February 28, 2011
Spending & Income Rise In February
Personal income and spending rose again in January, the U.S. Bureau of Economic Analysis reports. The news offers fresh ammunition for arguing that the trend remains encouraging for two key pillars of the economy. But there's some fine print to consider. It remains to be seen how (or if?) the Middle East turmoil, and the associated rise in energy prices, will alter consumer behavior. As such, the February numbers may already be dated. Meanwhile, the jump in income last month was primarily due to a new cut in payroll taxes that began last month. Nothing wrong with that, of course, but it's not the same thing as saying that companies were handing out big raises last month.
On its face, disposable personal income (DPI) continues to look strong, rising 0.7% last month, up from December’s 0.4% rise. That’s the fourth consecutive monthly increase. But after excluding the lower payroll deductions that started in January, DPI gained only 0.1%, according to the government.
Personal consumption expenditures (PCE) advanced in January too, and for the seventh month running, but at a much slower rate: 0.2% vs. 0.5% in December. After adjusting for inflation, PCE actually slipped 0.1%.
“This sees a much weaker start to the year for the US consumer than the market had been looking for,” David Semmens, US economist at Standard Chartered Bank, tells the Financial Times.
The fact that payroll taxes were cut but didn't translate into a clear boost for spending may or may not be a sign that the recent rise in consumption is headed for a downshift. Optimists are once again quick to roll out the explanation that severe winter weather put a lid on trips to the mall. Maybe, but while spring is coming, there’s no obvious resolution for the Middle East trouble, which is a bigger and more enduring threat than snowstorms. Yes, you can argue that democracy and freedom is coming to Egypt and other nations in the region. But for the moment, that's just talk, and there's no shortage of reasons for wondering if the chatter about a new age of liberty in the Middle East will be more than just visions of grandeur in policy journals in the West.
The stakes are clearly high. As the chart below shows, the trend for income and spending has been favorable recently with both metrics posting convincingly stronger results on a 12-month rolling basis. The growth is still well below the pace logged in the pre-recession period, but at least the trend has been encouraging. The question now is whether this rebound is at risk?
The potential for trouble is lower if job growth picks up. Whatever complications the Middle East throw our way will at least be minimized if the labor market grows at something more than a snail’s pace, which describes recent history as defined by net gains in nonfarm payrolls.
This Friday’s jobs report for February may bring better news. The crowd’s looking for a net gain of 193,000, according to Briefing.com. If so, that would be a considerably better number than January’s meek rise of 50,000. Even if the consensus forecast is right, and February’s update shows a gain of nearly 200,000 jobs for the economy, it’ll still be modest relative to what’s needed to reduce the 9%-plus unemployment by more than a token amount. Perhaps Friday will bring word of a surprisingly larger number. But woe to market sentiment if the number falls far short of expectations. Meanwhile, blaming a low number on snow just won’t cut it this time.
Can The Crowd Exploit The Rebalancing Bonus?
James Surowiecki's The Wisdom of Crowds makes a strong case for thinking that large groups of people are generally smarter than even the most intelligent few. The "wisdom" manifests itself in many ways, including price discovery, which is why indexing is such a competitive force in money management. A new research paper seems to reconfirm this point via the broad ebb and flow of mutual fund results. But on closer inspection, there's an intriguing nuance in this study that raises questions about whether investors generally are taking advantage of rebalancing's rewards.
"We find that fund investors alter the riskiness of their portfolios in response to shifting economic conditions, increasing risk as the economy improves and reducing risk in anticipation of economic downturns," advises "The Wisdom of Crowds: Mutual Fund Investors' Aggregate Asset Allocation Decisions," by professors John Chalmers, Aditya Kaul and Blake Phillips. In other words, investors overall make timely decisions in managing asset allocation. This is what you'd expect to find if markets are efficient, although the paper's results conflict with other lines of research that document a history of improving returns with some simple techniques, as I discuss in my book, Dynamic Asset Allocation.
The evidence in favor of rebalancing is quite strong. In fact, one recent study explains that the crowd's reluctance or inability to adjust asset allocation in a timely manner is a key reason why a minority of investors can exploit the rebalancing bonus. There's also a few studies that show that many investors hardly change the portfolio mix at all over long periods of time. It all seems to make sense in the context of rebalancing. Excess returns, after all, are a zero sum game and so winners must be financed by the losers. The idea here is that the many leave alpha on the table, which allows a relative few to reap the rewards.
Yet the new paper by Chalmers, et al. seems to contradict this idea. "Our evidence suggests that mutual fund investors collectively respond to the information in forward-looking financial variables," they write. If the crowd overall is wise, that pokes a hole in the concept that there's a rebalancing bonus that can be exploited by the few. But Chalmers and his co-authors also note that their results are skewed a bit in favor of "sophisticated investors." As they explain,
We study whether the relation between the predictive economic variables and flows varies across investor profiles. Using fund expense ratios and portfolio turnover as proxies for mutual fund investor sophistication, we find that the allocations of sophisticated investors are more sensitive to changes in economic conditions, and account for a large part of the relation between economy-wide flow and economic conditions. In contrast, the relation between flow for funds held by unsophisticated investors and economic conditions is much weaker.
Perhaps this new paper on the wisdom of crowd's doesn't overturn existing research on rebalancing after all. Common sense tells us that everyone can't be above average, even if everyone thinks otherwise.
But what does all this say about market efficiency? Surprisingly, perhaps, it's not necessarily a stake in the heart for the efficient market hypothesis (EMH). Rebalancing can improve returns and/or lower portfolio volatility, which seems to violate EMH. But while there's no increase in volatility (usually) with rebalancing, there's an increase in other risk measures. That starts with the recognition that rebalancing relies on reversion to mean as an asset pricing factor. This is a well-established empirical fact, but mean reversion can't be counted on like clockwork. There are also transaction costs to consider. And successfully rebalancing demands a fairly robust commitment to being a contrarian, which history shows is the exception to the rule for most investors.
There's also a separate point worth noting. Traditional active management in the aggregate can't beat indexing, a concept that also applies to multi-asset class investing, i.e., asset allocation. But that's independent to some degree of recognizing that systematic rebalancing is likely to enhance results for an otherwise identical portfolio that's unrebalanced.
The rebalancing bonus isn't a free lunch and most investors can't earn it, at least not in sizable quantities. But over the long haul, that's not a repudiation of the crowd's wisdom. Then again, wisdom isn't always conspicuous in the short term, nor is it always obvious when looking ahead in real time. History, of course, is quite clear: It's still tough to beat the market, even when you rebalance. That doesn't mean you should mindlessly buy and hold. But don't expect alpha to fall out of trees either.
February 26, 2011
Book Bits For Saturday: 2.26.2011
● ANTs: Using Alternative and Non-Traditional Investments to Allocate Your Assets in an Uncertain World
By Dr. Bob Froehlich
Excerpt via publisher, John Wiley
There is clearly overwhelming evidence that a large percentage of a portfolio’s performance is determined by the percentage of money that an investor places in stocks, bonds, and alternative and non-traditional assets. Then to a much lesser extent, the performance of a portfolio is affected by the individual’s investment selection within those asset classes. The purpose of this book is to help you decide how much of that important 90 percent portion of your portfolio should be allocated to alternative and nontraditional asset classes.
When most individual investors thought of asset allocation, they simply thought of the big three: stocks, bonds, and cash. The reason was that most individual investors really only had these choices available to them. Not so anymore. Individual investors now have the opportunity to invest just like the big institutional investors by having exposure to alternative and non-traditional asset classes as well.
● Safety Net: The Strategy for De-Risking Your Investments in a Time of Turbulence
By James Glassman
Review via Reuters
Glassman’s safe harbor strategy is designed to “protect you against the Category 5 hurricanes of the financial kind.” Forget about living long enough to bounce back from stock market losses. “The older you get, the less long term is left for recovery.”
In practice, Glassman advises cutting back on U.S. stocks, investing in “aspiring” markets (Brazil, China and India) and investing in bonds. Even more cautious these days, Glassman also recommends something a little exotic for most mainstream investors: a genuine hedging strategy. Here’s the skinny on that:
* Buy derivatives to protect against stock losses. You can do this through put options on stock you own or hedge the entire market. These vehicles rise in value if the market drops. There are also inverse exchange-traded funds “bear market” exchange-traded funds that do the same thing, only less precisely.
* Protect against inflation. That means boring Treasury Inflation-Protected Securities. Staples in my portfolio, unlike conventional bonds, TIPS climb in value when the Consumer Price Index rises.
* Find a safe level of stocks, bonds, currencies and hedges for your age and lifestyle and re-balance every year. Sound advice, but nothing new.
● Beyond Mechanical Markets: Asset Price Swings, Risk, and the Role of the State
By Roman Frydman and Michael Goldberg
Review via The Economist
In the past 20 to 30 years, the behavioural-finance school has been chipping away at the efficient-market hypothesis. Far from being hyper-rational actors, expertly analysing all available information and discounting future cashflows at the optimal rate, individual investors show psychological biases, such as being more willing to take profits than cut their losses. In short, they are more like Captain Kirk than Mr Spock...
A new book by Roman Frydman of New York University and Michael Goldberg of the University of New Hampshire tries to steer a third way between the efficient and behavioural schools. They build on an insight of John Maynard Keynes: the factors governing the success of any future investment are too complex to be calculable. Investors face a world marked by “known and unknown unknowns”, in the words of Donald Rumsfeld, a former American defence secretary...
The problem is not just that investors do not know how the fundamentals—profits, interest rates and so on—will develop. They also do not know which things other investors will choose to focus on at different times. For example, a study of Bloomberg news stories showed that only 5% mentioned inflation, which was then unusually low, as a factor driving asset prices between 2001 and 2003. By 2005, when inflation had gone back up again, this proportion had risen to 45%. The authors argue that investors develop strategies to deal with this uncertainty. As the fundamentals change they adjust their forecasts slowly.
● Financial Contagion: The Viral Threat to the Wealth of Nations
Robert W. Kolb, Editor
Excerpt via publisher, John Wiley
Contagion is a fairly new concept in the economics literature—before 1990, it was scarcely mentioned. Early interest in the concept stemmed from international finance, particularly the finance of emerging economies, and concern about contagion was exacerbated by the Asian financial crisis of 1997–1998. Because concern originated in the international arena, the idea of transmission of financial difficulties across national borders has always had a prominence in discussions of contagion. But the financial crisis of 2007–2009, which inaugurated the subsequent Great Recession, provided powerful evidence that contagion was not a phenomenon limited to emerging markets or the arena of international finance.
Although there is little agreement about the meaning of contagion, much has been written about the channels of contagion, or the mechanisms by which financial distress originating in one source spreads to other victims. The problem here is to identify the channels of contagion or themeans by which financial distress spreads from one arena to others...
● The Globalization Paradox: Democracy and the Future of the World Economy
By Dani Rodrik
Summary via publisher, W.W. Norton
Surveying three centuries of economic history, a Harvard professor argues for a leaner global system that puts national democracies front and center. From the mercantile monopolies of seventeenth-century empires to the modern-day authority of the WTO, IMF, and World Bank, the nations of the world have struggled to effectively harness globalization's promise. The economic narratives that underpinned these eras—the gold standard, the Bretton Woods regime, the "Washington Consensus"—brought great success and great failure. In this eloquent challenge to the reigning wisdom on globalization, Dani Rodrik offers a new narrative, one that embraces an ineluctable tension: we cannot simultaneously pursue democracy, national self-determination, and economic globalization. When the social arrangements of democracies inevitably clash with the international demands of globalization, national priorities should take precedence. Combining history with insight, humor with good-natured critique, Rodrik's case for a customizable globalization supported by a light frame of international rules shows the way to a balanced prosperity as we confront today's global challenges in trade, finance, and labor markets.
● Why America Must Not Follow Europe
By Daniel Hannan
Review via Andrew Klavan
I have recommended the Encounter Books’ Broadside series before, but allow me to recommend it again. There’s a new one coming out in about a week that’s just terrific: Why America Must Not Follow Europe by Member of the European Parliament Daniel Hannan. It’s 49 pages, reads smoothly and elegantly, makes its argument soundly and backs it up with facts. The next time some leftist says to you, “But socialism works in Europe,” in that, you know, sneery-whiny voice leftists have (all right, I’m joking), you can take out this book and make them eat it page by page. (Still joking. Sort of.)
February 25, 2011
Analyzing The United States Government... As A Business
If the federal government was a corporation--a very big corporation--how would it stack up? Mary Meeker takes a stab at an answer. Befitting the size of her target, the analysis is hefty in its own right, weighing in at 266 pages. "This report looks at the federal government as if it were a business, with the goal of informing the debate about our nation’s financial situation and outlook," writes Meeker, a partner at KPCB and former financial analyst at Morgan Stanley, in the newly released "USA Inc." The report examines the government's income statement and balance sheet and concludes: "By the standards of any public corporation, USA Inc.’s financials are discouraging." If you need additional details, this PDF file won't disappoint. If you prefer a bound copy of the dark details, you can find it here. Just don't read it aloud in mixed company. The red ink could be especially disturbing for children, who will inherit this mess eventually.
Q4 GDP Revised Down As Oil Threat Bubbles
Last year’s fourth-quarter rise in GDP wasn’t as strong as initially estimate, the U.S. Bureau of Economic Analysis reports. That’s discouraging for all the usual reasons, along with the fact that the economy needs all the momentum it can muster if there’s an oil-shock coming, courtesy of the turmoil in the Mideast.
As for the last three months of 2010, the U.S. economy grew at an annual rate of 2.8%--down from the initial estimate of 3.2%. Why the haircut? "The downward revision to the percent change in real GDP primarily reflected an upward revision to imports and downward revisions to state and local government spending and to personal consumption expenditures (PCE) that were partly offset by an upward revision to exports," according to BEA's press release.
Every new data point from here on out will be filtered through the prism of oil prices. Until the Mideast calms down, at least in relative terms, the threat of higher crude prices will be lurking behind every number with the not-so-subtle reminder that higher energy costs at some point are a headwind to growth. Are we at that point? Probably. The good news is that oil prices have stabilized in the mid-$90/barrel range in New York this morning, after breaking north of $100 yesterday. But events on the ground in Libya and elsewhere in the Mideast don't offer much confidence for predicting that energy prices won't spike again. The political upheaval coursing through the region almost surely has legs.
The recent surge in energy prices inspires the questions: Have we reached the point of demand destruction? That's the title of today's research note from the energy analysts at Bernstein Research. It's a good question, since even oil demand is elastic. Higher prices eventually inspire lower consumption, which helps drive prices lower. According to Neil Beveridge and Liang Zhang latest analysis on that point:
From peak to trough of the last cycle, demand destruction was almost exclusively centered on developed economies which bore the brunt of the financial crisis. In OECD markets oil demand dropped from 50 to 45mmbls between Q4 2007 to Q2 2009 accounting for almost all of the decline in global demand. Given that increased unemployment was a key factor behind demand destruction in OECD countries, it seems unlikely (unless unemployment becomes meaningfully worse) that we will see the same levels of demand destruction in the west, even at current prices.
What happens in emerging markets, which now account for 50% of global demand, may be more important this time round. For a number of reasons, emerging market demand tends to be more GDP sensitive than price sensitive, partly because of greater industrial demand for oil but also partly due to the use of subsidies. Although China and India have reduced fuel price subsidies through reform of fuel pricing, 60% of oil demand in India remains subsidized and refining losses have started to appear again in China as oil prices spike. In Malaysia and Indonesia gasoline and diesel prices remain heavily subsidized and will increasingly act as a drag on these economies. Credit to Vietnam however, who raised their fuel prices by 24% last week, which should have some impact on demand.
For the moment, the main risk is less about oil and more about uncertainty generally. As Time reports today:
…there's a growing sense that the Middle East region, which has the planet's biggest oil reserves, has been made deeply unstable by the revolutions in Tunisia and Egypt, and the uprisings in Libya, Bahrain and Yemen. Says Amrita Sen, an oil analyst for Barclays Capital in London: "The question now is, Who is next, Algeria?" Algeria, a major oil producer bordering Tunisia and Libya, has long been viewed by North Africa watchers as ripe for revolution, having been ruled by autocrats since the military canceled elections in 1991. Oil companies, which sign long-term production and revenue-sharing contracts with governments, have been shaken by the political uncertainty sweeping the region. They're asking, says Sen, "Who are we going to deal with? Who is going to come to power?" That uncertainty pushes up prices, which in turn slows the global economic recovery.
Strategic Briefing | 2.25.2011 | Oil & The Economic Outlook
Rising Oil Prices Pose New Threat to U.S. Economy
New York Times/Feb 24
In the last week, oil prices have risen more than 10 percent and even breached $100 a barrel. A sustained $10 increase in oil prices would shave about two-tenths of a percentage point off economic growth, according to Dean Maki, chief United States economist at Barclays Capital. The Federal Reserve had forecast last week that the United States economy would grow by 3.4 to 3.9 percent in 2011, up from 2.9 percent last year.
Calibrating the Macro Effects of Higher Oil Prices: Results from the MA Model
Assuming no change in long-term inflation expectations, no monetary policy response, and no financial-market spillovers, the partial effects of the rise in oil prices can be estimated by scaling up or down the following simulation result generated from our model. An increase in oil prices of $10/bbl for one year starting in the first quarter of 2011 would:
•Reduce GDP growth by about 0.3 percentage point over the first half of the year and by 0.2 percentage point over the entire year.
•Headline PCE inflation would be about 0.1 percentage point higher over the year, and the unemployment rate about 0.1 percentage point higher.
Oil resumes surge, keeps stocks under check
Analysts reckon the degree of vulnerability for G-10 oil importers is far less than that found in emerging economies. "Our own analysis indicates that net oil imports for many emerging economies in Asia are close to or greater than 5 percent of GDP," said Andrew Cox, G-10 strategist at Citi.
Oil Prices: $10 = 25 Cents at the Pump
Deutsche Bank via WSJ MarketBeat/Feb 24
According to our analysis, a $10 increase in oil prices translates into roughly a 25 cent increase in retail gasoline prices. Every one penny increase in gasoline is then worth about $1 billion in household energy consumption. (In decimal terms, it is actually $1.4 billion.) Therefore, a sustained $10 increase in oil prices translates into $25 billion in additional household energy spending. Assuming this price rise crowds out spending elsewhere in the economy, effectively acting as a tax, means that a sustained $10 rise in oil prices reduces annual real GDP growth by 0.2%. Therefore, we would need oil prices to rise substantially from their current level and then remain elevated for some time before becoming more concerned about economic growth.
Here We Go Again--Oil Through US $100
AMP Capital Investors/Feb 24
My view has been that the world oil price will rise above US$100 a barrel this year on the back of strong demand growth relative to constrained supply. The turmoil in the Middle East has simply brought this forward. The world could probably live with US$100 oil, as consumers and businesses are now used to it. Just like Australians now assume that petrol prices north of one dollar a litre are normal. It would still leave world spending on oil well below its 2008 peak.
However, a continuing surge in the oil price – particularly if unrest in the Middle East spreads – could start to be more of a dampener on growth. Of course, rising oil prices will add to the inflationary boost already flowing through from higher food prices. However, rising oil prices like higher food prices also act as a tax on growth, as it cuts into discretionary spending power. This is particularly so in Asia where the oil intensity of GDP is generally greater than that in developed countries. So it’s too early to get overly worried now but if the oil price continues to surge then it will become more of a problem.
Oil May Rise as Mideast Turmoil Disrupts Supplies, Survey Shows
Oil prices may rise from the highest levels in 29 months next week as violent clashes in Libya and tensions in other parts of the Middle East disrupt crude shipments from the region, a Bloomberg News survey showed. Twenty-three of 40 analysts, or 58 percent, forecast crude oil will climb through March 4. Nine respondents, or 23 percent, predicted prices will decline and eight estimated little change. Last week, 44 percent said futures would increase.
White House: Oil price shock wouldn't 'derail' economy
The Hill/Feb 24
The White House does not believe a shock to oil prices will “derail” the economy but is closely monitoring the situation, a top White House economic official said Thursday. Austan Goolsbee, the chairman of the White House Council of Economic Advisers, told reporters that, while no one likes to pay more at the gas pump, the United States would be better able to handle spikes in the price of oil today than in decades past. “If you look at energy consumption per dollar of GDP in the economy now, it’s dramatically lower that it was in 1979,” Goolsbee said, referencing an era when oil prices did become a drag on the economy. “We’ve become substantially more energy-efficient.”
Fed's Plosser-Would take big oil spike to hurt GDP
It would take a significant and sustained rise in oil prices to seriously hurt U.S. economic growth, Philadelphia Federal Reserve Bank President Charles Plosser said on Wednesday.
"I think that oil would have to rise significantly more and stay there for a while to have dramatic effects on GDP growth," he said in response to questions from reporters after giving a speech in Birmingham, Alabama.
Emerging markets less impacted by rising crude: JPMorgan
CNBC via MoneyControl/Feb 24
Crude oil prices hit two-year highs on Thursday amid continuing turmoil in many regions in the Middle East. However, Geoff Lewis, head of investment services at JPMorgan Asset Management believes a USD 10 a barrel rise in crude will not derail economic recovery in emerging markets. “Emerging markets may fall lesser than developed markets on crude price rise,” he says. Lewis feels a short-term spike in crude will not undermine the long-term fundamental story in emerging markets. If anything, developed markets have more to worry about. “The economic recovery in developed markets is at a greater risk with rise in crude,” he feels.
Oil Price & GDP Calculator
$191 per barrel: Price at which global GDP growth falls to zero
February 24, 2011
Mixed Messages In January Durable Goods Report
January may have been harsh on the labor market and other sectors of the economy, but there's no sign of a winter chill in today's durable goods report for last month. New orders for manufactured durable goods surged 2.7% on a seasonally adjusted basis in January, the highest monthly gain since last September. But the robust advance in the top-line number for new orders comes with some messy details.
A large gain for transportation equipment last month (+27.6%) was a key source of the rise. Excluding this volatile transport sector leaves new orders off by 3.6%. Even worse, new orders for capital goods excluding defense and aircraft tumbled nearly 7%. Demand for these products, such as computers, is closely watched as a leading indicator of future economic activity. As economist Bernard Baumohl of The Economic Outlook Group explains in his book The Secrets of Economic Indicators,
Orders for civilian aircraft occur in periodic bursts and are hugely expensive. When a large order is received, it swells the total value of new orders for a brief period, greatly exaggerating the underlying pace of demand for durable goods, only to plummet the next month when it returns to a more normal level. To eliminate these erratic movements, it’s better to study the behavior of durable goods orders without transportation.
Baumohl also notes,
Companies are less likely to spend on new capital equipment and goods if they suspect a business slowdown is looming.
For the past year, those suspicions were minimized, as the recent trend for non-defense capital goods ex-aircraft shows.
Is January's retreat in this indicator worrisome? Not necessarily, according to a report from Bloomberg today:
Over the past three years, these orders [non-defense capital goods excluding aircraft] have dropped in the first month of a quarter every time except once.
“It’s entirely seasonal factors,” Jim O’Sullivan, global chief economist at MF Global Inc. in New York, said before the report. “There’s been a pretty consistent pattern. If anything, manufacturing growth has accelerated recently.”
But with the Libya crisis running oil prices above $100 a barrel, concerns are mounting about the viability of the economic recovery. "If you go above $120 on a sustainable basis, you will have a meaningful shortfall in global growth relative to what the current consensus expects," warns Jonathan Garner, Morgan Stanley's chief Asia and emerging-market strategist.
Fatih Birol, chief economist for the International Energy Agency, advises that "oil prices are a serious risk for the global economic recovery. The global economic recovery is very fragile - especially in OECD countries [the major industrialized economies of the world]."
David Kotok, chairman and chief investment officer at Cumberland Advisors, cuts right to the chase and writes in a note to clients today that "the risk of recession in the US and European economies is rising daily."
To be fair, all the oil worries could blow over just as quick as they arose. But no one really knows where the Libya crisis is headed. Welcome to the latest edition of an unknown unknown. The bottom line: it's all about oil for the moment… again.
Jobless Claims Fall As Oil Prices Rise
Today's weekly update on new jobless claims offers a fresh reason for hope, but the crowd isn't likely to take the bait. The back and forth in this series in recent months has given rise to false hopes several times in the last few months that job growth is poised for better days. Is it different this time? Last week's tally of new filings for unemployment benefits dipped to 391,000 on a seasonally adjusted basis, the Labor Department reports. That's the lowest since the summer of 2008. But just when things are starting to perk up (maybe) for the labor market, it's all a moot point suddenly, thanks to the upheaval in Libya and the resulting spike in oil prices.
Yes, one could argue that the rise in jobless claims in previous weeks was a temporary blip. Maybe it was related to harsh winter weather. But as our chart below suggests, the rough patch seems to be passing.
“The labor market has been on the upswing,” opines Millan Mulraine, a senior U.S. strategist at TD Securities Inc. “As the pace of layoffs continues to decline, it is an indication that not only are businesses not firing as fast they used to, but they may in fact begin hiring.”
But just when the data may have been poised for a round of improvement, Middle East turmoil intervenes and throws a sizable wrench in the revival machine. Oil prices in New York are trading just over $100 a barrel this morning, the first visit to the land of triple digits since September 2008. The Libya mess may or may not have legs, but for the moment there's a lot more uncertainty in the world. Last week's news on jobs is a touch dated.
Rebalancing & Fundamental Indexing
The original “fundamental indexing” ETF—RAFI US 1000 ETF (PRF)—recently celebrated its fifth birthday, and there was reason to celebrate. The fund, which was launched in December 2005, posted a tidy premium in its first five years vs. its competitors: the likes of the S&P 500 and Russell 1000. Fundamental indexing, as practiced by Rob Arnott’s benchmarking designs at Research Affiliates, seems to be working.
For the five years through the end of last year, PRF earned a 4.3% annualized total return. That’s nearly double the performance of the S&P 500 (2.3%) and Russell 1000 (2.6%) over that period. The question, of course, is whether there’s reason to think that PRF’s premium is durable—or just a random draw that happened to come up a winner?
There’s a case for arguing that there’s something more than luck at work here, but not necessarily for the reasons that receive most of the attention in the press with fundamental indexing. Research Affiliates Fundamental Index (RAFI) is a process for weighting securities based on their economic footprint, which the firm defines in a specific way. The RAFI benchmarks contrast with market capitalization weighting, the conventional approach for indexing that holds securities in accordance with their market value. Analysts have been debating for several years if these indices deliver superior risk-adjusted returns relative to the traditional cap-weighted benchmarks. PRF's results suggest that they do.
Why? A better index, is one response. The RAFI design exploits some widely known weaknesses inherent in capitalization-weighted indices. If you build a better index, you'll reap the rewards. Another explanation is that RAFI has a value bias. Since value tends to beat the market over time, RAFI is simply piggybacking on this risk premium. Those advantages have merit, but they're only a partial answer.
The third factor, and arguably the main one, is rebalancing. "Rebalancing is the heart and soul of Fundamental Indexing—it’s what makes it work," Arnott told me earlier this month for a Q&A in The Beta Investment Report.
Even so, quite a bit of the wider discussion over the years about what makes RAFI tick has either focused on its alternative weighting design or on the fact that the value factor offers a tailwind. Relevant topics, to be sure, although rebalancing seems to have been marginalized in the conversation.
It remains to be seen, of course, if the years ahead will continue to treat PRF and its sibling benchmarks kindly relative to market-cap indexing. Meantime, the results to date speak clearly for the original RAFI fund. To be fair, PRF’s success hit a rough patch for a time. During the crushing losses of 2008, the ETF’s 40% retreat exceeded the cap-weighted Russell 1000’s 37.6% loss for the calendar year. But FTSE RAFI US 1000 has since regained its edge, as the chart below shows.
Should investors expect the RAFI edge to endure? Yes, assuming that you also expect that a rebalancing bonus will prevail. History suggests no less, at least over the long run. Why? It all boils down to the persistence with reversion to the mean in asset pricing.
That’s hardly a new or radical idea. The literature on rebalancing may be slim compared to other topics in finance, but what has been published generally supports the case for thinking that there’s a premium linked with routinely trimming the influence of winners and raising the allocation in losers. Yes, this is hazardous work when it comes to a handful of individual securities. But the risk diminishes considerably when systematically applied across a broadly defined asset class.
Rebalancing’s virtues are no less conspicuous in managing asset allocation. Arnott agrees, and he speaks from experience, having penned a number of studies on asset allocation over the years. He’s also a veteran of managing multi-asset class portfolios. In addition to overseeing all things related to RAFI, he supervises several asset allocation products, including the PIMCO All Asset Fund (PASDX). And, yes, the track record is strong, relative to multi-asset class funds generally.
How much excess return can you expect from a simple rebalancing strategy when applied to a broad mix of asset classes? Roughly 100 basis points over time, Arnott says. That
more or less echoes results in a number of studies. It’s also in the same neighborhood of the premium dispatched by the naïve year-end rebalanced version of our proprietary Global Market Index, an unmanaged, market-value weighted benchmark of all the major asset classes.
Is rebalancing guaranteed to generate excess returns? No, but no other strategy rises to that ideal either. Let’s also point out that rebalancing will pinch you at times. In addition, some analysts warn that rebalancing is less about minting alpha and more about lowering risk without giving up much, if any, expected return. In the end, much depends on how you define and implement rebalancing, how a portfolio’s structured, and the time period under scrutiny for analyzing historical results.
Don’t confuse the benefits of rebalancing with a free lunch. In order to participate in this bounty, you have to be comfortable with a contrarian mindset. Easy to say, tough to do. Expected return fluctuates, sometimes radically. That’s obvious in hindsight, of course, and it inspires promises to exploit the next bout of volatility. The challenge is quite a bit harder when markets actually dive or soar, at which point acting on the assumption that the ex ante rebalancing bonus will persevere is subject to a fair amount of second guessing.
There’s always fresh doubt in real time. But the crowd’s reluctance to exploit mean reversion in a timely and efficient manner, if at all, is a big part of the reason for why there’s excess-return gold in these hills, as one recent study reminds.
Meantime, quite a few of the rules-based strategies that are being securitized through ETFs these days owe some degree (perhaps a large degree) of their expected alpha to rebalancing of one form or another, either at the individual security or asset allocation level. That point isn’t always acknowledged, although Arnott’s not shy about discussing the leading source of RAFI’s alpha. Rebalancing "is a factor that is relentlessly rewarded for the long-term investor."
That's not surprising once you step back and consider the broader linkage between macro and financial markets. There's a growing body empirical research that connects the economic cycle with risk premia. Some recent examples include "Gains from Active Bond Portfolio Management Strategies" and "Business Cycle Variation in the Risk-Return Trade-Off."
The message in these and many other studies is that expected return fluctuates and that investors should be willing to adjust asset allocation at least modestly to take advantage of these fluctuations. Buy and hold can work, of course, although it may take too long for most investors. In addition, buy-and-hold strategies may not be as safe in the long run as once thought.
"Conventional wisdom views stock returns as less volatile over longer investment horizons," professors Lubos Pastor and Robert Stambaugh write in a recent study, "Are Stocks Really Less Volatile in the Long Run?" But hazards to your investment portfolio may actually rise over longer horizons, they demonstrate.
A bit of common sense helps illustrates the point as it relates to the challenges of trying to look far into the future. Imagine an investor in December 1988 who dutifully invested with a buy-and-hold strategy for 20 years. He did all the right things, but there was one fatal flaw: he needed the money exactly 20 years later, in December 2008, when financial markets were collapsing.
That's a simple and perhaps impractical example, of course, but it highlights the dangers of expecting the long run to always bail you out. The longer out your investment horizon, the greater the so-called parameter risk. Or, as some call it, the Black Swan risk.
Whatever you call it, that risk is out there. A robust risk-management strategy is needed to tame the darker side of uncertainty, along with diversifying within and across asset classes. For many investors (and even some sophisticated ETF products), a simple rebalancing strategy will do the job.
February 23, 2011
Inflation Expectations & Rising Oil Prices
But one closely watched measure of inflation expectations in the U.S. is holding steady. The yield spread on the conventional 10-year Treasury less its inflation-indexed counterpart remains in the 2%-to-2.5% range that's prevailed for months.
Higher oil and commodity prices could elevate inflation, of course. It's happened before. "The 68 percent increase in the price of oil in 1974 was an adverse supply shock of major proportions," writes economist Greg Mankiw in Macroeconomics. "As one would have expected, it led to both higher inflation and higher unemployment." But that was then. The Treasury market these days seems to be saying that the inflationary effect of rising oil prices will be mild. What's different in 2011? The blowback from the Great Recession, of course. But there are opposing forces too. The Fed's exit strategy for unwinding zero interest rates may stoke inflation down the road--if the monetary adjustment is executed poorly. But none of this seems to be worrying the Treasury market, at least at the moment.
Some analysts argue that inflation is driven by the trend in wages, which remains tame, as one commentator tells Bloomberg:
“U.S. inflation runs on wages, period,” and workers pay and benefits have declined, Brian Belski, chief investment strategist in New York for Oppenheimer & Co., said in a telephone interview. “Until we start to see expansive and robust job growth we are still several quarters away from any kind of semblance of wage inflation. Yields on the 10-year note will settle somewhere south of 4 percent.”
The latest data on wages suggest that inflationary pressures are minimal. For example, the Labor Department's index of weekly hours worked in the private sector fell last month for the first time in a year.
Meanwhile, the trend in average hourly earnings still looks subdued too. As the chart below shows, the 12-month percentage change in earnings remains under 2.5%, the lowest pace in years.
The recovery in the labor market, in other words, remains sluggish, and that's helping keep a lid on inflationary pressures. Last month's net gain in private industry nonfarm payrolls was a paltry 50,000—the lowest since May 2010.
Some economists blame the harsh winter weather for January's weakness, but warmer days are coming. The crowd expects a rebound in the February jobs report (scheduled for release on March 4). The consensus forecast calls for a gain 185,000 private nonfarm jobs in next week's update, according to Briefing.com.
If job growth strengthens, will that change the bond market's expectations on inflation? Perhaps the answer depends on the price of oil that day.
February 22, 2011
Strategic Briefing | 2.22.2011 | Libya: Oil & Political Crisis
Oil Rises to Highest Since 2008 as Libya Unrest Stokes Concern
Oil surged to the highest price in more than two years in London as violence escalated in Libya, stoking concern supplies will be disrupted as turmoil spreads through the Middle East and North Africa... “Libya is producing 1.5 million to 1.6 million barrels a day, so any unrest is concerning,” Andrey Kryuchenkov, an analyst at VTB Capital, said by phone from London. “Until things settle there, prices are underpinned.”
Crude Near 28-Month Highs On Libyan Supply Cuts
Dow Jones Newswires/Feb 22
"Libya is the first major oil exporter to be engulfed by the crisis...it has probably doubled the additional risk premium in oil prices" to around $10/barrel, according to consultancy Capital Economics.
Oil shock fears as Libya erupts
The Telegraph/Feb 22
"This is potentially worse for oil than the Iran crisis in 1979," said Paul Horsnell, head of oil research at Barclays Capital. "That was a revolution in one country, here there are so many countries at once. The world has only 4.5m barrels-per-day (bpd) of spare capacity, which is not comfortable."... While Egypt is a minor oil player, Libya's Sirte Basin holds Africa's largest reserves and supplies 1.4m bpd in exports, mostly to Italy, Germany and Spain.
IEA sees oil price danger, ready to use stockpiles
High oil prices were detrimental to the interests of both consumers and producers as they could derail economic growth and curtail fuel demand, the International Energy Agency's Fatih Birol said. "Oil prices are a serious risk for the global economic recovery," Birol told reporters on the sidelines of an energy conference in Indonesia on Tuesday. The IEA is adviser to 28 industrialised nations on energy policy. \"The global economic recovery is very fragile -- especially in OECD countries," Birol said, adding that oil prices had entered a "danger zone" for the recovery at above $90 a barrel.
Oil prices surge on fear of Libyan unrest
Washington Times/Feb 21
International Energy Agency official David Fyfe said the prospect of an interruption in oil production in the Middle East is “a real concern” because the region lays claim to 60 percent of the world’s proven oil reserves and 40 percent of global gas resources... He emphasized that major consuming nations such as the U.S., Japan and Germany have stockpiled 1.6 billion barrels of oil — enough to provide 4 million barrels a day for a year — in preparation for any disruption... Libya exports about 1 million barrels a day, primarily to European customers. The U.S. strategic reserves have been tapped twice in emergencies — once during the Persian Gulf War in 1991 and again after Hurricane Katrina interrupted U.S. production in the Gulf of Mexico in 2005.
Oil Statistics For Libya
U.S. Energy Information Administration
Libya, a member of the Organization of Petroleum Exporting Countries (OPEC), holds the largest proven oil reserves in Africa, followed by Nigeria and Algeria. According to Oil and Gas Journal (OGJ), Libya had total proven oil reserves of 44 billion barrels as of January 2010, the largest reserves in Africa...
With domestic consumption of 280,000 bbl/d in 2009, Libya had estimated net exports (including all liquids) of 1.5 million bbl/d. According to 2009 official trade data as reported to the Global Trade Atlas, the vast majority of Libyan oil exports are sold to European countries like Italy (425,000 bbl/d), Germany (178,000 bbl/d), France (133,000 bbl/d), and Spain (115,000). With the lifting of sanctions against Libya in 2004, the United States has increased its imports of Libyan oil. According to EIA estimates, the United States imported an average of 80,000 bbl/d from Libya in 2009, up from 56,000 bbl/d in 2005 but, as a result of the U.S. economic downturn and subsequent decline in oil demand, 2009 levels were below 2007 highs of 117,000 bbl/d.
CIA World Factbook
The Libyan economy depends primarily upon revenues from the oil sector, which contribute about 95% of export earnings, 25% of GDP, and 80% of government revenue. The weakness in world hydrocarbon prices in 2009 reduced Libyan government tax income and constrained economic growth. Substantial revenues from the energy sector coupled with a small population give Libya one of the highest per capita GDPs in Africa, but little of this income flows down to the lower orders of society. Libyan officials in the past five years have made progress on economic reforms as part of a broader campaign to reintegrate the country into the international fold. This effort picked up steam after UN sanctions were lifted in September 2003 and as Libya announced in December 2003 that it would abandon programs to build weapons of mass destruction.
February 21, 2011
Global Warming & Asset Allocation
If you think climate change is a real and present danger, your asset allocation should reflect that outlook, according to a new study from Mercer, the consulting firm. That's sure to be a controversial recommendation in some quarters. Anything related to climate change tends to stir debate of one kind or another, and so reviewing the topic as it relates to investing promises no less. Ready or not, it's time to take a hard look at the implications of climate change for designing and managing portfolios, Mercer explains in "Climate Change Scenarios—Implications For Strategic Asset Allocation"
The paper argues that climate change increases investment risk and so asset allocation strategies should adjust accordingly. The uncertainty surrounding policy regulations and the economic impact of climate change inspire "new approaches" for building portfolios. The analysis is a joint effort by Mercer and more than a dozen institutions, including the California Public Employees' Retirement System (CalPERS) and the International Finance Corporation.
Written for an institutional audience, the report introduces a new investment framework based on three key variables, which are summarized as:
● Technology: the rate of development and opportunities for investment into low carbon technologies
● Impacts: the extent that changes in the physical environment influence investments
● Policy: the implied cost of carbon and emissions levels due to policy changes
These so-called TIP variables "could contribute as much as 10% to overall portfolio risk," the Mercer analysis predicts. Even so, the equity risk premium is still expected to dominate most institutional portfolios. Mercer estimates that nearly three-quarters of the risk contribution in the "default" portfolio will come from equity markets.
The study advises that in order to properly manage climate change risks, "institutional investors need to think about diversification across sources of risk rather than across traditional asset classes." That's an increasingly familiar refrain, of course, via so-called factor analysis. For instance, it's now common to view equity risk in terms of three factors comprised of broad market, style (growth vs. value), and size (capitalization) betas. There, of course, many more factors to consider, and the new Mercer paper argues in favor of analyzing risk across yet another dimension.
The practical result, according to the paper, is raising portfolio allocations to TIP factors. As one example, the study notes:
…a typical portfolio seeking a 7% return could manage the risk of climate change by ensuring around 40% of assets are held in climate-sensitive assets (this includes opportunities across a range of assets including infrastructure, real estate, private equity, agriculture land, timberland and sustainable listed/unlisted assets)…. Some of these climate sensitive investments might be traditionally deemed as more risk on a standalone basis, but the report shows that selected investments in climate-sensitive assets, with an emphasis on those that can adapt to a low-carbon environment, could actually reduce portfolio risk in some scenarios.
February 18, 2011
Book Bits For Saturday: 2.19.2011
● The Great American Bank Robbery: The Unauthorized Report About What Really Caused the Great Recession
By Paul Sperry
Summary via publisher, Thomas Nelson Inc.
The average American household lost $123,000 in wealth during the financial crisis. The Financial Crisis Inquiry Commission says Wall Street stole it, appearing to confirm the narrative told by countless politicians, economists, and pundits. The verdict seems unanimous. In fact, it's unanimously wrong. The masterminds behind the biggest heist in history were radical social engineers on Pennsylvania Avenue, not financial engineers on Wall Street. The Great American Bank Robbery offers the first careful and thorough analysis of public policy's role in the calamity. With stinging clarity, it indicts the real culprits--many of whom have returned to the scene of the crime in Washington. Now they're planning an even bigger heist in the name of "economic justice."
● The Economics of Enough: How to Run the Economy as If the Future Matters
By Diane Coyle
Summary via publisher, Princeton University Press
The world's leading economies are facing not just one but many crises. The financial meltdown may not be over, climate change threatens major global disruption, economic inequality has reached extremes not seen for a century, and government and business are widely distrusted. At the same time, many people regret the consumerism and social corrosion of modern life. What these crises have in common, Diane Coyle argues, is a reckless disregard for the future--especially in the way the economy is run. How can we achieve the financial growth we need today without sacrificing a decent future for our children, our societies, and our planet? How can we realize what Coyle calls "the Economics of Enough"?
Running the economy for tomorrow as well as today will require a wide range of policy changes. The top priority must be ensuring that we get a true picture of long-term economic prospects, with the development of official statistics on national wealth in its broadest sense, including natural and human resources. Saving and investment will need to be encouraged over current consumption. Above all, governments will need to engage citizens in a process of debate about the difficult choices that lie ahead and rebuild a shared commitment to the future of our societies.
● The Asylum: The Renegades Who Hijacked the World's Oil Market
By Leah McGrath Goodman
Review via BusinessWeek
Anyone who accuses New York Mercantile Exchange (CME) traders of being greedy and lawless anarchists who blow up markets obviously was not working the floor in 1978. In that year a sign at the entrance decreed: Please check your guns at the desk. "A gunshot never went off on the floor," claims John Tafaro, a trader at the time. "That's where we drew the line." He says traders were pretty dutiful about checking their guns, too. The rest of the rules, though, they ignored, skirted, or subverted, sometimes with brazen crudity, sometimes through deft manipulation of the law—at least according to Leah McGrath Goodman's The Asylum: The Renegades Who Hijacked the World's Oil Market. "Any customer who traded there was molested, if not raped," says one ex-regulator with the U.S. Commodity Futures Trading Commission, speaking metaphorically, one hopes. "As far as we could see, the NYMEX traders did nothing but run scams."
● Rollback: Repealing Big Government Before the Coming Fiscal Collapse
By Thomas Woods
Audio interview with author via Pundit Review
Last night I got to speak with Thomas Woods, author of Rollback: Repealing Big Government Before the Coming Fiscal Collapse. The book goes far beyond repealing the monstrosity that is Obamacare, taking a close look across the entire government and the numerous ways Big Government is not just part of the problem, but the problem itself.
● Energy Politics
By Brenda Shaffer
Summary via publisher, University of Pennsylvania Press
In Energy Politics, Brenda Shaffer argues that energy and politics are intrinsically linked. Modern life—from production of goods, to means of travel and entertainment, to methods of waging war—is heavily dependent on access to energy. A country's ability to acquire and use energy supplies crucially determines the state of its economy, its national security, and the quality and sustainability of its environment. Energy supply can serve as a basis for regional cooperation, but at the same time can serve as a source of conflict among energy seekers and between producers and consumers.
Shaffer provides a broad introduction to the ways in which energy affects domestic and regional political developments and foreign policy. While previous scholarship has focused primarily on the politics surrounding oil, Shaffer broadens her scope to include the increasingly important role of natural gas and alternative energy sources as well as emerging concerns such as climate change, the global energy divide, and the coordinated international policy making required to combat them. Energy Politics concludes with examinations of how politics and energy interact in six of the world's largest producers and consumers of energy: Russia, Europe, the United States, China, Iran, and Saudi Arabia.
● The False Promise of Green Energy
By Andrew P. Morriss, William T. Bogart, Roger E. Meiners, Andrew D. Dorchak
Summary via publisher, Cato Institute
Green energy promises an alluring future—more jobs in a cleaner environment. We will enjoy a new economy driven by clean electricity, less pollution, and, of course, the gratitude of generations to come. There’s just one problem: the lack of credible evidence that any of that can occur.
The False Promise of Green Energy critically and realistically evaluates the claims of green-energy and green-jobs proponents who argue that we can improve the economy and the environment, almost risk-free, by spending hundreds of billions of taxpayer dollars in return for false or highly speculative promises. The book examines the claims green-energy proponents make, including assertions of how green energy will revitalize the job market, produce new forms of clean transportation, and improve environmental health and safety, energy efficiency, and more. The authors explore the underlying politics and gamesmanship lurking below the surface.
The Return Of The Budget Busters
Now it's getting serious. House Speaker John Boehner warns that he's won't sign off on a short-term spending extension to keep the deficit-laden federal government operating. "Read my lips," he says. "We are going to cut spending." The budget showdown is here.
The current authority for spending runs through March 4. Between now and then, Congress will either cut spending or come up with a temporary measure to keep the government running. Perhaps a bit of both. Barring a workable outcome, however, a shutdown looms.
That's unlikely, but the odds aren't zero either. Let's call it the risk of brinkmanship. The calendar is helping either. As Jaime Dupree notes,
Congress is off next week, so while the House will approve a stop-gap budget (with billions in budget cuts), the Senate won't be back until the week of February 28 to deal with it.
And as of right now, it's not even the first item on the agenda for the 28th.
"The Senate is adjourned until the 28th, at which point we'll take up the...patent bill," tweeted a bemused Don Stewart, spokesman for Senate GOP Leader Mitch McConnell (R-KY).
Paul Krugman charges that all the talk about the budget debate is essentially "fraudulent," asserting,
House Republicans talk big about spending cuts — but focus solely on that same small budget sliver [nonsecurity discretionary spending].
And by proposing sharp spending cuts right away, Republicans aren’t just going where the money isn’t, they’re also going when the money isn’t. Slashing spending while the economy is still deeply depressed is a recipe for slower economic growth, which means lower tax receipts — so any deficit reduction from G.O.P. cuts would be at least partly offset by lower revenue.
The whole budget debate, then, is a sham.
Krugman argues that "if you’re serious about the deficit, you should be willing to consider closing at least part of this gap with higher taxes." In theory, yes. But that opens the door to the ancient debate about whether we're in this mess because taxes are too low or spending is too high. We're not going to resolve that issue here, but a little perspective never hurts. Here's your fiscal Rorschach test for the day by way of a graph of the historical tax brackets for individuals.
In the end, the government can adjust two levers: revenue and spending. The details are messy, but that's the playing field once the political dust clears. On that note, one more chart to chew on. The annual change in current federal receipts (blue line) vs. current expenditures (red line) in seasonally adjusted terms recently moved into something approximating an encouraging state. Yes, that's a drop in an ocean of deficit projections. But at least there's a hope that if the government can restrain the growth of spending--a massive if--the possibility for some degree of progress in budgetary matters isn't doomed.
No matter what happens, getting the government's fiscal house in order is going to be painful, and the problems of red ink willl be with us for years. The real issue is deciding how to dig ourselves out of this hole without shooting ourselves in the head. Cutting the budget when job growth is weak carries risk, but so too does raising taxes. The numbers suggest that some of both will be necessary to make meaningful progress on the deficit. Everybody knows that. The question is how that reality will reveal itself in actual legislative changes.
February 17, 2011
Kauffman Foundation Survey: Economic Bloggers' Outlook Improves
The Kauffman Foundation published its new quarterly survey of "leading economics bloggers" today and the general outlook from this group is that there's "a bit of hope" twinkling on the horizon, according to the press release. The Capital Spectator is among those surveyed.
A couple of the report's excerpts...
● Economics bloggers are less pessimistic in their outlook on the U.S. economy than they were at the end of 2010, though 77 percent believe overall conditions are mixed, facing recession, or in recession. For an economy in which growth is the norm, 31 percent of respondents think that the U.S. economy is worse than official statistics indicate, and only 10 percent believe it is better. When asked to describe the economy using five adjectives, “uncertain” remains the most frequently used term to describe the economy.
● The number of competing explanations for the jobless recovery can be a bit mind-numbing, but the panel of economics bloggers had very strong feelings about which were true and which were not. Far and away the most popular explanation (with 95 percent agreeing and a full majority agreeing “strongly”) was the reluctance of firms to hire in an uncertain macroeconomy. Two other explanations were supported by a four-to-one margin: a structural change in the demand for labor (e.g., more knowledge jobs and a secular decline in muscle jobs) and an overall decline in aggregate demand. That means the bloggers think both a recessionary slump and a technological change in the economy are to blame, not one versus the other. The two ideas that bloggers rejected are (1) the theory that unions and employees have lost bargaining power, and (2) the U.S. level of wealth has increased the labor-leisure trade-off to the extent that people are more willing to tolerate leaving the labor force.
History May (Or May Not Be) Your Guide
Economist James Hamilton reminds that we should recognize a distinction between claims that the Fed is printing money proper and crediting accounts at banks that are part of the Federal Reserve system. "These electronic credits, or reserve balances, are what has exploded since 2008," Hamilton notes. Currency in circulation, by contrast, "has increased by 5.2% per year over the last two years, a bit below the average for the last decade."
Hamilton goes on to explain:
If you took a very simple-minded monetarist view of inflation (inflation = money growth minus real output growth), and expected (as many observers do) better than 3% real GDP growth for the next two years, you'd conclude that recent money growth rates are consistent with extremely low rates of inflation.
The great uncertainty, then, is how the Fed unwinds this electronic credit creation. Again quoting Hamilton:
As business conditions pick up, the Fed is going to have to do two things. First, the Fed will have to sell off some of the assets it has acquired with those reserves. The purchaser of the asset will pay the Fed by sending instructions to debit its account with the Fed, causing the reserves to disappear with the same kind of keystroke that brought them into existence in the first place. Second, the Fed will have to raise the interest rate it pays on reserves to give banks an incentive to hold funds on account with the Fed overnight.
Doing this obviously involves some potentially tricky details. The Fed will have to begin this contraction at a time when the unemployment rate is still very high. And the volumes involved and lack of experience with this situation suggest great caution is called for in timing and operational details. Sober observers can and do worry about how well the Fed will be able to pull this off.
But that worry is very different from the popular impression by some that hyperinflation is just around the corner as a necessary consequence of all the money that the Fed has supposedly printed.
Tricky isn't necessarily fate. Yes, central banks make mistakes, but they do get things right at times too. That includes some success stories with exit strategies. No guarantees, of course. The future's always unclear, even in the best of times. Assuming the worst, however, requires more than casual references to history.
Consumer Prices Rise In January
In a time of soaring commodity prices, it’s no surprise to learn that consumer price inflation turned modestly higher last month. The debate is over what the latest jump in the CPI Index means for inflationary pressures down the road. Is there a new inflationary surge heading our way, as some analysts warn? Or is the firming of prices last month merely a sign that disinflation/deflationary trend of last year has been reversed and stabilized?
The past isn't necessarily a window on the future, but history at least is clear. Headline inflation rose 0.4% last month on a seasonally adjusted basis, matching December’s rise, according to the Labor Department. At that rate, CPI is advancing at its highest monthly pace in more than a year. More worrisome is core CPI’s rise, which gained 0.2% in January, the fastest pace since October 2009. These are still modest figures relative to the long sweep of history, and so there's hardly a smoking gun in today's report. But worries about inflation are bubbling just the same.
Monthly numbers are subject to a fair amount of noise, of course, and so for a richer measure of the trend we turn to the rolling 12-month percentage change. Here too there is a shift in the trend, or so it seems. Headline CPI rose 1.6% over the past year, the highest rate since last May (not seasonally adjusted). Core CPI is now running at 1.0% on a year-over-year basis, the highest in 10 months.
Some will declare that inflation has returned. No one should dismiss that possibility, but it’s premature to jump to conclusions. The Federal Reserve has been trying to stabilize inflation, which recently meant reversing the declining pace. And it seems to be working. Core CPI, in particular, is no longer falling on an annual basis. A 1% rise in core CPI, in fact, is thought to be at the low end of the Fed’s unofficial target range.
Still, with commodity prices soaring and inflation worries bubbling in China and other emerging market nations, this is no time to look away from the potential hazards. As Bloomberg reports today:
Growing economies in Asia and Latin America are boosting global demand for oil and other commodities, raising costs for American factories. Accelerating growth is prompting some companies to carry out beginning-of-year price increases even as consumers remain constrained by unemployment at 9 percent.
“You’re going to see more companies that attempt to pass through” higher costs, said Tom Porcelli, chief U.S. economist at RBC Capital Markets Corp. in New York, who correctly forecast the gain in core prices. “How successful they are depends on the economic backdrop. We’re looking at a slightly firmer inflation backdrop.”
But a slightly firmer inflation isn’t the same as a new round of runaway inflation. Indeed, one reason for thinking that inflation isn’t poised to surge skyward in the near term arrives via the other news of the morning: a rise in new jobless claims last week of 25,000 to 410,000.
The continued weakness in the labor market “is in line with our view that the disinflation process bottomed in the fourth quarter,” Michael Gapen, a senior U.S. economist at Barclays Capital, tells Reuters today. “We do not see pricing power being passed along yet."
Research Review | 2.17.2011 | U.S. Labor Market
What Is the New Normal Unemployment Rate?
Justin Weidner and John Williams | San Francisco Fed | Feb 14, 2011
Mounting evidence suggests that structural factors may have increased the “normal” rate of unemployment to about 6.7%. Much of this increase is likely to be temporary. In particular, the extension of unemployment benefits probably accounts for about half of the increase. But, even with a 6.7% natural rate, current and forecasted levels of unemployment imply that significant labor market slack will persist for several years. It is important to stress that each of the methods used to estimate the natural rate is subject to considerable error, especially given the limited experience of very high unemployment in the post-World War II U.S. economy. As the recovery proceeds, we should develop a clearer picture of the new normal rate of unemployment.
A Quantitative Analysis of Unemployment Benefit Extensions
Makoto Nakajima | Philadelphia Fed | Feb 8, 2011
Facing the most severe recession since the Great Depression, the U.S. government enacted a series of extensions of UI benefits that provide an unemployed worker with the maximum of 99 weeks of UI benefits, compared with the regular duration of 26 weeks. While these extensions are one of the responses to the unemployment rate that reached 10 percent in late 2009, which was the second time this happened since 1982-83 in the postwar U.S. history, it is also possible that the extensions themselves contributed to the rising unemployment rate by encouraging jobless workers to remain unemployed so that they received the UI benefits for an extended duration and by discouraging the unemployed to search for a job intensively. Although there are existing attempts to measure the effect of UI benefit extensions on the unemployment rate, this paper is the only one that uses a structural model to answer the question....
I find that the extensions of UI benefits contributed to an increase in the unemployment rate by 1.2 percentage points, with a baseline conservative calibration. Since unemployment went up by 5.1 percentage points, from 4.8 percent before the current downturn started at the end of 2007 to 9.9 percent in the fall of 2009, the contribution of the series of UI benet extensions is about a quarter (24 percent). Among the remaining 3.9 percentage points, 2.4 percentage points are due to the large increase in the separation rate, while the staggering job-nding probability contributes 1.4 percentage points. I also find that the last extension moderately slows down the recovery of the unemployment rate. Specifically, the model indicates that the last extension keeps the unemployment rate higher by up to 0.4 percentage point during 2011.
Economic Freedom and Employment Growth in U.S. States
Thomas A. Garrett and Russell M. Rhine | St. Louis Fed | Jan/Feb 2011
The authors extend earlier models of economic growth and development by exploring the effect of economic freedom on U.S. state employment growth. They find that states with greater economic freedom—defined as the protection of private property and private markets operating with minimal government interference—experienced greater rates of employment growth. In addition, they find that less-restrictive state and national government labor market policies have the greatest impact on employment growth in U.S. states. Beyond labor market policies, state employment growth is influenced by state and local government policies, but not the policies of all levels of government, including the national government. Their results suggest that policymakers concerned with employment should seriously consider the degree to which their own labor market policies and those of the national government may be limiting economic growth and development in their respective states.
The Great Recession’s Long Tail
Rebecca Thiess | Economic Policy Institute | Feb 2, 2011
Overall unemployment numbers also mask enormous variation in joblessness among different racial and ethnic groups. Though the overall unemployment rate was 9.6% in 2010, it proved to be much higher for some groups than for others, as seen in Figure E. The unemployment rate among blacks, for instance, was nearly 16%, and among Hispanics it was around 13%. With overall unemployment projected to be 8.7% in 2012, we can expect unemployment among blacks to remain over 15% and among Hispanics to be around 11%.
Extended mass layoffs, fourth quarter 2010
US Bureau of Labor Statistics | Feb 15, 2011
Employers initiated 1,910 mass layoff events in the fourth quarter of 2010 that resulted in the separation of 295,571 workers from their jobs for at least 31 days.
February 16, 2011
Housing: Still Going Nowhere Fast
There's not much cheer in housing these days, unless you're a buyer with a fair amount of cash. Otherwise, the depressed state of residential real estate rolls on. Today's update on building permits and new housing starts doesn't change much, although with each month it's becoming clearer that the bleeding has stopped. There's also the usual bit of volatility on a monthly basis, and sometimes that dispatches a bit of good news. But it doesn't mean much when you look at the big picture for this market. A recovery worthy of the name is still nowhere in sight.
New building permits dropped more than 10% last month vs. December, the Census Bureau reports today. Meanwhile, new housing starts jumped 14.6% in January. But the monthly data should be used primarily for amusement at this point. As everyone knows, the housing market fell off a cliff a few years back and hasn't been able to climb back up.
A picture's worth a thousand words in that regard, as the chart below reminds. It's going too far to say that housing has reached a permanently lower plateau, but few analysts are making bold claims that this market's set to rebound sharply in the near term.
The good news, so to speak, is that housing has at least found a plateau. It's one at greatly diminished levels, of course, but that's certainly preferable to rapidly collapsing levels. But any cheer on that front is quickly muted once you realize that treading water will probably be with us for some time. There are any number of reasons why that's a reasonable guess of the foreseeable future, and more reasons for erring on the side of caution continue to roll in.
The latest obstacle for housing is the news that "the down payments demanded by banks to buy homes have ballooned since the housing bust, forcing many people to rethink what they can afford and potentially shrinking the pool of eligible buyers." According to the story from today's Wall Street Journal, "Higher borrowing costs and heftier down payments could send housing prices falling further."
If so, there's one more reason for thinking that any revival in housing is a ways off. "Housing activity is going to remain at depressed levels this year," opines Ellen Zentner, a senior macro economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York, via Bloomberg. "We’ve got home prices that have taken another leg down and will probably stay down through midyear."
So far, the weak housing market hasn't derailed the rebound in the overall economy. Job creation is still weak, but a broad measure of the macro trend has taken wing in recent months. The question is whether the ongoing slump in housing will eventually infect the economy's recent gains. The risk looks fairly low if housing stabilizes, which it seems to be doing. But another leg down in prices and activity would be more than slightly hazardous at this late date.
The Thrill of Victory, The Agony of Defeat
Morningstar reminds that there are lots of fund choices for diversifying across asset classes these days, perhaps too many. "Not only has the number of mutual funds expanded by the thousands over the past decade, but numerous exchange-traded and closed-end funds, many of them with very specialized, even exotic, mandates, have also popped onto the scene," writes Gregg Wolper,
It's easy to become overwhelmed with the possibilities. Fund companies are constantly rolling out new products, and increasingly that includes funds that claim to be all-in-one solutions. Most of the choices are, at best, redundant (relative to the existing lineup) or just plain misguided. That inspires stepping back from the sea of possibilities and refocusing on the strategic choices and the basic tools for managing portfolios. The good news is that much of the heavy lifting that delivers reasonable outcomes arises from relatively simple designs and management techniques with diversified investment strategies.
Most diversified portfolios share two common threads. First is the act of diversifying across some defined set of assets. The next step is managing the mix of assets. The possibilities are endless, of course, but the opportunity for earning higher return without taking on materially higher risk becomes increasingly marginal as you move beyond the basics. Generally speaking, you'll need either higher inputs of skill, luck, or both, to engineer superior risk-adjusted results through time vs. what's available from a simple diversification strategy.
In broad terms, the standard choices for diversification add up to a dozen major asset classes. That number can differ, depending on how we define "asset class." But as a starting point, the 12 broadly defined markets in the table below (13 if you included cash) are a reasonable starting point. In short, these asset classes represent the opportunity set for most investors. And if we own everything (except cash) in its market-value weights and simply let it ride, we have a robust benchmark for risky assets writ large, as defined by the Global Market Index (GMI).
For the five years through the end of last month, GMI's annualized total return is 4.6%. That's roughly average relative to the individual asset classes. In fact, history shows that GMI and similarly designed indices tend to deliver average to slightly above-average results in the long run. No surprise there. But what can we do to improve results?
There are many possibilities, of course, but some simple, forecast-free strategies are worth considering as a benchmark for asset allocation management. Rebalancing GMI every December 31 back to its market weights as of the close of 1997 (the date of the index's launch) juices performance a bit. Instead of earning 4.6% a year since 2006 with a buy-and-hold strategy, systematically rebalancing GMI earns 5.7%. Equal weighting the portfolio and resetting it to equilibrium at the end of every year does even better, delivering 6.7% a year.
But those are merely the opening bids in the sea of choices for elevating returns further. Of course, things get increasingly complicated and risky as we move beyond broad asset class diversification and simple asset management strategies. If we want to earn something different than the market, we have to move away from the market portfolio. For example, we could overweight one or more of the asset classes, perhaps radically so, relative to the market weight. We might sidestep several asset classes entirely. We could also engage in a more opportunistic form of rebalancing by adjusting the portfolio when volatility strikes vs. waiting for a pre-set date.
Another route is to own a more granular definition of a given asset class. For instance, instead of holding one fund as a proxy for a broad mix of U.S. stocks, we could break the asset class up into multiple pieces via style, capitalization and/or industry groups. This increases the rebalancing opportunities.
Yet another alternative is to incorporate return forecasts into the management process and tilt the asset allocation to those areas where the future looks brightest and cutting back on markets where the performance appears unattractive.
Moving further out on the limb of risk, we might add leverage or short exposure to the portfolio. We could use actively managed funds to populate one or more of the asset class categories. There are also alternatively weighted index funds to consider as well, offering the option of replacing the standard market-cap indexing products with something intent on earning better results. There are also hedge funds and other exotic realms to explore.
Even with all these additional choices, we've only scratched the surface. But while there's no shortage of potential for beating the unmanaged portfolio that holds everything (GMI), there's a limit on benchmark-beating results. There's a ceiling on how much alpha can be minted relative to GMI's beta for the simple reason that alpha must sum to zero. Winners are financed by the losers. That doesn’t mean we should ignore the possibilities for moving beyond a broadly defined, unmanaged portfolio, but it should keep us somewhat humble about what's required to beat GMI over the long run.
History suggests as much. Crunching the numbers on 900-plus multi-asset class funds in Morningstar Principia's database shows that GMI's results are slightly above average relative to the actively managed competition. That's no surprise. The zero-sum-game rule is alive and kicking... always.
February 15, 2011
Retail Sales Rise For 7th Straight Month
Retail sales forged higher to a new all-time record last month, rising 0.3% to $381.6 billion in January on a seasonally adjusted basis, according to this morning’s release from the U.S. Commerce Department. That was less than the 0.5% rise that economists were expecting, and January's gain is half as much as December's increase. But last month's growth in retail sales is the seventh straight month of higher numbers. The various troubles that hang over the economy are far from trivial, but it's still hard to argue at the moment that the blowback from the Great Recession is pinching consumer spending.
Even after excluding the volatile sales numbers for autos, last month’s rise was still 0.3%. Although some corners in retailing slipped in January, overall there were plenty of gains to go around. Meantime, monitoring retail sales on a rolling 12-month basis drives home the point that consumption is very much alive. Seasonally adjusted retail sales are up by nearly 8% over the past year, as the chart below shows. That’s near the best levels posted in the glory days of 2005 and 2006, when the biggest concern was deciding how long the Great Moderation would last. As it turned out, a kinder, gentler economic cycle didn’t last, but apparently that loss hasn't stopped Joe Sixpack from spending.
Still, January’s rough winter weather may have crimped what would have otherwise been a stronger report. “The weather kept people shoveling snow rather than heading to the mall,” says Russell Price, a senior economist at Ameriprise Financial, via Bloomberg. “The consumer’s role in the recovery will take greater prominence in coming months. We definitely need to see further improvement in the labor market to have continued increases in spending.”
Last month's 0.3% rise, although the seventh straight monthly increase, is the slowest advance for retail sales in the latest string of gains. In addition, some of the increase in January was driven for the wrong reason: rising gasoline prices. Excluding that jump, retail sales would have gained 0.2%, reports NPR.
“Spending growth has clearly lost some momentum,” senior U.S. economist Paul Dales of Capital Economics says. The question is whether the momentum is sustainable at some level above zero? That depends on where you look for clues. As The Wall Street Journal notes:
Retail, in particular, could see a boost after the White House and congressional Republicans in December agreed to a one-year cut in Social Security payroll taxes -- many workers saw the effects in their first paycheck this year.
"Higher net pay is likely to push up the level of consumer spending by half of a percentage point or perhaps slightly more, with more cyclical retail spending boosted by about twice this amount," Goldman Sachs said this week in a research note.
Still, not all signs are positive. Federal Reserve Board governor Sarah Bloom Raskin on Friday said already low home prices could decline further this year, hurting consumer spending and the wider economy.
Strategic Briefing | 2.15.2011 | The President's Budget Proposal
The White House released President Obama's 2012 budget yesterday, a document that's striking for its failure to address the main engine of the projected deficits: entitlement programs. The Republicans' budget proposal isn't published yet and so official comparisons aren't available. Meantime, the President's budget reportedly cuts the record deficit by $1.1 trillion over the next decade. Here are additional details/opinions on the numbers and the implications from various sources:
Budget Battle Lines Drawn
Wall Street Journal/Feb 15
If Congress accepted all the president's proposals—which is unlikely—and the economy recovered, the federal deficit would fall from 10.9% of GDP this year to 3%, Mr. Obama's goal, in 2017. The plan would place the federal government's deficit next year at $1.1 trillion, down from $1.6 trillion this year, and the White House said it would reduce the government's accumulated red ink over the next decade by a similar $1.1 trillion. Just over a third of that deficit reduction would come from Mr. Obama's previously announced freeze in domestic discretionary spending. The balance would come from tax increases, largely on businesses and upper-income taxpayers; assorted fee hikes and spending reductions; and a cut in government borrowing costs, which will continue to rise dramatically but not quite as fast if the deficit is reduced.
Obama’s Budget Focuses on Path to Rein in Deficit
New York Times/Feb 15
Neither Mr. Obama nor Congressional Republicans are tackling the large entitlement benefit programs. As for tax revenues, Republicans want only to cut taxes further while Mr. Obama has promised not to raise taxes for the 98 percent of American households with income under $250,000 a year... Mr. Obama and Republicans are left, then, competing to cut just 12 percent of the federal budget, the so-called nonsecurity discretionary spending that Congress appropriates each year.
The President Chickens Out on Spending Cuts
National Review/Feb 14
The budget has 2012 spending falling a bit from record 2011 levels, but that’s because “stimulus” spending is winding down, war costs are supposed to fall, and unemployment benefits should decline as the economy improves.
Obama Budget Proposal Kicks Off Battle Over Spending Cuts, Tax Increases
Money Morning/Feb 15
About two-thirds of President Obama's proposed deficit reduction is from spending cuts and the remaining one-third from tax hikes. The spending cuts affect a wide range of programs including spending for infrastructure, higher education, defense and farming subsidies. What the proposal does not address is any significant change in such deficit-inducing programs as Social Security and Medicare/Medicaid. It also falls short of meeting the suggested changes from President Obama's fiscal commission. President Obama's deficit commission said in December that about $3.9 trillion in deficit reduction would be needed through 2020 to make significant changes in federal debt.
Budget 2012: Obama vs. House Republicans
Monday’s release of President Barack Obama’s new 2012 budget puts in sharp focus the week-long brawl that lies ahead in the House, as newly empowered Republicans seek to deal a crippling blow to the president’s agenda, at home and abroad. Obama appears to have hurt his cause by not being more bold in approaching the debt problem facing the nation. At the same time, what began for Republicans as a budget-cutting exercise has grown into more of raw power play. Just hours after the White House documents arrived, the House Rules Committee was scheduled to meet late Monday in anticipation of floor debate Tuesday on the GOP’s own government-wide spending plan for the last seven months of this fiscal year. Never before has Washington seen two such complete budgets aligned at once — like two planets vying to eclipse one another.
The President’s budget: whistling past the graveyard
The fiscal problems of current law, which predate but were exacerbated by President Obama’s expansions of government in his first two years, should be driving the policy agenda. In this budget they are an afterthought. The President’s budget ignores the problem of entitlement spending under current law, and proposes Medicare and Medicaid savings only sufficient to offset a portion of his proposed spending increases. Team Obama’s topline message includes dangerous and misleading reassurances that Social Security is not an immediate problem. Demographics, unsustainable benefit promises, and health care cost growth are the problems to be solved. The President instead wants to build more trains and make sure rural areas have 4G smartphone coverage.
Obama’s Sideshow Budget Will Yield Little Real Fiscal Progress
Tax Policy Center/Feb 14
In today’s budget proposal, Obama would increase taxes to 17.9 of GDP in 2013. This is just about what revenues averaged under Reagan. And it would be a step in the right direction. Except the chances of it happening hover around zero. Obama would get there mostly with a collection of ideas that he failed to sell to even a Democrat Congress. They include: allowing the 2001 and 2003 tax cuts to expire at the end of 2012, capping the value of itemized deductions at 28 percent, taxing the compensation of hedge fund managers and other financiers at ordinary income instead of capital gains rates, and increasing taxes on multinationals.
President Obama’s FY 2012 Budget: An Analysis of the Budget Cuts
Economic Policy Institute/Feb 14
President Obama is proposing a number of budget cuts, many of which he and other administration spokespeople have been highlighting in an effort to show they take deficit reduction seriously. Outlined in the section of the budget titled “Terminations, Reductions, and Savings,” the administration is proposing 211 such actions that will save more than $33 billion in 2012 alone, essentially doubling the amount of cuts proposed in Obama’s FY 2010 budget request, and about $10 billion more in reductions than he proposed last year. And these proposed cuts should have a good chance of actually occurring: the Obama administration has, in the past, been more successful at getting proposed terminations and reductions actually passed compared with other administrations. Obama saw 60% percent of his proposed discretionary cuts become law for 2010, while other recent administrations have seen only between 15% and 20% of their proposed discretionary cuts approved by Congress.
Deconstructing the Spending Side of Obama’s Proposed FY2012 Budget
Cato Institute/Feb 14
President Obama's proposed budget for fiscal year 2012 has been released and there is lots of rhetoric in Washington about "budget cuts." At first glance, this seems warranted. According to the just-released fiscal blueprint, the federal government is spending about $3.8 trillion this year and the President is proposing to spending a bit more than $3.7 trillion next year. In other words, the White House is going beyond a budget freeze and is actually proposing to spend $90 billion less next year than is being spent this year. That certainly seems consistent with my proposal to solve America's fiscal problems by restraining the growth of spending. But you won't find a smile on my face. This new budget may be better than Obama's first two fiscal blueprints, but that's damning with faint praise. The absence of big initiatives such as the so-called stimulus scheme or a government-run healthcare plan simply means that there's no major new proposal to accelerate America's fiscal decline. But neither is there any plan to undo the damage of the past 10 years, which resulted in a doubling in the burden of government spending during a period when inflation was less than 30 percent.
February 14, 2011
Budget Battles, Round 1
House Speaker John Boehner wants to know “when are we going to get serious about cutting spending?" Perhaps today’s the day. The White House will formally release its 2012 budget plan later this morning, complete with a reported $1 trillion-plus in cuts.
That’s a big number and it has some Republicans scrambling over worries that Obama may be poised to take the lead in slashing Washington’s corpulent spending. Roughly two-thirds of Obama’s cuts will reportedly come from reducing domestic spending. E.J. Dionne Jr. calls it the “war over E2I2… the battle lines will be drawn on investments in -- or, as Republicans would say, spending on -- education, energy, infrastructure and innovation, thus E2I2.
For all the talk of pursuing fiscal rectitude in the country, there’s reason to wonder how much the public will swallow of domestic spending cuts in a time of high unemployment and sluggish job growth. The Pew Research’s latest poll of public opinion advises that while there’s a strong desire for keeping spending increases on a leash, there’s not much appetite for cutting. “The public's views about federal spending are beginning to change,” the Pew survey reports.
Across a range of federal programs, Americans are no longer calling for increased spending, as they have for many years. For the most part, however, there is not a great deal of support for cutting spending, though in a few cases support for reductions has grown noticeably. The survey also shows that the public is reluctant to cut spending -- or raise taxes -- to balance state budgets.
But that doesn’t change the fact that even with the President’s proposed cuts, the budget deficit would rise to $1.6 trillion—a new high.
Still, the main drivers of growth in domestic federal expenditures—Social Security and Medicare—are left more or less untouched in the new White House budget proposals. According to McClatchy Newspapers:
Obama largely will ignore the recommendations of his own bipartisan budget commission, which in November urged more than $4 trillion in cuts to projected deficits over the next decade. He will not propose any changes in the biggest domestic spending programs--entitlements including Social Security, Medicare and Medicaid--which the commission said must be revised if the debt is ever to be tamed.
No matter, since the President’s budget proposal is destined to be the first round in a long battle. But if there's any hope of making progress with the all-important long run trajectory of the fiscal deficit, a Willie Sutton moment is required eventually. "To solve our financial problems, you have to reform entitlement programs, you have to cut defense and other spending, and you have to engage in comprehensive tax reform to generate more revenue," says former Comptroller General David Walker. For the moment, those are still theoretical considerations.
February 13, 2011
A NEW REVIEW OF DYNAMIC ASSET ALLOCATION
The Independent Investor, an educational web site focused on personal finance, recently reviewed my book, Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor. It's a (mostly) positive critique. "The author does a useful overview of the risks, benefits and limits of a dynamic asset allocation approach," according to the piece. I'll take that as a compliment. You can read the full review here.
February 12, 2011
BOOK BITS FOR SATURDAY: 2.12.2011
● Central Banking in the Twentieth Century
By John Singleton
Summary via publisher, Cambridge University Press
Central banks are powerful but poorly understood organisations. In 1900 the Bank of Japan was the only central bank to exist outside Europe but over the past century central banking has proliferated. John Singleton here explains how central banks and the profession of central banking have evolved and spread across the globe during this period. He shows that the central banking world has experienced two revolutions in thinking and practice, the first after the depression of the early 1930s, and the second in response to the high inflation of the 1970s and 1980s. In addition, the central banking profession has changed radically. In 1900 the professional central banker was a specialised type of banker, whereas today he or she must also be a sophisticated economist and a public official. Understanding these changes is essential to explaining the role of central banks during the recent global financial crisis.
● Japan's Bubble, Deflation, and Long-term Stagnation
Edited by Koichi Hamada, Anil K Kashyap and David E. Weinstein
Summary via publisher, MIT Press
Japan's economic bubble burst in the early 1990s, and the country entered its famous "lost decade"—a period of stagnation and economic disruption that persisted until 2003. The current declines in global equity and real estate markets have eerie parallels to Japan's economic woes of the 1990s. If we are to avoid repeating Japan's experience on a global scale, we must understand what happened, why it happened, and the effectiveness (or ineffectiveness) of Japan's policy choices. In this volume, prominent economists—Japan specialists and others—bring state-of-the-art models and analytic tools to bear on these questions.
● Consumptionomics: Asia's Role in Reshaping Capitalism and Saving the Planet
By Chandran Nair
Summary via publisher, Wiley
Consumption has been the fuel that has driven the engine of global capitalism. The recent financial crisis has seen the West's leading economists and policy makers urging Asia to make a conscious effort to consume more and thereby help save the global economy. This is a view shaped by conventional wisdom which conveniently refuses to acknowledge both the unpleasant effects of consumption and the limits to growth. Consumptionomics argues that this blinkered view needs to be replaced by a more rational approach to the challenges of the 21st century. If Asians aspire to consumption levels taken for granted in the West the results will be environmentally catastrophic across the globe. Needless to say it will also have significant geopolitical impacts as nations scramble for diminishing resources.
● 2030: Technology That Will Change the World
By Rutger van Santen,Djan Khoe,and Bram Vermeer
Review via Foreign Affairs
This interesting book examines a potpourri of emerging technologies, discussing both the possibilities they may create to improve people’s lives in the future and the obstacles to developing and introducing them. The project started as a celebration of the 50th anniversary of Eindhoven University of Technology and involved interviews with more than 50 applied scientists and engineers on the evolution of diverse technologies in the coming decades. The technologies they describe are likely to be life-transforming in some respects (regarding personalized health care, for example) and disappointingly slow to arrive in others (regarding alternatives to fossil fuels, for example). The range of topics -- including cryptography, geothermal energy, and influenza -- is breathtaking, and the treatment of each subject is necessarily brief but informative. When discussing technology and finance, the book, started before the financial crisis but completed after it, is (rightly) harsh on the prevailing economists’ doctrinal view of financial markets.
● The Googlization of Everything: (And Why We Should Worry)
By Siva Vaidhyanathan
Review/interview via Publishers Weekly
There have been a few popular books in recent years detailing Google's ascent in the digital world, notably Ken Auletta's Googled: The End of the World as We Know It and Jeff Jarvis's What Would Google Do. But there is another story, says author and media scholar Siva Vaidhyanathan. In his new book, The Googlization of Everything: And Why We Should Worry (Univ. of California Press) Vaidhyanathan explores the young company's increasingly dominant role not just online but in our lives. "What is most fascinating about Google to me is its effect on us," the author tells [Publishers Weekly]. "Its effect on the media business is interesting, but I wanted to write a book that could inform a casual Google user about some of the hazards and habits of Google. In that sense, my book is much more about us than it is about Google. In fact, the critical faults of the story I tell are ours, because we've become so addicted to getting more stuff, faster, for free."
February 11, 2011
POLITICAL RISK & CHINA'S CURRENCY
China's economic rise increases the odds that its currency is destined to become a global currency, according to The New York Times. "No one expects that to happen immediately," the article carefully adds, even if the writing is on the wall. “The RMB is likely to become a reserve currency in the future, even if the government of China does nothing about it,” economist Robert Mundell predicts. Perhaps, although the story also recognizes the political risk that still haunts China.
"China needs to assure investors that its political system is stable and that its economy still has plenty of growth ahead," the Times advises. The warning resonates these days as Egypt sways to and fro under the winds of revolution, writes Barry Eichengreen, professor of economics and political science at Berkeley.
Eichengreen opines that upheaval in Egypt and Tunisia of late is less about economic growth per se. Rather, "the problem is that the benefits of growth have failed to trickle down to disaffected youth." On first glance, that may not appear to present a comparable threat in China, "but the warning signs are there." As Eichengreen explains,
Given the lack of political freedoms, the Chinese government’s legitimacy rests on its ability to deliver improved living standards and increased economic opportunity to the masses. So far those masses have little to complain about. But that could change, and suddenly.
First, there is the growing problem of unemployment and underemployment among university graduates. Since 1999, when the Chinese government began a push to ramp up university education, the number of graduates has risen seven-fold, but the number of high-skilled, high-paying jobs has not kept pace.
Indeed, the country is rife with reports of desperate university graduates unable to find productive employment. Newspapers and blogs speak of the “ant tribe” of recent graduates living in cramped basements in the country’s big cities while futilely searching for work.
Eichengreen is hardly alone in worrying about China's political stability. The risk consultancy Maplecroft recently analyzed such hazards for China. The country "is categorized as ‘extreme risk’ across several areas," according to Maplecroft, "including: civil and political rights, judicial independence, democratic governance, labor rights, and human rights violations committed by members of the security forces. Companies which are deemed in any way to be supporting a government or its agents in stifling democracy, liberty and human rights may suffer reputational damage, which will ultimately impact the bottom line."
Meanwhile, Reuters reports that "Egypt's uprising may prompt renewed focus on political risk in emerging economies at a time of rising food and fuel prices, raising investor fears of unorthodox or repressive policy moves."
Ely Ratner at the RAND Corporation and a research fellow with the National Asia Research Program considers the future for China and concludes that there are a number of potential trouble spots. Writing in the latest issue of the Washington Quarterly, Ratner discusses the complicated rise of China in the 21st century:
Beijing’s permissive attitude toward non-democratic principles and singular focus on domestic economic development have become potential sources of blowback, including the specter of international terrorism as just one example. This threat, which is one of the most serious challenges facing Beijing, is aggravated by the fact that China’s integration into the global economy has naturally meant a growing number of Chinese companies and expatriates in foreign lands—or in other words, an ever-expanding target set for those wishing to attack Chinese assets. From pipelines in Kazakhstan to refineries in Nigeria to ports in Sri Lanka, soft power begets soft targets.
Meanwhile, The Globe and Mail ponders what might happen if North Korea implodes:
There is more political risk in China than many investors realize. Just last year China justified its support of North Korea by saying that if North Korea collapsed, hundreds of thousands of refugees would stream over the border into China. But deeper interviews revealed that China viewed the North Korean regime’s survival as key to its own: “North Korea is our East Germany,” a senior Chinese security official told The Washington Post. “Do you remember what happened when East Germany collapsed? The Soviet Union fell.”
What if the North Korean regime faced a revolt like the ones in Tunisia and Egypt? What happens to China then – or to Chinese stocks and ETFs?
It's easy to overestimate the potential for trouble, of course. But it'd be a mistake to dismiss the possibilities for instability in China. No one's predicting another Tiananmen Square protest, although it's worth reminding that few expected that event. That's the nature of political risk: It surprises, and not often in a good way. The best we can do in real time is assess the odds. Most of the dire forecasts won't pan out. But it's the ones that do that are the problem.
Yes, China's currency is probably destined to become a global currency. Just don't bet the farm on it just yet. Getting from here to there could be rocky.
February 10, 2011
NEW JOBLESS CLAIMS FALL TO LOWEST IN MORE THAN 2 YEARS
Ah, now that’s better. New jobless claims dropped last week by a robust 36,000, pulling the total under the 400,000 mark on a seasonally adjusted basis for the second time since the Great Recession was formally declared null and void as of June 2009. Is the second time the charm?
There are lots of reasons to be cautious on declaring the latest descent below 400,000 as the start of a new round of strength in the labor market. But the case for optimism is far from hopeless. The primary factor for thinking positively is the general revival in the economy, as suggested by the stronger pace of growth in GDP in last year’s fourth quarter. The missing link so far is strong, or at least a stronger pace of job creation. The latest payrolls report for January, alas, isn’t very helpful on seeing the glass half full, although perhaps the weather skewed the numbers. If so, maybe the January jobs report is stronger than it appears.
As for jobless claims, the latest data point is at least a step in the right direction. Of course, that was true in late December, when claims dipped below 400,000 for the first time. But it was a head fake. Will it be different this time? Perhaps there’s significance in the fact that new claims have dropped sharply in three of the past four weeks.
"The labor market is improving," Brian Jones, an economist at Societe Generale, tells Bloomberg. "Fingers crossed, if the weather can hold off this week, we should get a pretty decent snap back in non-farm payrolls and maybe another drop in the jobless rate."
In between reading the weather forecasts, here's a little perspective on the long-run relationship between initial jobless claims and payrolls. The next chart below compares indices of each over the last four decades. The linkage isn’t surprising, nor is the trend obscure. When jobless claims rise, the annual change in total nonfarm payrolls falls. What’s striking in the recent data is the magnitude of the changes, and the lack (so far) of the snapback effect that usually prevails in a timely manner.
No one needs to be reminded that the rebound in the labor market has been sluggish, but facts are facts. But has the economy now paid sufficient penance to the macro gods for the sins of the past? Maybe, maybe not, but waiting and hoping is getting old. An unnamed Labor Department official boiled it all down to the essential point by reminding today: "Until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established."
It still not over till it’s over, and for the moment it’s still not over.
THE POWER OF MEAN REVERSION
The more you look at it, the larger it looms. Yes, rebalancing is an old idea—buy low, sell high. But it's forever new for at least two critical reasons. One is simply bound up with the recognition that rebalancing works, or at least it has a long history of working by enhancing return while keeping a lid on risk. But it's not always clear what constitutes "optimal" rebalancing, or even if such a state of financial nirvana exists. That keeps analysts turning over rocks in search of progress.
As for real-world results, much depends on the definition of rebalancing. Factors such as timing, the composition of portfolio assets, and the rules that guide rebalancing activity vary quite a bit. Accordingly, so too does the degree of risk from rebalancing strategies. Yet it's also true that rebalancing in one form or another is behind a number of the new-fangled attempts to mint alpha.
The rise of rules-based indexing products in particular rely on rebalancing, even if that's not always clear. Some products emphasize technical signals, for example, that offer insight on when to rebalance. Other funds focus on changes in accounting-based metrics, such as sales, earnings, etc. But at the heart of many strategies is a common denominator: rebalancing.
Some of this bleeds over into other risk factors, which can blur the lines for deciding where rebalancing's influence ends and something else begins. But no matter how you dress it up, rebalancing is the foundation for most strategies that have a decent chance of delivering alpha over the long haul. The lesson applies to many strategies within a given asset class, and it's true for most multi-asset class strategies.
For the latter, efforts at earning alpha by dynamically managing a set of betas range from the routine to rocket science. But you don't need to a Ph.D. in engineering to earn a modest premium over a passive asset allocation. What you do need is a fair amount of backbone to buy out-of-favor asset classes and sell the winners. That's a dangerous pursuit with individual securities, but history and a small library of empirical research suggests this is a worthy strategy for most investors at the asset class level.
As a review of the possibilities, consider how the major asset classes stack up against one another in recent history and how those returns compare to some simple forecast-free rebalancing strategies (see table below). Note the wide range of return results over the past five years within markets, ranging from a 1% annualized return for a broad mix of commodities up to nearly 10% a year for emerging market stocks. Holding all asset classes in a passive, unmanaged mix in weights that approximate their respective market values earned 4.6% a year (BIR Global Market Index). If you rebalanced this mix every December 31 back to the allocation from the previous year, you earned more: 5.7% . Equally weighting the same portfolio by rebalancing to equal weights every December 31 did even better, delivering 6.7% a year. By comparison, the U.S. stock market returned an annual 2.5% over the past five years, based on the Russell 3000.
The lesson is that by diversifying broadly and dynamically managing the mix in a simple but straightforward manner, you can earn competitive results. That's hardly a secret. As I explain in some detail in Dynamic Asset Allocation, the finance literature has been telling us no less in recent decades.
Results will vary, of course, although a fair amount of the variation is under your control. If you can stomach more than average risk, you might consider an aggressive rebalancing strategy. Instead of mindlessly rebalancing on pre-set calendar dates, you can be more opportunistic by taking advantage of volatility as it comes. Rebalancing in the fall of 2008, for instance, rather than waiting for the markets to calm down. You might also rebalance in something more than mild form, or more frequently, or allocate among a more granular definition of asset classes.
In fact, the possibilities are endless for boosting the rebalancing bonus, but so too are the risks. Earning higher returns by systematically adjusting asset weights isn't a free lunch. You have to be willing to assume a higher risk than the average investor. The main hazard is linked to mean reversion in prices. History shows that this phenomenon tends to persist over time, particularly with broad asset classes. But there's always a question of whether it'll prevail the next time, or how soon prices will revert to their mean after a large change in the market. Such questions help explain why most investors find it hard to rebalance when market volatility is high. But that's why the expected return from rebalancing looks so rewarding.
February 9, 2011
THE DOUBLE-EDGED SWORD OF "INVESTING" IN VOLATILITY
A new research paper casts some doubt on using volatility as an asset class. The warning isn't unexpected, given that the broad themes of the paper's findings have been discussed for years. Nonetheless, "The Hazards of Volatility Diversification Volatility" (by Carol Alexander and Dimitris Korovilas at the University of Reading) is a timely reminder that owning (or shorting) volatility directly can be a complicated affair.
Until recently, such warnings were academic beyond the world of professional money management. But with the rise of publicly traded funds that replicate volatility in something approaching its pure form, the opportunities and risks of this asset class (if we can call it that) are available to the average investor. Don't misunderstand—volatility has some intriguing attributes that make it worthy for consideration as a portfolio diversification tool. But those traits come with a number of caveats. Do the challenges offset the advantages? Possibly, although much depends on the investor and how volatility is integrated with a portfolio.
Volatility comes in many forms, although it's defined here as the popular VIX Index, which tracks "market expectations of near-term volatility conveyed by S&P 500 stock index option prices," according to the CBOE. Perhaps the leading strategic benefit of the VIX, which is securitized in a number of exchange-traded products, is its generally persistent negative correlation with the equity market.
The VIX usually moves in the opposite direction of stock prices. Consider a chart of recent history that compares the SPDR S&P 500 (SPY) with the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ). Looking at both products side by side clearly shows a negative relationship—a pairing that can come in handy for hedging the stock market's potential for large losses.
In the grand scheme of portfolio management, however, the negative correlation is both a help and a hindrance. The help arises because the VIX offers a reliable offset to equity market losses. But it's a hindrance because a buy-and-hold approach to volatility is likely to end up as a net loss in the long run.
That's partly because of the relatively high expenses of volatility-related products. You can buy equity market beta in ETFs for as little as 9 basis points, but volatility fund expense ratios will pinch you from 85 basis points and up.
The other problem is that in the long run, volatility's expected return is probably zero vs. a positive performance outlook for stocks. That's a function of the positive cash flows linked with businesses. Corporations will earn a profit over time. But volatility is akin to a commodity, which means that there are no cash flows. Gold and oil don't generate earnings, and neither does volatility. That implies that the VIX will be a losing proposition over time, after factoring in expenses and opportunity costs. As a broad brush forecast for the long run, the VIX's expected return is probably zero. Reviewing the last 20 years of the VIX suggests as much. The volatility measure has bounced around a lot in the short term, but after two decades it's more or less back where it started. The stock market, by contrast, has increased by roughly 280% over the last 20 years, based on the S&P 500.
That nature of the VIX inspires a tactical application to using this index. Of course, that introduces a new set of risks. As the new paper from Alexander and Korovilas advises, forecasting the optimal periods when volatility is useful is difficult, at best:
The problem is that such crises are extremely difficult to predict and relatively short-lived. In other words, equity volatility is characterised by unexpected jumps followed by very rapid mean-reversion, so expectations based on recent volatility behaviour are unlikely to be realised. In short, by the time we are aware of a crisis it is usually too late to diversify into volatility.
No wonder that Alexander and Korovilas recommend that "volatility is better left to experienced traders such as speculators, vega hedgers and hedge funds." Such challenges motivate looking for more cost-effective long-term hedges for strategic-minded investors. One example is a new generation of products that offer a more investor-friendly hedging of the potential for sudden, dramatic declines in stocks—the so-called fat tail risk, or as Nassim Taleb refers to it in his best-selling book on the phenomenon generally: The Black Swan: The Impact of the Highly Improbable. For instance, some financial planners use securities linked to Deutsche Bank's Emerald Index, as Jerry Mccollis, chief investment officer at Brinton Eaton, told me in a recent article I wrote for Financial Advisor magazine.
A cautious approach to using volatility as an asset class proper is generally sound advice, although almost everyone should monitor the VIX and other volatility metrics for context about the market and economic cycles. Yes, volatility is only one tool for evaluating investment opportunities, but it's a productive one for offering additional perspective. One reason is because volatility tends to cycle in a semi-predictable way, as the chart below illustrates.
In fact, predicting volatility is a bit less hazardous compared with forecasting asset returns directly. That's related to the fact that volatility's long run expected return is zero. One benefit of this somewhat less-mysterious long-run future for volatility makes it useful for assessing risk levels as an indirect clue about market returns. Unusually low levels volatility, for instance, may be a sign that equity prices are ripe for a correction. In 2007, the year before the stock market suffered its worst calendar-year performance since the Great Depression, volatility was unusually low by historical standards. The opposite is also worth pondering. When volatility spikes, as it did in the financial crisis, the cyclical nature of the VIX suggests stock market performance may be set for better days.
That's not surprising, given the intimate connection between volatility and markets. As noted Stock Market Volatility (edited by finance professor Greg Gregoriou): "Volatility is an inevitable market experience mirroring 1) fundamentals, 2) information, and 3) market expectations. Interestingly, these three elements are closely associated and interact with each other."
February 8, 2011
WORRYING ABOUT INFLATION... AGAIN
The "Bond Market Flashes Inflation Warning," advises The Wall Street Journal. CNBC reports that "Investors Starting to Believe That Inflation Threat is Real." Is this the start of an inflationary surge? Maybe, although there's still room for debate.
One of the reported warning signs is the rise in long-term interest rates. The benchmark 10-year Treasury yield is approaching 3.7%, up from as low as 2.5% last fall. But the current yield is still below the 4% mark reached last April. The implication: the rise in yield reflects the waning disinflation/deflationary worries that plagued sentiment last summer/fall. The Fed's second round of reflationary policies announced last November were intent on delivering no less. Surely it would be far worse if yields remained low and/or falling. The fact that higher yields have also accompanied signs of modest economic revival--such as the recent improvement in commercial lending and the ongoing gains in consumer spending and income--suggest that the inflation fears may be overdone, at least for the moment.
Another concern is that the yield curve is steepening. The spread between 10-year and the 2-year Treasuries, for instance, is around 2.9 percentage points, the widest in nearly a year. But this too still looks like a shift from the deflationary worries that prevailed last summer and fall, when the 10-year/2-year spread dropped to 2.0 percentage points.
There's also concern that rising commodity prices signal future inflation. Prices of raw materials are in fact rising. The iPath DJ-UBS Commodity ETN (DJP), which tracks a broad definition of commodities, is up 28% over the past year through February 7.
Commodities prices have been known to bring an early warning sign about mounting inflation risks, but not always. Commodities are quite volatile as a general rule, and so today's price increases may bring tomorrow's sharp declines. That's why economists monitor inflation with and without commodities (i.e., core inflation). Over time, the so-called core measures of inflation have proven to be superior indicators of the broad pricing trend.
For example, comparing the rolling 12-month percentage changes in headline and core inflation benchmarks for the U.S. shows that core CPI remains subdued (red line in chart below). Headline CPI, by contrast, is turning up (blue line). Keep in mind, however, that headline inflation is quite volatile and in recent years it's proven to be a misleading gauge. In 2008, for instance, headline CPI was soaring, even though inflationary pressures were set to collapse.
The trick, as always, is deciding if rising commodities prices is a trend with legs as opposed to the boom-bust cycle that usually prevails for the asset class. Some analysts argue that the risk of persistent price gains is quite real, in part because emerging nations like China and India are consuming ever-larger quantities of energy and other commodities. In a world of finite resources, surging demand threatens to unleash a secular bull market for oil, food, and other materials, which in turn raises the inflation danger.
Perhaps, although for the moment the crowd is on the fence. The market's inflation forecast is a modst 2.4%, based on the conventional 10-year Treasury yield less its inflation-indexed counterpart. That's up sharply from 1.5% last August, when worries of deflation were high, but inflation expectations in the mid-2% range doesn't look excessive relative to history.
The question is whether inflation expectations have merely rebounded now that the economic outlook has improved? Or is there something more ominous approaching? It's an open debate. But with the labor market still weak, the case for seeing inflation rising looks thin. Of course, all bets are off if job creation moves into a stronger phase. What if employment growth remains weak? The possibility of stagflation—rising inflation and weak growth—lurks too, some analysts say.
The other crucial variable is how the Federal Reserve manages its exit strategy for unwinding its monetary policy. The worry here is that the central bank, run by human beings, is subject to error. Given the history of the Fed, this may be the leading reason for worrying about future inflation.
February 7, 2011
STRATEGIC BRIEFING | 2.7.2011 | CORPORATE PROFITS
No Rush to Hire Even as Profits Soar
Wall Street Journal/Feb 7
With 73% of the Standard & Poor's 500-stock index by market value having reported fourth-quarter results, earnings are up 28% from a year earlier and sales are up 7.7%. But the contrast between profit and job growth remains a big hurdle for companies hoping to keep expanding their business.
Corporate profits surge
Corporate profits surged in 2010, according to analysis of fourth quarter 2010 company results by Deloitte, the business advisory firm. The results were stronger than expected with 69% of company results exceeding market forecasts, indicating a positive outlook for companies going into 2011. The 187 US companies that reported fourth quarter results posted an average growth in net income or profits of 45% over the last year. The 34 European companies in the study, most of them based in Continental Europe, have seen profits rise on average by 25% over the last year.
More Jobs Ahead as Spending, Corporate Profits Grow
Fiscal Times/Feb 7
U.S. workers have paid a heavy price for Corporate America’s skittishness about the economy. Uncertainty about future sales has put productivity gains and cost control uppermost in the minds of CEOs, while hiring and pay raises have been low priorities. Consequently, profit margins have staged one of the most rapid recoveries ever, and earnings have zoomed higher. For 2011, companies will have to start sharing some of the gravy with their employees. The fog of uncertainty is lifting, and companies will need more workers to meet stronger demand. That means earnings are sure to slow, but the bottom line should remain strong enough to keep investors happy. Improvement in the labor markets is gaining momentum, although the shape of that progress was distorted by January’s brutal weather.
Corporate America braces for commodity crunch
Wall Street has been riding a wave of strong corporate profits for months, but surging commodities prices are making some investors nervous about earnings growth in the second half of the year... The rise in raw commodities hasn't cut into companies' bottom lines yet and some analysts think they will continue to be able to absorb them. "The top-line momentum has more than offset rising input costs," said Alec Young, an equity strategist at Standard & Poor's. "It all depends on how high prices go, but it seems premature to sell stocks on this issue now.".. Brusca argues that commodities are a small part of the overall production cost for most companies, while labor costs, typically the largest, are relatively cheap. And companies continue to benefit from high levels of worker productivity.
Bill Gross (Pimco)/Feb 2011
Are record corporate profits a fair price for America’s soul? A devil’s bargain more than likely. This metaphorical devil’s bargain has its equivalent in the credit markets these days. Central bankers have lowered the cost of money for 30 years now, legitimately following global disinflationary forces downward, but also validating increased leverage via lower real interest rates. Today’s rock-bottom yields, however, have less to do with disinflation and more to do with providing fuel for an asset-based economy that promotes unsustainable wealth creation and a false confidence in perpetual capital gains. Real 10-year interest rates fell from over 5% in the early 1980s to just under 1% in recent months and have arguably been responsible for 3,000–4,000 Dow points and 2–3% annual appreciation in bonds over those three decades.
S&P 500 Earnings Per Share
Standard & Poors/Jan 2011
U.S. After-Tax Corporate Profits
St. Louis Fed/Q3:2010
February 6, 2011
OIL PRICES: TALKING TRASH... OR TRUTH?
"I expect oil prices to reach $110 during the first half of 2011, however, it could go above that level if Egypt's current crisis continues," says Imad al-Atiqi, a member of Kuwait's Supreme Petroleum Council, in an interview today with Reuters. "A huge amount of oil passes through the Suez Canal and the country's stability is essential for the Middle East's stability, particularly Israel."
Kuwait, an OPEC member, holds about 9% of the world's known oil reserves, according to the CIA World Factbook. "Almost 16,500 ships transited the Suez Canal from January through November of 2010, of which about 20 percent were petroleum tankers and 5 percent were LNG tankers," according to the U.S. Energy Information Administration (EIA). Total petroleum shipments through the Suez in the first 11 months of last year amounted to nearly 2 million barrels a day. For comparison, the U.S. imports last November totaled a bit more than 11 million barrels a day, according to EIA.
As for Imad al-Atiqi's price forecast, is it slightly overbaked? Perhaps, suggests Raymond J. Learsy, author of Over a Barrel: Breaking Oil's Grip on Our Future. "Clearly, the closing of the Suez Canal to the oil trade would be a hindrance, but hardly the disaster portrayed in the media and our friends at OPEC," writes Learsy in a column following Imad al-Atiqi's commentary.
Meanwhile, Mark Zandi, chief economist at Moody's Analytics, advises that "if the turmoil is contained largely to Egypt, then the broader economic fallout will be marginal. Now, obviously, if it spills out of Egypt to other parts of the Middle East, the concern goes to a whole other darker level. It is certainly now on my radar screen."
IS THE JANUARY JOBS REPORT STRONGER THAN IT APPEARS?
The raison d'être of economic analysis and data collection is enhancing the clarity of the broad trend and drawing conclusions about the future. That's a tough assignment under the best of circumstances, although sometimes the game is unusually confusing, as it seems to be with Friday's update on January's employment numbers. At issue is the odd sight of the jobless rate dropping to 9.0% from 9.4% in December without a commensurate gain in jobs. Nonfarm payrolls rose by a scant 36,000 last month (or +50,000 if you ignore the shrinking ranks of government workers). That's down sharply from December's 121,000 gain. January's rise is the worst month for jobs since last September's loss of 29,000.
Huh? Falling unemployment of more than a trivial amount without a strong uptick in job creation? "It doesn’t take a great grasp of economics to figure out that when firms cut down on hiring the unemployment rate should increase," writes John Cassidy, the New Yorker's writer of all things economic. "But last month, the opposite happened. Or did it? Fortunately, I wasn’t alone in my befuddlement," he confesses.
The leading explanation for the substantial fall in the jobless rate without a strong rise in payrolls is the weather. A number of analysts blame Old Man Winter's unusual ferocity of late for the negligible progress in job growth. But that explanation isn't completely satisfying, in part because it's unclear how much of a factor the weather played in trimming employment gains. "It’s all a mystery," complains Robert Brusca, chief economist at FAO Economics.
Meantime, expectations are already bubbling about the implications for the next employment report. "If weather suppressed the payroll numbers, the jobs report in a month should be fairly strong," reasons The Wall Street Journal's Sudeep Reddy.
Then again, maybe there's a statistical diamond in the employment rough for January's numbers. "As confusing as the government report is, when I dig into it and combine it with other job reports, it is very clear to me the employment situation is improving, perhaps even dramatically so," asserts Robert Johnson, Morningstar's associate director of economic analysis.
Since Friday's report was released, a number of analysts say that the jobs picture last month is brighter than it appears on first glance, courtesy of the household survey data, the lesser known counterpart to the more widely cited establishment survey. Both series are published monthly by the government, although the establishment numbers typically receive most of the attention. Is one superior to the other? Each has pros and cons, the Labor Department notes in Friday's press release:
The household survey and establishment survey both produce sample-based estimates of employment and both have strengths and limitations. The establishment survey employment series has a smaller margin of error on the measurement of month-to-month change than the household survey because of its much larger sample size. An over-the-month employment change of about 100,000 is statistically significant in the establishment survey, while the threshold for a statistically significant change in the household survey is about 400,000. However, the household survey has a more expansive scope than the establishment survey because it includes the self-employed, unpaid family workers, agricultural workers, and private household workers, who are excluded by the establishment survey.
The household survey reports a 117,000 rise in employment for January—far more than the 36,000 gain in payrolls via the establishment survey (see Summary Table A, p. 8, here for household data). Rebecca Wilder opines that the household statistics "show the number of employed increasing by 117,000. The annual revisions dropped the employed by 472,000, so the unrevised number of employed increased by 589k in the release. This is a big gain." Why the differing signals in the two series? The weather factor, she argues, casts less of a distorting influence on the household survey.
Stephen Stanley, chief economist at Pierpont Securities, is also inclined to look to the household data as salvation for the weak January employment profile depicted in the establishment numbers. "The household survey has a history of leading payrolls in a recovery, so we’re setting ourselves up for a pretty strong improvement in payrolls," he tells Bloomberg. "The numbers that look weak on the surface now will turn more robust by the March-April-May period. There’s ample evidence that firms are getting more comfortable about adding workers."
Stanley's not alone in thinking positively. "The severe weather likely explains much, if not all, the weakness in payrolls," advises Ian Shepherdson of High Frequency Economics. "The BLS reports 886,000 people unable to work because of the weather in Jan, compared to the 417,000 average for the month. This is taken from the household survey and is unadjusted so you can’t just add it to the headline payroll number, but it clearly signals the snows affected the data. Expect a rebound in February."
The future, of course, is up for grabs as always. As for the numbers for last month, the household survey paints a brighter picture, but a 117,000 gain is still modest, at best. But even that number—indeed, any one monthly employment number—should be approached with a healthy degree of skepticism. As Dean Baker of the Center for Economic and Policy Research explains:
The household survey is always erratic. It effectively is measuring the level of total employment in the economy. Even if it is off by just 0.2 percent, this implies an error of almost 300,000. If it errors by this much on the high side one month and then by an equal amount on the low side the following month, it would imply a drop in employment of 600,000 in a context where there was no actual change in employment. Looking back over the last two decades it is easy to find months with large changes in employment that did not coincide with any obvious upturns or downturns in the economy.
As the chart below shows, recent history of net monthly employment changes for the two series over the past five years does in fact confirm that the household numbers (red line) are significantly more volatile than the establishment data (blue line).
Baker also reminds that in the last recession, consistent job growth didn't arrive until initial jobless claims fell below 400,000. Unfortunately, we're not there yet, as the latest reading on new filings for jobless benefits reveals.
All of which leaves us in a familiar but increasingly inadequate position of waiting for better news in next month's employment report.
February 5, 2011
BOOK BITS FOR SATURDAY: 2.5.2011
● Why the West Rules--for Now: The Patterns of History, and What They Reveal About the Future
By Ian Morris
Review via New Statesman
Ian Morris describes how western pre-eminence came about through accidents of geography, technology and social change, and how these factors are universal. Yet what he presents is not a credible science of history, but a myth.
● The General Theory of Employment Interest and Money (2011 Reprint of 1936 edition)
By John Maynard Keynes
Review via Bloomberg
John Maynard Keynes’s “The General Theory of Employment, Interest and Money” was published 75 years ago today. Back then, there were queues outside the Economists’ Bookshop in Houghton Street, London. Opening hours had to be extended to deal with the rush of those eager for an alternative to policies that had ruined the global economy. The impact on the field of economics wasn’t unlike that on the scientific community when Charles Darwin published “On the Origin of Species” in 1859. Just as with Darwin’s book, Keynes’s shook the foundations of economic orthodoxy and had profound effects on his profession. The main thrust of Keynes’s work was also met with outright denial from his peers, including close colleagues, who reduced his theory to what one described as “diagrams and bits of algebra.” Above all, they denied the centrality of his theory of the rate of interest.
● The Future of Money (World Class Thinking on Global Issues)
Edited by Oliver Chittenden
Summary via publisher, Virgin Books
The state of the global economy affects every single one of us. With economic growth threatened by financial regulation and the East and West at competitive odds, the real solutions to global recession can only come through international co-operation. Featuring World leaders, Nobel Prize-winning economists, award-winning writers and opinion formers The Future of Money brings together the finest thinking to suggest solutions to this global predicament.
● How the West Was Lost: Fifty Years of Economic Folly--and the Stark Choices Ahead
By Dambisa Moyo
Review via Guardian
By the end of this century, most of the world will be developed: the era of western exceptionalism will be over. How the West Was Lost is a dyspeptic account of what this might imply. The rosy scenario that most economists would suggest (if they dared to tackle such a large issue) would be that the convergence of the emerging market economies on the west is mutually beneficial: we can all prosper together. Dambisa Moyo, author of the bestselling Dead Aid, is having none of this. She argues that the west has become mired in complacency: each of the drivers of growth – capital accumulation, skill accumulation, and technical innovation – have stalled, and there is no political will to salvage the situation. The market for capital has failed in its core task of finding investment opportunities that offer good returns at acceptable risk.
● Advantage: How American Innovation Can Overcome the Asian Challenge
By Adam Segal
Summary via Council on Foreign Relations
The emergence of India and China as economic powers has shifted the global landscape and called into question the ability of the United States to compete and maintain its technological lead. Advantage sorts out the challenges the United States faces and focuses on what drives innovation, what constrains it, and what advantages we have to leverage. Recasting the stakes of the debate, Adam Segal, an expert on technology and foreign policy, makes the compelling case for the crucial role of the “software” of innovation. By strengthening its politics, social relations, and institutions that move ideas from the lab to the marketplace, the United States can play to its greatest economic strengths and preserve its position as a global power.
● The Theory of Moral Sentiments; To Which Is Added a Dissertation on the Origin of Languages
● The Passions and the Interests
● Nudge: Improving Decisions About Health, Wealth, and Happiness
● Fault Lines: How Hidden Fractures Still Threaten the World Economy
● Winner-Take-All Politics: How Washington Made the Rich Richer--and Turned Its Back on the Middle Class
Recommendations by Robert Shiller via interview with The Browser
Yale economist Robert Shiller argues that rising inequality in the US was a major cause of the recent crisis, and little is being done to address it. He chooses books that give insight into human nature
February 4, 2011
DID SNOW FREEZE JOB GROWTH LAST MONTH?
There’s mixed news on the labor front today, according to this morning’s payrolls report for January from the Labor Department. The unemployment rate fell to 9.0% last month from 9.4% in December—that’s good. But January’s private sector growth in nonfarm payrolls rose by a slim 50,000, down sharply from December’s revised 139,000 gain—that’s bad. Analysts say that snow kept a lid on stronger job growth. Perhaps, but the crowd is stuck singing a familiar refrain once again: Next month’s job report will be better.
“Job growth is also much stronger than the payrolls suggest,” says Eric Green, a strategist at TD Securities, via MarketWatch.com. He predicts that “payrolls will be much higher next month, and so will unemployment.”
Ward McCarthy, chief financial economist at Jefferies & Co, agrees. “This looks like quite a firm report once you get those frozen-out workers off the tables,” he tells Bloomberg.
Meantime, the Labor Department revised the last two years of employment data, but the changes don’t improve the profile of sluggish job growth of late. As the chart below reminds, private-sector payroll increases have been modest at best. Unfortunately, the trend seems to be weakening. The revised numbers show that last month’s net change in private payrolls was the smallest since last May.
The leading sources for the deceleration in overall private-sector job growth last month: an acceleration in the loss of construction jobs and a dramatic slowdown in the rise of services employment.
Spring can't come too quickly for the labor market, but until stronger numbers arrive maybe it's prudent to keep expectations in check. "One might be tempted to read something positive also from the fall in the unemployment rate from 9.4% to 9%," notes Rob Carnell of ING via The Guardian today. But there's still reason to stay cautious, he adds. "Despite a 117,000 gain in employment measured by the household survey in Jan, most of this fall in the unemployment rate was the result of a further 507,000 decline in the civilian labor force, which contributed most of the 622,000 decline in 'unemployment' this month. Moreover, adding to the sense that all is not entirely well with the US labor force, the average duration of unemployment continues to drift higher."
STRATEGIC BRIEFING | 2.4.2011 | FOOD PRICES
Global food prices rise to new highs, not expected to fall in coming months – UN
UN News Centre/Feb 3
Food prices around the world surged to a new historic peak in January, for the seventh consecutive month, the United Nations Food and Agriculture Organization (FAO) reported today, adding that the prices are not likely to decline in the months ahead. According to the FAO, its latest Food Price Index, a commodity basket that tracks monthly changes in global food prices, averaged 231 points in January and was up 3.4 per cent from December last year – the highest level since the agency started measuring food prices in 1990. It added that prices of all monitored commodity groups surged in January, except the cost of meat, which remained unchanged.
World entering era of food price volatility: WFP
"We are entering an era of food volatility and disruptions in supplies. This is a very serious business for the world," Josette Sheeran, executive director of the World Food Programme (WFP), told Insider TV on the sidelines of a U.N. Conference in London. "If people don't have enough to eat they only have three options: they can revolt, they can migrate or they can die. We need a better action plan," she said.
Food inflation and QE2: the correlation is undeniable
International Business Times/Feb 3
Experts can argue all they want about the causality relationship between food inflation and the Federal Reserve’s second round of quantitative easing (QE2). What cannot be denied, however, is the correlation. Indeed, ever since QE2 was clearly signaled by the Fed, the price of food commodities surged.
Bernanke On Egypt: It Is "Unfair" To Blame The Fed For Rising Food Prices
ABC News/Feb 3
ABC News' Mary Bruce reports: Federal Reserve Chairman Ben Bernanke said today that it was “unfair” to blame the Federal Reserve’s monetary policies for inflation in emerging markets and defended the Fed against accusations that it has contributed to the rise of global food prices, which have fueled political instability in countries like Tunisia and Egypt.
Bernanke was asked about the situation in Egypt during a rare question and answer session following a speech today at the National Press Club in Washington, D.C. He initially rejected the premise of the question, but went on to discuss food prices. “The most important development globally is the fact that the world is growing more quickly, particularly in emerging markets,” he explained. “I think it’s entirely unfair to attribute excess demand pressures in emerging markets to U.S. monetary policy because emerging markets have all the tools they need to address excess demand in those countries… It really is up to emerging markets to find the appropriate tools to balance their own growth.”
Why your T-shirts could drive food inflation
The Globe and Mail/Feb 3
As global food inflation surges to ever greater heights, fears are mounting prices will be driven even higher by a commodity that’s not even edible: cotton. The price of cotton is at highs not seen in more than 140 years, sparking concerns that farmers in many countries will switch their crops for the more lucrative commodity, and stop planting food staples such as corn, soybeans and sugar.
India's Food inflation soars to 17.05%
Hindustan Times/Feb 3
India’s wholesale price index (WPI)-based inflation climbed to 17.05% for the week-ended January 22 — up from the previous week’s 15.57% — reflecting price shocks in essential commodities, data released on Thursday showed. Finance minister Pranab Mukherjee termed the rise in food prices as a matter of “grave concern.” “Price rise always, particularly, the commodity price and food items are matter of grave concern,” he told reporters.
Rice Hits 27-Month High
Wall Street Journal/Feb 3
U.S. rice futures reached 27-month highs Thursday on concerns Egypt will start importing in the face of escalating tensions and U.S. farmers will sow fewer rice acres come spring.
End of cheap food era as grain prices stay high: Reuters poll
U.S. grain prices should stay unrelentingly high this year, according to a Reuters poll, the latest sign that the era of cheap food has come to an end.
Egypt Unrest Was Sparked by Food Inflation
Egypt's problems have been simmering for years, but food inflation has brought it to a boil. Remember: food inflation is behind much of the unrest, not just in Egypt but all over the world. Commodity prices have been rising for months, and many countries have already seen unrest over higher food prices.
February 3, 2011
DATA POINTS | 2.3.2011
RBC U.S. Consumer Outlook Index Posts Slight Decline
U.S. consumer confidence for February declined slightly for a second month as consumers await a definitive signal on the direction of the economy, according to the monthly RBC Consumer Outlook Index. The Index for February declined to 44.5, down 0.4 points from January’s 44.9 but still above the 42.6 points recorded a year ago. In line with the volatility in the municipal bond market, the survey also found that a majority of Americans are not confident in municipal bonds as an investment. “Although the RBC Consumer Outlook Index has done nothing but move sideways since hitting a post-recession high in December, it’s surprising that consumer confidence didn’t fall even more, given recent events,” said RBC Capital Markets Chief U.S. economist Tom Porcelli. “The survey was conducted in the midst of daily headlines about unrest in Egypt, rising fuel prices and a sharp decline in the markets – all of which historically weigh on confidence. It appears that the Index was backstopped by future expectations, which reached their highest level in a year. This suggests that consumers view current events as transitory and are willing to look past them.”
RBC (Royal Bank of Canada)/Feb 3
US Factory Orders For Dec 2010 Rise 0.2%
New orders for manufactured goods in December, up five of the last six months, increased $0.7 billion or 0.2 percent to $426.8 billion, the U.S. Census Bureau reported today. This followed a 1.3 percent November increase. Excluding transportation, new orders increased 1.7 percent.
U.S. Census Bureau/Feb 3
US Nonfarm Labor Productivity Increases 2.6% in Q4:2010
Nonfarm business sector labor productivity increased at a 2.6 percent annual rate during the fourth quarter of 2010, the U.S. Bureau of Labor Statistics reported today. This gain in productivity reflects increases of 4.5 percent in output and 1.8 percent in hours worked.
U.S. Labor Dept/Feb 3
Services Sector Growth Picks Up Speed In January
The Institute for Supply Management reports that its index of non-manufacturing activity increased to 59.4 last month from 57.1 in December. That's the fastest pace in more than five years.
Institute for Supply Management/Feb 3
January Retail Sales Rise 4.8%
Retailers weathered the storms in January, both literally and figuratively. Based on ICSC’s tally of 32 retailers that reported monthly sales, aggregate industry comp-store sales rose by 4.8% in January—besting our forecast. Although retailers were impacted by storms in the Northeast and Southeast, in particular, strength across the board helped to lift overall industry sales performance to its strongest monthly gains since November’s 5.4% year-over-year pace and finished the extended holiday season, fiscal quarter and fiscal year on a strong footing.
International Council of Shopping Centers/Feb 3
STILL WAITING (AND HOPING) FOR A STRONGER LABOR MARKET
You can’t squeeze blood out of a stone and apparently you’ll grow old waiting for initial jobless claims to fall far enough, fast enough to inspire something more than fleeting confidence about the prospects for job creation. Ok, we're exaggerating, but anyone who's been watching the labor market these last several years understands the sentiment.
Today’s update on weekly claims for new unemployment benefits sets us up once again for thinking that better days are just around the corner for payrolls. New claims dropped by a hefty 42,000 last week on a seasonally adjusted basis, according to the Labor Department. That’s one of the biggest weekly declines in recent history, but it’s not likely to bring many cheers from the crowd. One reason is that it comes directly after the previous week’s huge gain. Even worse, the progress that was evident for a time in jobless claims late last year seems to have stalled.
The trend, of course, is far more important for this volatile series than any one data point, but there’s not much meat on this bone. As the chart below shows, the four-week moving average of new claims (red line) has ticked up recently. That’s discouraging, and for more than the obvious reason.
The last several months have witnessed an acceleration in the broad economy, the labor market and real estate excluded. As we observe in the latest issue of The Beta Investment Report, the economy closed last year on a strong note. In fact, our in-house measure of the broad economic trend rose in December (the last month with all major economic reports published) by a strong 2.1%. That’s the best month since the recession formally ended in June 2009 and the highest monthly increase in over a decade. Our benchmark of leading indicators performed even better in December, gaining over 3%.
Another way to measure the general drift in the economic trend is to monitor monthly changes in a broad sweep of economic indicators. By that standard, it's also clear that the forces of growth prevailed in the final months of 2010. As the second chart below shows, more than 80% of the economic stats regularly analyzed in The Beta Investment Report posted a gain in December—the highest ratio in four years.
There are signs that the recovery momentum has spilled over into 2011, as the thaw in commercial lending and the surge in manufacturing activity last month suggest. But the conspicuous missing link to what would almost surely be a far stronger and more convincing recovery: jobs.
Yes, today's drop in jobless claims is welcome news. But the absence of improvement in the level of new claims in late-2010 is troubling. If progress in the labor market can suck wind in the face of potent revival elsewhere in the broad economic trend, that's a sign that payrolls growth will remain sluggish, even as the second anniversary of the recession's formal end approaches.
Will tomorrow's jobs report for January tell us different? Not really, or so yesterday's ADP Employment Report implies. The ADP numbers don't paint a terribly strong picture for January private payrolls. Ditto for the consensus forecast that private payrolls will post a modest net increase of 163,000 in tomorrow's update from the government, according to Briefing.com.
Yes, the economy is creating jobs. Payrolls rose in each and every month last year. But it's a tepid recovery, which raises the question of whether it threatens the expansion in the non-employment corners of the economy? For the moment, it's a theoretical question, since the non-employment profile of the economy (housing excepted) appears to be making headway. Therein lies the hope that better days lie ahead for employment.
Jobs, after all, are usually among the last points of revival after a recession. That standard is alive and well this time around. Meantime, hope continues to spring eternal. Challenger, Gray & Christmas, reports that job cuts last month fell to the lowest level since the firm began tracking this data in 1993. “It is not unusual to see job cuts increase in January," says the firm's CEO, John Challenger, in a press release. "In fact, 2011 marks the fifth consecutive year and the tenth out of the last twelve in which January job cuts surpassed the December total." He goes on to note that "what made this January figure so unusual is that it was so low."
Does that give us courage to expect brighter days for job growth in the months ahead? Perhaps tomorrow's employment report for January will provide some fresh perspective on an answer. Stay tuned…
IS THE SLUMP IN COMMERCIAL LENDING OVER?
Commercial and industrial loans appear to be on the rise again. For the first time since the Great Recession slammed the economy, lending is increasing, according to Federal Reserve data. Banks are also loosening their lending standards, according to the latest Fed survey. It all adds up to evidence that another variable in the business cycle is no longer creating a drag on the forces of economic recovery. It's far from a sea change, but even a marginal shift is good news because it adds brings one more critical data point back from the dark side.
The signs of thawing in the big lending freeze are still tentative, but there's a case for cautious optimism. Commercial and industrial loans at large banks are showing signs of rising for the first time in two years, as the chart below shows. It's hardly a roaring surge, but the shift seems to mark a break with free fall that prevailed since late-2008. At the very least, it looks like the lending business is no longer contracting. If so, there's one less negative force weighing on economic momentum.
In support of thinking positively is the Fed's latest survey of bank loan officers, which finds that roughly 12% of banks in the polling had eased their lending standards for commercial and industrial loans. Yes, an iceberg melts slowly, but it's the general trend that's important for looking forward.
"If lending activity picks up, you can bet that corporate spending will too," writes Pimco money manager Anthony Crescenzi in his 2008 book Investing From the Top Down: A Macro Approach to Capital Markets.
It's too early to make definitive statements about lending and what it implies for the broader economy, but the uptick in C&I loans inspires thinking about the implications. “We’re starting to see loan demand turn up, and that’s a very important indication that the financial system is healing and the commercial banking system is getting stronger,” Michael Darda, chief economist and chief market strategist for MKM Partners, tells Bloomberg. “When that happens you usually see a step up in job creation as well.”
Yes, it's still mostly a jobless recovery, and that makes the economic expansion relatively vulnerable. But if lending is no longer falling like a rock and maybe, just maybe, it's even starting to trend higher, the recovery is a bit less vulnerable.
February 2, 2011
ADP EMPLOYMENT REPORT: MODEST JOB GROWTH IN JANUARY
Private-sector jobs increased by a modest 187,000 in January, according to this morning’s release of the ADP Employment Report. That’s a sharp slowdown from December’s 297,000 surge, which has since been revised down to 247,000.
“This month’s ADP National Employment Report suggests solid growth of private nonfarm payroll employment heading into the New Year,” according to the press release. “The recent pattern of rising employment gains since the middle of last year appears to be intact, as the average gain over December and January (217,000) is well above the average gain over the prior six months (52,000). Strength was evident within all major industries and across all size business tracked in the ADP Report.”
ADP's characterization of the labor market's revival is a bit too rosy given the modest numbers, but everyone's entitled to their opinion, especially when it comes to the uncertainty of the future. As to the past, all is clear, and by that standard it's hard to get overly excited at this point. The economy is creating new jobs, of course, and the trend almost certainly has legs. But so far, there's not much evidence indicating that the gains will soon be sufficient to attack public enemy #1 in economic policy matters: high unemployment.
The latest data point from ADP suggests that this Friday’s employment report from the Labor Department won’t deliver any large positive surprises. Of course, history also suggests that we should be cautious in reading too much into ADP estimates as a window into the more influential government payrolls report. Maybe that's a good thing. Last month, the initial ADP update revealed a strong revival in job creation for December, but the enthusiasm for thinking that the labor market had finally turned a corner fizzled a few days later when the official payrolls report for December threw cold water on the idea.
Even if you take today’s ADP report at face value, it’s unimpressive, given what the economy needs to lower the elevated 9%-plus unemployment rate. “Until we start seeing job gains above 250,000, these will just be stabilizing reports rather than true indications that the market will meaningfully come back,” says Michael Yoshikami, chief investment strategist at YCMNET Advisors.
THE JOBLESS RECOVERY ROLLS ON
Yesterday’s Institute for Supply Management's survey of manufacturers for January delivered a strong dose of optimism for thinking that the expansion has a head of steam. As an early look at how the economy fared last month, this index’s rise to its highest level in seven years signals that the growth is still bubbling in the new year. The U.S. stock market took the hint and posted a strong rally yesterday. In fact, equities have more or less regained all the losses suffered during the Great Recession.
“Overall, this [manufacturing] report ranks among the strongest signs to date that the economy is moving into a phase of stronger sustainable growth,” says David Resler, economist at Nomura Securities, via the LA Times. Looking at the recent trend in the ISM Index (see chart below), it's hard to argue.
"The economy is growing and it’s getting a little more momentum now," Treasury Secretary Geithner says in an interview this week. "We’re seeing exports stronger, private investment is stronger, you’re seeing manufacturing come back, the agricultural economy is very strong now, the strongest it’s been in a long period of time."
The rebound in January’s ISM Manufacturing Index has had corroboration of a degree in recent economic reports, including December’s rise in consumer spending and income and the increase in fourth quarter GDP to a new high.
Stepping back and reviewing the revival of macro fortunes in recent months after last summer’s stumble inspires some economists to explain the shift to growth are partly if not largely linked with the Fed’s second round of quantitative easing that was anticipated last fall and was formally announced in November. "We’ll need a few months more data, but so far it looks like the recovery is going from almost nonexistent during May through August, to moderate. That’s progress," writes economist Scott Sumner, who's argued long and hard in favor of monetary stimulus as the primary weapon in fighting economic contraction and disinflation/deflation.
And Bill Woolsey notes:
The estimate for Final Sales of Domestic Product for the fourth quarter of 2010 was $14,865 billion. This was a 7 percent increase from the third quarter. Since the sharp decrease in the 4th quarter of 2008, this is the first increase that was greater than the 5 percent trend of the Great Moderation. In fact, it was the first increase that wasn't less than 3 percent.
Meanwhile, the IMF suggests that there are no free lunches. Stimulus today, pay the bill tomorrow? Perhaps. As the IMF’s Carlo Cottarelli reports:
The United States and Japan are delaying their earlier plans to reduce their public deficits, choosing instead to provide further support to their economies. The change in plans is even more remarkable if you look at the cyclically adjusted balance… Some of the change in the fiscal stance with respect to our earlier projections is attributable to the somewhat better than projected fiscal results in 2010... Most of it, however, is due to additional stimulus measures introduced during the last two months. These two countries need to strengthen their fiscal adjustment credentials by detailing the measures they will adopt to lower deficits and debt over the medium term.
Many disagree on QE2’s influence in the current round of recovery, but even if you buy this argument the narrative is far from flawless. The main challenge remains the weak job growth. GDP, manufacturing and the stock market may have regained lost ground, but the labor market is still struggling and on some levels has shown precious little improvement from the depths of the previous contraction. Indeed, the 9.4% jobless rate in December is only slightly below the cyclical peak of 10.1% reached in October 2009 and a world away from the below-5% days that prevailed before 2008 (see chart below).
The persistence of high unemployment is a symptom of the weak pace of net job creation. December’s modest increase in private payrolls reflects a trend that’s been harassing the economy for much of the time since the recession was formally declared over as of June 2009.
The January update on payrolls arrives this Friday. The consensus forecast calls for a net rise of 163,000, which would be an improvement over December’s 113,000 gain. But as most economists note, materially higher and sustained levels of job growth are needed to lower the high unemployment rate. For the moment, we’re just not there yet, and by some accounts the odds don’t look encouraging for anticipating a substantial improvement anytime soon.
Some argue that the nature of the problem this time is structurally high unemployment, meaning that the problem won’t be solved with an economic recovery per se because there are deeper problems, such as a mismatch between employee skills and what’s needed by corporate America. If true, the high jobless rate could persist for longer than usual.
Even if the jobless problem isn’t structural, a quick fix may not be imminent. Economist Murat Tasci of the Cleveland Fed explains that high unemployment is cyclical rather than structural, but he still thinks that the jobless rate will fall slowly.
So, yes, the economy is effectively back on track in terms of the recovery that was in force before it was derailed in the spring and summer of 2010. But in terms of employment, not much has changed. Job growth is still challenged, and ultimately that raises doubts about the strength of the economic recovery.
In fact, the anxiety tied to unemployment is global. According to a new Ipsos/Reuters poll, the leading concern of adults surveyed in 24 countries around the world is joblessness, poverty and social injustice.
The more things change…
February 1, 2011
INDEXING, REBALANCING & ASSET ALLOCATION
SmartMoney asks: Is your index fund broken? Good question, although here’s a better one: Is your management of asset allocation broken?
The SmartMoney story reviews an increasingly popular subject: alternative indexing methodologies. At issue is whether there’s a better way to index and earn a higher risk-adjusted return. There is, or so the article and a number of studies in recent years advise. Perhaps, although a more-productive question is how all this affects asset allocation? Yes, superior index products will improve asset allocation results, but we should be cautious before rushing to judgment.
The broader your asset allocation, the less critical the choice of any given index, assuming we’re talking of broadly diversified funds that seek to capture the lion’s share of a given beta. Getting caught up in the indexing debate about this or that benchmark is worthwhile—up to a point. But keep in mind that all the alternative indexing methodologies share a common factor: rebalancing.
One of the reasons that a given alternative benchmark beats its cap-weighted in recent years is linked with rebalancing. There’s a healthy debate about how to rebalance, and when, and there always will be. The broad lesson that flows from academic research in recent decades, which I summarize in my book (Dynamic Asset Allocation), is that opportunistically managing the asset mix is at the heart of beating the market-value-weighted benchmark of those components. True for an individual market, such as U.S. equities, and true for a multi-asset class portfolio. But the details can be messy.
But there's an obvious place to start as a benchmark for this process. Simple year-end rebalancing of a broad asset allocation has a history of boosting performance by 50 to 100 basis points a year over the long haul, according to several studies published in The Beta Investment Report. This isn’t surprising. The notion of buying low and selling high needs no explanation. But is it a free lunch? No, of course not. What, then, is the risk?
Some of the answer (perhaps most of it, depending on the strategy) is bound up with reversion to the mean. Buying securities and/or asset classes when they’ve fallen in price on the expectation that prices will rise in the future is an assumption that mean reversion will prevail. There’s a small library of empirical studies that support the idea. In addition, there are many techniques for developing intuition about fluctuation in expected return based on mean reversion. A few tools that shed light on when it’s productive to adjust the allocation include moving averages, large changes in fundamental values (dividend yield, price-earnings ratio, yield spreads, etc.), and macroeconomic-related trends (yield curve changes, equity market/industrial production relationship, etc.).
Dynamically managing indices or asset allocation isn’t a free lunch, however. Mean reversion doesn’t unfold like clockwork. The various sources of mean reversion wax and wane through time. In some periods, the mean reversion may fade for lengthy periods. For example, in the latter half of 1990, positive momentum in growth stocks overwhelmed the value factor. As a result, rebalancing an equity portfolio didn’t do as well simply buying and holding during that stretch.
In the long run, the academic and empirical case for rebalancing in all its various forms is compelling. But sometimes waiting for the long run is asking for too much. Indeed, a number of value-oriented managers went under in the late-1990s waiting for this risk factor to reassert its historical edge.
By taking on rebalancing risk you can earn a higher return. But you have to be comfortable with a contrarian mindset. That's easier than it sounds in real time. Were you buying in late-2008? The main source of higher expected return with rebalancing in a multi-asset class portfolio is the rebalancing process itself, assuming you own a wide mix of asset classes. Picking an alternative indexing methodology to represent one or more of those asset classes may help, although you can’t count on the edge continually. In fact, alternative indexing products can and will lag market cap products at times.
There's also a new issue to confront: Which alternative index is superior? As the SmartMoney article reminds, some of these new benchmarks apply contrasting methodologies that presumably may deliver different results. Meanwhile, a simple equal-weighting strategy, which has beaten market-cap weighting in recent years, is primarily a play on the small-cap factor. That's great as long as you anticipate small caps will outperform big caps, but that edge ebbs and flows at times as well.
In any case, don’t lose sight of the bigger lesson: rebalancing asset allocation is the main source of beating a passive market-cap benchmark of a broad mix of asset classes. If you’re reasonably successful with the process, the choice of benchmark design will be a secondary factor, perhaps distantly so. That doesn’t mean that we should ignore the potential for superior index design. To be fair, there are some intriguing developments on this front and they deserve careful analysis. Just don’t let this tail wag the dog.