something sounds too good to be true, it usually is. In the case of the Minneapolis fraud, the principal was telling would-be investors that the fund earned 1% to 2% a month consistently, without losses, in recent years—with a speculative currency trading strategy, no less. That's the time-tested signal to run--not walk--out the door.
● It's not obvious that the regulators are acting in a timely manner. As the Times reports, the Commodity Futures Trading Commission received damning evidence as early as 2006 that the Minneapolis fund was a sham. One investor filed a lawsuit in 2008, which was later abandoned. His lawyer forwarded related documents to the CFTC, which did nothing initially, deciding that it lacked jurisdiction to act. Maybe things are different in 2010, but why take the risk with your money?
In the end, no one will guard your assets as carefully as you will. That doesn't mean you shouldn't seek prudent financial advice or consider investing with competent managers. But if you're handing over money to someone primarily because you think you're going to make some big money quickly, that's a sure sign that something's amiss.
Unfortunately, many investors make this mistake, and will continue to make it. You can count on it. The swindlers certainly do. Why? The problem, dear Brutus, is partly within ourselves. As Jason Zweig explains in Your Money and Your Brain: How the New Science of Neuroeconomics Can Help Make You Rich, "you will never maximize your wealth unless you optimize your brain."
That includes reminding yourself on a regular basis that there are lots of crooks out there trying to steal your money, and that a fair amount of what's marketed in finance is less than it seems. Sometimes a lot less.
Keep an eye out for subtle scams as well as the big ones. Some of the frauds are over-the-top schemes that are obvious swindles. But some of the deceptions are more subtle, and perhaps even legal. Avoiding huge losses is, of course, job one. Yet you can also lose a lot over long periods if you're not careful.
How many investors overpay for beta? Many. That's not a crime, but it should be, especially when the gouging is excessive. There are hundreds of S&P 500 index funds, for instance, but they don't all charge rock-bottom fees.
Ultimately, there's a fine line between legitimate and unethical investment products and strategies, and it's not always a function of what's legal and what's not. But that's a story for another day. Meantime, caveat emptor has never been more relevant. We've come a long way in financial economics, but some of the ancient hazards are still with us, and always will be. Act (and invest) accordingly.
October 9, 2010
BOOK BITS FOR SATURDAY: 10.9.2010
● King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone
by David Carey
Review via Basil and Spice
"King of Capital" describes how Blackstone went from two guys and a secretary to being one of Wall Street’s most powerful institutions, far outgrowing its much older rival KKR; and how Steve Schwarzman, with a pay packet one year of $398 million and $684 million from the Blackstone IPO (which came later in 2007), came to epitomize the spectacular new financial fortunes amassed in the 2000s. Along the way, private equity firms tried -- and largely succeeded -- in improving their image from predatory "grave dancers" that "stripped" --- sold off the assets -- of companies they bought and "flipped" -- quickly resold the companies, often to foreign companies that closed plants, laid off workers and beggared whole communities.
● Bought and Paid For: The Unholy Alliance Between Barack Obama and Wall Street
By Charles Gasparino
Review via Intellectual Conservative
For decades big business has been cast in the role of a conjoined twin with the Republican Party. Wall Street, the domain of some of America's biggest businesses, in terms of absolute money power has been considered the worst of the worst when it comes to "fat cats" and amoral greed. So what is the connection between Wall Street and Barack Obama? Charles Gasparino, an investigative reporter and author of several very revealing books on the world of high finance has the answer to that question…
Bought and Paid For reads, in many respects like a story. The characters are real people and the real anecdotes reveal their intentions, their motivations, and other reasons why Big Finance has become so closely involved with Big Government. We learn what is in it for both sides, and why it is unlikely that either side will call a halt to the relationship voluntarily. The run up to the 2008 presidential election is covered in detail; who received how much money from whom, and what it was used for. What Wall Street really believed about Barack Obama and John McCain. How the money Wall Street money machine works, and why the vaunted financial reform regulations of 2010 haven't and won't solve any problems. Perhaps most important to many Americans, why the so-called government stimulus hasn't stimulated anything.
● The Weekend That Changed Wall Street: An Eyewitness Account
By Maria Bartiromo
Review via Balance Junkie
A couple of weeks ago a representative of the public relations firm handling CNBC anchor Maria Bartiromo’s new book sent me an email asking if I would care to review it. I quickly agreed, but my interest stemmed more from a curiosity about the tenor and approach the book would take rather than its actual contents. The book is called The Weekend That Changed Wall Street: An Eyewitness Account. It’s about that fateful September weekend a little over 2 years ago when the 158-year-old financial icon Lehman Brothers declared bankruptcy, sending global financial markets into a panic.
● The New Road to Serfdom: A Letter of Warning to America
By Daniel Hannan
Video of speech by author in a forum on his new book via the Cato Institute.
● The Impending World Energy Mess
by Robert L. Hirsch, Roger H. Bezdek, Robert M. Wendling
Review via Huffington Post
The market does some crucial jobs so well that we're tempted to make a quasi-religion of it. But at other jobs it fails: for example, at giving a timely signal to prepare for "peak oil."
In their new book, analyst Robert Hirsch and his colleagues take on the coming decline in global oil production, or as they put it, "the impending world energy mess." They estimate that a decline will start in 2-5 years, following the present "fluctuating plateau" on a graph of production.
The kicker is their conclusion that, once we start a "crash program," shifting our fleet of vehicles will take "more than a decade"; and building the infrastructure for new fuels, 10-20 years.
● Macroeconomic Essentials, 3rd Edition: Understanding Economics in the News
By Peter E. Kennedy
Summary via publisher (MIT Press)
This introductory text offers an alternative to the encyclopedic, technically oriented approach taken by traditional textbooks on macroeconomic principles. Concise and nontechnical but rigorous, its goal is not to teach students to shift curves on diagrams but to help them understand fundamental macroeconomic concepts and their real-world applications… This third edition has been revised and updated throughout. New material covers the subprime mortgage crisis and other subjects; new "curiosities" (boxed expositions of important topics) have been added, as have "news clips" about recent events.
October 8, 2010
PRIVATE JOB CREATION INCHES HIGHER AS GOV'T LAYOFFS CONTINUE
Nonfarm payrolls dropped 95,000 last month and the unemployment rate was unchanged at 9.6%, the Labor Department reports. That’s bad. But it's not as bad as it seems because the trouble was due primarily to the government, which laid off workers—159,000 fewer government jobs overall last month. So much for employment stimulus from big brother. But if we focus on private-sector jobs, the net change in September reveals a rise of 64,000. That’s good. It’s not great, and in the grand scheme of the business cycle it's disappointing. But it could be worse. In fact, it might turn worse in the months ahead for all we know. But the trend in job growth for corporate America is still up at the moment.
September’s rise in private new jobs is the ninth consecutive month of positive change. Since February, the for-profit realm of the economy has minted almost 900,000 new jobs. That’s a sluggish pace by America's historical post-recession standard, but for the moment it’s all we have. As the chart below shows, it’s a trend of sorts with a modest positive bias. Still, no one will be inspired from this chart. The falling pace of net job creation in particular is worrisome. Add it to the list of macro issues weighing on the outlook.
“The private-sector growth is somewhat heartening but in total you have to expect that state and local and government jobs are going to be a drag for a number of months and perhaps a number of quarters,” Bill Gross, co-chief investment officer at Pimco, tells Bloomberg today.
Government, it seems, is the problem rather than the solution in the labor market, at least it has been in recent months. Otherwise, more of the same is on tap for the economy. "While economic growth is expected to remain positive, the pace of growth over the next year and a half is not likely to be sufficient to meaningfully improve the unemployment rate from its currently elevated level," says economist James Marple of TD Bank via AFP.
Andrew Leonard speaks for many when he complains that "this is not what recovery looks like." Whatever you call the current climate, the question is whether it's a prelude to a new recession? Probably not, at least not in the foreseeable future, but it’s still too close to say for sure. The current economic trend is about as sluggish as it can be without a double dip scenario. That's too close for comfort, but it's not obvious that it's about to change any time soon.
READING ROUNDUP FOR FRIDAY: 10.8.2010
►Unemployment claims drop, while job openings rise
Applications for unemployment benefits fell last week for the fourth time in five weeks, a sign that layoffs are declining.
The Labor Department said Thursday that initial claims for jobless aid dropped by 11,000 to a seasonally adjusted 445,000. It's the lowest level since the week ending July 10 and down from 504,000 initial claims in mid-August — the high point for the year.
Economists were mildly encouraged by the drop. But they also pointed out that claims remain at an elevated level consistent with weak job growth. Employers aren't hiring enough to bring down the 9.6 percent unemployment rate.
►China must fix the global currency crisis
George Soros/Financial Times
I share the growing concern about the misalignment of currencies. Brazil’s finance minister speaks of a latent currency war, and he is not far off the mark. It is in the currency markets where different economic policies and different economic and political systems interact and clash.
The prevailing exchange rate system is lopsided. China has essentially pegged its currency to the dollar while most other currencies fluctuate more or less freely. China has a two-tier system in which the capital account is strictly controlled; most other currencies don’t distinguish between current and capital accounts. This makes the Chinese currency chronically undervalued and assures China of a persistent large trade surplus.
►Financial Shock and Awe
Barry Eichengreen/Foreign Policy
It is a misunderstanding to believe that the policies pursued by the BOJ, the Fed, and the Bank of England come at one another's expense. What we are seeing, in all three cases, is not exchange rate manipulation but what is known as quantitative easing, actual or incipient. The evolution of BOJ policy makes this clear. What two weeks ago started as a modest foreign exchange market intervention has now turned into an explicit program of purchasing 5 trillion yen of Japanese treasury bonds and bills, commercial paper, exchange traded funds, and real estate securities. The Bank of England has made no bones about its continued commitment to quantitative easing. The Fed is moving slowly, slowly in the same direction.
This, of course, is precisely what is needed in a world where deflation has again become a problem and fiscal policy, for better or worse, is off the table. It is not a "beggar thy neighbor race to the bottom." If anything it is a race to the top.
►Fed Rhetoric Will be Tied to Mandate of Full Employment and Price Stability
Asha Bangalore/Northern Trust
Financial markets are largely convinced the Fed will embark on QE2 at the November 2-3 FOMC meeting. Bernanke's speech on August 27 was the trigger, followed by the FOMC policy statement on September 21 and recent rhetoric of Fed officials Dudley, Evans, and Rosengren.
►Using TIPS to gauge deflation expectations
Patrick Higgins/Macroblog (Federal Reserve Bank of Atlanta)
In the recent Survey of Professional Forecasters, economists were asked to give their subjective probability of deflation during the next year. Specifically, they were asked about the chances that the quarterly consumer price index excluding food and energy (core CPI) will decline in 2011. According to the respondents, the probability of core CPI deflation in 2011 was only 2 percent.
This rather sanguine view of the probability of deflation is encouraging. But is it a view shared by noneconomists? While there are many sources used to measure inflation expectations, there aren't many that gauge inflation uncertainty or the risk of deflation. However, one might estimate a probability of deflation as seen by investors by exploiting the different deflation safeguards of a pair of Treasury Inflation Protected Securities (TIPS), which have about the same maturity date but different issue dates.
►Weekly Rail Traffic Maintains Steady Growth
Mark Perry/Carpe Diem blog
The Association of American Railroads today reported that weekly rail traffic continues to maintain a steady pace with U.S. railroads originating 299,394 carloads for the week ending Oct. 2, 2010, up 7.7% compared with the same week in 2009, but down 10.7% from the same week in 2008.
►How Much Does the Market Organization of Economic Life Matter?
Brad Delong/Grasping Reality with Both Hands blog
We are fortunate--if that is the word--to be able to answer this question because the twentieth century provided us with a natural experiment in the form of High Stalinist central planning. Karl Marx, you see, completely missed the utility of markets as devices for providing decision makers with proper incentives and for achieving allocative efficiency. (Why he missed this is, I think, a result of his crazy metaphysics of value, but I won't go there today.) He saw markets only as surplus extraction devices--ways to quickly and fully separate the powerless from the value that they had created and that ought to have been theirs…
In 1989, the Iron Curtain came down, and we could see what a difference it made as we could examine levels of material well-being on both sides of the Curtain. This is as close to a perfect natural experiment as anyone could wish: the Iron Curtain's location was determined by where Stalin's and Mao's and Giap's armies marched--which is as exogenous to other determinants of economic well-being as anyone could wish.
Here are the results:
October 7, 2010
THE FINAL PHASE OF THE REFLATION TRADE IS NOW IN PROGRESS
The IMF's new forecast for the world economy calls for 4.8% growth for all of 2010, or slightly higher from the July prediction. The outlook for the U.S. economy, however, was revised down for this year: 2.6% vs. the summer forecast of 3.3%.
“The world economic recovery is proceeding,” IMF Chief Economist Olivier Blanchard explained in a press conference. “But it is an unbalanced recovery, sluggish in advanced countries, much stronger in emerging and developing countries.”
Same old, same old. But the difference now is that the Federal Reserve is mounting a stronger monetary response than it was during the summer. In essence, the central bank is trying to juice the economy by raising inflation expectations and thereby boost nominal GDP growth. Will it work? We'll find out soon enough, but this much is clear: various corners of the market are inclined to see inflation rising. It's only a marginal change from recent history, but it seems to building a head of steam. The first half of the strategy seems to be working. It's the second half that's the key, though, but figuring out if that's coming as well will take time.
Meanwhile, it looks like inflation expectations are on the rise. Exhibit A is the price of gold, which continues to run higher and is closing in on $1360/oz. Higher gold prices generally translate into a weaker dollar, and this time is no exception. The U.S. Dollar Index continues to weaken and is nearing its low point for the year. Unsurprisingly, the whiff of higher inflation has also elevated commodity prices generally. The S&P GSCI Index, for instance, is now trading at its highest level this year, due in no small part to the rising price of oil.
Of course, the bond market is responding too. The inflation forecast, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries, inched up again yesterday, settling at 1.89%, the highest since June.
What's extraordinary about the market's rising inflation outlook is that it's accompanied, at least for the moment, by a falling yield on the benchmark 10-year Treasury, which fell to 2.41% yesterday, based on Treasury data. That's the lowest since the depths of the 2008 financial crisis, when the 10-year yield hovered just above 2.0% at one point.
In short, the final act in the great reflation trade is in full swing. But if you're expecting a consensus among economists on whether this works, or not, you're expecting too much. Scott Sumner, for example, has been arguing for some time that monetary policy still has traction. Not everyone agrees. In fact, some dismal scientists see nothing but trouble ahead. Joseph Stiglitz estimates the odds of success for additional monetary stimulus at the zero bound is, well, zero, he writes.
From the Great Moderation to the Great Recession to the Great Reflation and now the Great Experiment in a few short years. Macroeconomics may be headed for a major rewrite (or not?). Details to follow.
October 6, 2010
IS RECESSION RISK FADING?
The first batch of September's economic reports are out and they suggest that the economy continued expanding last month. The ISM manufacturing and services indices (released on Friday and yesterday, respectively) show an economy that's still growing. It’s a mistake to read too much into these numbers, given the challenges that still confront the U.S. There are also several weeks of September reports to digest in the month ahead. But the early signs from the ISM benchmarks, at least, offer support for cautious optimism.
No one expects a robust expansion any time soon, in part because the job market continues to sputter. Maybe we'll learn otherwise on Friday with the update for September payrolls. (The consensus forecast, by the way, anticipates a mild net increase of 74,000 nonfarm jobs last month, according to Briefing.com.)
While we're waiting, the threat that there's a new recession in the offing looks a touch less potent in the wake of the twin ISM reports. Last Friday, the ISM manufacturing indicated growth in this corner of the economy, albeit at a slower pace from August. Better news arrived in yesterday's update for services, which showed that this sector grew last month, and at an accelerated pace. The ISM services sector index rose to 53.2, up from 51.5 in August (a reading above 50 indicates growth). The new-orders component of services also rose at faster rate in September vs. the previous month. That's encouraging because new orders are considered a leading indicator that economists use as a proxy for future demand.
The stock market took the hint today and rose sharply on Tuesday. The S&P 500 jumped more than 2% on the day, a gain that puts the market at its highest level since May. The surge helps erase the summer selloff that was accompanied by rising anxiety that a new recession was imminent. The stock market isn't a flawless forecaster, of course, and so we must be cautious in assuming too much from short-term trends in equity prices. But as we discussed at some length in an issue of The Beta Investment Report late last month, the linkage between stocks and the economy, while imperfect, is sufficiently robust on a rolling 12-month basis. Accordingly, the gains in the stock market for the past month are worth monitoring as a possible signal that there's a change brewing in the macro outlook.
Perhaps it's no accident that the rally in stocks that began in early September has been accompanied by a rebound in the annual rate of growth in the money supply. The 12-month change in the MZM measure of the nation's money stock, for instance, has turned up recently and is now increasing for the first time since this year's first quarter, as the chart below shows. The Fed, in other words, seems to be favoring more liquidity injections to juice the economy. That's a sharp change from the summer, when the rapidly falling year-over-year pace in money supply was fueling worries that the economy was headed for a new round of trouble.
Another encouraging sign comes from the bond market, if only marginally. The Treasury market's 10-year inflation forecast (measured by the yield spread between 10-year nominal and inflation indexed Notes) has been inching higher lately. As of yesterday, this outlook for inflation was 1.85%, the highest since early August. Deflation worries, it seems, are retreating. If the trend has legs, it's a bit tougher to argue that a new recession is approaching.
To the extent that higher inflation expectations are the answer to deflation/recession fears, the central bank appears to be leading a new frontal attack. As The Wall Street Journal reports today, "the dollar came under pressure again Wednesday amid expectations that the Federal Reserve will expand its quantitative-easing policy." Meanwhile, gold's ongoing rally to record highs also suggests that the deflationistas are on the run.
Yes, it could all be temporary. The real test is whether the economic reports for September provide corroboration or rejection of the stock market's recent optimism. The answer will dribble out over several weeks. Meantime, hope is still alive. We're a long way from a strong recovery and it's premature to dismiss the double-dip recession threat completely. But maybe, just maybe, the risk of a new contraction is receding. The equity market is inclined to think so. Let's see what the rest of September's economic reports have to say.
October 5, 2010
READING ROUNDUP FOR TUESDAY: 10.5.2010
►IIF warns of a dollar collapse, and rising capital flows to emerging markets
"The Washington-based Institute for International Finance has warned of a crash in the dollar as a result of the Federal Reserve’s expected policy of further monetary stimulus, according to Frankfurter Allgemeine. In a report, the IIF calls on the Fed to pursue a monetary policy that supports foreign demand for US goods. Otherwise there is a threat of a significant spike in capital flows to emerging markets, which would rekindle global imbalances and financial instability. The managing director of the IIF is quoted as saying that market participants have to be persuade that the large economies comprehend their collective responsibility to achieve balanced and sustainable growth. The IIF also published its forecast for net capital flows into emerging markets, raising its previous 2010 estimate of $709bn to $825bn."
►Yield Hunt Leads to Currency Debt
Alex Frangos and Mark Gongloff/Wall Street Journal
"The global rush for yield is driving investors to buy emerging-market debt issued in local currency, adding foreign-exchange fluctuations to the list of risks bondholders face."
►Do Past 10-Year Returns Forecast Future 10-Year Returns?
Bill Hester/Hussman Funds
"The argument that above-average long-term returns typically follow periods of poor past long-term returns is not wrong, it's just incomplete. The more complete argument is above-average long-term returns can be expected to follow long periods of low or negative, provided that they end with low P/E multiples on smoothed earnings and precede a period where the economy can be expected to enjoy robust growth. Today, valuations are at levels that have normally been followed by 10-year returns that are well below average. At the same time, based on a template from more than a dozen prior credit crises, the argument that the economy will grow strongly over the coming decade finds little support."
►Bank of Japan cuts benchmark rate
"The Bank of Japan lowered its key interest rate to virtually 0% Tuesday, citing concerns about the pace of the economic recovery."
►Euro-Zone Growth Slows Sharply
Nicholas Winning/Wall Street Journal
"The euro zone's economic growth slowed sharply in September as contractions in peripheral countries such as Spain and Ireland threatened the currency area's recovery, a survey by financial-information company Markit showed Tuesday."
►Bernanke warns of high budget deficits
Neil Irwin/Washington Post
"The nation's economic future would be endangered if the government does not rein in budget deficits in the years ahead, Federal Reserve Chairman Ben S. Bernanke said Monday, and Congress should consider new budgeting rules to try to make that happen."
►Deflation and the Fisher Equation
William T. Gavin/St. Louis Fed
"The current consensus is that the Federal Open Market Committee cannot raise interest rates because the unemployment rate is so high. The unemployment rate, however, is a poor guide for setting the policy rate during a recovery because unemployment lags growth in gross domestic product. The high unemployment rate will persist even as the economy recovers and real interest rates rise. So, according to Irving Fisher, one reason to worry about deflation is that the federal funds rate is expected to be held near zero as the economy grows out of this recession."
October 4, 2010
BUBBLES, REBALANCING & THE AVERAGE INVESTOR
Jason Zweig at The Wall Street Journal warns that the bond market is in a bubble. He may be right. Or not. It’s always hard to tell when bubbles are lurking. That doesn’t mean we shouldn’t try, but we need to be wary of going off the deep end too.
If we’re defining a bond bubble by low yields in the fixed-income market—Treasuries, in particular—there’s surely some substance to the bubble talk. Yields have almost never been lower. The path of least resistance, then, is up for yields. But when? Will interest rates start rising next week? Or next year, or five years from now?
Even when bubbles seem to be a clear and present danger, investing doesn’t necessarily get any easier, so the perennial dominance of mediocre returns suggest. But hope springs eternal, and sometimes for good reasons. If you accept the conventional wisdom among financial analysts in recent years, the markets have been plagued with a series of bubbles over the last generation in different asset classes. Of course, if we’ve been beset with bubbles, we must also have had periods when the opposite was true—anti-bubbles, or periods when asset prices are inexpensive. Looking back on it all, it must have been true that it was easy to boost investment results. Unfortunately, if you looked at returns earned by investors over the past decade, the results aren't often inspiring.
Yet in theory, bubbles and anti-bubbles should be an investor’s best friend. The presence of these peaks and valleys suggests that expected returns are below average (or above average for anti-bubbles). In fact, financial economists have been documenting for a few decades that expected return (and realized return) fluctuate for asset classes. Bubbles and anti-bubbles are part of the reason why. The problem is that returns also vary for another reason: few investors are able to take advantage of these fluctuations.
A number of studies over the years remind that most investors do a poor job of rebalancing, either because they wait too long to pounce after large price changes, or by not rebalancing at all. Because most investors don’t manage the asset allocation of their portfolios in a timely manner, the expected risk premiums linked to asset allocation are that much higher for those who are willing and able to act relatively quickly.
If everyone was dynamically managing their portfolios with great skill, the performance boost that appears to be related to opportunistic rebalancing would be smaller, perhaps even falling to zero. But don’t hold your breath. It’s hard for most folks to act when opportunity is at or near a peak. Why? For all the obvious reasons, of course. How many investors were buying stocks in late 2008? Or selling stocks in late 2009?
Studying history inspires thinking that we should focus on exploiting bubbles and anti-bubbles. Those points, after all, are where the low-hanging fruit prevails. But it should come as no surprise to learn that most investors, institutional or otherwise, end up with average results.
That’s partly due to the fact that cashing in on higher expected return takes lots of discipline. That’s because the biggest opportunities are usually associated with making contrarian decisions. There's a risk premium for embracing hazards at times when most people are running in the opposite extreme. In fact, you would expect no less in an efficient market. The only reason to buy stocks in late 2008, for instance, is that the expected risk premium is higher than normal. Why is it higher than normal? Because late 2008 was a period of extreme uncertainty and macro risk. Thus, investors needed to be compensated appropriately for wading into the market.
But there’s also the problem of uncertainty. Even if you’re a contrarian’s contrarian, you still don’t know what’s going to happen tomorrow, next week, next year. Bubbles and anti-bubbles can remain in those states for long periods of time. Not always, but enough to keep the crowd guessing… and making mistakes.
Taking advantage of fluctuations in expected return, in other words, is tough. Assuming, of course, that you’re trying.
It helps if you’re a financial whiz, but even a know-nothing investor can juice returns a bit. In my newsletter I regularly analyze several versions of a value-weighted index portfolio of all the major asset classes. One of the insights is that mindless rebalancing has added 50 to 100 basis points for this index over time vs. the passive version that does nothing other than initial setting asset allocation to market-based weights and letting the mix run. It's not a sure thing, of course, but it looks durable, especially over several business cycles for a broadly diversified portfolio.
Consider, for instance, that the fully passive Global Market Index has earned an annualized 4.4% for the past 10 years through the end of last month. The strategy that generated that result was simply holding all the major asset classes in their respective market-value weights and letting the financial tide manage the mix. The same strategy that was rebalanced every December 31 did a little better, earning 5.3% over that span. And if you equal weighted everything and rebalanced every December 31 to maintain equality, the trailing 10-year return surged to 8.4%.
In fact, if your investing talents are above average, you can do even better. But don’t forget that there’s always risk lurking. The presence of bubbles and anti-bubbles certainly contribute to the broad array of risks that bedevil investors’ best laid plans, and theoretically offer opportunity. But the uncertainty of deciding if this is (or isn’t) a timely moment to exploit bubbles and anti-bubbles is a risk too. Ditto for the question of whether we’re able to accurately assess if we’re even in a bubble or not.
There’s a wide assortment of avenues for beating a multi-asset class benchmark that makes no attempt to time markets or pick asset classes or individual securities. But there’s no shortage of pitfalls either.
Over time, most investors will have a hard time beating a passive mix that owns everything. That’s no surprise, since excess returns are funded by below-average returns, and losses. That simple mathematical truth inspires a deep round of self analysis for deciding if you think you have what it takes to make above-average investment decisions for the rest of you investing life. Most investors think they’re in the above-average category. The fact that so many are wrong in thinking that is why there’s opportunity for the relative few who truly reside in that exclusive club.
READING ROUNDUP FOR MONDAY: 10.4.2010
►Cheap Debt for Corporations Fails to Spur Economy
Graham Bowley/New York Times
"American corporations have been saving more money since the financial collapse of 2008. But a recent rush of blue-chip bond offerings — including a $4.75 billion deal last month by Microsoft, one of the richest companies in the world — has put even more money in their coffers.
Corporations now sit atop a combined $1.6 trillion of cash, a figure equal to slightly more than 6 percent of their total assets. In the first quarter of this year it was 6.2 percent of assets, the highest level since 1964, when it was 6.4 percent.
When will they start spending that money — in particular, by hiring?
That is part of what has become the great question of this long, jobless recovery: When will corporate America start to feel confident enough to put its cash to work, building factories and putting some of the nation’s 14.9 million unemployed to work?"
►The Trade and Tax Doomsday Clocks
Donald Luskin/Wall Street Journal
"If today's low rates expire at year-end per current law, that would at a stroke reduce after-tax income for every working American, the average reduction being 3.3% according to the Tax Policy Center. Do the math: 94% of income goes to consumption, and consumption is 70% of gross domestic product. All else being equal, if the Bush tax cuts don't get extended, that's a 2.3% hit to 2011 GDP. That means instant double-dip recession, starting at midnight, Dec. 31."
►The Outlook, Policy Choices and Our Mandate
William Dudley/New York Federal Reserve
"Although so-called 'soft-patches' are quite common during the early stages of an economic expansion, this soft patch is a bit different. First, it looks like it will last somewhat longer because the deleveraging process is not yet complete. Second, the current weakness is somewhat more concerning because it is occurring at a time that the central bank has already cut interest rates to near zero."
►QE2: estimates of the potential effects
"Although we are used to thinking of the Federal Reserve as playing a key role in determining interest rates, it is far from clear that the Fed matters that much for interest rates at the moment. The Fed's traditional influence comes from changing the supply of reserves injected into the banking system, which in normal times would quickly change the interest rate at which banks lend those reserves to each other overnight. But with over a trillion dollars in excess reserves and the overnight rate practically at zero, the Fed's primary policy tool is completely irrelevant at the moment…
There might still be some ability to affect longer-term interest rates from much more massive operations. The theory is that by taking some of the supply of longer-term bonds off the market, this might raise the price and thus lower the yield on those bonds.
I remain of the opinion that while the Fed is understandably reluctant to embrace QE2, it may have little other choice."
►Plosser voices concern over further easing
Robin Harding/Financial Times
"The US Federal Reserve must not launch a new round of asset purchases without setting out what they are meant to achieve, the president of the Philadelphia Fed has warned in an interview with the Financial Times."
►Risk, Uncertainty and Monetary Policy
Geert Bekaert, et al./Working Paper
"A lax monetary policy decreases risk aversion after about five months…Monetary policy may indeed affect asset prices through its effect on risk aversion, as suggested by the literature on monetary policy news and the stock market, but monetary policy makers may also react to a nervous and uncertain market place by loosening monetary policy…the relationship between risk aversion and monetary policy may also reflect the joint response to an omitted variable, with business cycle variation being a prime candidate."
October 2, 2010
BOOK BITS FOR SATURDAY: 10.2.2010
● The Shadow Market: How a Group of Wealthy Nations and Powerful Investors Secretly Dominate the World
By Eric J. Weiner
Review via New York Times Book Review
"The 'shadow market' Weiner refers to — not to be confused with the 'shadow banking system,' which was largely blamed for the collapse of our economy — is 'the invisible and ever-shifting global nexus where money mixes with geopolitical power,' a vague and ominous allusion to sovereign wealth funds, hedge funds and private equity funds. Weiner argues that these huge pools of unregulated capital have come to dominate the world financial system, largely without our noticing it, and that as a result the United States has lost much of its economic influence. While he discusses the investment arms of the governments of Qatar, Singapore, Abu Dhabi and Saudi Arabia, the book could have been subtitled 'How China Cooked America in Soy Sauce and Ate It for Dinner,' since China is Weiner’s most intimidating example. According to his worldview, our friendly adversary in the Far East has the United States in a headlock, and we should all be stockpiling potato seeds and scrambling to learn Mandarin."
● Risk and the Smart Investor
By David X. Martin
Commentary via author's web site
"Every person’s risk appetite—which, of course, varies throughout life—depends on a number of factors. Some of them are personal, some of them are social, and some of them are purely economic. Age is the most important of the personal factors. The young, as a rule, have both a greater appetite and a much higher tolerance for risk. The young, in fact, often seek danger for its own sake—perhaps because they have been shielded from it as children, and so want a look, or perhaps because they believe that any misfortune that befalls them can always be undone…Once one person settles in with another, however, their appetite for risk almost immediately declines. Add children, or adult dependents, and suddenly risk, once seductive, begins to lose its looks. It is one of the great ironies of life, however, that it is precisely at that moment that risk management becomes an even more essential component of one’s life plan."
● Hard Money: Taking Gold to a Higher Investment Level
By Shayne McGuire
Excerpt via John Wiley & Sons, Inc.
"The U.S. government’s freedom from risk was severely undermined by the 2008 financial crisis. In what Morgan Stanley’s chief global strategist called 'the Great Swap,' the U.S. government was forced not only to spend as consumers moved to save; it also had to swap its quality assets (Treasury obligations) for malodorous mortgage-backed securities and other assets of extremely poor quality to help banks cleanse their balance sheets and be able to lend again. Due to the severity of the credit crisis, the U.S. government was forced to undermine the quality of its balance sheet, which put the risk-free interest rate into question. Unfortunately, the crisis arrived just as government spending was about to begin to surge: On January 1, 2008, the first of 78 million Americans, members of the baby boom generation, began to retire and Social Security, Medicare, and Medicaid expenditures are beginning to expand dramatically. As our leaders deal with these tremendous challenges, which present investment risks to U.S. Treasury bondholders, it is probable that some part of the trillions the world has invested in U.S. Treasury obligations will begin to move into gold."
● The Rational Optimist: How Prosperity Evolves
By Matt Ridley
Review via Cato Institute
"Ridley, science writer and popularizer of evolutionary psychology, shows how it was trade and specialization of labor–and the resulting massive growth in technological sophistication–that hauled humanity from its impoverished past to its comparatively rich present. These trends will continue, he argues, and will solve many of today’s most pressing problems, from the spread of disease to the threat of climate change."
● History of Greed: Financial Fraud from Tulip Mania to Bernie Madoff
By David E.Y. Sarna
Review via Bloomberg BusinessWeek
"As Sarna shows, financial villains have weaved through history for centuries, but none actually causes booms or busts. The real threat is that, as the economy has become global, greed has been democratized."
October 1, 2010
SPENDING & INCOME RISE IN AUGUST, SUGGESTING LOWER RECESSION RISK
Today's spending and income report for August is no silver bullet, but it suggests that the risks of recession and deflation have fallen for the immediate future. The economy, in other words, appears stronger than it appeared over the summer.
Disposable personal income (DPI) rose a healthy 0.5% in August vs. July, the U.S. Bureau of Economic Analysis reports. That's the best gain since April, when the outlook for the economy, while still well short of stellar, was considerably brighter than it was in recent months. Meanwhile, personal consumption expenditures (PCE) gained 0.4% in August, matching July's pace. That's the highest since the 0.5% rise in March.
In short, spending and income have rebounded from the summer slowdown. The economy is still harassed with any number of challenges, but it's quite a bit tougher to argue that deflation and recession are lurking around the corner after reading today's numbers. Anything's possible, of course, but the August updates aren't indicating deterioration in consumer spending and income.
Skeptics will be quick to point out that monthly figures can be misleading and so we must also consider the broader trend. True, but there's encouraging news here as well, albeit with a caveat. Let's start by looking at the rolling 12-month percentage change in DPI and PCE, as shown in the first chart below.
Income remains in positive territory on a year-over-year basis (black line). In fact, the pace of increase for DPI has increased in recent months. But consumer spending has been slowing (red line). For August, PCE rose about 2.7% over the previous year. That's near the lowest 12-month pace this year.
Slower consumer spending isn't surprising. Household balance sheets are still loaded with debt and working through the red ink is going to take time and (presumably) higher levels of saving. We're seeing some of that in various reports of late. The unknowns are whether the savings rate continues to rise and, if so, how much damage the trend inflicts on spending? That's a topic that bears watching, and given the current climate there's reason to be cautious. Nonetheless, for the moment, at least, the August numbers don't suggest a dramatic slowdown. Will consumer spending growth remain sluggish? Or drop sharply in the months ahead? Stay tuned.
Meanwhile, let's not forget that the pace of growth in spending and income of late, even assuming it holds steady, is well below the rate of increase posted in the years before the Great Recession. The economy has recovered, but the lingering effects of 2008 and 2009 are still with us.
Fortunately, there's no sign that rate of growth in private sector wages is hurting. Yes, we're still below the rates posted in 2005 and 2006, when the economy was firing on all cylinders. But it's clear that there's a rebound in progress in 2010. Indeed, private industry wage and salary disbursements advanced 0.5% last month, matching July's pace. That's near the strongest monthly rate in more than a year. And on an annual basis, private wage growth continues to inch higher. For the 12 months through August 2010, wages rose 2%, the best level since before the start of the Great Recession in 2007, as the second chart below shows.
Does all this tell us that all's well? No, of course not. All the big challenges in the months and years ahead still await, starting with the problems associated with sluggish growth in the labor market. But the pressing issue of late has been worrying about a new recession. Today's report on consumer spending and income offer reasons for raising optimism a notch or two for expecting that we'll avoid that fate.
The acute risk, it seems, is falling. That’s good news, but don't celebrate for too long. The chronic ills are still with us and they require attention.