January 31, 2011
CONSUMER SPENDING & INCOME RISE IN DECEMBER
Disposable personal income (DPI) and personal consumption expenditures (PCE) increased in December, the Bureau of Economic Analysis reports. The update marks the sixth straight monthly rise in PCE and the third consecutive gain for DPI. In other words, if you’re looking for a reason to doubt the revival in consumer spending of late, you won't find it here.
Consumption’s 0.7% jump in December (the second-highest monthly gain in 2010) was largely driven by an acceleration in the purchases of goods rather than services. Goods-related PCE rose 1.2% in December, up from November’s 0.3% gain. Services-related PCE increased by a relatively spare 0.3% last month, about the same as November’s pace. Does the faster pace in goods-related purchases reflect growing consumer confidence? Or is it simply a temporary change bound up with the end-of-the-year holiday shopping?
One reason for thinking that sentiment may be improving for more than seasonal reasons can be found in the rise of private wages, which advanced 0.3% in December, up from November’s 0.1% rise. On an annual basis, private industry wage/salaries continue to increase at a 4% rate, the fastest in three years. That’s still well below the 6%-8% pace set back in 2005-2007, but apparently it’s high enough to keep consumer spending forging ahead.
Another sign that higher consumer spending is more than a glitch is the ongoing drop in the personal savings rate, measured as a percentage of DPI. Last month, the savings rate fell to 5.3% from 5.5% in November. In fact, the rate’s been dipping for most of the last six months. In June, the savings rate was 6.3%.
Still, the holiday factor can’t be ruled out just yet. As Bloomberg reports, “Retailers’ 2010 holiday sales jumped 5.5% for the best performance in five years, according to MasterCard Advisors’ SpendingPulse.” Impressive, but it's debatable if the holiday gains will endure or evaporate in January and beyond. It's tempting to assume that the good news will travel, but it's hard to take anything for granted when the labor market's rebound remains sluggish.
The outlook for the January payrolls report (scheduled for release on Friday, Feb. 4) calls for more of the same. Private non-farm job creation is expected to rise by a net 163,000 in the government’s update, based on the consensus forecast of economists via Briefing.com. That would be an improvement over December’s meek 113,000 advance, but we’re still a long way from a strong recovery in job creation. Until and if that changes, one can only wonder if the rebound in wages, which is essential for elevating consumer spending, can hold its ground.
STRATEGIC BRIEFING | 1.31.2011 | OIL & EGYPTIAN CRISIS
Oil price nears $100 on Egypt crisis
World oil prices rose to within a whisker of $100 a barrel Monday on fears that violent unrest in Egypt could disrupt the flow of oil through the Suez Canal on its way to the West, analysts said. Brent North Sea crude for delivery in March struck $99.97 a barrel in Asian deals. Crude last hit $100 dollars in October, 2008. In later London trade, it pulled back to stand at $99.20, down 22 cents compared with the close on Friday.
Oil Prices Rise as Egypt Unrest Gooses Market
There is no immediate threat to oil supplies at this time. The Suez Canal and Sumed Pipeline -- which combined carry over 2 million barrels of oil a day -- are operating normally right now. Egyptian oil output currently stands at under 700,000 barrels a day. Even combined with production in other areas where there have been protests -- Tunisia, Yemen, and Jordan -- their total output is about one-tenth that of Saudi Arabia, the region's top oil producer. OPEC has plenty of spare capacity (about 5.8 million barrels a day) -- and the International Energy Agency could even consider releasing strategic reserves if needed -- to meet a supply disruption. But a disruption in supply may not be the major catalyst for a big move in the price of oil. The main risk is not actual disruption of oil flows from Egypt, says Lawrence Eagles, head of commodity research at J.P Morgan. "It's the potential for these events to act as a catalyst to unrest in countries that are otherwise seen as stable," Eagles says. Uncertainty about the spread of the unrest could send oil prices significantly higher early this week.
Egypt riots and Oil
Nearly 3 million barrels of oil transit daily through the Suez Canal, as much as Canada's daily output, making it one of the world's most important oil routes. The tankers ferrying this oil are coming from Saudi Arabia, Kuwait and neighbouring producers and are for the most part headed to US shores and to a lesser extent Western Europe which also relies on the North Sea and Russia for its oil supply. Unfortunately Egypt is the country which controls the Suez Canal and as the food riots gradually take the shape of a revolution, the future of the Canal becomes a million dollar question. As it stands, the possibilities are endless, among which here are some likely scenario to ponder:
* A labor strike may cause a temporary transit disruption through the canal. Not good news for Egyptians as the food Egypt imports also comes through the canal.
* For a newly established government eager to prove its legitimacy, the most populist thing to do would be to significantly raise the Canal's Tariff: The tax levied by Egypt on all oil flowing through the canal. This would be in effect a tax on non-Egyptian oil to subsidize Egyptian food. As a result oil prices would soar worldwide.
Oil companies evacuate Egypt staff; oil prices retreat
International oil companies have evacuated foreign personnel from Egypt over concerns for their safety amid the past week's sometimes violent anti-governments protests, although initial worries about disruption to oil shipping through the Suez Canal seem unfounded so far... The potential impact of escalating political instability in Egypt would likely come from labor strikes shutting down operations at the Suez Canal or the Sumed pipeline rather than in the form of any organized paramilitary attacks on the two oil transit routes, Societe Generale said in a research report Saturday.
Opec ready to act on supplies amid Egypt turmoil
OPEC stands ready to increase oil production if the Egypt crisis cuts the flow of crucial supplies through the Suez Canal to the West, its secretary-general Abdalla Salem El-Badri indicated on Monday. El-Badri, head of the Organization of Petroleum Exporting Countries (Opec), warned that 'there could be a real shortage' of crude oil passing through the Suez.
OPEC worried about Egypt, but not acting yet
Oil producer group OPEC said on Monday it was worried about the unrest in Egypt but saw no reason to boost output to cool prices at the moment and would add more supply only if it saw a shortage in the market.
Oil Future: Crude Up On Egypt Unrest; No Supply Disruption Yet
"This affects the U.S. more so (than other countries), and that's why we're seeing more of a run-up in the U.S. WTI--at least temporarily," Carl Larry, president of Oil Outlooks & Opinions, said from Houston. "The North Sea can still produce for Europe, and Middle Eastern and Russian crude can still cover Asia, but the U.S. is stuck."
Egypt's troubles look likely to give us all a new 'oil shock'
The Independent/Jan 31
Whatever the purely political impact of the unrest in Egypt proves to be, it is pretty much the last thing a fragile world economy needs now. It will trigger more inflation, higher interest rates to tame it, falls in stock markets and a further hit to standards of living. The effect on China, in particular, could be especially dramatic, as the country has such an insatiable appetite for fossil fuels.
Pickens' Take on Egypt & Oil
CNBC Video/Jan 30
"This thing, it could be huge... I don't know how far reaching this is... this clearly shows us, the United States, we have to have an energy plan in America. We have no energy plan."
January 30, 2011
STRATEGIC BRIEFING | 1.30.2011 | TURMOIL IN EGYPT & GLOBAL ECONOMY
U.S. Stock Futures Decline on Concern Egypt May Slow Recovery
U.S. stock-index futures fell, indicating the Standard & Poor’s 500 Index may extend the biggest decline since August, as investors speculated Egypt’s crisis will slow the global recovery... “The situation in Egypt is the catalyst for a downturn,” said James Paulsen, chief investment strategist at Minneapolis- based Wells Capital Management, which oversees about $340 billion. “We have a market that is vulnerable to a technical correction. There’s an investor mindset that’s been expecting that to happen for a while now, given where the market is and how fast it’s come up.”
Egyptian Unrest Has Repercussions in Global Economy
Wall Street Journal/Jan 30
The Egyptian economy is relatively small, with total output of just about $217 billion last year. But the nation carries outsize importance as home to the Suez Canal, a key shipping route for oil and other products between the Red Sea and Mediterranean. Apart from oil, about 8% of the world's seaborne trade passes through the Suez canal, according to Egyptian government figures. Over the weekend, a dusk-to-dawn curfew across the country caused shippers operating in the canal to warn customers of potential delays. Canal traffic has continued unhindered through the protests. But if the violence in Egypt spreads to its oil-producing neighbors, crude prices will likely top $100 a barrel, which would damp an economic recovery gaining momentum in many countries.
Second Suez Crisis
Ground Report/Jan 30
Egypt matters for one reason -- the Suez Canal. The Suez Canal carries 10% of world trade and 4.5% of world oil production. Shut down the Canal and the world economy takes a tumble. Right now, the world economy can’t handle such an exogenous shock. The global economy would sink back into recession and the fiscal crisis would re-ignite. Governments would default in Europe. States would declare insolvency in the United States. Food prices and energy would sky rocket in the emerging markets. Stock markets will collapse. A wave of political upheaval would sweep the Mideast and then the world. Hosni Mubarak should not step down and flee Egypt like Ben Ali did in Tunisia. If he does, the Egypt unrest will immediately radicalize.
U.S. stock market falls as Egypt unrest continues
Washington Post/Jan 29
Egypt is central to U.S. interests in the Middle East as a moderate state and a key player in both counterterrorism operations and regional peace negotiations, said Helima L. Croft, a geopolitical analyst at Barclays Capital. If street protests were to end President Hosni Mubarak's nearly 30-year hold on power, "I think there would be a fear that you could see radicalism sweeping across the Middle East," Croft said, adding that the fear might be unfounded.
In Egypt, the Time Has Come for Mubarak to Go
Brookings Institution/Jan 29
Since the Nixon-Kissinger era, Egypt has served as the strategic cornerstone of U.S. policy in this volatile region. As the largest, militarily most powerful, and culturally most influential country in the Arab world, Egypt has disproportionate influence on the course of events there. And the Egyptian-U.S. alliance has been fundamentally important both to war and peace in the Middle East.
Egypt Spurs Jump in Developing Money-Market Rates
Money-market rates in developing nations are increasing at the fastest pace since 2008 as central banks from China to Brazil lift borrowing costs and banks hoard cash on concern unrest in Egypt may destabilize the Middle East.
Egyptian standoff: Mubarak stays, army won't oust him and people stand fast
debkafile's Middle East sources report that the Egyptian crisis looks like being in for a protracted period of uncertainty unless the army, which holds the key to breaking the deadlock, decided to step in and pick a side -Mubarak or the people. The generals alone have the clout to force Mubarak to step down and get out, as happened in Tunisia, or smash the street demonstrations. This would mean a massacre, the army's identification with a repressive regime and the end of its historic acceptance as the people's army. It will be noted that the new Vice President Gen. Omar Suleiman, 76, is seen more as a loyalist of the president, whom he served as intelligence minster and strong arm, than the military.
Israel 'anxiously monitoring' turmoil in Egypt
LA Times/Jan 30
The political upheaval could threaten the decades-old alliance between the neighbors, the cornerstone of Israel's regional strategy.
Arab Elite Say Monarchies Are Safe From Unrest
New York Times/Jan 30
The unrest engulfing Egypt caught business and political leaders at the World Economic Forum off guard, but it became the hottest topic among the Arab elite here... Few of the executives present expected a revolution to spread across the oil-rich nations of the Gulf, where the governments are monarchies, which often do not create the types of expectations that accompany a democracy. Rulers in these countries use their oil wealth to invest in social stability by ensuring that their own people lead comfortable lives through subsidies on things like electricity, education and food. “Saudi Arabia and the Gulf countries are going to be spared because they are not democratic regimes,” said Jamal Khashoggi, the general manager of Al Waleed 24 News Channel. People in those countries “don’t feel cheated because there are no elections,” he said.
January 29, 2011
BOOK BITS FOR SATURDAY: 1.29.2011
● Outrageous Fortunes: The Twelve Surprising Trends That Will Reshape the Global Economy
By Daniel Altman
Review via The Economist
Mr Altman writes with some verve, yet he makes only a partially convincing case in support of his predictions. He is best on purely economic ones. Thus he is surely right to argue that China’s seemingly inexorable growth will slow, though it is less clear that China may, like Japan before it, then slip back. He is also persuasive in maintaining that the rich world’s policies on immigration (taking in the brightest and best) and the environment (transferring polluting industries abroad) will damage the poorest countries.
● Moneymakers: The Wicked Lives and Surprising Adventures of Three Notorious Counterfeiters
By Ben Tarnoff
Review via The Wall Street Journal
As Ben Tarnoff tells us in "Moneymakers," his portrait of three American counterfeiters, Upham was probably not the first Union patriot to try this form of economic warfare; he certainly wasn't the last. An enterprising New Yorker, Winthrop E. Hilton, was soon selling his customers fake Confederate notes with a higher face value for less Union money—a sign that even counterfeit Confederate bills were depreciating rapidly. Upham conceived of his own venture as a form of souvenir vending. Perhaps it was, but the scale was immense: By his own estimate (offered a decade later), he produced bills with a total face value of $15 million. If all of them found their way to the Confederacy, then a whopping 3% of the South's circulating money was printed by one man in Philadelphia.
● The Great Stagnation: How America Ate All The Low-Hanging Fruit of Modern History,Got Sick, and Will (Eventually) Feel Better:A Penguin eSpecial from Dutton
By Tyler Cowen
Review via Yglesias
Tyler Cowen’s new ebook... is a bravura performance by one of the most interesting thinkers out there. I also think it’s a great innovation in current affairs publishing—much shorter and cheaper than a conventional book in a way that actually leaves you wanting to read more once you finish it. My guess is that this is the future of books. The argument is in many ways a continuation and expansion of Paul Krugman’s themes from The Age of Diminished Expectations, Third Edition: U.S. Economic Policy in the 1990s. Specifically, the argument is that growth has been slow for the past 30-40 years for fairly fundamental reasons related to a slowing rate of increase in basic science and that our politics has become dysfunctional insofar as it’s failed to adapt to those realities.
● Conquering the Divide: How to Use Economic Indicators to Catch Stock Market Trends
By James B. Cornehlsen and Michael J. Carr
Summary via publisher, W&A Publishing
Many writers focus on economy time series, but James B. Cornehlsen and Michael J. Carr are the first to outline a comprehensive, rigorously tested, easy to understand model. In Conquering The Divide, the authors provide documentation of their model’s validity. Using statistical verification, Cornehlsen and Carr don’t dumb down the economy; they lay out its signals and indicators.
● Probable Outcomes: Secular Stock Market Insights
By Ed Easterling
Summary via publisher,Cypress House
Probable Outcomes continues the Crestmont Research tradition of full-color charts and graphs that enable investors and advisors to differentiate between irrational hope and a rational view of the stock market. The unique combination of investment science and investment art explores the market from several perspectives, and addresses the implications for a broad range of investors. Ed Easterling delivers an insightful analysis of the likely course for the stock market over the 2010 decade. Investors and advisors will benefit from this timely outlook and its message of reasonable expectations and value-added investing. This essential resource provides a comprehensive understanding of the fundamental principles that drive the stock market. Based on years of research, Probable Outcomes offers sensible conclusions that will empower you to take action, guide your investment choices during the current period of below-average returns, and allow you to invest with confidence, whatever your financial strategy.
● The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States
By the Financial Crisis Inquiry Commission
Press release for report's release via Financial Crisis Inquiry Commission
Today the Financial Crisis Inquiry Commission delivered the results of its investigation into the causes of the financial and economic crisis. The Commission concluded that the crisis was avoidable and was caused by:
* Widespread failures in financial regulation, including the Federal Reserve’s failure to stem the
tide of toxic mortgages;
* Dramatic breakdowns in corporate governance including too many financial firms acting recklessly and taking on too much risk;
* An explosive mix of excessive borrowing and risk by households and Wall Street that put the financial system on a collision course with crisis;
* Key policy makers ill prepared for the crisis, lacking a full understanding of the financial system they oversaw;
* And systemic breaches in accountability and ethics at all levels.
January 28, 2011
RISING OIL PRICES: FUNDAMENTALS & GEOPOLITICAL RISK
Oil prices are climbing again. Since bottoming in late-2008, amid the depths of the financial crisis, crude has nearly doubled. Yet oil is still far below the record higher of $145/barrel reached in July 2008.
Even with today’s price spike to nearly $90, we’re a long way from the former peak. But triple-digit prices may be coming, advises a new report from Bernstein Research, and Mideast political turmoil is only part of the story.
“With confidence toward economic growth on the rise, industrial-linked commodities have soared in anticipation of tightening supply/demand dynamics, following several years of underinvestment,” Bernstein analyst Scott Gruber writes today in a report titled “Is There a Case for $125 Oil?” He goes on to opine that industrial commodities, much like gold, “should rise in an environment of currency debasement, as long as there is underlying economic growth to support demand.” Judging by recent market action, it's hard to argue. No wonder, then, that Gruber describes his thesis as “alive and well.” He continues:
No industrial commodity offers the depth and liquidity of the crude market. Thus, it is not surprising to see material funds flowing into crude futures, likely originating from both active and passive investors. Open interest on the NYMEX and ICE combined is up 16% year over year, and now eclipses the peak in 2008 by 17%
Fundamentals may fall short of bullish expectations, depending on what happens next with the global economy, but there’s also geopolitical risk to consider. In particular, the rioting in Egypt has clearly caught the attention of investors and speculators the world over. True, Egypt isn’t much of an oil producer to the world in terms of exports (it largely consumes what it produces), but the potential for cross-border reverberations in the oil-rich Middle East is considerable. It was political trouble in nearby Tunisia, after all, that seemed to spill over to Egypt. “If this can happen in Egypt, there is no reason that it can’t occur in Libya or Saudi Arabia,” John Kilduff, a partner at Again Capital LLC, an energy-focused hedge fund, tells Bloomberg.
"People are concerned that this could change the face of the Middle East, and no one knows what direction that might take,” opines oil analyst Phil Flynn of PFGBest Research Chicago via the LA Times. “Will it be liberal and democratic or will it be fundamentalist and Islamic?"
Fundamentals are critical in the long run for oil prices, of course, and that surely plays a role in the recent rise. But there's a new factor in town, albeit one that's no stranger to higher prices in the annals of energy markets: fear.
US ECONOMY GROWS 3.2% IN Q4:2010
U.S. economic growth picked up speed in last year’s fourth quarter, the Bureau of Economic Analysis reports. But the 3.2% pace of annualized real growth was below economists' 3.6% consensus forecast. Still, a 3.2% gain for GDP represents a substantial acceleration from the third quarter’s 2.6% rise.
Much of the increase in growth in last year’s three months is due to a higher rate of consumer spending, which represents more than two-thirds of GDP. Personal consumption expenditures rose by a real annualized 4.4% in Q4:2010, up sharply from 2.4% in Q3:2010. Notably, consumer spending in the cyclically sensitive durable goods sector rose by even more, surging 21.6% in 2010’s fourth quarter, well above the 7.6% pace in Q3. That's the biggest quarterly rise for durable goods spending in nine years.
“It’s a consumer-driven recovery,” says Burt White, chief investment officer at LPL Financial Corp, via Bloomberg. “People had been saying that the rebound in GDP was happening because of government spending and inventory build-up. Today’s numbers show that inventory isn’t the key to drive economic growth. It’s a self-sustaining recovery. That’s a positive for both consumer and investors’ sentiment.”
Perhaps, but some economists still worry that the pace isn’t strong enough to create enough new jobs to cure the elevated rolls of jobless in the U.S. "Unfortunately we still need to see much stronger growth to begin to really make a dent in the unemployment rate," says Ryan Sweet at Moody's Analytics via BBC News. "Right now we are just barely creating enough jobs to stabilize the unemployment rate."
GDP for all of 2010 rose 2.9%, based on today's advance estimate for Q4, which will be revised in the months ahead. Assuming last year's 2.9% GDP gain holds, 2010's economy expanded at the highest rate since the 3.1% rise for 2005.
Update: The original headline for this post mistakenly quoted a 3.6% GDP increase; in fact, the rise was 3.2%.
STRATEGIC BRIEFING | 1.28.2011 | DEFICITS & ECONOMIC GROWTH
Fiscal Monitor Update: Strengthening Fiscal Credibility
The pace of fiscal consolidation in 2011 is now projected to be slower on average, and more varied across countries. The overall pace of deficit reduction in advanced economies in 2011 will be below earlier estimates. On average, fiscal consolidation among the advanced G20, measured in cyclically adjusted terms, is now projected to equal less than ¼ percent of GDP compared to the 1 percent of GDP projected in November. Their debt ratio is anticipated to rise by almost 5 percentage points, to exceed 107 percent of GDP.
A Two-Track Plan to Restore Growth
John Taylor (University of Stanford)/Wall Street Journal/Jan 28
The best way to reduce unemployment is to restore sound fiscal and monetary policies. There are some welcome signs that the policy pendulum has begun to swing back in that direction. The recent election revealed deep concern about high debt, deficits and spending. Three-fourths of business economists and one-half of academic economists say that easy monetary policy exacerbated the housing boom and bust that led to the financial crisis. Reactions to a second round of quantitative easing have been negative at home and abroad. The very word "stimulus" is now avoided by former proponents of spending stimulus. The recent agreement to extend existing income tax rates represents a shift to more predictable policies.
Conrad eyes alternate path for deficit reduction
One day after budget forecasters projected a record $1.5 trillion deficit for this fiscal year, Democratic Senator Kent Conrad said he might use his post as Budget Committee chairman to force his colleagues to confront the country's grim fiscal picture. "Who else is going to do it? That's the frustration," Conrad told reporters after a budget hearing.
CBO chief: Deficit problem really comes down to health care costs
The day after the Congressional Budget Office released its new estimate of a $1.5 trillion budget deficit for this fiscal year, CBO chief Douglas Elmendorf told the Senate Budget Committee that health care is the biggest driver of the budget problem.
CBO Director: Trillion-Dollar Deficits Risk 'Fiscal Crisis' in U.S.
Fox News/Jan 27
The top numbers cruncher for Congress warned Thursday that the federal government increasingly risks sending the country into a "fiscal crisis," projecting that unless cuts are made, within a decade the national debt could reach nearly 100 percent of all annual economic activity.
The New Republic/Jan 28
Memo to Republicans: You’re rightly critical of George W. Bush’s fiscal performance. But there is no evidence—none—that you can get the deficit and debt under control with your preferred combination of spending cuts and tax cuts. Have you noticed that Paul Ryan’s famous Roadmap allows the national debt to reach 100 percent of GDP? Do you care about facts?
Memo to Democrats: Denouncing the proposal offered by the president’s [deficit] commission as a “cat food” budget for the elderly is a political talking-point, not a serious argument. Is Dick Durbin no longer liberal enough for you? Have you forgotten that fiscal restraint and full employment were partners, not adversaries, little more than a decade ago?
Memo to Obama: During your 2008 campaign, you said that the president has to be able to walk and chew gum at the same time. You were absolutely right. You can talk, as you should, about vital public investments and take the lead, as you must, to head off a fiscal train wreck.
Should Congress Raise the Debt Ceiling?
Ludwig von Mises Institute/Jan 27
Perhaps the strongest argument for not raising the debt ceiling is that the United States is bound to default — whether explicitly by reneging on payments, or implicitly by massive inflation — at some point anyway in the next decade or two. The government's own projections show the debt quickly rising to alarming levels under certain assumptions, and none of their models deals with the possibility of a continued depression and a collapsing dollar. As others have noted, a firm debt ceiling would be a "balanced-budget amendment with teeth." Politicians notoriously cannot recommend particular budget cuts for fear of alienating powerful interest groups. But if the newly elected budget "hawks" really wanted to impress us, they could refuse to raise the debt ceiling. Then they and their colleagues would have no choice but to start slashing.
Fiscal Adjustment and the Costs of Public Debt Service: Evidence from OECD Countries
Christoph A. Schaltegger (University of St. Gallen) and Martin Weder (University of Lucerne)/Center for Economic Studies/Dec 2010
...historically, governments have employed different fiscal adjustment strategies when confronted with high deficits and rising debt. Accordingly, these measures not only differ in duration, size and composition, but also in their success. Controlling for various economic, fiscal and political factors, we find that the size and the composition of a fiscal adjustment significantly affect long-term interest rates as well as yield spreads. Large adjustments and those that mainly depend on expenditure cuts lead to substantially lower interest rates. On the other hand, a budget consolidation that predominantly relied on tax increases, or on modest and gradual measures – even it was successful and led to lower deficits and debt levels – did not have an influence on interest rates. These results are significant and are robust to a variety of specifications and alternative models. We thus conclude that financial markets only seem to value strict and decisive measures. Therefore, expenditure cuts are a clear sign that the government’s pledge to cut the deficit is credible.
The U.S. Fiscal Imbalance and the Challenge for Tax Policy
Tax Policy Center/Jan 27
Three related issues dominate budget talk in Washington these days: eliminating the deficit, cutting spending, and reforming the tax system. Achieving the first will require accepting painful doses of the second and designing the third so we raise more revenue. No easy tasks there. The difficulty shows clearly in a graph I prepared for a recent talk for the Tax Section of the American Bar Association (slides are available here) . The graph plots spending and revenues using the latest budget estimates from the Congressional Budget Office. Balancing the budget means getting to the dark blue 45-degree line where spending matches revenues. The further northwest of the line, the bigger the deficit.
For most of the past four decades, the federal budget has been above that line. Spending has averaged just under 21 percent of gross domestic product (GDP), well above the 18 percent average for revenues. Only for a few years, from 1998-2001, have revenues fully paid the government’s bills—those four lonely dots below the diagonal line. And the last few years have found us well above the balanced budget line with deficits around 9 percent of GDP. Those huge recent deficits result mainly from reduced tax revenues due to the economic collapse and counter-cyclical policies on both the spending and the tax side.
January 27, 2011
DURABLE GOODS ORDERS RETREAT IN DECEMBER
New orders for durable goods dropped by 2.5% last month, the third monthly decline in a row. Excluding the volatile transportation sector, however, new orders rose slightly in December.
Fortunately, the broad trend is still encouraging. On a rolling 12-month basis, durable goods orders are still comfortably in positive territory, as the chart below shows. Yes, the trend is slowing, but that's not surprising. The huge year-over-year gains in the recent past were destined to fall. But with today’s news that jobless claims surged last week, the onus turns to a familiar challenge: job creation.
"The December report presented evidence of slowing in both U.S. business investment and manufacturing activity," says Cliff Waldman, economist for the Manufacturers Alliance/MAPI, via Industry Week. "Recent signs of stronger consumer demand are encouraging for U.S. economic growth prospects but significant risks remain in labor markets, housing, and state and local finances."
The question is whether the downshift in durable goods orders and the uptick in jobless claims is a prelude to the update on January payrolls scheduled for next Friday (Feb. 4).
JOBLESS CLAIMS SURGE… DUE TO SNOW?
New jobless claims rose sharply last week, surging 51,000 to 454,000 on a seasonally adjusted basis, the Labor Department reports. New filings for unemployment benefits are now at the highest since last October. Is it time to rethink the economic revival that appeared to be chugging along anew in recent months?
The four-week moving average of new claims is drifting higher now too, suggesting that there’s more than weekly volatility at work here. It may all prove to be temporary, of course. This series is known for whipsawing the audience. Nonetheless, it’s getting harder to ignore the lack of continued progress in jobless claims.
But maybe there's less risk than it appears. Reuters reports that the jump in new claims was partly due to snow. "I'll buy that it can be blamed on the weather," says Peter Tuz of Chase Investment Counsel. "But it does show that the recovery is growing in fits and starts."
Meanwhile, Dow Jones advises:
A Labor Department analyst said seasonal factors, particularly bad weather, likely distorted the latest numbers. Alabama, Georgia, North Carolina and South Carolina all reported a higher than expected increase in claims because of snow, he said.
"I'm fairly certain the data was distorted," the analyst said. Snow can lead to higher jobless claims because schools are closed, delivery trucks can't run and construction stalls.
If nothing else, there's one more reason to cheer on the arrival of spring. Unfortunately, it's still January.
INFLATION: CAN IT HAPPEN HERE?
The Fed announced that it would continue purchasing Treasuries for its second round of quantitative easing (QE2). The news wasn't a surprise, but yesterday's FOMC statement triggered fresh talk about inflation. But if there's a higher risk, it's not showing up in the implied forecast via the yield spread on nominal less inflation-indexed 10-year Treasuries.
As of yesterday, the market's inflation outlook is 2.29%, or roughly in the range of the past month. The low-2% forecast is in line with the market's prediction that prevailed before the autumn financial crisis of 2008 ushered in a deflation scare. The low-2% prediction is also the level of last spring, just ahead of the summer anxiety that spread fear that a new recession was brewing. But thanks in part to expectations that the central bank would stabilize inflation expectations via QE2, the outlook for prices has rebounded to what some might call "normal" altitutdes.
That doesn't appease critics, who worry that inflation pressures are building. Exhibit A in this view is the rise in commodity prices overall. The iPath Dow Jones-UBS Commodity ETN (DJP), for instance, a proxy for a broad mix of raw materials prices, has been climbing steadily since last summer.
Meanwhile, the yield curve has recently steepened. As Bloomberg reports,
The difference in yield between 2- and 30-year Treasuries widened for the first time in four days on concern inflation expectations may be on the rise due to prolonged monetary accommodation. It reached 3.96 percentage points.
“The longer part of the curve is moving up, suggesting that people may be rethinking inflation expectations and whether the Fed overshoots on its inflation target, given their monetary stance,” said Christopher Sullivan, who oversees $1.6 billion as chief investment officer at United Nations Federal Credit Union in New York.
Rising commodity prices, assuming they continue to rise, could force the Fed to moderate or even end QE2. But not yet. Unemployment remains stuck at elevated levels (9%-plus) and job growth is still sluggish. Until there are signs of improvement in the labor market, the Fed isn't likely to rethink the current path of monetary policy.
The next big opportunity for changing the crowd's sentiment on jobs arrives next week (Feb. 4), with the update on nonfarm payrolls. The last employment report revealed a modest pace in job growth. Will the next one bring better news? Perhaps, as a new survey of economists advises: "Employers will hire more workers this year, and the economy will grow faster than envisioned three months ago, according to an Associated Press survey that found growing optimism among leading economists."
But there's plenty of skepticism about the future path for employment. That includes the new Budget and Economic Outlook released yesterday by the Congressional Budget Office. The CBO's current projection for the labor market is tepid, at best. Unemployment will fall only slightly, to 9.2% by the fourth quarter of this year, CBO predicts. By the end of 2012, the jobless rate will drop only to 8.2%, the report continues.
Do economists know something that CBO policymakers don't? Until we receive more clarity on an answer, the Fed's going to have plenty of cover for keeping interest rates low. Whether that fuels inflation is debatable. Meantime, the risk of stagflation hangs in the balance. That risk may be descending on Britain. The question du jour: Can it happen here?
January 26, 2011
IT WAS A VERY GOOD DECADE… FOR GOLD
Asset classes don’t usually post gains in each and every calendar year in a given decade, but sometimes the exception is the rule. That was certainly the case for gold. As a new report from the World Gold Council reminds, everyone’s favorite precious metal had a very good decade through the close of 2010.
Gold’s price, the Council notes, “rose for the tenth consecutive year driven by a recovery in key sectors of demand and continued global economic uncertainty. Not only was gold’s performance strong, but its volatility remained low, providing a foundation for a well diversified portfolio.”
US GDP FORECASTS
The first estimate of 2010's fourth-quarter GDP for the U.S. arrives on Friday and the consensus forecast is expecting the Bureau of Economic Analysis will report a 3.7% real annualized increase. Assuming the guess is accurate, that would be a robust acceleration from the 2.6% rate posted for last year's Q3. A 3.7% gain for Q4:2010 would also be the best pace since last year's first quarter, which coincidentally logged a 3.7% increase.
The optimism may look excessive to some, but the IMF is thinking positively these days too, if only marginally. The International Monetary Fund's new forecast of world economic growth released yesterday sees global GDP higher by 4.4% this year, up slightly from a 4.2% prediction last October. A fair amount of the improvement comes from the IMF's upgraded outlook for U.S. GDP for 2011: 3.0% growth, which is comfortably higher than the 2.3% gain the IMF expected previously.
The upward revision for world GDP "reflects stronger-than expected activity in the second half of 2010 as well as new policy initiatives in the United States that will boost activity this year," the IMF advises.
Earlier this month, The Beta Investment Report reviewed recent forecasts of U.S. GDP estimates for 2011. The guesses ranged from 1.8% to 4.0%, as detailed in the table below.
Update: The original version of this post erroneously cited Q3:2010 GDP growth at 2.7%. In fact, GDP rose 2.6% in Q3.
DECONSTRUCTING THE ECONOMIC CYCLE...AGAIN
Have we solved the mystery of the business cycle yet? It may be tempting to answer "yes" after tomorrow's release of the Financial Crisis Inquiry Commission's final report on the causes that gave us the financial and economic crisis of 2008.
Weighing in at nearly 600 pages, the report will have lots of finger pointing on what went wrong. Much of what will be discussed is sure to hit home in terms of mistakes. From failures of markets to ill-conceived regulations, there's plenty of blame to go around. That implies that progress is coming. After all, if the mistakes are clear for all to see, there's no reason to keep banging our heads against the wall. Sounds good, but there's just one small problem: we're talking of economics and finance, and therein lies the problem.
No one confuses money and the dismal science with aerospace engineering or plumbing. Obvious fixes aren't all they're cracked up to be in economics. That doesn't mean we shouldn't try to learn from the past. But expecting real progress that solves the problem of macro volatility once and for all is expecting too much.
“The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire,” according to the report, as cited by The New York Times, which obtained an advance copy. “The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand and manage evolving risks within a system essential to the well-being of the American public. Theirs was a big miss, not a stumble.”
Of course, you could say that was true of every financial and economic crisis in history, of which there are many. Tomorrow's report surely deserves careful analysis in an effort to right the wrongs. But the one thing this report won't do—can't do—is tell us how to avoid the next recession. Here's a prediction: There will be a new recession. Probably not this year, or even next. But another downturn is coming. Timing is always unknown, as is the depth and duration. But it's coming.
The business cycle is a resilient beast, and it keeps biting. That doesn’t deter economists, who endeavor to figure out why economies stumble. New studies are written, innovative theories are proposed, and armies of researchers slice and dice the data with great precision, focusing the collective intellect on solving one of society’s greatest challenges. It’s easy to see this as a quixotic pursuit. The recessions keep coming, and there’s no reason to expect the future will be any different.
What nefarious forces conspire to keep recessions alive and kicking on an irregular but otherwise recurring basis? The post mortems usually turn up lots of insight, creating the raw material for thinking that the enigma of the business cycle has finally been exposed. The trouble started here, migrated over there, and before you knew it—wham! The boom turned to bust. It’s always clear what should have been done to prevent the last downturn. But they keep coming anyway. Is that evidence that economics has failed? Or is the political will simply lacking to apply the lessons that economists have discovered? Or maybe human nature is such that it’s beyond our capacity for making tough choices today in exchange for sidestepping problems tomorrow? Are recessions simply inevitable?
There are lots of theories, but there’s only partial confidence that any one understands the full, unvarnished truth. Skepticism that greets the diagnosis du jour surely is well founded. Economists have been advancing theories on why economies rise and fall for as long as there have been economists. But the track record is littered with abandoned notions, some of which age with no more dignity than a list of political promises.
Will this time (or more properly, next time) be any different? Don't count on it. A more reasonable expectation is that we'll learn how not to exacerbate recessions by turning garden variety downturns into macro catastrophes. Many thought that lesson had been learned after the 1930s. Apparently not. The best laid plans of mice and men, policy analysts and economists.
If the past is any guide to the future on such matters, what we do know is that the stock market is likely to peak ahead of the official start of the next recession. That was certainly true the last time around. We may also see short rates rise above long rates. The so-called inversion of the yield curve has a history of preceding recessions. There are some other warning signs as well.
But perhaps the main thing we know about the business cycle is that it's a hardy perennial, and nothing in tomorrow's report from the Financial Crisis Inquiry Commission will change that sobering fact.
January 25, 2011
TONIGHT'S STATE OF THE UNION SPEECH, ECONOMICS & POLITICS
President Obama delivers the State of the Union address tonight and the economy, of course, will be the topic du jour. Considering the venue, no one will be surprised to learn that a heavy dose of politics will be part of the mix. Here’s a sampling of the chatter on the intersection of the dismal science and Washington's favorite sport as it relates to tonight’s show…
Obama State of the Union: spending, but restraint
Eager to show some budget toughness, President Barack Obama will use his State of the Union address to call for a five-year freeze on all discretionary government spending outside of national security, the White House said Tuesday.
Obama to Call for Nonsecurity Spending Freeze
Wall Street Journal/Jan 25
President Barack Obama will call for a five-year freeze on nonsecurity discretionary spending in his State of the Union address Tuesday night "as a down payment toward reducing the deficit," a White House official said.
House endorses budget cuts before Obama's speech
USA Today/Jan 25
Just hours before President Obama delivers his State of the Union Address, the GOP-led House easily endorsed cutting the federal budget to 2008 levels or less... The 256-165 vote was aimed at getting Democrats to go on record about federal spending, a key issue in the 2010 election that helped Republicans take the House majority.
GOP to hit Obama hard on economy
Rep. Paul Ryan, the Republican Party's resident budget wonk, is expected to take the Obama administration to task Tuesday night for its handling of the economy and budget. Ryan, a 40-year-old Wisconsin native, will deliver the Republican response to President Obama's State of the Union address. He will focus on unemployment, the debt and what the GOP terms a Washington spending binge that is hampering private sector growth, according to a senior Republican congressional source. "Ryan will make clear that in order to boost private-sector job creation we must cut spending," the source said.
What to expect from Obama tonight on the economy
The Lookout/Jan 25
In what could be a difficult balancing act, Obama also will stress the need for deficit reduction -- but he isn't likely to offer many specifics. The White House has said that he won't endorse a proposal by his commission on debt reduction to raise the retirement age or make other cuts to Social Security. A plan released last year by Wisconsin GOP Rep. Paul Ryan, who will give the Republican response to Obama's speech, would make major cuts to Social Security.
Will Obama Call for Cutting the Corporate Rate in SOTU?
Tax Policy Foundation/Jan 25
In a recent preview of the State of the Union address emailed to supporters, President Obama said his number one focus "is going to be making sure that we are competitive, that we are growing, and we are creating jobs not just now but well into the future." While these are sure to be popular themes with the American public, the question is what policies will he put forward to achieve those goals?
Goolsbee Says Obama to Focus on Economy in His Speech
President Barack Obama would consider lowering corporate taxes as one of a variety of proposals intended to boost the economy, Austan Goolsbee, chairman of the U.S. Council of Economic Advisers, said today.
Reality Checks: 10 Economic Benchmarks for the State of the Union and GOP Response
Huffington Post/Jan 25
1. The federal government isn't a runaway fiscal monster.
You'll probably hear Rep. Ryan say that the United States government is relentlessly devouring everything in its past, consuming an ever-greater portion of our national prosperity. The president may even echo this notion, in a milder way. But it ain't so.
Rape of the Union: Corporate Profits and Lost Jobs
Atlantic Wire/Jan 25
Looking ahead to tonight's economically-themed State of the Union address from Barack Obama, one encounters conflicting numbers. In some significant ways, the US economy has appeared to recover, returning to non-recession levels in many measurements, and exhibiting growth as well. Corporate profits have soared, with major corporations and businesses posting their highest third quarter ever in fall of 2010 and increasing their share of the total economic output at the same time. Halliburton--can't forget about them--just reported the doubling of their profits. What's all this downer talk about a recession anyway? Yet for most of the country, the economy seems to be in more of a hobble than a gallop, with unemployment--one of the more palpable measurements of economic viability--still above 9 percent, more than double the roughly 4 percent joblessness in 2000.
The Economic State of the Nation Is Not Good
The Brookings Institution/Jan 24
The economic state of the nation is not good. The President will surely address this fact in his State of the Union address. Unfortunately he faces three big impediments which limit the actions he can take: political opposition, the budget, and the limited tools available to any President. He faces a dragon but lacks a sword.
MARKET FOCUS | 1.25.2011 | LARGE CAPS VS. SMALL CAPS
Large-cap stocks will outperform small caps over the medium to long term, BNY Mellon Beta Management predicts. "Looking at the differential between the expected returns of large cap and small cap stocks, it appears that large caps have a good chance of outperforming small stocks over the next decade," Mark Keleher, CEO at the company, says in a press release today.
The future is always dicey, of course, but the past is forever clear. Reading BNY’s outlook inspires a fresh look at where we stand with small- and large-cap stocks in the U.S. Using the Russell 1000 as a proxy for large caps, and Russell 2000 for small caps, let’s start with a summary of returns through yesterday, courtesy of Russell.com:
Static performance updates don’t reveal much, however, and so we need to look a bit deeper. A review of rolling 3-year annualized total returns for small- and large caps offers a bit more insight. For example, small-cap returns have recently been accelerating relative to large caps, based on trailing 3-year data. The chart below runs through the end of 2010, and the trend of late suggests that small cap performance has a head of steam.
Is this a good time to overweight small caps? Or have we missed the boat for the time being? In search of an answer, we might consider how momentum between the two equity slices compare in terms of recent prices relative to their respective 50- and 200-day moving averages. Using the iShares Russell 1000 ETF (IWB) as a proxy for large caps, it looks like the bulls are still in command when the blue chips.
The technical picture looks a bit less robust for smaller firms, based on the iShares Russell 2000 ETF (IWM). As the next chart below shows, IWM has been fading in recent days. It may nothing more than short-term trading noise. Nonetheless, IWM has recently fallen to just above its 50-day moving average, an intermediate support level. That's a warning sign, particularly if prices drop below this mark.
For another perspective, consider the return spread between the Russell 1000 and Russell 2000 on a rolling 3-year basis, as shown in the next chart below. Clearly, the small-cap edge has been alive and kicking recently. At the end of last year, the small-cap premium amounted to 360 basis points relative to large caps. That’s still modest compared with the heights that small caps climbed on a relative basis in recent years.
Finally, let’s compare the fundamentals, courtesy of data from Standard & Poor’s:
Small-caps don’t appear particularly cheap vs. large caps. Of course, everyone knows that history delivered a small-cap premium over the long run, and so it’s not surprising to see that the crowd values small caps at a higher level. Then again, one might wonder if the small-cap premium already priced into these stocks for the moment. The numbers in the table above suggest as much. Perhaps the folks at BNY have a point in projecting better days ahead for large caps.
RISK ANALYSIS @ WORLD ECONOMIC FORUM
The annual World Economic Forum is set to begin, but already there's a sea of reports and commentary flowing from the confab in Davos. One of the highlights is Global Risks 2011 Sixth Edition. As a preview, here are some excerpts from the report:
A Risky World…
"The world is in no position to face major, new shocks. The financial crisis has reduced global economic resilience, while increasing geopolitical tension and heightened social concerns suggest that both governments and societies are less able than ever to cope with global challenges. Yet, as this report shows, we face ever-greater concerns regarding global risks, the prospect of rapid contagion through increasingly connected systems and the threat of disastrous impacts. In this context, Global Risks 2011, Sixth Edition reveals insights stemming from an unparalleled effort on the part of the World Economic Forum to analyse the global risk landscape in the coming decade."
Two Big Risks…
"Economic disparity and global governance failures emerged from the Forum’s Global Risks Survey 2010 as the two most highly connected risks and were perceived as both very likely and of high impact… They influence the context in which global risks evolve and occur in two critical ways: first, they can exacerbate both the likelihood and impact of other risks; second, they can inhibit effective risk response."
Five risks to watch…
"Five risks have been designated as 'risks to watch', as survey respondents assessed them with high levels of variance and low levels of confidence while experts consider they may have severe, unexpected or underappreciated consequences:
• Cyber-security issues ranging from the growing prevalence of cyber theft to the little-understood possibility of all-out cyber warfare
• Demographic challenges adding to fiscal pressures in advanced economies and creating
severe risks to social stability in emerging economies
• Resource security issues causing extreme volatility and sustained increases over the long run in energy and commodity prices, if supply is no longer able to keep up with demand
• Retrenchment from globalization through populist responses to economic disparities, if emerging economies do not take up a leadership role
• Weapons of mass destruction, especially the possibility of renewed nuclear proliferation
Red Ink Risk…
"There is a high degree of risk and uncertainty regarding how much debt can be borne by the public sector, particularly in advanced economies, before the debt burden seriously impacts economic growth through increasing borrowing costs, politically unacceptable amortization payments, and the subsequent need for fiscal austerity."
"Lack of agreement on how to reduce global imbalances makes it difficult to create joint responsibility at the international level. Diverging interests in the short-term are driven by both political and economic factors. While advanced economies see continuing imbalances as economically unsustainable, emerging economies running trade surpluses fear that adjustments involving currency appreciation would hurt employment in export sectors and potentially threaten social stability. Political leaders in advanced economies are under increasing pressure to seek short-term solutions – but uncoordinated actions, such as simultaneous currency depreciation by multiple countries, could create new risks. For all countries to attempt to devalue their currencies at the same time would only have negative impacts.
January 24, 2011
ARE STOCKS STILL CHEAP ON A GLOBAL BASIS?
Yes, according to a new report from Morgan Stanley Smith Barney's global investment committee. "Despite the recent rally, global equities are still priced at a forward P/E ratio of 13, at the lower end of their 40-year historical range," advises the committee's latest monthly update (Jan 2011) for clients.
The report also notes: "The global equity dividend yield is also high, as compared with its history versus sovereign bond yields and cash (see Chart 4). As a result, we consider global equities to be attractively valued in absolute and relative terms."
GLOBAL CHATTER ABOUT INTEREST RATES
European Central Bank head Jean-Claude Trichet tells The Wall Street Journal that higher interest rates may be near. He’s not alone when it comes to considering a tighter monetary policy.
The Reserve Bank of India may be close to hiking rates as well, according to The Economic Times. There are also signs that the Bank of England is in the same monetary boat. China too has been tightening lately and the country may be heading for another round. Speaking of hikes, Hungary's central bank announced one today.
The common catalyst: worries of higher inflation. Or, as Trichet says via the Journal today: "All central banks, in periods like this where you have inflationary threats that are coming from commodities, have to…be very careful that there are no second-round effects" [on domestic prices].
In the U.S., official inflation measures are still quite low by historical standards, as shown by rolling one-year percentage changes in headline and core consumer price indices in the chart below. But nothing lasts forever, even if it's tempting to think that low rates are here to stay.
“By the middle of the year, the economic momentum will be building, and all the hawks are going to be crazy about tightening," says Larry Meyers, a former Fed governor who now heads up Macroeconomic Advisers.
Perhaps, but there's still no sign of inflation worries in the Treasury market. The implied inflation forecast, based on the yield spread between the nominal and inflation-indexed 10-year Treasuries, for instance, is in the low-2% range, or roughly where it's been since late last year.
NABE SURVEY: BRIGHTER OUTLOOK FOR GROWTH & JOBS
The outlook for economic growth has "improved significantly," according to a survey of economists released today by the National Association for Business Economics. Expectations for employment are also brighter, NABE’s poll shows.
"Employment at respondents’ firms improved significantly in the fourth quarter of 2010, with the employment NRI [net rising index] rising to 28, a 10-point increase over the prior quarter," the survey reports (see chart below). "This is the highest level for the employment NRI since 1998, and the percent of respondents indicating rising employment at their firms (34%) is slightly higher than the prerecession average. This is quite a turnaround from the January 2010 survey, in which the hiring momentum was decidedly negative (-15 NRI)."
Of the 84 private economists surveyed by NABE, 42% said that employment at their respective firms would increase over the next six months. That’s up from 39% in October and 29% a year ago.
Expectations are one thing; hard numbers are something else. The next opportunity for statistical confirmation (or rejection) in today’s NABE survey arrives later this week, with Thursday’s weekly update of initial jobless claims. Based on the consensus forecast (as per Briefing.com), corroboration of the cheery outlook will have to wait. New filings for jobless benefits are predicted to rise slightly to 410,000 (seasonally adjusted) vs. last week’s 404,000. That's hardly a tragedy, assuming it proves accurate, but anything north of 400,000 claims fuels worries that the labor market is still struggling.
But there's always another number waiting in the wings if the stat du jour doesn't suffice. Next week is scheduled to deliver two employment reports. First up is ADP’s estimate for January payrolls (Wed., Feb. 2), followed in two days by the Labor Department’s report on jobs (Friday, Feb. 4).
Stronger job growth, of course, is exactly what’s lacking at the moment, or so December’s jobs report suggests. Will January offer better news? Even if it does, there are still plenty of challenges to solve, including two rather large weights on the economy's neck: housing and lending to corporate America.
A NEW LEADER IN THE EMERGING MARKET ETF SPACE
Vanguard Emerging Market (VWO) is now the largest ETF in the emerging market equities category measured by portfolio assets. The fund held $46.2 billion last week, according to Bloomberg, just ahead of the long-time leader iShares MSCI Emerging Markets (EEM). Both ETFs track the same index: MSCI Emerging Markets.
The rise of VWO is intriguing for several reasons. One is that EEM has been considered the market leader by virtue of its earlier launch in 2003 vs. 2005 for VWO. The first-mover advantage is considered a powerful force in the ETF marketplace, or at least it was until VWO displaced assumed the throne.
But ETF rankings are multi-faceted when it comes to practical considerations. VWO may have more assets, but EEM still has the edge by far in terms of liquidity. Average daily volume for EEM is nearly 60 million shares, several fold higher than VWO's 16 million daily average over the past three months, according to Yahoo Finance. For traders, EEM is still likely to be the first choice.
But there's another difference between the two funds, and one that may explain the Vanguard portfolio's rise: VWO's expense ratio of 0.27% is a good deal lower than EEM's 0.69%. Expense ratios don't mean much in the short run, but over time the differences add up. Maybe that's why the less-costly VWO's trailing 5-year annualized total return through Friday is 10.77%, comfortably above EEM's 10.27% rise over that span, according to Morningstar.com (based on market price returns).
No one should choose ETFs based solely on expense ratio, but cost is a key factor for strategic-minded investors. All the more so if there's a relatively wide difference in otherwise comparable funds.
Within the equity space, the spread between the expense ratios for VWO and EEM is quite wide for what usually prevails among the leading ETF choices within a given niche. Among broad U.S. equity ETFs, for example, there are at least seven worthy candidates with expense ratios ranging from 0.06%--Schwab U.S. Market (SCHB)—to several funds charging 0.20%, including iShares Russell 3000 (IWV).
A lower expense ratio is an obvious plus, but investors should consider a range of factors, including liquidity, the ETF's benchmark, and the outlook for the product's viability, for instance. Indeed, a number of lesser ETFs closed last year. In some cases, the shuttered funds were the low-cost leader.
Another factor is how you plan on using the ETF. Will you be day trading? Or is the fund a core holding that will sit in your portfolio for years?
In the grand scheme of investing in the context of a multi-asset class portfolio, small differences in expense ratios probably won't make a big difference in net results. There's a stronger case for spending time on asset allocation design and management. Even so, expenses can't be ignored, especially when they're relatively high and strong alternatives exist.
That caveat applies to EEM. Now that VWO has more assets, it'll be interesting to see if Blackrock lowers EEM's expense ratio to stay competitive. Comparing ETFs in other sectors suggests no less. It's hard to rationalize charging more than twice as much for essentially the same product.
The ETF industry is now a commodity business when it comes to replicating betas for broadly defined asset classes. Not every investment firm recognizes this fact...yet.
January 22, 2011
BOOK BITS FOR SATURDAY: 1.22.2011
● The Triumph of Value Investing: Smart Money Tactics for the Postrecession Era
By Janet Lowe
Author interview with US News & World Report
Q: After the market turmoil at the beginning and end of the last decade, many investors appeared to give up on the value of value investing and stocks in general, preferring bonds and commodities instead. Do you believe there are ever multi-year periods when value investing doesn't work?
A: No, I don't, because value investing, if you follow it, you would have been a little better prepared. Of course it was such a massive event that hardly anyone escaped unscathed, but value investors overall did better. And then an event like this is a great opportunity for value investors to buy what they need and ride the market higher. Even in my own experience with my own portfolio, I came back faster than most people in the economy.
● Bust: Greece, the Euro and the Sovereign Debt Crisis
By Matthew Lynn
Review via International Business Times
Since the eruption of the Greek debt crisis, many have declared the failure of the euro currency experiment. Matthew Lynn, a business writer, gives a detailed explanation of this failure in his book Bust: Greece, the Euro and the Sovereign Debt Crisis. First, it was indeed an experiment. "No one has tried to merge the currency of 17 nations before," said Lynn. Moreover, the experiment is more of political rather than an economic undertaking. This is problematic because highly impactful economic policies -- like the introduction of the euro currency -- were not made primarily out of economic considerations.
● Why the World Economy Needs a Financial Crash and Other Critical Essays on Finance and Financial Economics (Anthem Studies in Development and Globalization)
By Jan Toporowski
Summary via publisher, Anthem Press
These essays explain why financial crisis breaks out, its social, economic and cultural consequences, and the limitations of policy in the face of economic stagnation induced by financial inflation... The essays in this volume explain how financial inflation shifts banking and financial markets towards more speculative activity, changing the financial structure of the economy and corroding the social and political values that underlie welfare state capitalism. The essays begin with an article that was published in the 'Financial Times' that highlights the problems of excess debt, which emerges when financial inflation exceeds the rate at which prices and incomes are rising.
● Scarcity and Frontiers: How Economies Have Developed Through Natural Resource Exploitation
By Edward B. Barbier
Excerpt via publisher, Cambridge University Press
The difference in public attitudes between the American crowd listening to President Wilson in 1913 and the French electorate in 2009 illustrates that much has changed over the past hundred years in how we view the role of natural resources in economic development. In Wilson’s day, associating “natural resource abundance with national industrial strength” was the norm. Today, we no longer believe that this association holds. Instead, we see our economies and societies potentially threatened by a wide variety of constraints caused by natural resource scarcity. Such problems range from concerns over the cost and availability of key natural resources, including fossil fuel supplies, fisheries, arable land and water, to the environmental consequences of increasing global resource use, degradation of key ecosystems, such as coral reefs, tropical forests, freshwater systems, mangroves and marine environments, and the rising carbon dependency of the world economy. Contemporary unease over natural resource scarcity, energy insecurity, global warming and other environmental consequences is to be expected, given the rapid rate of environmental change caused by the global economy and human populations over the twentieth century.
At the beginning of the twenty-first century, therefore, we are more accustomed to viewing “the exceeding bounty of nature” to be running out, rather than providing unlimited supplies for “our genius for enterprise.”
● The Elgar Companion to Hyman Minsky
Edited by Dimitri B. Papadimitriou and L. Randall Wray
Summary via publisher, Edward Elgar Publishing
This Companion provides a timely and engaging treatment of Hyman Minsky’s approach to economics, which is enjoying a renewed appreciation because of its prescient analysis of the slow but sure transformation of the capitalist economy in the post-war period. Many have called the global financial crisis that began in the United States in 2007 a ‘Minsky crisis’, and these collected contributions demonstrate precisely why both academic economists as well as policymakers have turned to Minsky for guidance. The book brings together the foremost Minsky scholars to provide a comprehensive overview of his approach, with extensions to bring the analysis up to date.
January 21, 2011
I'll be speaking at IMN's 2nd Annual World Series of ETFs & Indexing in Boston on March 29. I'm a panelist on the "Enhancing the asset allocation process" seminar." Details and the full agenda for the conference are available here.
STRATEGIC BRIEFING | 1.21.2011 | CRUDE OIL
OPEC Pressured as African, Asian Oil Tops $100: Energy Markets
Bloomberg, Jan 20
OPEC is facing growing calls to boost oil production as crude prices in Asia and Africa surpass $100 a barrel for the first time in two years.
Bernstein Energy: Conference Call Transcript - Key Themes or 2011 and Bernstein's Best Ideas
Bernstein Research, Jan 21
As we start 2011 we see a number of key themes that can help drive higher earnings in the energy sector over the next few years. On the oil price, we see improving economic data driving oil demand ahead of consensus expectations. Combined with limited supply increases, this should lead to reduced spare capacity and a rising oil price out to 2015, when we expect to see $130 oil.
BP releases Energy Outlook 2030, sees greater dependence on OPEC for oil supply
Industrial Fuels & Power, Jan 20
The report is striking in the emphasis it places on developing countries for future energy demand growth and the expectation that OPEC will gain in power over the international oil markets as non-OPEC production declines. According to the report, non-OECD energy consumption will be 68% higher in 2030, averaging 2.6% annual growth from 2010, and will account for 93% of global energy growth. It puts renewables in the lead in terms of growth, at 8.2%, followed by natural gas at 2.1%. By comparison, oil’s share of primary energy is expected to continue to decline. While fossil fuels presented 83% of the growth in energy over the 1990-2010 period, BP believes that this figure will fall to 64% over the next two decades.
Emerging Economies to Lead Energy Growth to 2030 and Renewables to Out-Grow Oil, Says BP Analysis
BP, Jan 19
World energy growth over the next twenty years is expected to be dominated by emerging economies such as China, India, Russia and Brazil while improvements in energy efficiency measures are set to accelerate, according to BP’s latest projection of energy trends, the BP Energy Outlook 2030.
Highlights of the latest Oil Market Report
International Energy Agency, Jan 18
Global oil product demand for 2010 and 2011 is revised up by an average of 320 kb/d on higher-than-expected submissions, reflecting buoyant global economic growth and cold northern hemisphere weather. Global oil demand, assessed at 87.7 mb/d in 2010 (+2.7 mb/d year-on-year), rises by 1.4 mb/d to 89.1 mb/d in 2011.
This Week In Petroleum
U.S. Energy Information Administration, Jan 20
Crude oil prices have risen to over $90 per barrel fueled by world petroleum demand growth, particularly in non-Organization for Economic Cooperation and Development Asian countries such as China and India, and other factors. As highlighted in the Energy Information Administration's (EIA) most recent Short Term Energy Outlook (STEO) and last week’s This Week In Petroleum, EIA expects continuing tightening of world oil markets over the next two years, keeping upward pressure on crude oil prices.
Over a barrel: Crude oil & policy
Economic Times, Jan 21
Many analysts say oil prices could rise further. The Opec, which represents the leading oil producers, says the global oil market is well supplied, and blames speculation for high prices. But the International Energy Agency , which was set up by the developed countries in response to skyrocketing oil prices in the early 1970s, says current oil prices are at an “alarming” level and can dent economic recovery.
Higher oil price empowers Iran, blunts sanctions
Reuters, Jan 20
Oil's ascent towards $100 a barrel, which OPEC blames on western financial speculators, has handed Iran a windfall to help contain domestic discontent and take the sting out of sanctions designed to squeeze its economy. Tehran's financial room for manoeuvre is likely to expand, while oil prices are expected to stay firm following a rally that earlier this month took it to its highest level since October 2008. "A particular challenge for the United States is that rising oil prices undermine policy on Iran," said Simon Henderson, of the Gulf and Energy Policy Program at the Washington Institute think-tank.
Brown blames speculators for rising oil prices
Columbus Dispatch, Jan 20
If you want to blame somebody for high fuel prices, take a look at investors who speculate in oil futures.That is Sen. Sherrod Brown's response to $3-plus-per-gallon gasoline. At a Downtown gas station today, the Ohio Democrat called on a federal panel to crack down on hedge funds and other investors that he thinks are manipulating oil prices.
Mexico Sees 2011 Drop In Oil Output Before Rebound
Dow Jones, Jan 21.
Mexico's crude-oil production is likely to dip slightly this year to 2.567 million barrels a day on average, but rebound in 2012 to end a seven-year slide, according to an Energy Ministry report.
January 20, 2011
IS THE BOND MARKET IRRATIONAL TOO?
One of the themes that the market-is-inefficient crowd likes to point to as a smoking gun is the volatility in the stock market, which at times ramps up considerably. Robert Shiller was the first to use this argument in his widely cited 1981 paper: "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?" There's been a lot of back and forth over this paper in the decades since, but that's a subject for another day. Meantime, if the volatility in stock prices indicates inefficiency and irrationality in the equity market, the same framework must hold for bonds, right? Enter Paul Krugman, who had an interesting blog post yesterday about fixed income: "What's moving interest rates?"
Krugman points to a chart showing the wide fluctuation in the 10-year Treasury Note yield in recent years:
Keep in mind that Krugman is no fan of the efficient market hypothesis. As to the chart above, Krugman notes:
The red line is the 10-year rate, the blue line the level of new claims for unemployment insurance, a leading indicator for changes in the labor market. [Unemployment insurance] claims are a pretty crude indicator of expected economic performance; even so, you can see that 10-year rates plunged in the worst of the slump, when people thought we might actually be seeing a second great depression; they rose as people started to think, well, maybe not; they fell through much of 2010, as the recovery lost steam; and they’ve picked up somewhat recently, as the data flow has looked somewhat better.
Sounds like a fairly reasonable view of how investors might evaluate the state of fluctuating bond rates. Economic conditions change, which moves interest rates, and in turn that influences investment decisions. The market responds to macroeconomic data as it arrives. Expected return and risk fluctuate, in other words, and so investors adapt to the fluctuations. Is that irrational? Or maybe it's a rational response to a irrational market behavior. But can one side be rational and the other crazy? Hmmm...
JOBLESS CLAIMS FALL TO 404,000
This morning’s weekly update on new jobless claims delivers a refreshing reversal of last week’s surge in filings for unemployment benefits. New claims on a seasonally adjusted basis dropped by a hefty 37,000 last week, more than erasing the revised 30,000 jump for the week through January 8.
That puts us back within shouting distance of the cyclical low of 391,000 from Christmas week. The case for optimism is revived once again. Yes, we’re getting whipsawed here, but that’s typical with this data series. That inspires looking at a smoothed version of the numbers via the four-week moving average. On that score the trend is still encouraging, albeit with reservations. As the chart below shows, the four-week average is only a hair above its low from a few weeks ago.
Deciding if the glass is half full, or half empty, when it comes to divining the next big move in job creation (or the lack thereof) is as much art as it is science. But for those who read the tea leaves, the case for thinking positively isn't beyond the pale. “The preconditions for stronger hiring are in place,” Ryan Sweet, a senior economist at Moody’s Analytics tells Bloomberg. “Strong corporate profit growth, improvement in business confidence and signs that the recovery has reaccelerated should really begin to entice businesses to hire a little more aggressively.”
Maybe, but we’ll need to see some hard evidence in the payroll numbers before jumping on this bandwagon. So far, the best you can say about job creation is that it’s been modest and ongoing. Private sector payrolls gained on a net basis in every month last year, and that’s something. But it’s not enough to make a serious dent in the 9%-plus unemployent rate any time soon. Payrolls are moving in the right direction, but in the grand scheme of the U.S. economy it still looks weak. And that means job growth is still vulnerable. Last month, for instance, private payrolls increased by 113,000. At that pace, it's hard to forecast much more than a continuation of what we've had in recent months: a sluggish labor market recovery.
Today’s jobless claims report doesn’t do much to change that view, although it does keep hope alive.
"The trend of the last three [in jobless claims] months is clearly downward,” says Christopher Low, chief economist at FTN Financial via Reuters. “The pace of layoffs is clearly lower." But there’s still the lingering problem that’s plagued the recover from the start, as low reminds: "Hirings are still frustratingly slow."
MACRO RISK & EQUITY RETURNS: HAVE WE LEARNED ANYTHING YET?
The case for mean reversion is alive and well when it comes to developing intuition about future returns in the equity market, as I discussed earlier this week. True, you can't prove anything definitively in the money game, but the empirical record is persuasive for thinking the expected returns in the stock market will fluctuate a) dramatically over time and b) with some degree of consistency in connection with fundamental value measures, such as dividend yield, p/e ratio, book value and other metrics. The insight doesn't help much when it comes to short-term trading, but it provides a fair amount of strategic insight. But that leaves open the question of why return varies so much in the first place?
The answer, of course, is linked with the changes in the broader economy. There's lots of debate about the specifics, although there's a growing body of research that finds that macroeconomic volatility is the primary factor for major swings in financial market prices. Some critics argue it's the other way around and that market crashes sometimes, if not always, trigger recessions. But that's an increasingly outdated view of how markets and economies interact. That was argument outlined by John Kenneth Gailbraith in the 1950s in his popular book The Great Crash 1929.
Some still embrace this idea, such as Richard Posner's recent book A Failure of Capitalism. But many economists describe a more nuanced view in the 21st century. That is, the equity risk premia varies because of macroeconomic volatility. Some strands of this research, such as Robert Barro's "Rare Disasters and Asset Markets in the Twentieth Century" (2006, Quarterly Journal of Economics) argues that the high risk premium in stocks is connected with the risk of economic implosion. As Barro writes, "The potential for rare economic disasters explains a lot of asset-pricing puzzles."
Perhaps the empirical smoking gun is the fact that the stock market peaks ahead of recessions, as formally defined by NBER. That was certainly true for the Great Recession, which began in December 2007, as per NBER. The stock market (S&P 500) peaked two months earlier.
Economists continue to analyze this apparent relationship on a deeper level, with intriguing results. For example, last year's working paper by Francois Gourio at Boston University offers a model in which
…risk premia vary because the real quantity of risk varies, leading to a reaction of both asset prices and macroeconomic aggregates. An increase in the probability of disaster creates a collapse of investment and a recession, as risk premia rise, increasing the cost of capital. Demand for precautionary savings increase, leading the yield on less risky assets to fall, while spreads on risky securities increase.
Another paper from last year ("The cyclical component of US asset returns" by D. Backus, et al.) reports that "equity returns, the term spread, and excess returns on a broad range of assets are positively correlated with future economic growth." The paper goes on to note:
We look at asset prices from the perspective of macroeconomists and ask: What do they tell us about the structure of the economy that generated them? We document two sets of facts that we think are worth exploring further. The first is the well-known tendency for equity prices (or their growth rates) and term spreads (differences between long- and short-term interest rates) to lead the business cycle. In US data, and to some extent in data for other countries, fluctuations in these variables are positively correlated with economic growth up to 6 to 9 months in the future.
Of course, if markets are anticipating changes in the economic cycle, that opens the door to the idea that market shifts are partially responsible for the fluctuations in the economy. Maybe Gailbraith was right after all? Then again, one can argue that markets are simply anticipating a new round of economic volatility. In other words, don't blame the messenger.
The fact that the causes of the business cycle are still hotly debated reminds that there's plenty of room for disagreement on all sides. Perhaps Eugene Fama was right when he said: "We don’t know what causes recessions. Now, I’m not a macroeconomist so I don’t feel bad about that. (Laughs again.) We’ve never known. Debates go on to this day about what caused the Great Depression. Economics is not very good at explaining swings in economic activity."
January 19, 2011
THE CAPITAL SPECTATOR ON TWITTER
I'll be tweeting on Twitter on the usual subjects. Here's my Twitter page:
NEW BUILDING PERMITS SURGED IN DECEMBER
The housing market has shown signs of recovery before, but to date it’s come to naught. Is there any reason to think that the latest rise in new building permits issued offers real hope this time? Unlikely, but the trend bears watching just the same.
New building permits ticked up sharply last month, the Census Bureau reports. The 16.7% rise in December is the highest monthly percentage increase in more than two years. Permits are considered a leading indicator that offers clues about the future. Permits, howver, aren’t a perfect measure of things to come. We’ve been here before, only to find disappointment. In June 2008, housing starts surged by nearly 19%. It turned out to be a statistical glitch, and the housing market resumed its descent in the months ahead.
But that was then. What’s changed since 2008? For one thing, the Great Recession isn’t raging as an all-out force of darkness. The blowback from the contraction still hobbles the housing market and other corners of the economy, but growth has a stronger footing, at least compared with 2008. Will that be enough to overcome the real estate’s markets various headwinds? Maybe, although it’s going to take a lot more digging to climb out of this hole. And even if permits have started to climb, that's only one statistic in an otherwise gloomy marketplace.
As the chart above reminds, new housing starts continued to slump in December. In fact, starts continue to bounce around near all-time lows. This forward-looking measure of the housing market isn’t dead, but it’s still deep in slumber.
Some analysts say that housing is in the throes of an outright depression that will last for years. That’s probably going too far, but not by much. Nonetheless, the breadth of the headwinds in housing inspires the expectation that last month’s surge in newly issued permits is simply statistical noise rather than a sign of an impending turnaround.
“With sales still near record lows and a lot of unsold properties in the market, there’s very little reason for builders to add more homes to the supply,” Sal Guatieri, a senior economist at BMO Capital Markets, tells Bloomberg. “Housing remains a key downside risk to the economy.”
The challenge of housing is compounded by the still-weak growth in the labor market. Then again, compared with housing, it’s easier to be optimistic on the outlook for job creation. The Fed certainly is. According to the central bank’s Beige Book report released last week, “Labor markets appeared to be firming somewhat in most Districts, as some modest hiring beyond replacement was said to have occurred and/or was planned in a variety of sectors.”
Finding similarly optimistic observations for housing is quite a bit tougher these days, even after a five-year bear market in real estate. The best you can say with any confidence is that the housing correction appears to have stabilized, albeit at sharply lower levels compared with the pre-2006 era.
As for the upturn in permits, that’s encouraging, as far as it goes, but it’s going to take a lot more to convince the crowd that the housing market’s ready to grow again on a sustainable basis. Don’t hold your breath. With foreclosures still running high, job creation sluggish, and excess inventory keeping a lid on prices, this industry is still looking at a long, slow recovery—and that’s the optimistic view.
"We wouldn't be shocked to see home prices drop another 5% this year before starting to rebound," says Rick Sharga, a senior vice president at RealtyTrac via TheStreet.com. "Really, until you start to see the inventory levels start to become more manageable, it's going to be difficult to see the housing market come back appreciably."
STRATEGIC BRIEFING | 1.19.2011 | CHINA
Leading economist warns against rapid yuan rise
Global monetary authorities should focus on stabilizing the price of the dollar and euro – as part of a new monetary regime that would also see the yuan appreciate slowly against the greenback, Columbia University Professor Robert Mundell told a financial forum in Hong Kong on Tuesday. Mundell, a Nobel Laureate in Economics in 1999 and also recognized as intellectual godfather of supply-side economics, said the approach would help curb volatility in global currency markets.
Geithner Says China Gets ‘Unfair’ Advantage From Weak Yuan
U.S. Treasury Secretary Timothy F. Geithner said the Obama administration will continue to press China to allow the yuan to rise so that companies around the world can compete fairly. “We think they should move faster,” Geithner said in a radio interview with National Public Radio’s “All Things Considered” program broadcast today. He said a stronger yuan is in China’s interest and would also help the global economy.
China's Hu: currency system 'product of the past'
China's President Hu Jintao has said the international currency system was "a product of the past," but it would be a long time before the yuan is accepted as an international currency.
Talk Of Chinese Currency Bill Coincides With Hu's Visit
Talk Radio News Service/Jan 18
A bipartisan duo in the Senate is preparing legislation aimed at discouraging China from undervaluing its currency. In a letter to Treasury Secretary Tim Geithner, Sens. Sherrod Brown (D-Ohio) and OIympia Snowe (R-Maine) said they would reintroduce a bill that the House passed overwhelmingly just a few months back. The Currency Reform for Fair Trade Act would instruct the Commerce Department to “treat currency undervaluation as a prohibited export subsidy.” As a result, the federal government would have the power to impose taxes on Chinese exports.
China’s Currency Isn’t Our Problem
NY Times/Jan 17
When President Hu Jintao of China visits Washington this week, many Americans will clamor for Beijing to stop manipulating its currency. We think we are being cheated on a huge scale, but we should reconsider. When it comes to lost jobs, the negative impact of China’s currency, the renminbi, is less than one might think. Adjusting the exchange rate should not take priority over more vexing issues like North Korea, Iran and bilateral trade.
China’s lending hits new heights
Financial TImes/Jan 17
China has lent more money to other developing countries over the past two years than the World Bank, a stark indication of the scale of Beijing’s economic reach and its drive to secure natural resources. China Development Bank and China Export-Import Bank signed loans of at least $110bn (£70bn) to other developing country governments and companies in 2009 and 2010, according to Financial Times research. The equivalent arms of the World Bank made loan commitments of $100.3bn from mid-2008 to mid-2010, itself a record amount of lending in response to the financial crisis.
China Business Environment for U.S. Firms Fails to Improve, Chamber Says
The business environment in China for U.S. companies has failed to improve and has in some cases worsened, according to a survey by the American Chamber of Commerce in Shanghai. Nearly two-thirds of U.S. companies in China surveyed said the regulatory environment has “not changed” or has deteriorated over the past year, according to the report released today. A total of 71 percent of companies surveyed said China’s enforcement of intellectual property rights has remained the same or gotten worse, an increase from the 61 percent that answered similarly in the chamber’s 2009 survey.
Foreign investment in China rebounded in 2010
Foreign direct investment in China weakened slightly in December but ended 2010 up strongly after falling the previous year amid the global crisis, official figures showed Tuesday. Foreign spending on Chinese factories and other nonfinancial assets in December rose 15.6 percent from a year earlier to $14 billion, the Commerce Ministry said. That was down from November's 38.2 percent surge.
China's outbound direct investment up 36 percent last year
Xinhua, Jan 18
China's outbound direct investment in the non-financial sector hit 59 billion U.S. dollars last year, up 36.3 percent year on year, the Ministry of Commerce (MOC) announced Tuesday. Total outbound direct investment in the non-financial sector had amounted to 258.8 billion U.S. dollars by the end of 2010. Though China's outbound direct investment grew rapidly last year, most of it went to the Hong Kong Special Administrative Region, as well as countries in Asia and Latin America, with a very small amount to Europe, the United States and Japan, said MOC spokesman Yao Jian.
Chinese Overseas Direct Investment in the U.S. to surge
China's investment in the United States will grow by more than 50 percent this year, as the US market becomes more open and transparent, said an official from the Ministry of Commerce.
Last year, China's total overseas direct investment (ODI) in the non-financial sector grew by 36.3 percent from a year earlier to $59 billion, but comparatively, the nation's ODI in the US surged by as much as 81.4 percent year-on-year to $1.39 billion, according to statistics released by the Ministry on Tuesday. As bilateral economic relations become stronger and Chinese companies' aspiration for overseas expansion increases, the nation's investment in the US will "probably continue to grow rapidly, say by 50 percent", said Yao Jian, a ministry spokesperson.
January 18, 2011
THE LIMITS OF THE NEW NORMAL
The world has changed after the Great Recession, but some of the fundamental tenets of investing still apply and probably always will. Exhibit A is mean reversion, a theory that says that prices fluctuate around an average of historical prices or some other measure of value. True, you can't count on mean reversion to apply like clockwork, particularly in the short run. In fact, there's no way to know if mean reversion will apply at all in the years and decades ahead. Par for the course in finance: everything's always open for debate. But a small library of empirical analysis suggests that we should take mean reversion seriously. In other words, buy low and sell high is a worthwhile investment strategy, even if the details are messy.
For example, buying stocks when trailing dividends are historically high, and selling when yields are relatively low, has delivered above-average returns vs. buying and holding a basket of stocks over long periods of time. Will this work in the future? No one really knows the answer, but there's a lot of history that suggests we should be reluctant to dismiss the idea entirely.
Consider Professor John Cochrane's November 2008 op-ed in The Wall Street Journal, in which he briefly reviews the history of current dividend yield and subsequent stock market performance since 1945. Buying when yield is high, and selling or paring equity allocations when yield is low, has been a powerful strategy for capturing the equity risk premium in something more than average doses. In fact, lots of researchers have come to similar conclusions over the years. As Cochrane notes,
When prices are low relative to dividends, subsequent seven-year returns are likely to be high. Stocks do not follow a "random walk." More deeply, price declines above and beyond declines in dividends over the following year have entirely rebounded. This finding is confirmed by 30 years of research, ranging from "behaviorists" such as Robert Shiller and Richard Thaler to "efficient marketers" such as Eugene Fama and Ken French, to "economists" such as John Campbell and myself. The same pattern also appears in price/earnings, book/market and other ratios, and in many other markets.
And let's not forget that buying stocks when Cochrane's article appeared (the dividend yield was relatively elevated at the time) would have delivered unusually high returns. Since Cochrane's op-ed was published, the S&P 500 has climbed nearly 50%. Coincidence? Maybe, although there's a strong case for arguing that expected returns were unusually high in late-2008, when the financial crisis was raging and prices were crashing.
But no matter how times the mean reversion idea seems to work, there's always fresh criticism that this time is different. In the wake of the Great Recession, a number of analysts have argued that it's going to be tougher to earn above-average returns from mean reversion. They may be right—the future, after all, is still uncertain, and Mr. Market's rule book is always in some degree of flux. But GMO's James Montier isn't ready to throw in the towel just yet. "In order for mean-reversion-based strategies to work, it is not required that the mean be realized for long periods of time, but that markets continue to behave as they always have, swinging pendulum-like between the depths of despair and irrational exuberance, or, from risk-on to risk-off," he writes in a research essay published last month ("In Defense of the “Old Always," Dec. 2010 via gmo.com) "As long as markets display such bipolar disorder and switch from periods of mania to periods of depression, then mean reversion should continue to merit worth as an investment strategy."
Montier, a member of GMO’s asset allocation committee and author of Value Investing: Tools and Techniques for Intelligent Investment, goes on to advise,
History is littered with the remains of proclaimed, but unfulfilled, new eras. Exhibit 6 [see chart below] shows the long-run history for the Graham and Dodd P/E for the U.S. market. Over this time, we have witnessed some quite remarkable, and quite appalling, things – the deaths of empires, the births of nations, waves of globalization, periods of deregulation, periods of re-regulation, World Wars, revolutions, plagues, and huge technological and medical advances – and yet one thing has remained true throughout history: none of these events mattered from the perspective of value!
Montier concludes: "So, rather than throwing out the handbook of investment, investors may well be better advised to stay true to the principles that have guided sensible investment since time immemorial."
Indeed, the empirical evidence continues to stack up in favor of these principles. Or, in the words of financial economists, expected return fluctuates. Why does it fluctuate? That's a bit tougher to nail down, although the mounting evidence leans in favor of looking to macroeconomic factors for an answer. That's not surprising, although the details are intriguing, as several recent economic studies reveal. In an upcoming post, I'll take a closer look at some of the latest research that relates macroeconomic volatility to risk premia.
Meantime, let's recognize that the new normal has limits. The world that existed before 2008 is gone, but some of the old rules still apply when it comes to evaluating investment opportunity.
January 17, 2011
RESEARCH REVIEW | 1.17.2011 | INFLATION
Investing in Inflation Protection
Anand S. Iyer and Jennifer C. Bender/MSCIBarra/Nov 2010
The current tug of war between inflation and deflation has created considerable confusion for investors. Consequently, in this report we explore the characteristics of inflation-protected bonds [IPBs] to see if, and to what extent, these securities have contributed to portfolio diversification and provided investors with protection from inflation and deflation... We find that IPBs have exhibited some distinct differences from other asset classes during the past decade:
1) IPBs as an asset-class-level inflation hedge: We find that IPBs provided reasonable protection against inflation during this period...
2) IPBs in a deflation scenario: Nominal bonds had stronger protection (or put optionality) on deflation relative to IPBs during the last decade...
3) IPBs for portfolio diversification: The correlations of IPBs with other asset classes have been relatively low for equities, commodities, and real estate, and only slightly higher than correlations of nominal bonds with those assets.
Monetary Policy, Commodity Prices and Inflation: Empirical Evidence from the US
Florian Verheyen/University of Duisburg-Essen/Oct 2010
The past years were characterized by unprecedented rises in prices of commodities such as oil or wheat and inflation rates moved up above the mark of two percent per annum which is typically referred to as price stability. This led to a debate whether commodity prices indicate future CPI inflation and if they can be used as indicator variables for central banks. To answer this question, we have investigated what the connection between commodity prices and inflation is like in the US. After having looked at the economic theory which delivers reasons for and against a relationship between prices of both sorts of goods, we applied various econometric methods like Granger causality tests and SVAR models to answer this question. All these tools pointed to one conclusion. While there was a strong link between commodity prices and CPI inflation in the 1970s and the beginning of the 1980s, the relationship has weakened, respectively diminished over time. Today we are unable to detect a reaction of commodity prices to commodity price shocks. Thus, commodity prices might not serve as good indicator variables for monetary policy.
Are Commodities a Good Hedge Against Inflation? A Comparative Approach
Laura Spierdijk and Zaghum Umar/University of Groningen and Netspar/Nov 30, 2010
For long-term investors it is attractive to invest in assets that provide some protection against an increase in the general price level...Inflation hedging has become particularly relevant in the light of the subprime crisis of 2007, which resulted in the first major recession of the 21st century. To circumvent this financial catastrophe, unconventional tools such as quantitative easing and stimulus packages have been employed by regulators and policy makers. However, the efforts to overcome recession are likely to instigate inflation...
By analyzing the various commodities and sub-indices that are part of the S&P GSCI Total Return Index it turns out that non-precious metals provide the best inflation hedge. The similarities in the findings of the hedging measures can be explained from the fact that all but one measures boil down to an increasing function of the correlation between inflation rates and nominal asset returns.
The Debt-Inflation Cycle and the Global Financial Crisis
Peter J. Boettke and Christopher J. Coyne/George Mason University (via SSRN.com)/Dec 21, 2010
...the debt-inflation theory of economic crises must be considered as a viable alternative to replace the debt-deflation theory of economic crises. Under the debt-deflation theory policymakers interpret every downturn in economic activity as a potential deflation, and therefore counteract it with easy monetary policy. When this happens market corrections will be cut short, and the previous boom is recreated through the manipulation of money and credit. Ludwig von Mises (1949) and F.A. Hayek (1979) were early expositors of an expectation based macroeconomics arguing that efforts to off-set economic downturns through monetary policy enter a dangerous game of expectations and anticipated inflation. As Hayek argued: ‘We now have a tiger by the tail: How long can this inflation continue? If the tiger (of inflation) is freed, he will eat us up; yet if he runs faster and faster while we desperately hold on, we are still finished!' (1979, p. 110) It is this theory of the ‘crack-up boom’ (see Mises 1949, pp. 426-428 that very well may be what we have seen manifesting itself in reality with the onset of the Great Recession in 2008. If this is accurate then the policy steps taken to date have merely reinforced, rather than ameliorated, the problem as a market correction to previous malinvestments has been turned into a global crisis by the very steps taken to prevent the market correction from occurring.
Stock Returns and Inflation Risk: Implications for Portfolio Selection
Tomek Katzur/University of Groningen and Laura Spierdijk /University of Groningen and Netspar/Nov 30, 2010
This paper focuses on the exposure of common stocks to inflation risk and assesses the impact of this exposure on portfolio choice. We show that the relation between real stock returns and inflation rates, as well as the parameter uncertainty involved with this relation, has substantial influence on optimal asset allocations. During the 1985 – 2010 period, inflation risk induces a typical long-term investor to allocate up to 40 percentage points less of his wealth to stocks, as compared to a benchmark investor who believes that stocks are not exposed to inflation risk. The benchmark investor generally overstates expected stock returns and/or understates return volatility, resulting in too high stock allocations.
“Real‐Feel” Inflation: Quantitative Estimation of Inflation Perceptions
Michael Ashton/Enduring Investments LLC (via SSRN.com)/Oct 27, 2010
The state of inflation expectations is generally supposed to influence actual inflation and
therefore policymaker actions to maintain price stability. However, the methods usually employed to evaluate inflation expectations are insufficient. Survey methods either record economists’ forecasts of official CPI, or consumers’ flailing attempts to calculate the weighted average price increase personally experienced in a consumption basket consisting of hundreds of items purchased at different intervals (and the latter survey results do not mesh with anecdotal evidence that most consumers believe the inflation they face is higher than the official CPI). In this paper, I propose functional forms for several adjustments that can be made to reconcile official price measurements with consumers’ perceptions.
These adjustments are corrections for cognitive biases related to loss aversion and mental accounting. I identify several other biases that may be candidates for research into additional adjustments...
In the case of inflation, although consumers are wrong about the actual pace of changes in prices, their perceptions matter. Their perceptions of inflation will affect their perceptions of real yields and, ergo, investment opportunities.20 Their perceptions may also feed more efficiently into price pressures via a cost‐push inflation mechanism. For example, workers who perceive a higher inflation rate may hold out for higher wage increases. If true, this will matter to policymakers.
January 15, 2011
BOOK BITS FOR SATURDAY: 1.15.2011
● The Comeback: How Innovation Will Restore the American Dream
By Gary Shapiro
Interview with author via CNBC
The president of the Consumer Electronics Association, and author of the new book "The Comeback: How Innovation Will Restore the American Dream," believes that America’s love for these products will help bolster the economy. “The U.S.,” he says, “is in trouble and innovation is the best path towards letting our kids have a better future.” The question is now whether there is enough innovation to jump-start things for 2011, especially after consumer confidence unexpectedly dipped in December. The Conference Board last Tuesday released a private report that said its index of consumer attitudes slipped in December. Shapiro says we will see improvement in 2011. “I do believe that consumer electronics has been a savior for the economy,” says Shapiro, noting that sales were down in 2009 but that 2010 actually saw growth. The Consumer Electronics Show, which had also seen declining attendance numbers over the last two years, is also predicted to be way up, according to Shapiro, “in every sector possible. There is phenomenal optimism.” The event begins January 5 in Las Vegas.
● Sonic Boom: A Guide to Surviving and Thriving in the New Global Economy
By Gregg Easterbrook
Summary via publisher, Random House
What did America get right in the nineteenth century that it’s getting wrong in the twenty-first? If Karl Marx were alive today, would he be hosting a show on Fox News? These are just a few of the provocative questions asked by Sonic Boom, a (mainly) optimistic look at the near future. Sonic Boom tells why the world’s economy is likely to be just fine, with prosperity increasing; why globalization will soon drive us even crazier than it does today; why “a chaotic, raucous, unpredictable, stress-inducing, free, prosperous, well-informed, and smart future is coming.” The book is rich with specific examples and advice on how to navigate your own way through the craziness that’s ahead. Forbes calls Gregg Easterbrook “the best writer on complex topics in the United States,” and Sonic Boom will show you why.
● Risk Tolerance in Financial Decision Making
Edited by Caterina Lucarelli and Gianni Brighetti
Summary via publisher, Macmillan
This book sheds light on the emotional side of risk taking behaviour using an innovative cross-disciplinary approach, mixing financial competences with psychology and affective neuroscience. In doing so, it shows the implications for market participants and regulators in terms of transparency and communication between intermediaries and customers.
● The Essential Financial Toolkit: Everything You Always Wanted To Know About Finance But Were Afraid To Ask
By Javier Estrada
Summary via publisher, Macmillan
Math and jargon make essential financial concepts seem intimidating, but that is simply because most books do not have the goal of being accessible to interested readers – this book does. In ten easy-to-read chapters, it explains all the essential financial tools and concepts, fully illustrated with real-world examples and Excel implementations.
Math and jargon make essential financial concepts seem intimidating, but that is simply because most books do not have the goal of being accessible to interested readers – this book does. In ten easy-to-read chapters, it explains all the essential financial tools and concepts, fully illustrated with real-world examples and Excel implementations.
● When Wall Street Met Main Street: The Quest for an Investors' Democracy
By Julia C. Ott
Summary via publisher, Harvard Unviversity Press
The financial crisis that began in 2008 has made Americans keenly aware of the enormous impact Wall Street has on the economic well-being of the nation and its citizenry. How did financial markets and institutions—commonly perceived as marginal and elitist at the beginning of the twentieth century—come to be seen as the bedrock of American capitalism? How did stock investment—once considered disreputable and dangerous—first become a mass practice?
Julia Ott tells the story of how, between the rise of giant industrial corporations and the Crash of 1929, the federal government, corporations, and financial institutions campaigned to universalize investment, with the goal of providing individual investors with a stake in the economy and the nation. As these distributors of stocks and bonds established a broad, national market for financial securities, they debated the distribution of economic power, the proper role of government, and the meaning of citizenship under modern capitalism.
January 14, 2011
TODAY’S TRIO OF ECONOMIC REPORTS
Three major economic reports were released this morning:
1) Headline consumer inflation jumped sharply higher last month, the Bureau of Labor Statistics reports. On closer inspection, however, it’s all about energy. The so-called core reading of inflation (excluding the volatile energy and food sectors) still looks tame.
2) Retail sales in December continued forging higher, reaching a new all-time high, according to the Census Bureau.
3) Industrial product rose at a healthy clip last month, advancing the most since last July, the Federal Reserve reports.
Overall, today’s trio of numbers add up to some much-needed encouragement that a) economic growth still has the upper hand; and b) inflation doesn’t appear threatening.
But what of last month’s pop in CPI? Is that a sign of things to come? Headline inflation rose 0.5% in December, up dramatically from November’s 0.1 increase. The change, however, is due almost entirely to higher energy prices last month. That’s hardly trivial, but energy prices are volatile and so what goes up may come down. Even if you expect oil and gasoline prices will remain elevated, they’re unlikely to continue surging month after month, and so the case for monitoring core readings of inflation as a guide to the future has some merit.
By that standard, consumer inflation still looks docile. Core CPI was up just 0.1% in December. Over the past year, core CPI is higher by less than 1%--a 50-year low. Even headline inflation’s annual pace is still bumping along at its slowest rate since the early 1960s. Inflation’s probably headed higher in the years ahead, but it’s hard to find an imminent threat in today’s numbers.
If inflation is, in fact, contained, that makes the gains in retail sales and industrial production all the sweeter. Indeed, industrial production continues to expand at an annual rate of 5%-plus. That’s strongest rate of expansion since the mid-1990s. The pace probably isn’t sustainable, but for the moment it’s clear that the industrial sector is humming along.
So too are retail sales. In fact, December’s 0.6% rise—the sixth straight monthly increase—puts seasonally adjusted retail sales at an all-time high, surpassing the previous peak set back in late-2007, on the eve of the Great Recession’s arrival.
The case looks good for expecting continued expansion in the economy, as today’s numbers suggest. If nothing else, the latest reports lend fresh support for the recent forecasts of U.S. GDP growth this year in the 2%-to-4% range.
What could derail this rosy outlook? Jobs, which have yet to deliver a convincing run of growth. As we discussed yesterday, the on-again/off-again nature of the labor market rebound continues to raise questions about the durability and depth of the otherwise encouraging macro trend. There’s a recovery in progress, but it still looks more or less like a jobless recovery. There will be growth this year, but it’s still precarious until (or if) job creation picks up.
Retail sales in particular may be vulnerable without a stronger labor market, which in turn would raise fresh questions about the broader economy. No sign of that today, of course, although focusing exclusively on the rear-view mirror is always hazardous, perhaps more so than ever.
READING ROOM FOR FRIDAY: 1.14.2011
►Uncle Sam Wants His AAA Rating
Two major credit ratings agencies warned Thursday that the United States might tarnish its triple-A credit rating if its national debt kept growing...But many economists say the reckoning, if it comes, is still years or even decades away. The bond market shrugged at Thursday’s news. Indeed, even some experts who want to see the deficit reduced said now is not the time to cut federal spending drastically, given the weakness in the economy and high unemployment.
New York TImes, Jan 14
►New Hit to Strapped States
With the market for municipal bonds tumbling, cities, hospitals, schools and other public borrowers are scrambling to refinance tens of billions of dollars of debt this year, another sign that the once-safe market is under duress. The muni bond market was hit with the latest wave of bad news Thursday, prompting a selloff that sent the market to its lowest level since the financial crisis. A New Jersey agency was forced to cut the size of a bond issue by about 40% because of mediocre demand, and pay a higher rate than expected. And mutual fund giant Vanguard Group shelved plans for three new muni bond funds, citing market turmoil.
Wall Street Journal, Jan 14
►India's annual inflation accelerates past 8%
India's inflation rate accelerated to 8.43 percent in December on a 12-month basis, raising the prospect of another rate hike from the central bank later this month, government data showed on Friday.
►Home Foreclosures Top 1 Million for First Time in 2010
Banks seized more than a million U.S. homes in one year for the first time last year, despite a slowdown in the last few months as questions around foreclosure processing arose, a leading firm said Thursday. Banks foreclosed on 69,847 properties in December, bringing the year's total to 1.05 million, topping the prior record of 918,000 homes seized in 2009, real estate data firm RealtyTrac said.
►Europe Failed to Clear 'Skepticism' on Debt Crisis, IMF Says
Europe has yet to allay investor “skepticism” about the sustainability of the region’s debt, and any spread of the crisis would cloud global economic prospects, the International Monetary Fund’s number three official said. “At least for now it looks like the spillover from the European sovereign crisis to areas outside of the region will be limited,” Naoyuki Shinohara, deputy managing director at the IMF, said in an interview in Tokyo yesterday. “However, if the European sovereign debt problems were to become bigger, we need to keep in mind that that could bring about considerable downside risks.”
►Strengthen Ties with China, But Get Tough on Trade
As President Obama prepares to host Chinese President Hu Jintao next week, Americans increasingly see Asia as the region of the world that is most important to the United States. Nearly half (47%) say Asia is most important, compared with just 37% who say Europe, home to many of America's closest traditional allies
Pew Research Center/Jan 12
►Could Federal Spending be Capped at 20 Percent of GDP? Should it Be?
As the budget debate heats up, we will hear much about capping U.S. federal government spending at 20 percent of GDP, roughly its level for several decades leading up to the global financial crisis. Likely presidential candidate Rep. Mike Pence (R-Ind.) has been among the most vocal backers of this idea. Together with colleagues, he has packaged it in the form of a proposed Spending Limit Amendment. Would it really be possible to impose such a spending limit? Yes. Would we like the results if we tried it? Not all of us would. Here is why.
Part of its attraction is that the 20 percent solution appears to require no real sacrifice. If we were content with the level of government services enjoyed in past, pre-crisis decades, why would there be any hardship in holding to that level in the future? Unfortunately, the pretense that it would be possible to maintain the same level of real government services as in the past without future increases in spending is an illusion. The reality is that holding government spending to past levels would require a significant reduction in real public services
Ed Dolan's Econ Blog/Jan 13
►The End of Procyclical Labor Productivity?
The fact that falling hours have been accompanied by rapidly-rising productivity is what has given us not a jobless recovery but a massive job-loss recovery. The normal pattern we would expect from the past two years' output growth would be that employment and hours would have been nearly flat. Why the different pattern this time? We think that it is because firms are no longer "hoarding labor" when times are slack because the industries losing jobs no longer expect employment to bounce back...
These days U.S. labor productivity looks to be countercyclical: firms take advantage of downturns in demand to rationalize operations and increase labor productivity, pleading business necessity in the face of the downturn to their workers.
It seems fairly clear to me that calling this "structural change" is somewhat of a misnomer. Structural change is when workers find jobs in expanding industries. That happens overwhelmingly during booms. For workers to lose jobs in contracting industries and to not find them in expanding industries is not "structural change" but rather something else.
The Semi-Daily Journal of Economist J. Bradford DeLong/Jan 13
January 13, 2011
JOBLESS CLAIMS SURGE
Ouch! Suddenly the new year looks a lot less inviting. New jobless claims surged higher last week by 36,000 to a total of 445,000 on a seasonally adjusted basis, the government reports. That’s the biggest weekly gain since last July and the jump pushes the total to its highest in 10 weeks. Quoting the immortal question of every shell-shocked solider through history: Wha’ happn’d?
One possibility is simply that the reported decline in new filings for unemployment benefits in late-2010 was a mirage, a statistical illusion, a joke imposed by the financial gods on mere mortals hoping for signs that the labor market was finally turning the proverbial corner. Then again, the optimistic view is that the number du jour is itself a quirk. Jobless claims, after all, are notoriously volatile. We still have the four-week average of new claims, which continues to trend down...for now, sort of.
But there’s no way to minimize the disappointment in today’s update. Once again we’re far above the psychologically important 400,000 mark. Been there, done that, and we're set for another round apparently. The latest surge fuels suspicion that the holiday happenings of late-December delivered a temporary balm to the otherwise deep challenges that continue to afflict the labor market. But the party's over...again.
Indeed, the many challenges in the labor market are still with us, and will be for some time. As we reported in yesterday's edition of The Beta Investment Report, there’s no shortage of ongoing headwinds to keep optimism in check when it comes to thinking about jobs. The portion of the labor force that's suffering from “long-term” unemployment—collecting benefits for 27 weeks or more—is at a record high (4% plus) since these records were started in the late-1940s. There’s also the falling rate of labor force participation, which dropped to 64.3% last month--the lowest since the early 1980s and therefore a sign that last month’s robust fall in the unemployment rate to 9.4% from 9.8% in November isn't quite the good news it appears to be.
Of course, last week’s numbers for December payrolls was already casting dark shadows right out of the gate. Job growth is still modest, at best.
There’s enough forward momentum in the economy to keep a new recession at arm’s length, but growth isn’t going to be terribly impressive, particularly where it’s needed most, starting with job creation. Meantime, next week's installment on jobless claims promises to garner lots of attention. Any guesses what the next number will be?
THE POLITICS OF THE DEBT CEILING
A new poll says the public's against it, but the debt ceiling's probably going to rise anyway. So much for representing the people's wishes.
A mere 18% of citizens support a higher limit on the nation's debt vs. 71% opposed to the idea, according to poll released yesterday by Reuters/Ipsos. The current ceiling is the tidy sum of $14.3 trillion. That's a chunk of change everywhere else on the planet, but it won't suffice in Washington for much longer.
In a letter to Congress dated January 6, Treasury Secretary Geithner wrote that failure raise the debt ceiling "would have catastrophic economic consequences that would last for decades." According to his missive,
Never in our history has Congress failed to increase the debt limit when necessary. Failure to raise the limit would precipitate a default by the United States. Default would effectively impose a significant and long-lasting tax on all Americans and all American businesses and could lead to the loss of millions of American jobs.
White House economic advisor Austan Goolsbee is equally convinced that elevating the government's capacity for red ink is necessary. "You know, the debt ceiling is not…is not something to toy with… If we hit the debt ceiling, that's the…essentially defaulting on our obligations, which is totally unprecedented in American history," he said on ABC's "This Week" TV program on Sunday. "The impact on the economy would be catastrophic. I mean, that would be a worse financial economic crisis than anything we saw in 2008."
There's that word "catastrophic" again. That stark analysis may be meant to sway the Republicans into giving the White House the green light on a higher debt limit, but there's some debate about how to proceed. As AP reported last week,
In power scarcely a day, House Republicans bluntly told the White House on Thursday its request to raise the nation's $14.3 trillion debt limit will require federal spending cuts to win their approval, laying down an early marker in a new era of divided government.
But those sentiments were expressed before Saturday's shooting rampage in Arizona that wounded Congressman Giffords, killed a federal judge, among others, and changed the political calculus in Washington. Before the shooting, the new House Speaker, Rep. John Boehner, issued a statement that observed that "the American people will not stand for such an increase [in the debt ceiling] unless it is accompanied by meaningful action by the President and Congress to cut spending and end the job-killing spending binge in Washington." But in a sign of how tricky this process will be, the Speaker also advised,
While America cannot default on its debt, we also cannot continue to borrow recklessly, dig ourselves deeper into this hole, and mortgage the future of our children and grandchildren. Spending cuts – and reforming a broken budget process – are top priorities for the American people and for the new majority in the House this year, and it is essential that the President and Democrats in Congress work with us in that effort.”
It's inconceivable that the U.S. would default on its debt, and so all the posturing is somewhat hollow. The Treasury market, at least, doesn't appear worried. The yield on the benchmark 10-year Note, for instance, remains in the 3.3% neighborhood, the low end of recent weeks. That's not to say that higher rates aren't coming. But the risk of inflation, monetary stimulus and even a stronger-than-expected economic recovery in 2011 are more likely catalysts for expecting yields to rise compared with political risk in Congress.
Nonetheless, advocates for paring government largess continue to press their message as Congress finds its new political footing in the wake of last week's shooting. In an op-ed in today's Wall Street Journal, Arthur Laffer leads the charge for austerity. "Cutting spending and cutting it drastically would not hurt the economy," writes the author of Return to Prosperity: How America Can Regain Its Economic Superpower Status. "It would, in fact, help the economy, even if done now."
Political momentum for such thinking among the Republican majority in the House still seems to be on board with the idea. As The Hill noted yesterday, "Some House Republicans are expressing renewed confidence that the push for a balanced-budget constitutional amendment will gain real steam in the 112th Congress — aided by the newly elected crop of budget-slashing GOP freshmen."
A balanced budget is bound up with the debt ceiling, of course—politically as well as financially. No one expects a default, but there's also a rising tide that demands fiscal responsibility, or at least the appearance of austerity. But it still comes down to the numbers and deciding where to cut spending isn't easier today than it was last week, or last year. Meaningful cuts that make a difference are linked with entitlement spending, such as the Medicare program. Politically, it's going to be hard—very hard—to pare that puppy, at least in one fell swoop.
No wonder, then, that some veteran Republican supporters are laying the groundwork for austerity light. "We've got to do the debt ceiling," Tom Donohue, president of the U.S. Chamber of Commerce and steadfast Republican ally, said on MSNBC yesterday. "There'll be a lot of political carrying on, but it will be done."
Thy will be done? Yes, albeit by holding one's nose, predicts former Democratic Senator Evan Bayh. “The debt ceiling cannot be avoided,” he said on Wednesday, but “nobody will want to vote for it.”
That doesn't mean that the Republicans are unanimously on board with a higher debt ceiling. There are any number of Tea Party types and others who argue that this is a critical battle that will set the tone for the new austerity. Suffice to say, the Republicans are divided on how this drama should play out. Throw in the fact that the White House is adamant on raising the ceiling and you have the potential for some fireworks.
Morgan Stanley economists David Greenlaw and Ted Wieseman earlier this week wrote that "the political winds appear to be pointing to a repeat of the 1995-96 showdown between the president and House Republicans, when the US Treasury came perilously close to missing a coupon payment, auction schedules were disrupted, and the federal government shut down for weeks at a time."
Could that really happen again? Perhaps. The Republicans seem to have backed themselves into a political corner. Voting yea on a higher debt ceiling that's not funded with spending cuts will look like betrayal to the Tea Party movement. But the Republicans have to govern, and saying no to a higher debt limit is unthinkable in fiscal terms. It's also politically hazardous in the context of right-of-center constituency. The problem is that spending cuts now, at a precarious moment for the economy, come with their own risks.
There's time to sort all this out, but the clock is ticking. Estimates vary, but it's thought that the government has another $300 billion or so to spend before the current ceiling kicks in. That implies that as early as late-March the fiscal jig will be up and a new vote will be needed. Meantime, the political posturing rolls on.
January 12, 2011
MACRO SURVEILLANCE FOR WEDNESDAY: 1.12.2011
China central bank adviser sees Q1 interest rate rise
Another Chinese interest rate increase in the first quarter is likely, a central bank adviser said on Wednesday, but a vice governor cautioned against raising rates too steeply for fear of luring in hot money.
Reuters, Jan 12
China's exchange reserves at issue
China's central bank said Tuesday that Beijing's holdings of foreign cash and securities amount to $2.85 trillion - a jump of 20 percent over the year before - despite Chinese promises to try to balance its trade and investment relations with the United States and other countries...The reserves are so large and the recent run-up so rapid that it's casting new doubts over whether Beijing is reforming the handling of its currency and curbing its heavy reliance on exports as a source of jobs and growth.
Washington Post, Jan 12
The Dollar: Dominant no more?
If the euro’s crisis has a silver lining, it is that it has diverted attention away from risks to the dollar... Now it is Europe that has deep economic and financial problems. Now it is the European Central Bank that seems certain to have to ramp up its bond-buying program. Now it is the Eurozone where political gridlock prevents policymakers from resolving the problem.
In the US meanwhile, we have the extension of the Bush tax cuts together with payroll tax reductions, which amount to a further extension of the expiring fiscal stimulus. This tax “compromise”, as it is known, has led economists to up their forecasts of US growth in 2011 from 3% to 4%. In Europe, meanwhile, where fiscal austerity is all the rage, these kind of upward revisions are exceedingly unlikely. All this means that the dollar will be stronger than expected, the euro weaker. China may haves made political noises about purchasing Irish and Spanish bonds, but which currency – the euro or the dollar – do you think prudent central banks will it find more attractive to hold?
Barry Eichengreen (VOX), Jan 10
Consumers and the Economy, Part I: Household Credit and Personal Saving
In the years since the bursting of the housing bubble, the personal saving rate has trended up from around 1% to around 6%, while the ratio of household debt to disposable income has dropped from 130% to 118%. Changes over time in the availability of credit to households can explain 90% of the variance of the saving rate since the mid-1960s, including the recent uptrend, according to a simple empirical model.
R. Glick and K. Lansing (San Francisco Fed), Jan 10
NFIB Small Business Optimism Index Remains Weak
The National Federation of Independent Business Index of Small Business Optimism lost 0.6 points in December, dropping to 92.6, and disappointing those who were anticipating a rebound that might signify more growth in the small business sector. Weak sales remains the top problem, stagnating hiring and spending on capital projects. All of which are sidelining the small business sector from a recovery. This marks the 36th month of Index readings in the recession level.
National Federation of Independent Business, Jan 11
Issing repents, says euro may fall apart
Otmar Issing, the former chief economist of the European Central Bank and the German Bundesbank, is a genial number-cruncher who believes in the overall benefits of European integration but is genuinely is open to others’ views. He is a key bellwether for Germany’s stance on the euro... And he unashamedly says — in an essay in the January Bulletin of the Official Monetary and Financial Institutions Forum due to be published this week — the days of the single currency may be numbered. “The present seemingly unstoppable process toward further financial transfers will generate tensions of an economic and especially political kind. The longer this process is characterized by unsound conduct of individual member countries, the more these tensions will endanger the existence of EMU.”
MarketWatch, Jan 10
The Shattered American Dream: Unemployed Workers Lose Ground, Hope, and Faith in their Futures
The November 2010 survey finds that only one-third of those originally looking for work in August 2009 had become employed by November 2010, either as full-time workers (26%) or part-timers who do not want a fulltime job (8%). This figure is up slightly from the March 2010 survey when 13% were found to have gotten full-time jobs and another 8% had gotten part-time jobs... Almost a majority of reemployed workers (48%) were forced to take a cut in pay, and for most, a significant one. Nearly 60% are earning at least 20% lower at their new position compared to their last full-time job. For panelists who are employed full time, 53% are making less now than they did in their most previous job before becoming unemployed, with many (56%) reporting that they earn at least one-fifth less in their current position than in their last job.
John J. Heldrich Center for Workforce Development (Rutgers University), Dec 2010
Government, the Anti-Stimulus
The job machine has remained relatively weak for the past year. We do expect acceleration to 220,000 new jobs per month in 2011, but even this would be less than historical recoveries have produced. Some argue this is a new and weaker “normal,” and that it signals a fragile underlying recovery that will be permanently at risk of a double dip. Some say debt, housing and shattered consumer confidence are the cause. But, in reality, this is what we should expect when government has become so large.
B. Wesbury and R. Stein (First Trust), Jan 10
The Debt-Inflation Cycle and the Global Financial Crisis
Writing over 230 years ago, Adam Smith noted the ‘juggling trick’ whereby governments hide the extent of their public debt through ‘pretend payments.’ As the fiscal crises around the world illustrate, this juggling trick has run its course. This paper explores the relevance of Smith’s juggling trick in the context of dominant fiscal and monetary policies. It is argued that government spending intended to maintain stability, avoid deflation, and stimulate the economy leads to significant increases in the public debt. This public debt is sustainable for a period of time and can be serviced through ‘pretend payments’ such as subsequent borrowing or the printing of money. However, at some point borrowing is no longer a feasible option as the state’s creditworthiness erodes. The only recourse is the monetarization of the debt which is also unsustainable due to the threat of hyperinflation.
P. Boettke and C. Coyne (George Mason University) via SSRN.org, Dec 21, 2010
January 11, 2011
WILL AUSTERITY BITE CONSUMPTION?
This may be the age of austerity, but consumer spending has surprised the pessimists and rebounded sharply over the past year. That's no trivial revival, considering that personal consumption expenditures (PCE) represent 70% of GDP in the U.S. For good or ill, ours is a consumer-based economy. But is the consumer still up to the job?
For reasons that need no explanation, there's some doubt if Joe Sixpack can continue his spendthrift ways. For the moment, however, it's clear he's making a valiant effort. The year-over-year pace of growth in seasonally adjusted personal consumption expenditures has revived to almost 4%, as of last November. That compares with a roughly 2.5% decline in the depths of the Great Recession.
But it's also clear that PCE isn't growing as fast compared with the pre-recession gains, when 4% to 6% was typical. For the moment, those rates exist only in history. The next update on PCE is scheduled for release on January 31, when the government reports the December numbers.
Ultimately, consumption and the labor market are tightly connected. But if a robust employment trend is at the heart of spending, the latest jobs report leaves plenty of room for doubt about the future. Private payrolls are growing, but the trend appears to be stuck in a below-average range, which suggests that PCE will suffer headwinds in the year ahead.
One of those headwinds is the reluctance to borrow at anything close to the levels seen before the recession. Total outstanding consumer credit, for instance, is roughly 7% below the cyclical peak set in 2008, and the trend of late offers limited support for thinking new highs are coming any time soon. Total outstanding consumer credit is still contracting on a year-over-year basis, falling by a bit more than 2% for the year through last November. The self-imposed austerity is fading a bit, but it's an open question if this trend will sustain itself and run up borrowing to levels of yore.
Haver Analytics reports that over the past decade there's a 60% correlation between the annual rate of change in outstanding credit and consumer spending. By that standard, it's still too early to dismiss the austerity factor.
January 10, 2011
STRATEGIC EYE CANDY
Strategic investment perspective is essential, but it doesn’t grow on trees. If you’re looking for context beyond the usual suspects, you’ll have to dig deeper. The good news is that there are lots of opportunities for mining strategic intelligence. Too many, perhaps. One of the biggest challenges in developing intuition about portfolio design and management is deciding where to cut off the analysis and start making actual investment decisions.
It’s not obvious where to begin either, but here are a few possibilities. Let’s start with Sharpe ratio, a risk measure that compares excess returns over the risk-free rate with return volatility. Higher Sharpe ratios equate with superior risk-adjusted return. Imagine two securities, each with the same annualized historical return—10%, for instance. But one security posts a 15% annualized standard deviation (volatility) and the other weighs in at 20%. The Sharpe ratio for the first security (0.66) is higher than the second (0.5). The difference implies that the first security delivered a higher return per unit of risk, i.e., a higher risk-adjusted return.
Sharpe ratios are only one risk measure in a sea of atlernatives and so this metric should only be considered in context with additional analysis. But every thousand-mile journey must begin with the first step and Sharpe ratios are a worthy launch of any investment expedition. With that in mind, consider how rolling 3-year Sharpe ratios for U.S. stocks (S&P 500), REITs (MSCI REIT), U.S. bonds (Barclays Aggregate Bond), and commodities (Dow Jones-UBS Commodity) compare since the late-1990s, as shown in the chart below.
Sharpe ratios obviously aren’t written in stone. Risk-adjusted performance fluctuates, sometimes by more than a little in a short period. Unfortunately, the fluctuation can be random, but only partly. High Sharpe ratios tend to give way to lesser readings, and vice versa. Timing is always unknown, but the cyclical aspect is intriguing and perhaps useful to a degree. On that note, bonds generally post relatively high Sharpe ratios vs. stocks, REITs and commodities these days. That profile more or less reverses the state of affairs for Sharpe ratios in the days before the Great Recession and financial crisis of 2008.
Next up is rolling 3-year correlations between U.S. stocks and REITs, bonds and commodities. Correlation of return is a measure of performance independence. Two return series with a 1.0 reading are said to have perfect positive correlation. In effect, they’re indistinguishable, and therefore of no value for portfolio diversification. At the opposite extreme is a -1.0 reading, or perfect negative correlation. That is, one security moves in the exact opposite direction at all times vs. another. In the middle is a zero correlation, which equates with totally random behavior between two securities.
The obvious trend in the correlation chart above is that there’s a fair amount of change through the years. Indeed, correlations between U.S. stocks and the other three asset classes have risen in recent years. But within that broader trend it’s also true that the correlation between stocks and bonds is trending down. Is something comparable on tap for stock/commodity and stock/REIT correlations?
The third chart below compares rolling 3-year annualized total returns. Lots of volatility here too, albeit with the exception of bonds. Unsurprisingly, investment-grade fixed income is a relatively tame asset class. That doesn’t mean you can’t lose money in bonds, but the short-term whipsaws are likely to be less of a roller coaster ride vs. stocks, REITs and commodities.
What can you do with the strategic information in the charts above? One possibility is using the trends to identify productive periods for rebalancing a multi-asset class portfolio. In late-2002 and early 2003, for instance, the Sharpe ratio on U.S. bonds was soaring as the Sharpe ratio on U.S. stocks was crashing. As it turned out, that was a ripe moment for rebalancing.
That brings up the observation that bond Sharpe ratios have been relatively elevated lately while the equivalent for U.S. stocks, REITs and commodities are somewhat depressed. Hmmm….
Political assassination and the United States aren’t usually discussed in the same breath, but they are now. In the wake of the Arizona shooting rampage on Saturday at a public event that critically injured U.S. Rep. Gabrielle Giffords, killed a federal judge, and left more than a dozen others dead or wounded, morning in America today has a sad new meaning.
“There is little that we can do but pray for those who are struggling," Rep. Giffords’ husband wrote in a statement released last night. In the coming days and weeks there will be ramifications beyond the personal tragedies of this horrendous crime as well. Exactly how this event will change the debate and the focus is unclear. Meantime, "everyone has pulled back to pause and reflect," The Washington Post observes, adding:
The practical question raised by the tragic events in Tucson is how much risk politicians must accept as part of their job. Elected officials live with risk every day. Only a handful of lawmakers have security protection: the top leaders and occasionally a member who has received extraordinary threats. The rest carry on their duties fully exposed to whatever fury may await them, whether rhetorical insults hurled from a crowd at a town hall meeting or the violent act of a sick individual with access to a gun.
It's likely that members of Congress, or candidates running for other offices, will reconsider how they hold public events.
The suspected gunman has been labeled as "mentally unstable," but that hasn't stopped a new debate about whether the political rhetoric in the nation is partly to blame. Meantime, House majority leader Eric Cantor (R) announced on Saturday that all legislation scheduled for debate this week, including a vote to repeal the health-care reform law, is postponed “so that we can take whatever actions may be necessary in light of today’s tragedy.”
It's unclear how this crime will affect policy, but there will be repercussions. What looked plausible and possible last week is now open for debate. Details to follow.
January 7, 2011
BOOK BITS FOR FRIDAY: 1.7.2011
● Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System
By Barry Eichengreen
Summary via publisher, Oxford University Press
For more than half a century, the U.S. dollar has been not just America's currency but the world's. It is used globally by importers, exporters, investors, governments and central banks alike... This dependence on dollars, by banks, corporations and governments around the world, is a source of strength for the United States. It is, as a critic of U.S. policies once put it, America's "exorbitant privilege." However, recent events have raised concerns that this soon may be a privilege lost. Among these have been the effects of the financial crisis and the Great Recession: high unemployment, record federal deficits, and financial distress. In addition there is the rise of challengers like the euro and China's renminbi. Some say that the dollar may soon cease to be the world's standard currency--which would depress American living standards and weaken the country's international influence.
In Exorbitant Privilege, one of our foremost economists, Barry Eichengreen, traces the rise of the dollar to international prominence over the course of the 20th century. He shows how the greenback dominated internationally in the second half of the century for the same reasons--and in the same way--that the United States dominated the global economy. But now, with the rise of China, India, Brazil and other emerging economies, America no longer towers over the global economy. It follows, Eichengreen argues, that the dollar will not be as dominant. But this does not mean that the coming changes will necessarily be sudden and dire--or that the dollar is doomed to lose its international status.
● The Price of Everything: Solving the Mystery of Why We Pay What We Do
By Eduardo Porter
Review via Bloomberg
“Every choice we make,” Porter writes, “is shaped by the prices of the options laid out before us -- what we assess to be their relative costs -- measured up against their benefits.”
Porter, a member of the New York Times editorial board, finds value where others see garbage. A child in New Delhi can make 20 to 30 rupees a day -- 45 to 67 U.S. cents -- picking through dumps (and risking her health) for plastic bottles that many Americans wouldn’t bother returning to the supermarket for the nickel deposit. Rich or poor, we humans weigh prices against opportunity and risk.
“The price we put on things -- what we will trade for our lives or our refuse -- says a lot about who we are,” he says.
Each chapter riffs on the main theme: the Price of Things, the Price of Life, the Price of Happiness and so on. Though short on firsthand reporting, the book smoothly synthesizes economic research and anecdotal evidence.
● The Futures: The Rise of the Speculator and the Origins of the World's Biggest Markets
By Emily Lambert
Review via The Wall Street Journal
In "The Futures," Emily Lambert addresses the subject with as much affection as is ever likely to be stirred by the pork-belly business. She's a believer: "With futures, traders were more than gamblers. Gamblers created risk to bet on. They threw dice that didn't have to be thrown. But in the futures business, men bet on risks that already existed. The corn crop could fail."...Trading developed because of the inherent delay in some of these commodities' coming to market—eggs could be stored, corn had to be harvested and beef had to be butchered. The time-lag involved in each introduced an element of risk. Ms. Lambert thus portrays the Chicago Board of Trade, founded in 1851, and the Merc, begun in 1874, as organic extensions of their various industries, providing, in effect, insurance to protect the growers and other producers.
Thankfully Ms. Lambert, a writer for Forbes magazine, does not portray these markets as Hallmark incarnations of perfect capitalism. She lavishes attention on a rogues' gallery of traders who routinely tried to corner (that is, monopolize) the supply.
● Your Money Ratios: 8 Simple Tools for Financial Security
By Charles Farrell
Review via JoeTaxPayer.com
I think that this book would benefit people at any stage of their life (hmm, maybe the blurb on the cover stating “for every stage of life” really sunk in). Someone just starting out can get a good understanding of how to start on a good financial path, knowing in their 20′s what their goal is 30 some years hence. An older reader can get an understanding of whether or not they’re on target and perhaps better calculate what their goals are. More than anything, the writing style and tone of the book was something that put me at ease. We are offered targets but not made to feel that these number are rigid, carved in stone.
● Basic Economics 4th Ed: A Common Sense Guide to the Economy
By Thomas Sowell
Summary via publisher, Perseus Academic
The fourth edition of Basic Economics is both expanded and updated. A new chapter on the history of economics itself has been added, and the implications of that history examined. A new section on the special role of corporations in the economy has been added to the chapter on government and big business, among other additions throughout the book.
LABOR DEPT REPORTS MODEST JOB GROWTH FOR DECEMBER
Private-sector payrolls increased in December—the 12th consecutive monthly gain, the Labor Department reports. The trend is certainly favorable, although the details are disappointing. That's partly because the net rise in job creation in corporate America was well below the increase implied by ADP's estimate for December. Foiled again.
Nonfarm private payrolls increased by a net 113,000 last month. That's up from November's revised 79,000 gain, but the pace is still weak by historical standards and far below what economists say is required to put the economy on a sustainable growth path that delivers more than simply keeping the next recession at bay.
On the other hand, the crowd can point to a relatively large fall in the jobless rate last month to help ease the frustration with the lack of stronger job growth. The unemployment rate dropped to 9.4% in December from the previous month's 9.8%. December's jobless rate is the lowest since May 2009. It's also the biggest monthly decline in unemployment since the recession officially ended in June 2009. Some analysts think there's a disconnect between the decline in unemployment and the tepid net gain in payrolls, but questioning the good news is par for the course these days too. There's always a reason for skepticism with the macro number du jour, and today's no exception.
Any way you slice it, the drop in the jobless rate is bittersweet. The ADP report from earlier this week, after all, juiced up expectations that the labor market had finally turned the corner and so substantially stronger job growth was at hand. That may still be true, but the revised thinking will have to wait at least another month.
For now, the pace of job creation reflects more of the same: modest growth. That's better than losses, but one might wonder how long the market will accept lukewarm numbers before throwing a hissy fit.
What will change the middling trend in employment growth? Good question. For the moment, no one has a good answer.
“The economy is adding workers but there are no reliable signs the pace of hiring is improving,” Julia Coronado, chief economist for North America at BNP Paribas, tells Bloomberg. “We are staying on track but I’m not sure growth is set to accelerate.”
Nor does a closer look at December's modest employment increase necessarily stir thoughts that salvation is around the next statistical bend. For starters, the cyclically sensitive goods-producing corner of the economy continues to slump, posting a slightly net loss in payrolls last month, which follows November's setback. Government employment continues to shrink as well.
Let's turn to the bright spots, which includes one corner of the goods-producing sector: manufacturing, which netted 10,000 new positions last month. Of course, the big gains remain firmly in the services sector, which employs the lion's share of the nation's workforce. Last month witnessed a net rise of 115,000 payrolls in services, up from November's 84,000 gain. So far, so good. But nearly 40% of the increase in services jobs was in the education and health industries. A comparable rise was posted in leisure and hospitality. Nothing wrong with that, and the gains are surely welcome in a time of high unemployment. But gains in these areas aren't exactly the type of economic growth that motivates expectations that the U.S. is poised to return to the heady days of robust labor market increases in the pre-2008 era. Then again, maybe the next boom will be centered in hospitals and hotels. Stranger things have happened.
But let's not overdo the pessimism. The economy is minting new jobs and the recession is clearly over, at least from a macro perspective. That's not going to satisfy Main Street necessarily, but for the moment that's all we've got. Yes, the era of diminished expectations is still here, and today's job report isn't making it easy to revise the diagnosis.
“The trend towards employment growth is intact," says Peter Kenny, managing director at Knight Capital Group, via Fox Business. "It’s disappointing but it’s still a gain."
WHEN WILL JOB GROWTH END THE HOUSING SLUMP?
The labor market and housing are two of the biggest headwinds still hobbling the economy. Job growth, at least, seems to be picking up, as ADP’s latest estimate of payrolls suggests. The case for optimism faces a higher hurdle with housing, however, a sector where the suffering rolls on.
How bad is it? A picture’s worth a thousand words, as they say. Consider the annual rate of change in four housing indicators:
• New housing starts
• New single-family houses sold
• New building permits issues
• The S&P Case-Shiller 20-City Home Price Index
As the chart below shows, all are now falling on a year-over-year basis. After a brief recovery, the housing market is trending down once more.
Housing has been in a bear market for some five years. Is there any end in sight? The optimistic view is that this sector is due to stabilize. Growth worthy of the name, however, is still a long way off. It’s not for lack of incentives. Mortgage rates are at or near rock bottom. Meanwhile, it’s a buyer’s market in every sense of the phrase in terms of supply and demand. Indeed, in most regions and cities across the country, there’s still a glut of houses relative to buyers.
What’s the solution? Ultimately, it’s still all about jobs. When the net change in nonfarm payrolls is rising on a sustained level at, say, 200,000-plus, it’s reasonable to expect that housing may finally be headed for better times.
The good news is that job growth seems to be recovering. Private nonfarm payrolls are rising once more, as the chart below shows. But the pace of recovery in the labor market is still modest by historical standards. The net change in private nonfarm payrolls has averaged +90,000 for the past year. That’s not good enough to bring the housing market out of its slump. Perhaps the December payrolls report from the Labor Department that’s scheduled for release later today will bring better news.
“Real estate remains a pothole due to uncertainty,” John Tuccillo, a housing analyst and former chief economist for the National Association of Realtors, says in a recent interview. “The ‘what-if’ factor is hurting us. People don’t know if they’ll have a job; don’t know if we’ve reached the bottom of the market; don’t know if more bank failures are imminent; don’t know if housing is the answer at all.”
January 6, 2011
JOBLESS CLAIMS ROSE LAST WEEK, BUT THE TREND IS STILL FAVORABLE
New filings for jobless benefits jumped by 18,000 to 409,000 on a seasonally adjusted basis in the final week of 2010, according to this morning’s Labor Department update. That’s a bit of a disappointment after last week’s news that initial claims dipped below 400,000 for first time since the summer of 2008. But it’s hardly time to throw in the towel on expecting better days ahead for the labor market.
One reason for optimism is that weekly claims are still trending lower overall. The four-week moving average of jobless claims is now at its lowest level since late-July 2008 (see red line in the chart below). The media usually focuses on the latest weekly figure, and so today’s update may look distressing to a general audience. But the initial claims series is volatile and so any one data point should be viewed skeptically, particularly when we’re talking of the Christmas and New Year’s holiday weeks. The longer-term trend is far more relevant, and that standard still implies that a modest improvement in the labor market is unfolding.
Yesterday’s surprisingly good news in the December ADP Employment Report suggests as much. So too does the broad macro trend. The proprietary U.S. economic index published in The Beta Investment Report tracks 18 indicators, with an emphasis on leading indicators. November is the last full month with data for all 18 metrics. The percentage of those indicators rising on a monthly basis reached its highest point in November since the previous spring, suggesting that there’s a bit more strength in the economy these days.
Nonetheless, the recovery is still precarious. Jobless claims running in the 400,000 range on a weekly basis is hardly a sign of a strong economy. It’s still debatable if the labor market is headed for a higher level of sustainable growth. Perhaps we’ll find more clarity in tomorrow’s employment update for December from the U.S. Labor Department.
Meantime, the risk of expecting too much too fast can't be dismissed. "There has been a steady decline in new filings,” observes Patrick O'Keefe, director of economic research at the tax firm J.H. Cohn via TheStreet.com. “But the reduction in continuing claims has not been significant enough to suggest that hiring is really robust. That said, we are down half a million [in continuing claims] since Labor Day, which is not insignificant."
Omair Sharif, an economist at RBS Securities, tells Bloomberg that “the recovery in the labor market is continuing to move along at a gradual pace.” That implies that “employers are getting to the point where they are becoming a little more confident about the strength of the recovery.”
Will tomorrow's payrolls update for December juice confidence further? Stay tuned.
MACRO SURVEILLANCE FOR THURSDAY: 1.6.2011
Predictions for 2011 by BlackRock’s Bob Doll
● U.S. stocks will record 3rd straight year of double-digit gains
● US Real GDP Will Hit All Time High in ’11, Marking Economy’s Transition from Recovery to Expansion
“Our expected gains for the equity markets for 2011 are not much different from what we expected for 2010,” he said. “What’s different for 2011 is that market risk will be more to the upside than was the case in 2010.”
The possible upside factors include an acceleration in jobs gains, a surprise in real GDP, earnings exceeding expectations as occurred in 2010, and Washington D.C. beginning to address the nation’s fundamental debt and budget problems. On the other hand, Doll’s “what can go wrong?” list includes the possibility of credit problems resurfacing (including US housing, sovereign nations, and state and local governments), commodities price increases causing profit margin pressure, inflation fears, a greater than expected rise in interest rates, undue emerging markets tightening to curb asset bubbles, and
currency and capital flow concerns leading to protectionist trade wars.
Blackrock, Jan 5
US Economic and Interest Rate Outlook, January 2011
With regard to 2010 real GDP growth, we now expect Q4/Q4 growth of 2.9% vs. 2.3% in the November forecast Based on Q4 forecast. 2010 available data, real GDP appears to be coming in at an annual rate of 3.6% rather than the 1.9% we were projecting in November. In addition, the Commerce Department revised up Q3:2010 real GDP growth from 2.0% to 2.6%.
Northern Trust, January 2011
Grubb & Ellis 2011 Forecast
Grubb & Ellis expects GDP growth in the range of 2.5 to 3 percent in 2011, still a little below the economy’s long-term growth potential of around 3 percent. U.S. companies are sitting on record cash reserves of nearly $2 trillion, some of which they will deploy as demand from businesses and consumers expands modestly. Employers are likely to add 1.5 million net new payroll jobs, right at the level needed to accommodate the growing labor force, which means that the unemployment rate will remain stubbornly high.
Grubb & Ellis, January 2011
Monster U.S. online jobs index 130 in December
A monthly gauge of online labor demand in the United States in December edged down from the previous month, but was 13 percent above the reading from a year ago, a private research group said on Thursday. Monster Worldwide Inc., an online careers and recruiting firm, said its employment index fell to 130 points in December from 134 in November. The current month's reading is 13 percent above the 115 mark a year ago. Labor demand has been especially strong in areas associated with business investment, including utilities, wholesale trade and transportation and manufacturing, while public sector hiring has lagged, Jesse Harriott, a vice president at Monster, said in an interview.
Reuters, Jan 6
Inflation, Capital Inflows: Asia and the Challenges of Success in 2011
Asia—including the Association of Southeast Asian Nations, industrial and Emerging Asia—is expected to post an average of 7 percent growth in 2011, one percentage point slower than last year, but the region will still need to continue managing its exit from stimulus programs and the large capital inflows pouring into the region, says one of the IMF’s leading economists.
International Monetary Fund, Jan 4
Junk Bond Spreads Narrow to the Least Since November 2007 as Economy Grows
Investors are accepting the lowest relative yields on speculative-grade debt in more than three years as new issues from borrowers such as Charter Communications Inc. rally amid signs the economy is improving...Spreads on junk bonds declined 5 basis points yesterday to 527 basis points, or 5.27 percentage points, Bank of America Merrill Lynch index data show...Spreads have declined from a record 21.8 percentage points in December 2008 as the default rate for U.S. junk bonds fell for a 12th consecutive month in November to 3.35 percent, according to Standard & Poor’s.
Bloomberg, Jan 5
China PBOC's Zhou: Growth Sound But Inflation Pressure Rising
The momentum of China's economic expansion remains sound, though inflation pressure is on the rise while quantitative easing by other countries will only add to imported price pressures, People's Bank of China Governor Zhou Xiaochuan said in an interview with China Finance.
"The extreme conditions of the financial crisis have moderated and external demand is stable. We can maintain stable and relatively fast economic growth with a prudent monetary policy," Zhou told the central bank-backed magazine.
iMarketNews, Jan 5
Minutes of the Federal Open Market Committee (December 14, 2010)
With the recent data on production and spending stronger, on balance, than the staff anticipated at the time of the November FOMC meeting, the staff revised up its projected increase in real GDP in the near term. However, the staff’s outlook for real economic activity over the medium term was little changed, on net, relative to the projection prepared for the November meeting. The staff forecast incorporated the assumption that new fiscal actions, some of which had not been anticipated in its previous forecast, were likely to boost the level of real GDP in 2011 and 2012. But, compared with the November forecast, a number of other conditioning assumptions were less favorable: House prices and housing activity were likely to be lower, while interest rates, oil prices, and the foreign exchange value of the dollar were projected to be higher, on average, than previously assumed. As a result, although the staff projection showed a higher level of real GDP, the average pace of growth over 2011 and 2012 was little changed from the November forecast, and the unemployment rate was still projected to decline slowly.
Federal Reserve, Jan 4 (release date for Dec 14 minutes)
Obama renominates MIT economist Diamond for Fed Board
President Barack Obama on Wednesday renominated economist and Nobel laureate Peter Diamond to the Federal Reserve Board, sticking with a pick that has already been thwarted by Senate Republicans twice.
Diamond, who won the Nobel Prize for economics in October, together with two other economists for their analysis of labor markets, has been backed twice by the Senate Banking Committee but both times was denied a full Senate vote.
Reuters, Jan 5
Health-care spending rose less in 2009
The nation's expenditures on health care in 2009 grew by 4 percent, the smallest increase in at least a half-century, according to new federal figures that suggest Americans stinted on medical services as they lost jobs and insurance in the recent recession.
Washington Post, Jan 6
January 5, 2011
2010’s STOCK MARKET WINNERS… AND LOSERS
It was a very good year in 2010 for individual stock markets around the globe. Most of the world’s exchanges ended the year at higher levels. Of the 40 bourses in the Russell Global Index, only five suffered a loss.
Greece had the deepest setback, retreating by more than 40%, according to Russell Investments. At the top of the list: the Philippines, which soared by 77%.
The Russell Global Index, a market-cap weighted benchmark of the 40 markets, rose 15.2%. U.S. equities advanced by 16.9% last year, according to Russell.
How did the other markets fare? Here’s how the crowd stacks up...
ADP: DECEMBER PAYROLLS SURGE
The economy created a net 297,000 jobs in the private sector last month, according to the ADP National Employment Report. That’s the largest monthly gain in the 10-year history for this series. The relatively large increase suggests that Friday’s employment report from the U.S. Bureau of Labor Statistics will bring equally encouraging news.
A strong rise in payrolls based on the widely followed government numbers would certainly be welcome after November’s disappointing news. Private sector employment added only 50,000 jobs on a net basis in November, according to the Labor Department—one of smallest gains since the labor market began recovering more than a year ago. Today’s report from ADP implies that job creation is poised for better days.
Thinking positively jibes with the latest batch of economic reports. The manufacturing sector, for instance, expanded again in December—the 17th straight month of growth, according to the Institute for Supply Management. And last week’s report on weekly jobless claims advises that new filings for jobless benefits dropped below 400,000 on a seasonally adjusted for the first time since the summer of 2008. The embedded message: job creation is picking up.
Additional confirmation may arrive on Friday, but tomorrow’s weekly update on jobless claims comes first. The first order of business is deciding whether last week’s drop below the 400,000 mark was a sign of things to come, or just a head fake from the week leading up to the Christmas holiday. What does the crowd think? For the moment, the consensus forecast anticipates a mild bit of backtracking in tomorrow's number. Economists are expecting weekly jobless claims of 405,000, or moderately above last week's 388,000, according to Briefing.com.
DO LABOR COSTS DRIVE INFLATION?
Discussions over what’s in store for the economy and the markets inevitably turn to inflation. That’s a bit odd, considering that there’s none to speak of at the moment, at least according to official yardsticks. Consumer price inflation is rising at about 1% a year, according to the U.S. Labor Department, or near the lowest pace in decades.
One might expect that historically low inflation would banish worries over pricing pressures. But pondering the risk remains topical, as it was at a press briefing yesterday in New York hosted by Prudential that focused on the investment landscape for the year ahead. One strategist advised that the inflation threat continued to look subdued. “The odds of inflation picking up are very, very low,” said Ed Keon, managing director and portfolio manager for asset allocation, at Quantitative Management Associates, a Prudential unit. Why? Labor costs are falling, he told a capacity crowd at the Le Parker Meridien hotel's Estrela Penthouse that overlooks Central Park.
A check with the Labor Department numbers confirms no less. Unit labor costs in nonfarm businesses slipped 0.1 percent in last year’s third quarter and are lower by 1.1% vs. a year earlier.
It all looks fairly cut and dry. Labor costs are falling, and so that translates into lesser inflation. A reasonable assumption, in part based on research that shows that labor costs generally account for around two-thirds of total business costs. If the biggest expense in the private sector is declining, inflation pressures must be waning, runs this school of thought.
Monetarists argue otherwise, invoking Milton Friedman’s famous quote: "Inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output." Yes, although the relationship between monetary aggregates and inflation is complicated, particularly in the short term. But that’s an issue for another day.
Speaking of complications, the research literature on labor costs and inflation is nuanced too. The intuition for a relationship between the two comes from the Phillips curve, which posits that inflation and the unemployment rate are inversely correlated. In other words, an increase in the jobless rate is linked with lower inflation, and vice versa. But the empirical record on testing this idea is, at best, mixed.
“An important implication of price-type Phillips curve models is that prices are determined by the behavior of labor costs,” a 1990 study from the Richmond Federal Reserve advises. “If so, then labor costs should help predict the price level. The empirical evidence reported in this article does not support this conclusion.”
The case for skepticism about the so-called cost-push framework driving inflation is hardly the brainchild of one rogue analyst. A number of reports over the years have also cast doubt on the theory, including a paper published last year that argues that wage trends aren’t all that useful for predicting inflation. On the other hand, there does seem to be some evidence that the relationship works in reverse: inflation appears to forecast wage growth.
A few years ago, the Economic Policy Institute's Jared Bernstein (who's now Vice President Joe Biden’s chief economist) wondered if inflation and unit labor costs are a “phantom menace.” Maybe, but not everyone thinks the connection is feeble. A recent working paper by economist Farrokh Nourzad at Marquette University advises that unit labor costs are a “reliable indicator of price inflation.” In fact, there’s a global dimension to rising inflation via higher labor costs, a 2009 study from the European Central Bank asserts.
Fed Chairman Ben Bernanke has been known to embrace the concept of wage-based inflation as well.
But what should we make of the conflicting research on the question of whether labor costs drive inflation? Is this a genuine threat? Perhaps the answer is…it depends.
Labor cost inflation is cyclical, argues Anirvan Banerji of Economic Cycle Research Institute in a 2005 essay. “While there is obviously some rough correspondence between labor cost inflation and consumer price inflation, the question is whether, empirically, cyclical turns in the former systematically anticipate cyclical turns in the latter. If so, labor cost inflation would be an important predictor of consumer price inflation, validating the cost-push model of inflation.” But as he goes on to explain,
…labor cost inflation is not a consistent predictor of cyclical upswings and downswings in general consumer price inflation. As a result, analysts should use caution when interpreting cyclical swings in labor costs growth rates--as recent history shows, price inflation may enter a cyclical upturn before labor cost inflation does.
In other words, sometimes labor costs are critical factor in assessing the risk of future inflation, sometimes not. No one would accept such middle-of-the-road evaluations in aerospace engineering or plumbing. Economics, of course, is different.
January 4, 2011
RESEARCH REVIEW: THE GREAT RECESSION
The Great Recession versus the Great Depression: Stylized Facts on Siblings That Were Given Different Foster Parents
Karl Aiginger/May 2010/Economics-ejournal.org
The aim of this paper is to investigate whether the drop in economic activity in the recent crisis1 has been as large as in the Great Depression of the nineteen thirties…The data show that the drop in activity has definitely been smaller in the recent crisis. The crisis had however the potential to become as severe as the Great Depression…In the recent crisis economic policy reacted expeditiously, prudently, and to a surprising extent coordinated at an international level.
The Great Recession and Its Aftermath from a Monetary Equilibrium Perspective
Steven Horwitz and William Luther/Oct 2010/Mercatus Center, George Mason University
We argue that the primary source of business fluctuation observed over the last decade is monetary disequilibrium. Additionally, we claim that unnecessary intervention in the banking sector distorted incentives, nearly resulting in the collapse of the financial system, and that policies enacted to remedy the recession and financial instability have likely made things worse…The origins of the Great Recession in the housing market have been well documented. Austrian economists have consistently argued that excessively expansionary monetary policy generated a credit boom while a series of regulatory and institutional interventions encouraged the resulting malinvestment to concentrate in the real estate sector of the economy. Policy errors—not a market gone mad—created a bubble that eventually had to burst.
internal Sources of Finance and the Great Recession
Michelle L. Barnes and N. Aaron Pancost/Dec 2010/Boston Federal Reserve
The financial crisis and ensuing credit supply shock that began in August 2007 was distinguished in part by the largest and most persistent drop in real private nonresidential equipment and software investment growth since the Bureau of Economic Analysis (BEA) began data collection in 1947. At the same time, aggregate cash holdings as a share of total assets for non-financial corporations were at a 30-year high as the crisis began, which should have provided firms with a very large cushion to absorb any shock to the supply of credit...
We show, using accounting identities and a few simplifying assumptions, that the large build-up in cash noted by Bates, Kahle, and Stulz (2009) and other authors is the result of increased saving of internally generated cash flows. Consistent with a precautionary motive for saving cash, we show that rms that had stock-piled more internal cash had better investment outcomes in the Great Recession than other firms.
Effects of the Financial Crisis and Great Recession on American Households
Michael Hurd and Susann Rohwedder/Nov 2010/Rand Corp
In this paper we present results about the effects of the economic crisis and recession on American households. They come from high-frequency surveys dedicated to tracking the effects of the crisis and recession that we conducted in the American Life Panel – an Internet survey run by RAND Labor and Population. The first survey was fielded at the beginning of November 2008, immediately following the large declines in the stock market of September and October. The next survey followed three months later in February 2009. Since May 2009 we have collected monthly data on the same households...
According to our measures almost 40% of households have been affected either by unemployment, negative home equity, arrears on their mortgage payments, or foreclosure. Additionally economic preparation for retirement, which is hard to measure, has undoubtedly been affected. Many people approaching retirement suffered substantial losses in their retirement accounts: indeed in the November 2008 survey, 25% of respondents aged 50-59 reported they had lost more than 35% of their retirement savings, and some of them locked in their losses prior to the partial recovery in the stock market by selling out. Some persons retired unexpectedly early because of unemployment, leading to a reduction of economic resources in retirement which will be felt throughout their retirement years. Some younger workers who have suffered unemployment will not reach their expected level of lifetime earnings and will have reduced resources in retirement as well as during their working years.
Unconventional Monetary Policy and the Great Recession - Estimating the Impact of a Compression in the Yield Spread at the Zero Lower Bound
Christiane Baumeister and Luca Benati/Oct 2010/European Central Bank
The paper’s main focus is on two questions:
• ‘How effective have central banks’ unconventional monetary policy actions been at countering the recessionary shocks associated with the 2007-2009 financial crisis?’
• ‘More generally, how powerful is monetary policy at the zero lower bound, once all traditional ammunition has been exhausted?’
The paper’s main results may be summarised as follows:
First, in all the countries which are analysed herein, a compression in the longterm yield spread exerts a powerful effect on both output growth and inflation.
Second, evidence clearly highlights the importance of allowing for time variation, as the impact of a spread compression exhibits, in several cases, important changes over the sample period. In the United States, for example, the impact on inflation exhibits three peaks corresponding to the Great Inflation of the 1970s, the recession of the early 1990s, and the most recent period, whereas the 1990s were characterised by a significantly weaker impact. By the same token, in the United Kingdom the impact on both inflation and output growth appears to have become stronger in recent years.This automatically implies that, for the present purposes, the use of fixed-coefficient models estimated over (say) the last two decades would offer a distorted picture, as it would under-estimate the impact resulting from yield spread compressions engineered by central banks via asset purchase programmes in countering the recessionary shocks associated with the 2007-2009 financial crisis.
Third, conditional on Gagnon et al.’s (2010) estimates of the impact of the FED’s asset purchase programme on the 10-year government bond yield spread, counterfactual simulations indicate that U.S. unconventional monetary policy actions have averted significant risks both of deflation and of output collapses comparable to those that took place during the Great Depression. The same holds true for the United Kingdom conditional on Bean’s (2009) broad estimate of the impact of the Bank of England’s asset purchase programmes on long-term yield spreads.
January 3, 2011
WHAT A YEAR...WHAT A DECADE!
It was a very good year—no doubt about it. The capital and commodity markets delivered strong gains in 2010. It was nearly a clean sweep, in fact, with prices rising across the board among the major asset classes. But it was also a volatile year. The handsome gains for the past 12 months masks the turmoil that roiled the markets at times. As a result, attempts at trading in pursuit of market-beating returns was a treacherous game. As usual, those who succeeded came at the expense of those who failed. Meantime, a broadly defined, passively weighted mix of everything dispensed middling performance.
Last year’s annual performance tally also gave us an expansive array of returns. As our chart below shows, the return spread was wide—more than 20 percentage points—for the major asset classes in 2010. If you also consider cash, which suffered a near-zero return, the performance spread widens to nearly 30 percentage points among the broadly defined markets.
The big winner in 2010's return race: real estate investment trusts (REITs). Securitized real estate gained nearly 29% last year. In last place (excluding cash): developed-market government bonds excluding the U.S. (in unhedged U.S. dollar terms), dispensing a relatively tepid 5.2% over the past 12 months.
The red bar in the chart above shows the return for the Global Market Index (GMI), a passively weighted, unmanaged benchmark of all the major asset classes. In 2010, GMI rose by a strong 11.4%. In other words, mindlessly buying everything and making no effort to time or trade the components delivered roughly average results vs. the performance records for the constituent parts. Not bad for a know-nothing strategy that can be implemented with low-cost ETFs for around 50 basis points.
How has GMI fared over the past decade? It pales compared with the year that just passed. GMI’s trailing 10-year annualized total return through the end of 2010 is 5.3%, as indicated by the red bar in the second chart below. In addition to suffering a haircut in absolute terms vs. 2010's results, the past decade for GMI is also below average in relative terms as measured by the individual asset classes.
What happened? Returns in the developed world’s equity markets posted unusually modest results. U.S. stocks, for instance, earned only 2.2% a year since the end of 2000. Foreign equities in mature economies didn’t do much better. Because those two pieces of capital markets comprise slightly more than half of GMI’s market cap, the sluggish performance took a toll.
The good news is that there are low-risk methods for boosting return for a multi-asset class strategy, and the decade behind us was no exception. A simple year-end rebalancing of GMI would have boosted the index’s 10-year annualized trailing performance to 6.2%, or comfortably above the 5.3% performance for the unmanaged buy-and-hold version of the benchmark.
Another intriguing possibility is equal weighting GMI’s components, which some observers might label a model-free index design. Whatever you call it, resetting GMI’s constituents to equal weights every December 31 generated an 8.8% annualized total return for the last 10 years.
The lesson once again is that some simple strategies that require no skills or forecasting powers can bring decent results--even in a decade that was burdened with extraordinary financial and economic challenges.
There are, of course, alternative strategies for besting GMI. You could, for instance, buy a handful of asset classes on the assumption that you picked the winners and shunned the losers. Or, you could use actively managed funds to fill out your asset allocation. But history lessons on this front inspire caution. Indeed, as a recent study in The Beta Investment Report reveals, a bit more than half the efforts at active asset allocation in multi-asset class mutual funds trailed GMI return over the last 10 years. The question is whether you’re confident that you’ll be in the half that wins over the next 10 years? This much, at least, is clear: roughly half of investors and institutions are destined for below-average results, relative to GMI's performance. Because this benchmark represents the opportunity set for most conventional investment strategies, it's highly likely to end up as an average performer over time.
One way to improve your chances of doing slightly better than average is embracing broad diversification across all the major asset classes and periodically rebalancing the mix. That's a low-risk methodology with encouraging odds for capturing a big slice of the global risk premium in the long run, and perhaps over shorter periods as well.
Yes, you can do better, but you can also do worse. If you can’t afford to suffer the latter, you should think twice before pursuing the former.