September 30, 2011
Has Anyone Seen Those Vigilantes?
The bond vigilantes are MIA, observes Ronald McKinnon, a professor at Stanford. This is unusual, he advises. "In past decades, tense political disputes over actual or projected fiscal deficits induced sharp increases in interest rates—particularly on long-term bonds." But as anyone who watches the Treasury market these days knows, rates have been falling, and for longer than many veteran market pundits and traders expected. To put it simply, these are extraordinary times... still. On that point, at least, there's no debate.
"Even with great financial disorder in the stock and commodity markets since late July 2011, today's 10-year Treasury bond rate has plunged below 2%," McKinnon notes. "The bond market vigilantes have disappeared."
The disappearing act has consequences, he continues:
Without the vigilantes in 2011, the federal government faces no immediate market discipline for balancing its runaway fiscal deficits. Indeed, after President Obama finally received congressional approval to raise the debt ceiling on Aug. 2, followed by Standard & Poor's downgrade of Treasury bonds from AAA to AA+ on Aug. 5, the interest rate on 10-year Treasuries declined even further… The more interest rates are compressed toward zero, the less useful the market becomes in reflecting risk and allocating private capital, as well as in disciplining the government.
What's going on? McKinnon argues that "the vigilantes have been crowded out by central banks the world over." This isn't normal, he complains.
When interest rates dipped in the past, at least part of their immediate expansionary impact came from the belief that interest rates would bounce back to normal levels in the future. Firms would rush to avail themselves of cheap credit before it disappeared. However, if interest rates are expected to stay low indefinitely, this short-term expansionary effect is weakened.
McKinnon is effectively saying that low rates are the problem, the implication being that tighter monetary policy will cure not only the unusual state of interest rates but the economic conditions that induced the low interest rates in the first place. But such a policy isn't likely to be productive at a time when inflation expectations are falling, money demand is rising, the economy is weakening, and the Fed is engaging in passive tightening via monetary policy, zero nominal rates notwithstanding. Switching to an active policy of tightening, in other words, sounds a bit premature, to put it mildly.
Whereas McKinnon is chomping on the bit for tighter policy, others look at the world and call for the opposite. Martin Wolf, for one, thunders:
It is the policy that dare not speak its name: the printing press. The time has come to employ this nuclear option on a grand scale. The alternative is likely to be a lost decade. The waste is more than unnecessary; it is cruel. Sadists seem to revel in that cruelty. Sane people should reject it. It is wrong, intellectually and morally.
For the reasoning, Wolf cites a speech from earlier this month by Adam Posen, an American who sits on the Bank of England's monetary policy committee:
Both the UK and the global economy are facing a familiar foe at present: policy defeatism. Throughout modern economic history, whether in Western Europe in the 1920s, in the US and elsewhere in the 1930s, or in Japan in the 1990s, every major financial crisis-driven downturn has been followed by premature abandonment—if not reversal—of the macroeconomic stimulus policies that are necessary to sustained recovery. Every time, this was due to unduly influential voices claiming some combination of the destructiveness of further policy stimulus, the ineffectiveness of further policy stimulus, or the political corruption from further policy stimulus. Every time those voices were wrong on each and every count. Those voices are being heard again today, much too loudly. It is the duty of economic policymakers including central bankers to rebut these false claims head on. It is even more important that we do the right thing for the economy rather than be slowed, confused, or intimidated by such false claims.
Even the former bond vigilantes seem inclined to agree these days.
The Slow Grind
The recent downshift in economic activity is grinding down consumer spending and income, according to this morning's update from the Bureau of Economic Analysis. Disposable personal income slipped marginally in August vs. the previous month—the first decline in 11 months. After adjusting for inflation, however, DPI was down a considerable 0.3%, the second real monthly drop in a row. Personal consumption expenditures fared better, rising 0.2% in nominal terms, but that was a sharply slower rate from the July bounce and on an inflation-adjusted basis PCE was flat last month.
"What you're basically getting is a scene where consumers are losing momentum, they're losing momentum on income and as a result of that they're slowing down on spending," explains Steven Ricchiuto, U.S. chief economist at Mizuho Securities.
For a clearer perspective of what's going on, let's switch to rolling one-year percentage changes. As the chart below shows, the falling trend in DPI is now conspicuous. Disposable personal income was higher by 3.2% for the year through August, but that's the slowest pace in more than a year. Personal income is doing better, advancing 4.7% in August vs. a year earlier. But unless income growth is poised to grow sharply in the months ahead, spending is set to trend lower.
One way or another, the relatively wide gap between spending and income on a 12-month basis will narrow. Unfortunately, it's not hard to imagine that it'll narrow through lesser consumption rather than higher incomes. What can arrest this decline? Job growth, of course. Unfortunately, recent reports don't look kindly on expecting good news. True, yesterday's drop in initial jobless claims offers a fresh round of hope. But after August's flat performance, there's little confidence that salvation is near for the labor market.
“Without payrolls picking up, you’re not going to get any boost in economic activity,” says Rudy Narvas, an economist at Societe Generale. “People are very worried about the economy.”
September 29, 2011
Jobless Claims Drop Sharply. Can We Believe It This Time?
New jobless claims dropped last week by a hefty 37,000 to a seasonally adjusted 391,000. That’s the biggest weekly tumble since May, pushing new filings for jobless benefits under the 400,000 mark for only the second time in 25 weeks. It looks good, and it surprised a lot of economists. But let's refrain just yet from declaring this as the start of something big.
Indeed, new claims dipped under 400,000 several times in the early months of this year, but it didn’t mean much, at least not by the only standard that matters at this point: job growth. The growth in private nonfarm payrolls has weakened considerably since the spring, with August’s report indicating virtually no change. Does today’s surprisingly strong dip in claims foretell of better days ahead for the labor market? Perhaps, but you’ll excuse me if I remain a wee bit skeptical until further notice. The dip under 400,000 earlier this year looked like the real deal for a time, and it was based on more than one data point. But stuff happened and so the revival turned out to be an imposter. Perhaps the second time’s the charm, but it’ll take much more than one (so far) brief flirtation under 400k.
For the moment, though, the change of pace is refreshing. Even the four-week moving average managed a small retreat—the first in six weeks.
The trend also looks stronger on a rolling 12-month basis. Unadjusted claims are roughly 13% lower vs. the year-earlier period, a substantial change for the better compared with the readings in recent weeks.
The bad news is that claims are still elevated. The good news is that the trend is still encouraging, which is to say that weekly claims continue to fall on an annual basis. But they’re not falling fast enough to inspire high confidence that job growth will be strong. Instead, jobless claims are signaling that the economy will struggle but avoid another recession.
If there’s a case for upgrading this outlook to a stronger dose of optimism it’ll take more than one good week in claims data. “Apart from what might be an anomaly, the underlying trend in the labor force is still disappointing,” notes Sean Incremona, a senior economist at 4Cast Inc. “There is a lot of economic uncertainty weighing on the broader economy.”
Maybe it's reasonable to say that there's a bit less uncertainty today, at least on the margins, a theme that also finds support in this morning's third estimate of second-quarter GDP. The U.S. economy grew at a real 1.3% annualized pace during April through June of this year, up from the previous 1.0% estimate.
A small upward revision for the state of the economy several months ago is better than a kick in the head, but it doesn't change the facts on the ground in the here and now. “We’ve had close to 10% unemployment now for a number of years, and of the people who are unemployed, about 45% have been unemployed for six months or more," Fed chairman Ben Bernanke said yesterday. "This is unheard of" and it represents a "national crisis."
Can today's drop in jobless claims inspire a brighter outlook for Q3 GDP? Maybe, but it's going to take some corroborating numbers in the weeks ahead. Meantime, cautious optimism is the new new thing this morning. "It's encouraging to see jobless claims come in below a 400 handle," advises Omer Esimer, chief market analyst at Commonwealth Foreign Exchange, via Reuters. "And even the GDP number, which at this point is dated, is adding to the overall improved tone in markets," he adds. "But the overall landscape hasn't changed much, so it probably doesn't warrant all the optimism we're seeing. I'm still somewhat bearish on the outlook for growth."
The Case For Monetary Cranks
Kansas City President Thomas Hoenig is the Uriah Heep of central banking. "We ought to be very, very humble in our expectations of what we can do with this instrument we call monetary policy," says Hoenig, who retires this week after racking up eight straight dissents last year as a voting member of the FOMC. But would tighter monetary policy imposed six months or a year earlier be paying macro dividends now? Let's be generous and say that it's debatable. Still, the prescription endures.
In an interview with NPR, Hoenig complains that "in a world of instant gratification, we have had two decades in this country of consuming more than we produce by a considerable margin." As part of the solution, he recommends spending cuts and tax hikes, NPR reports. Now? In this economy? So much for humility.
The punishment, it seems, must fit the crime, Hoenig suggests. Monetary policy as punitive social policy? But austerity now isn't helping Europe, and it's not clear that it would help the U.S. economy at this point, as history suggests.
What is conspicuous is that the market's inflation expectations have been falling since the spring. The implied inflation outlook via the yield spread on the nominal 10-year Treasury less its inflation-indexed counterpart is under 2%, the lowest in nearly a year. That's a problem for a weak economy, a point that Fed Chairman Ben Bernanke seemed to notice anew. In a speech yesterday, he explains that "if inflation falls too low or inflation expectations fall too low, that would be something we have to respond to because we do not want deflation."
The comment inspires Marcus Nunes to recommend that "we must reevaluate Bernanke´s supposed knowledge about the power of monetary policy."
Meanwhile, facts are stubborn things. As David Beckworth explains, the Fed's "passive tightening" is squeezing the economy. "The result is that current dollar spending--the product of the money supply and money demand--is not where it should be, as seen in the figure below:
Isn't an accommodative monetary policy at this point just reckless money printing? Scott Sumner dispatches that idea with in one fell swoop: "Yes, but like a broken clock the monetary cranks are right twice a century; 1933, and today. The other 98 years I am a Chicago-trained, libertarian, inflation-hawk. Twice a century I put on my Irving Fisher super-hero suit, and emerge from my deep underground bunker."
September 28, 2011
Durable Goods Orders Hold Their Ground In August
New orders for durables goods, considered a leading indicator for the business cycle, slipped 0.1% last month on a seasonally adjusted basis. The slight decline follows a strong 4.1% jump in July. Given all the recent worries about rising recession risk, it’s a wonder that new orders didn’t fall further. The fact that this critical measure of economic activity managed to hold on to virtually all of July’s gains implies that the economy may continue to struggle but it will avoid a recession. That relatively optimistic view is strengthened after learning of the 1.1% rise last month in business investment (a proxy for capital spending, as measured by nondefense capital goods orders excluding aircraft).
You can’t tell much from looking at monthly data, given all the short-term noise. A better measure is comparing rolling 12-month percentage changes. By that standard, news orders for durable goods and capital spending continue to rise at strong rates, as you can see from the chart below.
It’s true that the annual rates of change have been slipping for most of the past year, but that's not ominous on its face. The former 10%-to-20% year-over-year increases were always destined to slow. Those rates were a byproduct of the bounce-back effect of an economy that suffered a massive shock. But the pace wasn’t sustainable. The question, of course, is how much more will the pace decelerate?
For the moment, there’s no immediate warning sign in the annual trend. Durable goods orders continue to advance at a healthy clip vs. the year-earlier period. The key problem is that employment isn’t delivering a comparable rebound, as indicated by the weak recovery in private nonfarm payrolls. The labor market’s sluggish response is hard to see in the chart above so let’s review payrolls alone on a rolling 12-month basis:
Weak job growth remains the primary threat for the macro outlook. Spending on durable goods, by contrast, continues to rise at a healthy clip on a year-over-year basis. But let’s not ignore the potential for trouble. As the rate of growth for durable goods orders slows, as it likely will, the danger for the economy rises without stronger job growth. Indeed, it’s no surprise to see that new orders slumped in the early stages of the Great Recession, as the first chart above shows. The good news these days is that new orders are still growing at rates well above what might be considered a danger level. But for how long?
“Large companies are so cash-rich that they can keep spending despite lower confidence,” says Ian Shepherdson, chief U.S. economist at High Frequency Economics, via Bloomberg. “In competitive industries, the company which does not spend loses market share.”
The 1.1% rise last month in capital spending "shows that we're not falling off a cliff, which helps,” Wayne Kaufman, chief market analyst at John Thomas Financial, tells Reuters. “This is a sigh of relief, and slightly reassuring in the short-term."
For now, it looks like we dodged another statistical bullet.
Research Review | 9.28.2011 | Volatility & Portfolio Management
Volatility-responsive asset allocation
Bob Collie, et al. (Russell Investments) | Aug 2011
The use of fixed weights in strategic asset allocation policy does not result in a stable risk/return pattern over time, but rather leads to greater risk at times of high market volatility and to lower risk in unusually stable markets. For investors who are sensitive to volatility, a more consistent outcome can be achieved – both in terms of the volatility of returns and in terms of how volatile that volatility itself is – by adopting a dynamic, or volatility-responsive, approach... The principle that underpins volatility-responsive asset allocation is to reduce exposure to risky assets when volatility is high, and to increase that exposure when volatility is low. This might result in a portfolio that averages, say, 50% exposure to the equity market, but which has more than that at times of market stability and less during volatile markets.
Benchmarking Low-Volatility Strategies
Pim Van Vliet and David Blitz (Robeco Asset Mgt.) | Feb 2011
An increasing number of investors are adopting low-volatility investment strategies designed to benefit from the empirical result that low-risk stocks offer high risk-adjusted returns... In this paper we discuss the benchmarking of low-volatility investment strategies, which are designed to benefit from the empirical result that low-risk stocks tend to earn high risk-adjusted returns. Although the minimum-variance portfolio of Markowitz is the ultimate low-volatility portfolio, we argue that it is not a suitable benchmark, as it can only be determined with hindsight. This problem is overcome by investable minimum-variance strategies, but because various approaches are equally effective at minimizing volatility it is ambiguous to elevate the status of any one particular approach to benchmark. As an example we discuss the recently introduced MSCI Minimum Volatility indices and conclude that these essentially resemble active low-volatility investment strategies themselves, rather than a natural benchmark for such strategies. In order to avoid these issues, we recommend to simply benchmark low-volatility managers against the capitalization-weighted market portfolio, using risk-adjusted performance metrics such as Sharpe ratio or Jensen’s alpha.
Is the Relation Between Volatility and Expected Stock Returns Positive, Flat or Negative?
Pim Van Vliet and David Blitz (Robeco Asset Mgt.) | Jul 2011
In theory the relation between volatility and expected stock returns should be positive, but the empirical evidence suggests that the relation is flat or even negative in reality. We have reconciled the conflicting empirical results by showing how methodological choices can lead to different, or even opposite conclusions. In our 1963-2009 U.S. sample we find that the empirical relation between historical volatility and expected returns is negative, with an average quintile return spread of -3.7%.The relation becomes 2% less negative when small caps are excluded, but 3% more negative when compounding effects are taken into account. We also show that studies which have reported a strong positive relation between volatility and expected return consider strategies which are not feasible in practice due to look-ahead biases. Our results provide an empirical basis for low-volatility and minimum-variance investment approaches.
What is the Shape of the Risk-Return Relation?
Alberto Rossi and Allan G. Timmermann (University of Calif.) | Mar 2010
The notion of a systematic trade-off between risk and expected returns is central to modern finance. Yet, despite more than two decades of empirical research, there is little consensus on the basic properties of the relation between the equity premium and conditional stock market volatility... Using a flexible econometric approach that avoids imposing restrictive modeling assumptions, we find evidence of a non-monotonic relation between conditional volatility and expected stock market returns: At low-to-medium levels of conditional volatility there is a positive trade-off between risk and expected returns, but this relationship gets inverted at high levels of volatility as observed during the recent financial crisis... These findings make it easier to understand why so many studies differ in their results regarding the sign and magnitude of the empirical volatility-return relationship and why results from linear models appear not to be robust to the sample period used in the analysis. In particular, studies that are conducted over periods without bouts of high (conditional) volatility are more likely to find a positive tradeoff between volatility and returns, while studies that include such episodes are more likely to find a negative or insignificant trade-off.
The Common Component of Idiosyncratic Volatility
Jefferson Duarte, et al. (University of Washington) | Aug 2011
We advance that a systematic risk factor, missing from Fama and French (1993), explains why high idiosyncratic volatility (IV) stocks yield lower risk-adjusted returns than low IV stocks. A single principal component, associated with business cycle variables, explains 32% of IV variation... Taken together, our empirical results provide support for the hypothesis that a systematic risk factor, which is not captured by the Fama-French factors, explains the puzzling relationship between seemingly idiosyncratic volatility and expected returns, first identified by Ang et al. (2006).
September 27, 2011
Too Much Of A Good Thing?
The gold bugs should be happy, but they're not. Yet inflation expectations are falling, and it's no short-term trend. The Cleveland Fed reports that expecting less on the inflation front has been intact for three decades. Matthew Yglesias suggests ours is an "era of ever-falling inflation expectations."
Is this a random event? Yglesias has his doubts:
Certainly it’s striking that during the past thirty years of FOMC statements and speeches by chairmen and Fed governors, not a single sentence starts with the clause “as part of our thirty year drive for ever-lower inflation expectations…” even though it’s hard to believe that inflation expectations have been steadily falling for thirty years by accident. Is there some actual reason to be doing this? I feel like if there were, the people doing it wouldn’t be so hesitant to admit that it’s what they’re doing.
Accidental or not, the market's outlook for inflation continues to fall. As of yesterday, the implied inflation forecast via the interest rate spread between the 10-year nominal and inflation-indexed Treasuries is 1.91%.
That's not so bad if it remains at 1.91%, although the market has its doubts that stability is destiny. James Bullard, St. Louis Fed president, isn't so sure either, albeit a doubt expressed in central bank-speak. "The behavior of inflation over the last year supports the idea that the fundamental output gap has been smaller than recognized, and that asset purchases are a potent tool for influencing inflation and inflation expectations," he says.
Context is important, of course. Are we in a growth environment? Or do risks to economic expansion lurk? Even a casual review of the evidence leaves no doubt about the answer. That leads Adam Posen, an American economist at the Bank of England, to warn that inflation fear these days is "exaggerated."
The market seems to agree. Policy makers here and abroad are another matter, albeit with the occasional exception.
September 26, 2011
Tactical ETF Review: 9.26.2011
September has been a cruel month for risky assets, although bonds continue to defy gravity. As uncertainty rises on a number of fronts, risk aversion has taken on a life of its own... again. But the search for a safe haven has narrowed recently to U.S. fixed income, Treasuries in particular. The greenback is popular once more, advancing in excess of 6% over the last month, based on the U.S. Dollar Index. The world's reserve currency comes with a fair amount of baggage these days, but for the moment the buck is still considered the safest, or at least the safer paper port in a storm. It's no trivial detail that the rising appetite for dollars comes at a time of heightened fears for the euro's survival. It all adds up to crumbling prices for foreign bonds in broad terms for both developed- and emerging-market nations when measured in dollar terms. Here's a closer look at how the bloodletting has been unfolding in the major asset classes via our usual list of ETF proxies…
US STOCKS • Vanguard Total Market (VTI) • Benchmark: MSCI US Broad Market Index
A vote of no confidence for the economic outlook...
FOREIGN DEVELOPED MARKET STOCKS • Vanguard Europe Pacific (VEA) • Benchmark: MSCI EAFE
There seems to be even less macro optimism for non-U.S. developed economies...
EMERGING MARKET STOCKS • Vanguard Emerging Markets (VWO) • Benchmark: MSCI Emerging Market
The deterioration in sentiment is afflicting emerging-market stocks too...
US BONDS • Vanguard Total Bond Market (BND) • Benchmark: Barclays US Aggregate
Worries about what comes next has inspired a rush to safety...
INFLATION-INDEXED US TREASURIES • iShares Barclays TIPS Bond (TIP) • Benchmark: Barclays US TIPS
Inflation-indexed Treasuries remain a port in the storm, but is the crowd becoming more cautious here?
HIGH YIELD BONDS • SPDR Barclays High Yield Bond (JNK) • Benchmark: Barclays High Yield Very Liquid
No sign of ambiguity in junk...
COMMODITIES • iPath Dow Jones-UBS Commodity (DJP) • Benchmark: DJ-UBS Commodity
Commodities are in broad retreat (and gold is no exception this time)...
REAL ESTATE INVESTMENT TRUSTS • Vanguard REIT (VNQ) • Benchmark: MSCI US REIT
Real estate is suffering too ...
FOREIGN DEVELOPED MARKET GOVERNMENT BONDS • SPDR Barclays Int’l Treasury (BWX) •
Benchmark: Barclays Global Treasury ex-US Capped
Thanks to euro fears and a surging dollar, the safety net in foreign government bonds has evaporated...
EMERGING MARKET GOVERNMENT BONDS • Van Eck Market Vectors Emg Mkt Local Currency Bond (EMLC) •
Benchmark: J.P. Morgan GBI-EMG Core
Emerging market bonds aren't holding up either...
FOREIGN GOVERNMENT INFLATION-LINKED BONDS • SPDR DB International Inflation-Protected Bond (WIP) •
Benchmark: DB Global Government ex-US Inflation-Linked Bond Capped
Foreign inflation-indexed government bonds have lost their allure as well...
FOREIGN CORPORATE BONDS • PowerShares International Corporate Bond (PICB) •
Benchmark: S&P International Corporate Bond
Investors aren't giving a pass to foreign corporate bonds either...
Charts courtesy of StockCharts.com
September 24, 2011
Book Bits For Saturday: 9.24.2011
● The The Third Industrial Revolution: How Lateral Power Is Transforming Energy, the Economy, and the World
By Jeremy Rifkin
Review via Bloomberg
The world economy will face shocks and depressions, punctuated by ever-shorter and weaker recoveries, as long as it relies on outdated fossil fuels, says Jeremy Rifkin, author of “The Third Industrial Revolution.” “There will be cycles of growth, collapse, growth, collapse, every three years or so,” he said in an interview in Berlin, where he was scheduled to speak on a panel about sustainable growth introduced by Chancellor Angela Merkel. We are on the cusp of a major upheaval as the world switches to renewable energies and our power-distribution networks undergo a transition similar to that experienced by communications systems with the advent of the Internet, he said. Until the “third industrial revolution” is in full swing, debt crises such as those plaguing the euro area will recur, Rifkin said.
● A Governor's Story: The Fight for Jobs and America's Economic Future
By Jennifer Granholm
Summary via publisher, Public Affairs Books
A candid account by Michigan's charismatic, controversial former governor of reckoning with the profound economic challenges her state—and the country—face. Jennifer Granholm was the two-term governor of Michigan, a state synonymous with manufacturing during a financial crisis that threatened to put all America's major car companies into bankruptcy. The immediate and knock-on effects were catastrophic. Granholm's grand plans for education reform, economic revitalization, clean energy, and infrastructure development were blitzed by a perfect economic storm.
● The Greatest Trades of All Time: Top Traders Making Big Profits from the Crash of 1929 to Today
By Vincent Veneziani
Summary via publisher, Wiley
Financial and commodity markets are characterized by periodic crashes and upside explosions. In retrospect, the reasons behind these abrupt movements often seem very clear, but generally few people understand what's happening at the time. Top traders and investors like George Soros or Jesse Livermore have stood apart from the crowd and capitalized on their unique insights to capture huge profits. Engaging and informative, The Greatest Trades of All Time chronicles how a select few traders anticipated market eruptions from the 1929 stock market crash to the 2008 subprime mortgage meltdown and positioned themselves to excel while a majority of others failed. Along the way, author Vincent Veneziani describes the economic and financial forces that led to each market cataclysm and how these individuals perceived what was happening beforehand and why they decided to place big bets, often at great risk and in opposition to consensus opinion at the time.
● But Will the Planet Notice?: How Smart Economics Can Save the World
By Gernot Wagner
Review via Publishers Weekly
You can replace all your light bulbs, bike to work, and OD on sustainably produced, locally sourced tofu, but much as you may try to minimize your environmental footprint, individual actions are largely useless. It will take a critical mass of people changing their behaviors to make real change, says economist Wagner, who argues for economic solutions to environmental crises. He challenges readers to consider how to corral the masses; what if the pope, for instance, advised the world's Catholics to reduce their personal carbon emissions? Papal edict aside, most significant change can only come from simple economic legislation--Ireland's 2002 PlasTax, for instance, which reduced the demand for landfill-clogging plastic bags by 90%. Applying economics at both the macro level (making dirty energy more expensive to maintain) and the micro (increasing the cost of filling your car with gas) can help us create a greener world in a larger, more substantive way. Wagner's wry, witty prose brings rationality to an emotionally charged subject and urges us to take personal responsibility for the planet by demanding an economically sound solution to guiding market forces in the right direction, making it in our best interests to do the right thing.
● Love and Capital: Karl and Jenny Marx and the Birth of a Revolution
By Mary Gabriel
Review via The Wall Street Journal
In an era when Karl Marx's work appears increasingly consigned to the ash heap of history, the shrewdness of undertaking a lengthy new study of Marx is not immediately obvious. Yet in "Love and Capital," journalist Mary Gabriel provides a fresh approach to this oft-examined topic, planting Marx, the great socio-political philosopher, firmly within the context of Marx, the paterfamilias of a group whose presiding focus was the nurturing of his intellectual life.
● A Contest for Supremacy: China, America, and the Struggle for Mastery in Asia
By Aaron L. Friedberg
Review via Foreign Policy
Like tossing a dead skunk into a garden party, A Contest for Supremacy aims to shake things up among the foreign-policy elite inside the United States. Friedberg presents all of the arguments employed in favor of optimism and complacency regarding the trends facing the United States in East Asia then systemically shoots them down. His book is the most thorough wake-up call yet regarding the security challenges presented by China's rise. It is also a plea to have an honest conversation about the difficult questions facing the United States in Asia.
● Eclipse: Living in the Shadow of China's Economic Dominance
By Arvind Subramanian
Review via Center For Global Development
Chinese rapid ascendancy is not a new story. Arvind takes a fresh look, devising an index of economic dominance that includes GDP, trade, and creditor-debtor status, and showing how these three factors have historically determined which countries are in a position to call the shots in global affairs. According to his calculations, the United States is a lot closer to falling behind than most people think. He describes the competition for global dominance as China’s to lose, rather than America’s. Even if the United States recovers soon from its current economic and political maladies, China’s huge population and rapid, sustained growth mean it will surpass the United States in all three measures of economic power by 2030—even assuming a substantial slowing of China’s blistering growth rate.
September 23, 2011
The Market Turns Red
After yesterday’s sharp 3% drop in the stock market, the S&P 500 is in the red on a year-over-year basis for the first time nearly two years. Just barely, but it's a minor milestone just the same. As of September 22, the S&P is off fractionally, slipping by roughly 0.4% vs. a year ago on a price basis. Should we be worried? Of course. No one needs another excuse these days, but we've got another one to add to the list.
It may still be a bit premature for a formal forecast of macro contraction via the stock market, although a number of analysts have already given up hope that we'll avoid the "R" word. But I still think that much depends on whether the annual losses persist and deepen. History suggests that recession risk rises dramatically when the stock market’s performance turns negative on an annual basis. As the first chart below shows, equities have posted annual losses either in advance of a new recession or in the early stages of an economic contraction (based on NBER definitions of recession dates). But as Paul Samuelson famously observed, “the stock market has predicted nine of the last five recessions.”
Point taken. As the chart reminds, sometimes the stock market dips into negative territory on an annual basis even though the economy avoids an NBER-defined recession. Yet an annual loss in the market is usually associated with macro weakness regardless of whether there’s another economic downturn waiting in the wings. Presumably that point isn't lost on anyone these days.
There’s a long history in economics of finding a connection between asset prices and the business cycle. A recent study follows in this tradition by noting that “patterns of the business cycle can be consistent with the standard view that asset prices reflect expectations about the future health of the aggregate economy.” William Schwert made a similar comment more than 20 years ago, explaining that a century of data demonstrates that “there is a strong positive relation between real stock returns and future production growth.”
The equity market isn’t infallible, of course, although the same caveat applies to every other predictor. The only solution is to review a range of factors when evaluating the outlook for the business cycle. The stock market is a reasonable place to start for a number of reasons, including a pretty good track record of anticipating trouble via its 12-month percentage change. Again, this is a start, not an end to looking ahead.
It’s true that this measure has issued false signals at times, but if you take a closer look at those flubs you’ll notice that several were associated with economic activity that was indeed precarious. The main exception is 1987, when the stock market tumbled sharply in the October crash without obvious economic fallout.
As for the here and now, what is clear is that the stock market’s annual return has deteriorated rapidly over the past month. At the close of this past August, despite a fair amount of economic anxiety in the air, the S&P 500 remained higher over the previous 12 months by a robust 16%. It’s been downhill ever since, reaching a fractional loss vs. the year-ago figure as of yesterday, as the second chart reminds.
That's troubling, but it'll be far more worrisome if the selling continues. To the extent that we take the market's recession forecast seriously, history suggests that something on the order of a 10% annual loss is at or near the point of no return. Yes, we're still a good ways above that mark. Unfortunately, the margin of safety has been evaporating quickly over the last month, and since momentum has a habit of persisting at times, well, there's good reason to be wary.
Perhaps the next question is whether the earnings outlook generally suffers from here on out. Don Luskin of Trend Macrolytics, writing in a note to clients today, reports that the "greatest concern to us is the earnings outlook. Bottom-up S&P 500 consensus forward earnings-per-share peaked on August 29, and have been very gradually moving lower ever since."
Yes, we're in a precarious state. Standing on the precipice isn't the same thing as falling over the edge, but no one can ignore the possibility that the odds of slipping are uncomfortably high and perhaps rising. But higher risk isn't without its bright side, assuming you can stomach the ride. Indeed, the market's expected return is surely higher today than it was in the recent past. Why is it higher? There's more risk swirling about. Deciding if you can assume the higher risk in pursuit of theoretically higher returns is the question. Decisions, decisions…
Luskin, for one, is a reluctant bull by those terms. "It's painful for us to say this, but our sense remains that this is where you buy, not where you sell."
It's a safe bet that many will disagree. No wonder that expected return and risk vary through time. Sometimes, however, that's more than just a dry bit of theory.
September 22, 2011
A 15-Year Review
John Bogle, the founder of Vanguard and the man who gave the masses the first index fund, was reminiscing recently. In a talk he gave earlier this month, Bogle reviewed the lessons in a 15-year-old bit of investment advice. "I thought it would be fun, interesting, and provocative to examine what’s happened over the exciting era since I made my policy recommendations." In particular, he revisited his recommendations from the summer of 1996 and "how they compared with the actual results of the average endowment fund tracked by The National Association of College and University Business Officers," aka NACUBO.
Ever the skeptic, Bogle was cautious about reading too much into a rear-view mirror approach to investment analysis, even his own. "Perhaps we can learn something from that past, or perhaps not," observed the author of several worthy investment tomes, including The Little Book of Common Sense Investing and last year's Don't Count on It!: Reflections on Investment Illusions, Capitalism, "Mutual" Funds, Indexing, Entrepreneurship, Idealism, and Heroes. But sometimes the basic facts do all the talking for you. Indeed, Bogle reports that the average endowment fund earned a 7.3% compounded return for the decade-and-a-half through this past June.
Meanwhile, Bogle summed up his 1996 recommendation as follows:
George Putnam and yours truly recommended a balanced approach. With bonds then yielding 7 percent and stocks but 2 percent, we both liked the concept of earning more income for endowments that must pay out returns to their universities, as well as the likelihood of substantially reduced volatility. I also urged endowment managers not to rely on “history and computers” to forecast stock and bond returns. My major recommendation couldn’t have been more specific: a 50/50 portfolio using U.S. stock and bond index funds, a balanced portfolio with extraordinary diversification and remarkably low costs—“on automatic pilot,” if you will. Simplicity writ large.
How did Bogle's advice fare? He continues:
My principal recommendation would obviously have been best implemented with the lowest cost stock and bond index funds, so I had no choice but to rely on Vanguard Total Stock Market Index Fund and Vanguard Total Bond Market Index Fund, rebalanced each quarter to 50/50. Our institutional shares—net of all fund expenses—provided an annual rate of return of 7.1 percent—6.2 percent for the bond fund and 6.0 percent for the stock fund, itself a surprising outcome. (That the total portfolio provided a higher return than either of its components is explained by the quarterly rebalancing.)
Bogle's recommendation, in short, trailed the average NACUBO result, if only slightly. But the performance looks somewhat better on a risk-adjusted basis, he notes. "The indexed portfolio had a standard deviation of annual returns of 8.9 percent, exposed to some 20 percent less risk than the 11.3 percent volatility of the average endowment. As a result, the risk-adjusted return of the 50-50 portfolio, measured by the Sharpe Ratio was 0.45, well above the 0.38 Sharpe Ratio for the average endowment."
What's interesting is that Bogle's simple, perhaps even naive strategy turned out to be competitive with some of the best investment minds in the NACUBO universe over a fairly long stretch of time. The average figures no doubt mask some big winners among endowment funds (along with some big losers). But the outliers don't tell us much, since most of the money was surely invested in and around the average performers.
I don't have access to the data, but I'm willing to bet that most of the NACUBO funds' returns cluster around the average. I say that based on numerous studies over the years that tell me that this is a fairly typical result when looking at a broad sample of portfolios. I've also crunched the numbers in various ways over the years and found similar results, including my ongoing comparisons of actively managed asset allocation mutual funds vs. my Global Market Index (GMI), an unmanaged benchmark that holds all the major asset classes in their market value weights. As I reported a few weeks ago, GMI boasts a competitive if not exactly stellar record against the sea of managers intent on doing better.
Bogle's 15-year retrospective offers yet another bit of support for thinking that a bit of modesty can do wonders for a portfolio strategy. No, the lesson isn't that we should turn our minds off and do nothing. But we should be mindful that there's also lots of risk in going to the opposite extreme.
"Remember reversion to the mean," Bogle concludes. Why? James Montier of GMO’s asset allocation team explains by noting that "reports of the death of mean reversion are premature."
A Little Recognition Never Hurts
$avingsAccount.org thinks The Capital Spectator is among the top-50 investment blogs. Thank you very much. Unfortunately, I left my acceptance speech in my other suit. No matter--the real tribute is sharing a list with so many extraordinary blogs and web sites. Suffice to say, I'm humbled. Meanwhile, if you're looking for an accounting of some of the leading analysts on economic and financial matters, the $avingsAccount.org roster is sure to please.
Jobless Claims Fell Last Week, But The Trend Still Looks Troubling
New jobless claims fell last week, but the drop doesn’t look all that convincing. It’s been clear for some time that filings for unemployment benefits have been trending higher, and for a fundamental reason: the economy has slowed. The surge in new claims back in the spring warned of no less, when the consensus outlook for the economy was still relatively bubbly. Once again, claims have proven their value as a forward-looking indicator. Alas, the current forecast in these numbers isn't encouraging. In sum, it’s going to take a lot more than one modest down week to persuade the crowd that this series has returned to a virtuous cycle.
With that nasty thought out of the way, we can digest the number du jour in the proper context. Initial claims slipped last week by 9,000 to a seasonally adjusted 432,000. The four-week moving average, however, inched higher for the fifth week in a row. That's bad enough, but it's even worse when you consider that claims are at elevated levels. And without an obvious catalyst for changing the momentum, it's hard to see how we get out of this trap anytime soon.
If you're looking to see the glass half full, the unadjusted annual pace of new jobless claims offers some respite. Claims by this measure fell 8.4% last week vs. a year ago. Sure, it could be the start of something positive, but the trend still looks worrisome and so we'll need to see many more weeks of declines. Don't count on it. Anything's possible, but not everything's likely.
"The labor market has been quite weak and employment growth has been quite soft," Conrad DeQuadros, senior economist at RDQ Economics, tells Bloomberg. “It’s hard to imagine we’re going to get the kind of employment growth we would need to see to get the jobless rate to come down significantly.”
Is there anything in today's jobless claims update to encourage a change of thinking? Not really. At best, we're caught in a funk in the labor market. Let's be optimistic and go with that thought. Ok, but even that relative bit of optimism is getting tougher to rationalize.
It's still reasonable to expect that the U.S. will avoid a recession, which is to say a contraction in GDP. But sidestepping the grim reaper of macro promises (threatens) to be most unsatisfying this time. The recovery has stalled, but it hasn't stopped, at least not yet. It's an anemic expansion, but even that's not the biggest problem. Rather, the worry is that the feeble growth will roll on for the foreseeable future. Unfortunately, today's jobless claims numbers don't offer any reason to think otherwise.
Strategic Briefing | 9.22.2011 | The Fed's "Operation Twist"
Twist and Yawn
David Beckworth (Macro and Other Market Musings) | Sep 21
The Fed decided today it would lower the average maturity of publicly-held treasuries by selling $400 billion of shorter-term treasuries and buying the same amount of longer-term treasuries. In addition, the Fed also reconfirmed its commitment to maintain the size of its mortgage holdings and anticipated its targeted interest rate would remain low through mid-2013. The burning question now is how big of an impact will the Fed's new treasury maturity transformation or "operation twist" program have on the economy? Not much in my view. It should add some monetary stimulus, but like the original operation twist its effects will probably be modest and do little to spark a robust recovery... Without an explicit target to permanently shape expectations about future spending and inflation, it is hard to see how this new stimulus program will have any more lasting power than QE2. The Fed needs to quit throwing large dollar programs at the economy and instead commit to buying up as many assets as needed until some nominal GDP (or price) level target is hit.
It's What They Didn't Say
Scott Sumner (The Money Illusion) | Sep 21
I’m on record that the Fed’s goal should be much higher long term interest rates (achieved through monetary stimulus.) The econ textbooks rarely even discussed the original operation twist (from the 1960s), except occasionally to note that it probably had no effect. There’s a reason it was tried and then abandoned. So I thought it worse than nothing—something that diverted the Fed’s attention, and made effective moves less likely...
This looks more and more like the Hoover Administration. Initially his initiatives were greeted with big stock rallies. But by mid-1932 the stock market reacted to his speeches with big declines. Not because we were “out of ammunition;” the minute FDR got in things turned around. Well that’s not quite right, the stock market did nothing until the April 1933 dollar devaluation, when it began rocketing upward. Symbolism isn’t enough, you need level targeting. Ben Bernanke understood this when he recommended the Japanese show “Rooseveltian resolve.” What happened to that Bernanke?
FOMC Reaction – The Extended Version
Tim Duy's Fed Watch | Sep 21
I think Fed official believe they are being bold; I see them as continuing to ease policy in 25bp increments. Expect that to continue. Assuming the economy fails to regain momentum, the Fed will follow up with additional action – QE3 will be the next stop. Ignore the dissents; they are background noise. Don’t expect miracles; expect small moves, the equivalent of 15bp here, 25bp there. The real leverage could potentially come from fiscal policy leveraging the easy monetary policy. Print the money and spend it. Open up the refinancing channel. Overall, make the objective of national economic policy simply be to decisively move us off the zero bound. Not deficits, not the dual mandate, just commit to pulling us off the bottom.
FOMC Decides to Implement Operation Twist
Mark Thoma (Economist's View) | Sep 21
This shifts the duration of the balance sheet, but it does not change its size. I would have preferred balance sheet expansion, i.e. QE3, as that would have a much better chance of helping the economy. But the inflation hawks on the committee will not tolerate further expansion in the balance sheet due to worries about inflation.
Operation Twist--Conditional Support
Bill Woolsey (Monetary Freedom) | Sep 21
By having the Fed sell off its holdings of short term government bonds, the Fed will relieve that underlying excess demand for those securities and lessen any shift of that excess demand to an excess demand for money. It should help relieve the monetary disequilibrium. Of course, if the Fed reduced the quantity of base money, as would be the usual consequence of an open market sale, then any decrease in money demand would be offset by a decrease in the quantity of money. However, by purchasing long term bonds, the Fed sterilizes the impact of the sale of short term bonds on the quantity of base money.
The other way to look at the issue is that with nominal interest rates on T-bills (nearly) at zero, they are perfect substitutes for money. By selling T-bills and purchasing long term government bonds so that base money does not decrease, the total quantity of money, T-bills held by households and firms and base money, increases. This will tend to relieve the excess demand for money.
“Operation Twist” Gets Underway
Jay Bryson (Wells Fargo) | Sep 21
In our view, however, the problem is not that long-term interest rates, especially mortgage rates, are too high. Indeed, the interest rate on the 30-year fixed rate mortgage is only about 4 percent at present, the lowest rate in decades. Rather, the problem is that credit remains very tight and many homeowners are “underwater,” preventing them from refinancing at very attractive rates. Despite historically low rates, mortgage applications for purchase remain depressed (Figure 2). Applications for refinancing have ticked up in recent weeks, but much less than what would be expected given today’s historically low rates.
Therefore, we do not believe that “Operation Twist” will be the silver bullet that is needed to solve all the economy’s problems. We do not mean to criticize the Fed for its actions today. The Fed long ago ran out of conventional “ammunition.” That is, the FOMC cut the fed funds rate to essentially zero percent in December 2008, the level where the fed funds rate remains today. If the Fed could cut its main policy rate even further, it clearly would. However, the lower bound of zero percent is preventing the Fed from undertaking further conventional stimulus. The Fed is in uncharted territory at present, and it is doing all it can to help the struggling economy get back on its feet via unconventional policy actions.
Could the Fed do more? Arguably, the FOMC could authorize another round of quantitative easing (QE). However, the efficacy of further QE is unknown, and the policy is seen as controversial, certainly outside of the Fed and arguably within the Fed as well. As they did at the last policy meeting, at which the FOMC said that it would keep the fed funds rate at “exceptionally low levels…at least through mid-2013,” three FOMC members voted against today’s decision because “they did not support additional policy accommodation at this time.” QE3 could eventually occur. However, we think that the bar for further QE is relatively high. Only if inflation recedes significantly over the next few months and/or the economy appears to be rolling back into recession do we think that a critical mass of Fed policymakers will support another round of QE.
September 21, 2011
The Decline & Fall Of Inflation Expectations... Again
The Federal Reserve’s two-day FOMC meeting on monetary policy concludes today. Nothing unusual about that. It’s just the latest installment of this regularly scheduled confab. What's different, however, is the growing political pressure aimed at influencing the outcome. “In an unusual move, Republican leaders of the House and Senate are urging Federal Reserve policymakers against taking further steps to lower interest rates,” the AP reports.
There’s also no shortage of voices in the private sector urging restraint on the stimulus issue. David Malpass, president of Encima Global LLC, advises in today’s Wall Street Journal that the Fed should cease and desist in its monetary efforts because "these policies have hurt growth and added to unemployment by distorting financial markets." Instead, he recommends that the central bank should refocus on fiscal policy by "directing calls for action to the administration for tax reform, spending restraint and bank regulatory reform—each a proven job creator. The central bank has already bought nearly $2 trillion in longer-term bonds, a massive intervention in markets, with no constructive results. It's time to move on."
Move on? To what? Allowing inflation expectations to continue dropping? The implied inflation forecast based on the yield spread for the 10-year nominal Treasury Note less its inflation-indexed counterpart is under 2% again, and falling. That's not a good sign for an economy facing an elevated risk of recession. The habit of arguing that lower inflation is always and forever preferable isn't justified these days. What's needed is a policy that addresses the problems of the moment, i.e., a policy that stabilizes if not raises inflation. Such is the prescription for what Irving Fisher called the debt-deflation problem.
The last time the market-based outlook for inflation was tumbling was in the summer of 2010. What revived the trend? The Fed's QE2 is an obvious suspect, a policy that was announced at the end of August that year. As economist Scott Sumner reminds:
The market reaction to hints of QE2 suggests that open market purchases can be successful, even at the zero bound. The most likely explanation is that the markets weren’t reacting so much to the action itself, but rather to the implied signal it sent about Fed determination to prevent deflation. And the Fed action succeeded (so far) in preventing Japanese-style deflation.
But QE2 faded a few months back and the economy is stumbling again. The message is that any emphasis on keeping inflation low at the moment is economically misguided, as are the comparisons in some quarters with our current predicament with the inflationary burdened 1970s. Tim Duy at Fed Watch explains:
The constant comparisons to the 1970s are increasingly tiresome. At the end of the day, in the 1970s we were not in a liquidity trap. Today we are. The world is simply different. And we need policymakers that recognize that difference, not dinosaurs who refuse to do anything but live in a narrow view of their youth.
In any case, the numbers are compelling. As Michael Darda, chief economist at MKM Partners, points out in a research note on Monday: "A negative velocity shock appears to be under way in the U.S., as the demand for risk-free cash assets (money) has spiked." He goes on to report that "the surge [in money demand] looks very similar to late 2008 and late 2001, both recessionary periods. Moreover, the surge in broad money comes as the Fed’s balance sheet has flat-lined; commercial bank credit has been flat for more than 3-1/2 years."
Darda also observes:
Inflation breakeven spreads have not responded to the Fed’s two-year commitment to keep rates at zero and speculation of an impending sterilized “Operation Twist.” In other words, the credit markets are sending a fairly unambiguous signal that these efforts will either be ineffective or counterproductive. Stronger medicine could help to boost velocity, but is unlikely to be forthcoming in the near term, in our view.
That continuation of passive tightening may please the Republican Congressional leadership (and the White House?!?!). From an economic perspective, however, it's hard to see how a post-QE2 policy of doing nothing, much less tightening, as some propose, will promote a productive future for the broad trend.
What can we expect with the real yield roughly at zero, and perhaps headed into sub-zero realms? At least two forecasts come to mind: higher gold prices coupled with a lower stock market. Should we be surprised, given current conditions? No, although higher inflation worries have nothing to do with it.
Correction: The original version of this post advised that the Fed's FOMC meeting begins today; in fact, it concludes today.
September 20, 2011
Business Loans & Job Creation: Where's The Connection?
Commercial lending continues to chug along, according to the latest data from the Federal Reserve. That’s an encouraging trend when other economic news warns of sluggish growth or worse. But in a sign of the times, more lending isn’t translating into more jobs.
"Our loan growth this year has been robust," says Mark Watkinson, the head of commercial banking for HSBC Holdings in North America, via MarketWatch. "Our month of July, for example, was the best month for loan growth this year. August was also strong."
But the connection between loan growth and job growth isn’t obvious. Indeed, the dollar value of commercial and industrial loans jumped 1.7% in August vs. the previous month. That’s the fastest monthly increase since the recovery began in mid-2009. The annual pace of C&I loans looks strong too, advancing more than 6% in August compared to a year earlier—the fastest rate since the recession ended.
But the revival in lending has coincided with a downshift in job growth, as the dismal August employment report shows. This disconnect between loans and jobs is unusual, like so many other ills on the macro front these days. What’s behind this strange coupling?
Matthew Rieker’s Marketwatch story offers an explanation:
The reason the lending isn't putting much oomph in employment is that the lending is largely to replace machinery and make repairs and upgrades, as exports are boosted by the falling dollar. Little of the lending is funding the kind of expansion of business that would generate robust hiring.
Businesspeople "have come to a point where they have to spend money to replace infrastructure... that they have put off for the last two or three years," said Michael Slocum, head of commercial banking at Capital One Financial Corp. COF +0.12% , where loans to midsize businesses rose 6%, to $11.4 billion, in the second quarter.
The numbers for business investment certainly don’t contradict that view. Capital spending (nondefense capital goods orders excluding aircraft) rose by nearly 12% for the year through July. That’s a strong pace, although in the absence of employment growth it’s questionable if it'll continue. No wonder that President Obama is again focused on job creation. Predictably, his renewed interest in the biggest economic problem in the country seems to be helping his poll numbers, at least for the moment.
Passing laws and minting fresh incentives is one thing; convincing companies to hire is going to be a much tougher nut to crack. Capital spending, meanwhile, doesn’t seem to be all that relevant for job creation these days. A new Duke Unviersity/CFO Magazine survey of chief financial officers reports that business spending is expected to rise at a slower but still respectable 4.5% rate. But that outlook is coupled with plans in corporate America to hold on to cash amid a forecast that employment will rise by a tepid 1%.
What’s the solution? Perhaps it’s time to think outside the box (or outside the country for those who need a job NOW.
September 19, 2011
Strategic Briefing | 9.19.2011 | Debating Central Bank Policy
End the Fed's Dual Mandate And Focus on Prices
John Taylor (via Bloomberg) | Sep 16
Some worry that a single focus on the goal of price stability would lead to more unemployment. But history shows just the opposite. A single mandate wouldn't stop the Fed from providing liquidity, or serving as lender of last resort, or reducing the interest rate in a financial crisis or a recession. But it would make it more difficult for the Fed to engage in the kinds of discretionary actions that frequently have resulted in higher unemployment.
John Taylor defends a troublesome target
Marcus Nunes | Sep 18
In fact, inflation after 1982 exhibits substantially less persistence than in the previous years (see figure below) so that increases in inflation in one month are viewed as temporary. In other words, inflation is much less auto correlated so that lagged values of inflation provide little information about future inflation. As a result, unexpected movements (or innovations) in inflation no longer require a monetary policy response (which sits well with the argument that the fed funds can be a poor indicator of monetary policy).
This leads me to think that “inflation targeting” as the sole mandate for the Fed may not be a good idea. What propels the economy is nominal (or dollar) spending, so to achieve economic stability we should be concerned with “spending stability” along a target path.
It appears that the “Great Moderation” came about exactly because, even if unwittingly, Greenspan managed for the most part to keep spending pretty stable along a determined path... So no Professor Taylor, the proper single mandate should be “Spending Stability”, i.e. targeting NGDP.
From an American in London, Global Warnings
The New York Times | Sep 17
Governments are pushing austerity; bankers are hoarding cash; a recession looms in the United States and Europe. But Adam S. Posen has a solution: a shock-and-awe display of coordinated central bank attacks aimed at reviving sluggish economies. An American economist on the Bank of England’s monetary policy committee, Mr. Posen is no academic scribbler or lonely blogger, but someone inside the central banking establishment...
There is a certain tilting-at-windmills aspect to his crusade. The Fed will probably stop well short of the aggressive bond buying that Mr. Posen has advocated. Already, some Fed officials — and most Republican leaders, including the presidential hopefuls Rick Perry and Mitt Romney — believe that the Fed is at risk of rekindling inflation.
But that hasn’t stopped Mr. Posen from pressing his case. Earlier this month, he had lunch with Kiyohiko Nishimura, a deputy governor at the Bank of Japan, and Charles Evans, the president of the Federal Reserve Bank of Chicago. And, last Tuesday, he traveled to this small hamlet in southeast England to issue his most passionate cry yet. "I am here to warn policy makers in the United States, Europe, everywhere that we cannot take our foot off the pedal,” Mr. Posen said before a roomful of small-business leaders and bankers. "The outlook is grim — the right thing to do now is engage in more monetary stimulus."
A Little Inflation Can Be a Dangerous Thing
Paul Volcker (via NY Times) | Sep 18
It’s not yet a full-throated chorus. But remarkably, at least one member of the Fed’s policy making committee recently departed from the price-stability script.
The siren song is both alluring and predictable. Economic circumstances and the limitations on orthodox policies are indeed frustrating. After all, if 1 or 2 percent inflation is O.K. and has not raised inflationary expectations — as the Fed and most central banks believe — why not 3 or 4 or even more? Let’s try to get business to jump the gun and invest now in the expectation of higher prices later, and raise housing prices (presumably commodities and gold, too) and maybe wages will follow. If the dollar is weakened, that’s a good thing; it might even help close the trade deficit. And of course, as soon as the economy expands sufficiently, we will promptly return to price stability.
Well, good luck.
Some mathematical models spawned in academic seminars might support this scenario. But all of our economic history says it won’t work that way. I thought we learned that lesson in the 1970s. That’s when the word stagflation was invented to describe a truly ugly combination of rising inflation and stunted growth.
My point is not that we are on the edge today of serious inflation, which is unlikely if the Fed remains vigilant. Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.
What we know, or should know, from the past is that once inflation becomes anticipated and ingrained — as it eventually would — then the stimulating effects are lost. Once an independent central bank does not simply tolerate a low level of inflation as consistent with “stability,” but invokes inflation as a policy, it becomes very difficult to eliminate.
Rearranging the Deck Chairs
Tim Duy | Sep 18
Here we are, again staring down the barrel of an FOMC meeting while deeply entrenched in a subpar equilibrium, with output well below the pre-recession trend and unemployment stuck in the high single digits. What will the Fed bring to the table this time around? Considering the magnitude of the economic challenge, expectations are low: A modification of the FOMC statement to reflect an increasingly pessimistic outlook couple with some version of “Operation Twist,” an effort to reduce longer-term interest rates by extending the duration of the Fed’s portfolio of Treasury securities. There is an outside change the Fed lowers interest on reserves, but I view that as unlikely at this juncture. Even more unlikely is another round of quantitative easing. I don’t think there is much appetite at the Fed for additional asset purchases given the inflation numbers and the stability of longer-term inflation expectations relative to the events that prompted last fall’s QE2...
Larry White on the International Gold Standard
Bill Woolsey | Sep 15
Over on Free Banking, Larry White linked to an article where he advocated the international gold standard in combination with free banking...
While I favor free banking, I don't favor an international gold standard. Rather, I favor a monetary regime that stabilizes the growth path of nominal GDP. This sometimes requires printing money, and sometimes the floating exchange rate depreciates, resulting in more exports.
If we consider a situation where some error has resulted in inadequate money creation so nominal GDP falls below target, the result would likely be slower growth or even reduced real expenditure, real output, and employment. In other words, this error would lead to a recession.
Fixing the error, and returning nominal GDP back to its target growth path, would involve expanding the quantity of money, which could involve a depreciation in the exchange rate, and an expansion of exports (and in the demand for import competing goods.) This would be one avenue by which the expansion in the quantity of money would increase nominal expenditure back to target, which would lead to a recovery of real output and employment.
More importantly, it is quite possible that preventing the exchange rate depreciation would require that less money be created, so that nominal GDP would remain below its targeted growth path. Given that lower growth path for nominal GDP, recovery would require that prices and wages shift to a lower growth path, so that real expenditure and output can return again to their previous growth path.
September 17, 2011
Book Bits For Saturday: 9.17.2011
● Confidence Men: Wall Street, Washington, and the Education of a President
Review via The New York TImes
A new book claims that President Obama’s response to the economic crisis was hampered by a White House economic staff plagued by internal rivalries, a domineering chief adviser and a Treasury secretary who dragged his feet on enforcing decisions with which he disagreed.
The book, by Ron Suskind, a former Wall Street Journal reporter, quotes White House documents that say Mr. Obama’s decisions were routinely “re-litigated” by the chairman of the National Economic Council, Lawrence H. Summers. Some decisions, including one to overhaul the debt-ridden Citibank, were carried out sluggishly or not at all by a resistant Treasury secretary, Timothy F. Geithner, according to the book.
● Pivotal Decade: How the United States Traded Factories for Finance in the Seventies
By Judith Stein
Summary via publisher, Yale University Press
In this fascinating new history, Judith Stein argues that in order to understand our current economic crisis we need to look back to the 1970s and the end of the age of the factory—the era of postwar liberalism, created by the New Deal, whose practices, high wages, and regulated capital produced both robust economic growth and greater income equality. When high oil prices and economic competition from Japan and Germany battered the American economy, new policies—both international and domestic—became necessary. But war was waged against inflation, rather than against unemployment, and the government promoted a balanced budget instead of growth. This, says Stein, marked the beginning of the age of finance and subsequent deregulation, free trade, low taxation, and weak unions that has fostered inequality and now the worst recession in sixty years.
● Street Freak: Money and Madness at Lehman Brothers
By Jared Dillian
Review via Bloomberg
One grim night before Lehman Brothers Holdings Inc. (LEHMQ) imploded, trader Jared Dillian drank himself into a frenzied scream, hugged his cat and downed half a bottle of the only drug on hand: Tylenol PM, he says.
“I could not even kill myself properly,” he rages in his disturbingly candid memoir, “Street Freak: Money and Madness at Lehman Brothers.”
The cause of Dillian’s distress wasn’t Lehman’s collapse; that drama unfolded some six years later. His despair reflected something much more common and corrosive about markets. His job, index arbitraging, had been automated by a computer program.
“The diabolical index arb robots had taken over my trade,” he writes in the mocking voice familiar to readers of his financial newsletter, the Daily Dirtnap.
● Impact Investing: Transforming How We Make Money While Making a Difference
By Antony Bugg-Levine and Jed Emerson
Excerpt via publisher, Jossey-Bass
Impact investing recognizes that investments can pursue financial returns while also intentionally addressing social and environmental challenges. Despite, or perhaps because of, this simplicity, it can seem threatening to some people. Many mainstream investors reject the idea that they should pay attention to the social impact of their investing, insisting instead that these considerations be left to governments and charities. And for their part, most traditional philanthropists reject the idea that they should use their investments to advance their mission or that businesses generating profits have a right to stand alongside philanthropy and civil society in the noble work of promoting equality and justice.
But impact investing is not a modern aberration. The idea that our investment decisions can have an impact on the wider world beyond financial return did not begin when Jed first described ‘‘blended value’’ in 2000 or when Antony was part of the group that coined the phrase ‘‘impact investing’’ seven years later. In many ways, it reconnects with a centuries-old tradition that held the owners of wealth responsible for the welfare of their broader community.
● The Quest: Energy, Security, and the Remaking of the Modern World
By Daniel Yergin
Review via The Economist
Providing sufficient energy to seven billion increasingly affluent humans without burning up the planet may be humanity’s greatest challenge. “What is at stake”, writes Daniel Yergin, “is the future itself.”
Mr Yergin’s previous book, "The Prize", a history of the global oil industry, had the advantage of an epic tale and wondrous timing. Years in the making, it was published, to critical and popular acclaim in 1990, two months after Saddam Hussein invaded Kuwait, thereby putting Saudi Arabia’s oilfields in peril. “The Quest”, as its more open-ended title suggests, is a broader and more ambitious endeavour. It is, first, an account of the many ways in which people have sought to produce energy—by burning fossil fuels, harvesting the wind, brewing biodiesel and trapping the sun’s heat. It is also an analysis of the increasingly fraught political context in which this business is conducted, especially with regard to three big and longstanding fears: energy scarcity, energy security and, more and more, the environmental ruin that energy can cause.
● Retirement Heist: How Companies Plunder and Profit from the Nest Eggs of American Workers
By Ellen E. Schultz
Review via Publishers Weekly
The retirement crisis is no accident, claims Wall Street Journal investigative reporter Schultz; large companies have played a significant role in its creation to protect the wealth of its top executives. When GE, IBM, Verizon, and others slashed pensions and medical benefits for millions of American retirees, they pointed fingers everywhere but at themselves--but who was really at fault? Pension funds were not bleeding the companies of cash. GE hadn't contributed a cent to the workers' pension plans since 1987, but still had enough money to cover all current and future retirees. Executive pensions at GE, with a $6 billion obligation, are a drag on earnings. These are largely hidden, however, lumped in with the figures for regular pensions. Schultz's methodical cataloguing of these abuses paints a highly unflattering picture of companies that cut benefits to boost earnings, lay off older workers who are entering the years in which their pensions will spike, inflate retiree health benefits to boost profits, lobby for laws that keep the system inequitable, hoard death benefits, and fire whistle-blowers.
● Erasing the Invisible Hand: Essays on an Elusive and Misused Concept in Economics
By Warren J. Samuels, Marianne F. Johnson and William H. Perry
Summary via publisher, Cambridge University Press
This book examines the use, principally in economics, of the concept of the invisible hand, centering on Adam Smith. It interprets the concept as ideology, knowledge, and a linguistic phenomenon. It shows how the principal Chicago School interpretation misperceives and distorts what Smith believed on the economic role of government. The essays further show how Smith was silent as to his intended meaning, using the term to set minds at rest; how the claim that the invisible hand is the foundational concept of economics is repudiated by numerous leading economic theorists; that several dozen identities given the invisible hand renders the term ambiguous and inconclusive; that no such thing as an invisible hand exists; and that calling something an invisible hand adds nothing to knowledge. Finally, the essays show that the leading doctrines purporting to claim an invisible hand for the case for capitalism cannot invoke the term but that other nonnormative invisible hand processes are still useful tools.
September 16, 2011
Industrial Production Vs. Credit Spreads
Yesterday’s update on industrial production looks surprisingly good at a time when the only news from the economic front seems to be bad news.
True, industrial production’s rise of 0.2% last month was relatively modest, but the 3.4% annual percentage increase for this series suggests that the economy will chug along. History implies that if there’s a recession approaching we’ll see the annual change in industrial production drop rapidly, and soon. For now, however, it’s holding up quite nicely. But how much confidence do we have that it'll remain so?
Looking forward is tricky, of course, but researchers offer a number of guides for developing some reasonable guesses. For instance, credit spreads have a decent record of dropping some clues about the future path of industrial production. As a 2001 study from the IMF reports:
Corporate spreads reflect default risk, which conveys information about the business cycle. Our empirical results support this assertion and indicate that corporate spreads to treasuries predict changes in real activity up to a twelve-month horizon, as increases in corporate spreads precede industrial production slowdowns.
Unfortunately, corporate spreads are rising again. There’s still room for debate about whether they're at the point of no return, but the recent jump in credit yields over Treasuries isn’t encouraging in the current climate.
Consider the difference in yields between Moody’s Baa Corporate Bond and 20-year Treasuries (the 20-year maturity is used because that approximates the average maturity for the Moody’s benchmark). As of September 14, Moody’s Baa Corporate yield exceeded the 20-year Treasury by roughly 240 basis points—the highest since July 2009 (see second chart below). Based on the forward-looking properties of credit spreads, and what we know about current economic conditions, that’s not a good sign.
Another study (“Credit Spreads and Business Cycle Fluctuations”) from last year explains why:
An increase in the excess bond premium reflects a reduction in the risk appetite of the financial sector and, as a result, a contraction in the supply of credit with significant adverse consequences for the macroeconomy.
Other analysts have uncovered similar results. A Dallas Fed study, for instance, notes:
We find that shocks to lending spreads in the market for long-term corporate debt cause immediate and prolonged contractions in output. Credit market shocks were found to have had a negative impact in the 2001 and 2007-9 recessions.
But the Treasury yield curve is still positive, the 12-month change in the stock market remains in the black, and there are several other sources for optimism. Perhaps it's premature to run the white flag up the pole just yet. But let’s not kid ourselves about recent activity. Job growth has weakened and it may be destined to fade further, as yesterday’s discouraging news on jobless claims suggests.
"It feels like a recessionary environment,” says Bart van Ark, chief economist of the Conference Board via The Wall Street Journal. He estimates the odds of a new downturn at 45%. The Journal notes that “since 1988, every time the Conference Board's estimate of the probability of recession topped 40%, a downturn followed shortly thereafter.”
But the future’s still unclear, as always, and that may be a good thing at this point. A few more dispatches of major slices of macro updates will bring quite a bit more clarity on what’s coming. Meantime, no one needs much of an excuse to stay wary. All the more so if the credit spread keeps rising.
Research Review | 9.16.2011 | Recessions & Rebounds
The Sluggish Recovery from the Great Recession: Why There Is No ‘V’ Rebound This Time
Mark A. Wynne | Federal Reserve Bank of Dallas | Sep 2011
Unlike all other post-World War II recessions, the 2008–09 episode was precipitated by a banking crisis. A number of researchers have shown that downturns associated with banking crises tend to be more severe, and furthermore, in their aftermath, output takes a lot longer to recover. In some cases, the crisis seems to persistently affect the trend rate of growth, while in other cases, the growth path of activity seems to shift down.
Investment Behavior and Policy Implications
Econobrowser | Sep 13
In fact, it is interesting that nonresidential investment has performed better in this recovery from recession as opposed to the preceding recovery from the 2001Q1-2001Q4 recession. One might want to take into account the fact that the recession has been particularly deep. I have normalized on the beginning of the downturn (2008Q2 and 2000Q4) instead of the trough.Hence, taking into account the depth of the recession, one finds that [business fixed investment] is doing better than in the recovery from the previous recession (as well as the previous recession+recovery). It makes one wonder about this argument that great regulatory uncertainty is dampening business enthusiasm for capacity increases. After all, this bivariate logic would imply that regulatory uncertainty was greater in the years after the first Bush recession, relative to now.
Do equity price drops foreshadow recessions?
Vox | Sep 14
There are concerns that the recent sharp drop in equity prices in the advanced economies may signal a rise in the risk of a double-dip recession. This column examines the performance of equity prices as predictors of new recessions in the G7 economies. The findings suggest that equity prices are useful predictors of recessions in most of these countries. Recent drops in equity prices suggest that the probability of a double-dip recession in France, the UK, and the US has increased substantially.
How Can Recessions Be Brought to an End? Effects of Macroeconomic Policy Actions on Durations of Recessions
TOBB University of Economics and Technology | Aug 1, 2011
This paper analyzes how effective macroeconomic policy actions are in ending recessions. We also investigate which structural factors help the country to get out of recessions, in other words experience shorter recessions. We implement survival regression analysis and conclude that expansionary monetary policy significantly decreases durations of recessions whereas fixing the exchange rate does not have an effect on the durations of recessions. Expansionary fiscal policy has undesired effects and decreases the probability that recession will end; in other words, increases the durations of recessions.
Is the Fed Too Obsessed with Inflation? A Proposal for a New FOMC Regime
Macroadvisers | Sep 8
When the Chairman discusses the FOMC's medium-term inflation objective, we suspect that many in the market interpret him as saying that the inflation goal is also a near-term objective. This interpretation undermines the FOMC's ability to ease under current circumstances... A key issue is providing clarity on how tolerant the FOMC is, or should be, about short-run departures of core inflation from 2%. We propose a new policy regime, called monitoring-range inflation targeting (MRIT, pronounced "merit") that provides such clarity.
September 15, 2011
How Much More Of This Can The Economy Take?
Initial jobless claims are moving higher again. It’s not terribly surprising after another summer of economic discontent. In recent weeks there was some hope that new filings for unemployment benefits (a key leading indicator) was stuck in neutral, albeit at elevated levels. Now even that thin reed seems to be giving way as the numbers edge higher. Maybe it's noise; maybe we're in another one of those extended head fakes that have plagued these numbers several times in the recent past. Maybe, maybe, maybe.
What we do know is that new claims rose 11,000 last week to a seasonally adjusted 428,000, the Labor Department reports--the highest since late-June. It takes an enormous amount of confidence to dismiss this increase once you also consider that the four-week moving average for this series has been rising steadily for the past month. The implication: This is not a drill.
Jobless claims are notoriously volatile, of course, and so that's our cue for looking at the annual change in the unadjusted numbers in search of a more reliable measure of the trend. But here too there’s more bad news. New claims are down by 4.6% vs. a year ago, but that’s the smallest annual drop since early May, as the second chart below shows. The margin of comfort grows thinner by the week.
Readers of this site know that I’ve been slightly optimistic that the U.S. would avoid a recession. Part of that analysis has been that unadjusted claims falling by 10% or more on a year-over-year basis isn't the stuff that recessions are made of. The continuing deterioration of jobless claims, however, suggests that it may be time to reconsider. Much depends on what happens next, of course, but based on what we know now the trend doesn't look healthy.
Adding to the burden is the high levels of continuing claims numbers. For the week through September 3 (this series is released with a one-week lag relative to initial claims), continuing claims totaled a seasonally adjusted 3.726 million. In nearly half a century of history for this series, those numbers have only been associated with recessions. Unfortunately, continuing claims are stuck in the clouds, suggesting what’s been obvious for some time: the labor market isn’t healing. Even if you adjust for population growth, these numbers don't look good.
Unless we start to see a change for the better in jobless claims, and soon, the business cycle’s fate may be sealed. The hour is late and the numbers are disappointing. A sharp reversal of the Fed’s passive tightening might be able to buy some time, but politics may have already short-circuited this option.
If I had to come up with odds, I’d say the chance of a new recession is now 50/50, which is to say that I’m a bit more pessimistic than I’ve been in recent weeks. But there are still several indicators that keep hope alive. One is the stock market, which has yet to go negative on a year-over-year basis. No recession in the last 50 years has started without a sustained decline in the S&P 500 on an annual basis. For the moment, the market’s still in positive territory by 6% as of yesterday vs. 12 months previous. Mr. Market is keeping his chin (and prices) up.
There’s also the upwardly sloping Treasury yield curve to consider. History suggests that until short rates exceed long rates, the odds for another recession are low. By that accounting, the fact that the benchmark 10-year Treasury yield is 200 basis points over the three-month T-bill yield of zilch offers some comfort. Then again, the yield curve has been manipulated on the short end by more than the usual degree, a fact that some analysts say diminishes the value of this indicator this time.
Perhaps, although there are other corners of optimism to consider, including the annual change in retail sales, as I discussed yesterday. Even so, if the all-important labor market continues to weaken from an already weakened state, well, the blowback may be enough to overcome whatever good news is out there. Indeed, we’ve been warned that this risk is rising via the August jobs report, the weakest since the so-called recovery began.
Another shot across employment’s bow arrived in today’s jobless claims numbers. As Scotty told Kirk many times: “We can't take much more of this, Captain!” That just about sums up the state of macro.
September 14, 2011
Another Zero For August Economic Activity
Retail sales last month were essentially unchanged, offering another sign that the economy has slowed. The flat performance mirrors the stagnation in jobs creation for August. Zero and zero add up to a discouraging outlook for the economy. Nonetheless, let’s be fair and recognize that the annual trend in retail sales still looks robust.
For the 12 months through August, retail sales climbed 7.2%. That’s in the range of the annual pace over the last year or so, and since a 7% rise over 12 months is historically a strong number there’s a case for thinking that there’s no capitulation in these numbers, at least not yet.
Nonetheless, it’s hard to overlook the slowdown in August. The flat performance is the worst monthly reading since May’s modest decline in retail sales.
“Consumers are being more cautious given all the economic headwinds,” Michael Feroli, chief U.S. economist at JPMorgan Chase, tells Bloomberg. “Policy makers have to be focused on growth because growth seems to have come close to stalling in August.”
"The consumer reacted to the debt ceiling, the downgrade and the equity market swoon by basically hunkering down and not spending,” according to Tom Porcelli, senior U.S. economist at RBC Capital Markets. “It was flat on the headline, but even more troubling for us is flat on the control number, which excludes gas, building and auto dealers. This is not a good sign for an economy that is struggling.”
But Eric Green, chief market economist at TD Securities, isn’t ready to throw in the towel just yet. “The consumption data along with a broad swath of economic data are all consistent with slow growth, but not recession,” he opines.
If he’s wrong, we’ll start to see a deterioration in the annual rate of change in retail sales. For the moment, consumption hasn’t succumbed by that standard.
Another approach to digging into the numbers in search of the true trend comes by way of economist Bernard Baumohl, who writes in his book The Secrets of Economic Indicators:
There’s a risk in relying too much on advance estimates of retail sales because they are based on a relatively small sampling. A more accurate sense of the underlying trend in consumer spending patterns can be discerned by monitoring sales on a three-month moving average basis or by looking at the last three months worth of data and comparing it with the same-three-month period the year before.
By that reasoning, there's a statistical case for moderate optimism. Using the average of the three months through August, retails sales rose by roughly 8% from the year-earlier period. That’s quite a bit better than the near-5% gain for the 2010/2009 comparison. In fact, an 8% rise in the three-month average vs. its counterpart from a year earlier is near the highest pace in the last several years. Looking backward is no guarantee of what’s coming, of course, and one data series has limits for predicting changes for the overall economy. That said, the robust trend in retail sales remains intact, based on the numbers we have.
Let’s simply note that a 7%-8% annual rise in retail sales doesn’t jibe with a recession. The implication: either retail sales are set to drop a lot, or the recession risk is due to fall. Stay tuned for the answer…
Strategic Briefing | 9.14.2011 | The Crisis In Europe
Moody’s Downgrades 2 French Banks
The New York TImes | Sep 14
Moody’s downgraded two of France’s biggest banks Wednesday and maintained the rating for a third bank under review, highlighting the escalating worries about the European banking system and renewing jitters in the global financial markets. Mounting worries about the exposure of three leading French banks — Société Générale, Crédit Agricole and BNP Paribas — to Greece and their ability to handle a potential default by Greece on its debt had sent the stocks of all three financial institutions sharply lower in recent days.
ECB Lends Dollars to European Banks as Markets Tighten
Bloomberg | Sep 14
The European Central Bank said it will lend dollars to two euro-area banks tomorrow, a sign they are finding it difficult to borrow the greenback in markets.
European Stocks Rise; Hopes For China Bond Buying
The Wall Street Journal | Sep 14
European stocks edged higher early Wednesday, amid renewed hope that the beleaguered peripheral countries of the euro zone could still get external help in financing their hefty debt piles...Central to the positive tone Wednesday was a report quoting an official from China's economic planning agency stating that the super power is will to buy bonds of the crisis-hit nations. Market participants had been hoping China could use some of its foreign-exchange reserves to boost investment in European assets, including the sovereign debt of the so-called peripheral nations. However, it's debatable how representative these remarks are given Chinese Premier Wen Jiabao had declined earlier Wednesday to give any indication of what specific support or investments China is prepared to undertake when speaking before an audience of global business leaders at a meeting of the World Economic Forum in Dalian, China.
Risk Rises at ECB as European Banks Lose Deposits
Bloomberg | Sep 14
European banks are losing deposits as savers and money funds spooked by the region’s debt crisis search for havens, a trend that could worsen economic and financial conditions.Retail and institutional deposits at Greek banks fell 19 percent in the past year and almost 40 percent at Irish lenders in 18 months. Meanwhile, European Union financial firms are lending less to one another and U.S. money-market funds have reduced their investments in German, French and Spanish banks.
Time for Germany to make its fateful choice
Martin Wolf (Financial Times) | Sep 13
The least bad option would be for the ECB to ensure liquidity for solvent governments and financial institutions, without limit. It should not, in fact, be intellectually difficult to argue that buying bonds is compatible with continued monetary stability, since broad money has been growing at a mere 2 per cent a year. It is sure to be politically hard, however, particularly for Mario Draghi, the incoming Italian ECB president. Yet it is what has to be done given the inadequate size of the European financial stability facility if called on to help larger beleaguered euro-member countries. Politicians must then dare to support such action.
Moody's cuts French banks as euro crisis deepens
Reuters | Sep 14
Investors are increasingly skeptical the debt debacle in the 17-nation currency area can be resolved. Credit markets are factoring in a 90 percent chance Greece will default on its debts and they demanded the highest risk premium on Italian five-year bonds at auction on Tuesday since the country joined the euro in 1999... Trying to contain the crisis, Italy is expected to approve a 54-billion-euro ($73 billion) austerity package on Wednesday, although news of the measures has so far done little to reverse investor alarm over whether the euro area's third-biggest economy can manage its debts.
Spanish banks' ECB borrowing up sharply in August
MarketWatch | Sep 14
Spanish banks sharply increased their borrowing from the European Central Bank in August as a deepening sovereign debt crisis cut off alternative ways for banks in southern Europe to fund themselves. According to data released Wednesday by Spain's central bank, gross borrowing by Spanish banks at the ECB's liquidity window shot up to EUR81.22 billion in August, compared with EUR57.20 billion in July.
Greece Should ‘Default Big’ to Address Worsening Debt Crisis, Blejer Says
Bloomberg | Sep 13
Mario Blejer, who managed Argentina’s central bank in the aftermath of the world’s biggest sovereign default, said Greece should halt payments on its debt to stop a deterioration of the economy that threatens the European Union. “This debt is unpayable,” Blejer, who was also an adviser to Bank of England Governor Mervyn King from 2003 to 2008, said in an interview in Buenos Aires. “Greece should default, and default big. A small default is worse than a big default and also worse than no default.”
Get ready for the next crash
MSN Money | Sep 12
European leaders may stave off a banking crisis for a few more weeks. Markets may even stage a relief rally as Greek debt worries abate. But make no mistake -- a deeper crisis in foreign banks is coming.
September 13, 2011
Another Attempt At Looking Forward
Forecasting risk premiums is a dirty business, but it’s necessary unless you’re truly a buy-and-hold investor with a very long time horizon. How many individuals fit into that category? Very few is probably a good estimate. For the rest of us, developing some intuition about expected risk premiums—the returns that are left after subtracting a risk-free rate a la Treasury bills—is useful, perhaps essential. It can be dangerous as well, but that's the nature of toiling in risk.
In any case, it’s a constructive exercise if only to think through your assumptions and stress test them against history and the alternative methodologies for predicting risk and return, of which there are many. It’s a devilishly tricky subject, mainly because of our old nemesis… uncertainty. Accordingly, there’s no silver bullet and so it’s wise to consider several applications and compare the results.
Where to start? I like to begin with equilibrium estimates of risk premia. Why? One reason is that it’s a process that doesn’t attempt to forecast returns directly. Instead, it uses risk and correlation assumptions, which are somewhat easier to predict, as a means for considering the implied ex ante risk premia. Let me emphasize again that this is a starting point—a benchmark, if you will. With equilibrium estimates in hand, we have some context for adjusting the forecasts with any number of competing approaches. For some background and a review of how to crunch the numbers, consider Chapter 3 by Gary Brinson in The Portable MBA in Investment. I also dive into a bit of the details in Chapter 9 of my book Dynamic Asset Allocation.
For now, let’s update recent history on some of the fundamental inputs. Here’s how the annualized risk premia compare over the trailing three and 10-year periods through August 2011 for the major asset classes and my Global Market Index (GMI), an unmanaged value-weighted mix of these assets. GMI is our benchmark for “the market.”
Let’s also consider how the major asset classes and GMI stack up on a risk-adjusted-return basis in recent history via the Sharpe ratio:
Next, let’s make some assumptions for calculating equilibrium estimates of risk premia, as per the formula:
Risk premium estimate = Sharpe ratio * volatility * correlation
First, we need an estimate for the market’s price of risk. For simplicity, let’s simply use GMI’s Sharpe ratio of 0.2 for the past three years. Yes, this is naïve, but in the interest of brevity let’s take it at face value for now. On that note, 0.2 is somewhat conservative, at least relative to recent history over the past decade, and so if anything we're probably erring on the side of caution here.
Up next are the estimates of volatility for each of the major asset classes. In this case I’ve reviewed each individually and made some assumptions, based on a mix of history and forward-looking guesstimates. Ditto for the expected correlations for each asset class and how they relate to GMI.
After plugging the estimates into the equation above, we end up with the following equilibrium risk premia forecasts:
Formally, these are the long run risk premia estimates for the infinite future for the average investor based on the assumption that in time the markets will “clear.” The value in these estimates is the process rather than the data points per se. Yes, our heroic attempt to peer into the future is likely to be wrong in some degree. But that inspires thinking about why it will be wrong and how we could improve our estimates.
One implication of assuming our predictions are subject to uncertainty is that we should be cautious in thinking that we’ll be able to beat the market portfolio easily, if at all over the long run without making sizable bets that incur a high degree of risk. The history of real world track records indicates as much, as I recently discussed here. Sure, you can make relatively dramatic changes to Mr. Market’s asset allocation by, say, overweighting stocks, leaving out a few asset classes altogether, emphasizing active management, adding “alternative” betas to the mix, etc. In fact, there are fundamental reasons for customizing the passive asset allocation mix. Depending the degree of your relative bets, you’ll either beat the market or trail it. It all boils down to how much confidence you have in your forward-looking estimates of risk premiums. Again, history suggests that most investors should be somewhat humble. For those who can tolerate a high degree of tracking error relative to GMI (or whatever benchmark you deem relevant), well, by all means, embrace your convictions.
Meantime, keep in mind that there are some enduring truths in finance—truths that don’t change no matter how much confidence you can muster. One is that in the grand scheme of investing, market-beating return (alpha) is financed solely by the losers. The benchmark ends up in the middle, as usual. And depending on trading costs, taxes and other frictions, the benchmark could very well end up in the above-average category relative to the active competition.
September 12, 2011
The Real Yield: A Critical Factor In The Current Climate
Conventional wisdom says that gold prices are a reliable indicator of the prevailing inflation winds. At best, that's only a half-truth. The relationship between the precious metal and inflation is a two-way street. Yes, gold tends to rise when inflation's trending higher. The linkage inspires the belief that the commodity's price rises are driven solely by rising inflation. But gold prices can also increase during periods of disinflation and deflation. The lesson is that the crucial factor for gold prices is the real (inflation-adjusted) interest rate, which ebbs and flows over time.
"Gold can be a hedge against the risks of both more inflation and more deflation because both phenomena entail the prospect of serious trouble for financial assets," wrote John Makin of the American Enterprise back in 2003:
More recently, Paul Krugman crunches the numbers and reviews the theory on this dual relationship, following in the analytical footsteps of a 1988 paper by Robert Barsky and Larry Summers. The results lead Krugman to say of the current bull market in gold: "it is deeply, deeply wrong to think of rising gold prices when bond yields are low as some kind of symptom of monetary excess."
Brad DeLong joins the discussion:
Basically, gold pays no dividends or interest. It is thus expensive to hold in your portfolio when real interest rates are high, and cheap to hold it in your portfolio when real interest rates are low. When interest rates are high, you have to be pretty confident that gold is going to rise in price in order to hold it in your portfolio--which means that when interest rates are high you sell gold unless you think the price of gold is low.
But enough talk of theory; let's review how markets are behaving. Consider gold's price in recent history relative to the real yield, as represented by the 10-year inflation-indexed Treasury (see chart below). Note how the two have been moving together in a fairly tight range for the last two years or so, which is to say since the financial crisis of late-2008 unleashed havoc on the economy.
Gold and the real yield are forever linked, but the degree can and does vary. When real rates fall to unusually low levels or go negative, there's a stronger connection between the precious metal and inflation-adjusted interest rates. As of Friday, the real yield on the 10-year inflation-index Treasury was just under zero while the 5-year TIPS was negative to the tune of -0.84%. In fact, the crowd has been pricing the 5-year TIPS yield in sub-zero terrain for the better part of this year.
The stock market also shares an unusually robust relationship with inflation expectations during periods when those expectations are subdued. A recent study ("The Fisher Effect Under Deflationary Expectations") by David Glasner lays out the connection:
Sharp downturns in asset prices are associated with deflationary expectations when ex ante real interest rates are low. Thus if recessions are associated with falling real interest rates owing to falling profit expectations, and if the expected rate of inflation falls below the possibly negative real rate of interest, monetary attempts to reduce inflation may trigger a crash in asset prices, and, in a highly leveraged economy, precipitate a financial crisis. Second, the key to a recovery in asset prices is to raise inflation expectations above the real rate of interest to induce asset holders to shift out of holding cash into real assets.
Glasner is quick to note that higher inflation isn't always a solution. "Indeed, the case for inflation depends on a very low, or negative, real rate of interest, an exceptional circumstance."
It's safe to say that we're in one of those exceptional circumstances, or at least we've been flirting with it on and off for the past several years, and at the moment the flirtation is on once more.
"It is well known that there is normally little correlation between U.S. inflation expectations and U.S. stock prices," Scott Sumner wrote earlier this year. After reading Glasner's paper, Sumner concluded:
There is no way to overstate the importance of [the paper's] findings. The obvious explanation (and indeed the only explanation I can think of) is that low inflation was not a major problem before mid-2008, but has since become a big problem. Bernanke’s right and the hawks at the Fed are wrong.
And that was in January. The macro outlook at the time was somewhat brighter than it is now. If Sumner's concern was topical when this year opened, it's even more pressing now.
It's obvious these days that the economic recovery is stumbling, perhaps to the point that a new recession is upon us. The possibility of another leg down in the business cycle is particularly alarming at this stage given the high levels of debt that still plague the economy. Indeed, some sectors continue to suffer outright deflation—the residential real estate market comes to mind. For roughly four years in a row, the U.S. House Price Index has been falling, according to the Federal Housing Finance Agency.
Given all this, no one should be surprised to find that the stock market is closely tracking the falling trend in the implied inflation outlook as defined by the yield spread for the nominal 10-year Treasury less its inflation-indexed counterpart. In the present circumstances, it's unlikely that equities will rally for any length of time until inflation expectations stabilize if not rise.
This is a job for the Federal Reserve, of course. Fed chairman Bernanke noted in a speech last week that the central bank still has "a range of tools that could be used to provide additional monetary stimulus." Alas, the political pressures for austerity threaten to minimize the efficacy of any policy response. Passive tightening, as a result, reigns supreme, both here and in Europe. Greece just unveiled yet another round of fiscal tightening, there's new pressure on Ireland to do the same, and the entire euro edifice continues to reel from the weight of debt and ill-advised policy responses. In short, "Europe is again on the precipice," warns Barry Eichengreen, an economist at University of California, Berkeley and author of Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System.
"Despite the ongoing spate of bad economic news in both the Eurozone and the United States, monetary authorities in both places have decided to do nothing new for now," complains David Beckworth.
Money demand, in other words, is still too high and appears to be rising… again and so central banks need to respond... still.
Meantime, we shall reap what we sow. "In the present context, Treasury bills (or more broadly, short-term government guaranteed instruments) are like gold," according to Zoltan Pozsar of the IMF.
Just as in the 1960s there were too many dollars relative to U.S. gold reserves, today there is too much demand for safe, short-term and liquid instruments relative to the volume of (i) short-term, government guaranteed instruments; (ii) high-quality collateral to “manufacture” alternatives to short-term, government guaranteed instruments (see Bernanke (2011)); and (iii) capital to support the safety, short maturity and liquidity of such alternatives (see Acharya and Schnabl (2009)).
Citing the quote above, FT Alphaville observes: "It’s for this reason gold does equally well in deflation as it does in inflation."
September 10, 2011
Book Bits For Saturday: 9.10.2011
● That Used to Be Us: How America Fell Behind in the World It Invented and How We Can Come Back
By Thomas L. Friedman and Michael Mandelbaum
Review via The New York Times
“That Used to Be Us” is a morality play, in which responsible and irresponsible leaders contend against one another: the senator willing to make compromises against the senator who cravenly signs a no-tax pledge; the C.E.O. rebuilding a manufacturing plant against the banker engaged in paper manipulations; the governor who persuades teachers to rewrite their contract to end tenure for the incompetent against the politicians who dismiss today’s deficits as tomorrow’s problem.
● Lost Decades: The Making of America's Debt Crisis and the Long Recovery
By Menzie D. Chinn and Jeffry A. Frieden
Summary via publisher, W.W. Norton
Two acclaimed political economists explore the origins and long-term effects of the financial crisis in historical and comparative perspective. Welcome to Argentina: by 2008 the United States had become the biggest international borrower in world history, with almost half of its 6.4 trillion dollar federal debt in foreign hands. The proportion of foreign loans to the size of the economy put the United States in league with Mexico, Pakistan, and other third-world debtor nations. The massive inflow of foreign funds financed the booms in housing prices and consumer spending that fueled the economy until the collapse of late 2008. The authors explore the political and economic roots of this crisis as well as its long-term effects. They explain the political strategies behind the Bush administration's policy of funding massive deficits with the foreign borrowing that fed the crisis. They see the continuing impact of our huge debt in a slow recovery ahead. Their clear, insightful, and comprehensive account will long be regarded as the standard on the crisis.
● Grand Pursuit: The Story of Economic Genius
By Sylvia Nasar
Review via Bloomberg BusinessWeek
It’s a dubious hour to proclaim the triumph (much less the genius) of the “dismal science.” Western economies are a wreck, the U.S. is suffering 9.1 percent unemployment, and Europe is teetering on the abyss of default. The economics profession bears no small measure of blame—first for inventing or adopting modern risk management, which failed so spectacularly during the financial crisis, and second for believing that central bankers had unlocked the key to managing growth. In the U.S., politicians have been reenacting a tired budget deficit debate from the 1930s. Whatever economics we may have learned, we seem determined to forget.Yet proclaim a triumph is precisely what Sylvia Nasar, author of the acclaimed A Beautiful Mind, sets out to do. Nasar has written a compelling history of modern economics, a story of the theorists as well as of their theories.
● The Two-Second Advantage: How We Succeed by Anticipating the Future—Just Enough
By Vivek Ranadive and Kevin Maney
Summary via publisher, Crown Business/Random House
What made Wayne Gretzky the greatest hockey player of all time wasn’t his speed on the ice or the uncanny accuracy of his shots, but rather his ability to predict where the puck was going to be an instant before it arrived. In other words, it was Gretzky’s brain that made him exceptional. Over the past fifteen years, scientists have found that what distinguishes the greatest musicians, athletes, and performers from the rest of us isn’t just their motor skills or athletic abilities—it is the ability to anticipate events before they happen. A great musician knows how notes will sound before they’re played, a great CEO can predict how a business decision will turn out before it’s made, a great chef knows what a recipe will taste like before it’s prepared. In a powerful narrative that takes us from the research in the labs to the implementation of predictive technology inside companies, Vivek Ranadivé and Kevin Maney reveal how our understanding of human mastery is being applied to the way computers "think." In the near future, the authors argue, the most advanced computer systems and the most successful businesses will anticipate the future much like Wayne Gretzky’s brain does. As a result, companies will be able to use a new generation of technology to anticipate customer needs before customers even know what they want, and see production snafus before they occur, traffic jams before they materialize, and operational problems before they arise. Forward-thinking companies will be able to predict the future just a fraction ahead of everyone else with a little bit of the right information at the right time—what the authors call the two-second advantage—and it will transform the way businesses are run and offer companies an enormous competitive edge in the marketplace.
● The Great A&P and the Struggle for Small Business in America
By Marc Levinson
Excerpt via NPR
On a sunny Saturday in September 1946 — the federal courts worked six days a week back then — Lindley issued what would be the most controversial decision of his long judicial career. Before a crowded courtroom on the second floor of Danville's post office, he declared that George L. Hartford, eighty-one; John A. Hartford, seventy-four; their company, the Great Atlantic & Pacific Tea Company; and other company executives had conspired to violate the Sherman Antitrust Act. The fact that the secretive Hartford brothers, two of the wealthiest men in America, were deemed criminals was startling, but their crime was truly remarkable. Rather than being accused of acting like monopolists to keep prices artificially high, the Hartfords were found to have done the opposite. They and their company, Lindley declared, had acted illegally in restraint of trade by using A&P's size and market power to keep prices artificially low.
● The Ultimate Financial Plan: Balancing Your Money and Life
By Jim Stovall and Tim Maurer
Press release via publisher, Wiley
We need to allow our minds to be re-programmed (regularly) to put money in its place—or places, really. Those places often include tangible “buckets” like checking accounts, savings accounts, 401ks, IRAs, Roth IRAs, education savings plans, and real estate as well as home, auto, business, health, disability, and long term care insurance. But other less tangible places are investments in our knowledge, understanding, and wisdom, which lead to purpose-filled careers, sleep-at-night security, artistic endeavors, creative philanthropy, fulfilled retirements, and meaningful legacies. This is where the intersection between your life and your money truly occurs. The Ultimate Financial Plan is the application of the resources at your disposal for the purpose of living your life to the fullest, and this book will show you the quickest route to getting started on the path to ultimate success. The ultimate gift is “life lived to its fullest,” so the ultimate financial plan is the deliberate application of the tangible and intangible resources at your disposal for the purpose of living your life to the fullest.
September 9, 2011
Macro Solutions, Practical And Otherwise
President Obama outlined a new plan to create jobs last night in his speech before a joint session of Congress, although the old debate about what's keeping the economy from recovering in a meaningful way rolls on. But if the perspective appears fuzzy on cause and consequence, Paul Kasriel, chief economist at Northern Trust, insists that your perspective isn't properly focused. As a solution, he dispatches a crisp review of what went wrong and what, in theory, could go right, assuming a certain institution headed by one Ben Bernanke acts decisively.
Kasriel begins by noting what isn't a problem. For example, some pundits charge that the recovery is being held back by the weight of uncertainty on businesses, which are said to be responding by refraining from investment and spending. But the numbers suggest otherwise, as Kasriel points out in this chart, which shows a strong rise in real business expenditures recently.
"If there has been so much uncertainty," he asks, "why have businesses been so willing to purchase capital equipment and software?"
Kasriel goes on to use the numbers to show:
• The case for arguing that U.S. businesses are no longer competitive because of "high taxes and regulation" looks weak in light of the sharp rise in the country's real exports of goods and services.
• Federal government spending hasn't exploded on the scale that some politicians suggest. As evidence, Kasriel offers a graph that shows the 12-month percentage change in cumulative total federal outlays is relatively low vs. the past decade while real federal government consumption/gross investment is near a 20-year trough.
• The charge that record federal deficits of late are "crowding out" private spending by raising bond yields doesn't stand up to scrutiny either.
• The argument that the weak economy is due to structural unemployment looks weak too. Instead, it's mostly cyclical, which implies that we need cyclical solutions.
What's the solution? Kasriel explains why the Fed is the only true choice left, and economist Milton Friedman, the former darling of the GOP, would agree. "Some dare call it quantitative easing treason," but that's misinformed, he asserts:
Because the essence of quantitative easing is for the Federal Reserve to create the credit that depository institutions would otherwise be creating under normal circumstances, rather than specifying ahead of time the amount of securities it would purchase, the Federal Reserve should purchase an amount of securities such that combined Federal Reserve and depository institution credit grow at some specified target rate, perhaps consistent with some desired rate of growth in nominal domestic demand.
By targeting a growth rate in combined Federal Reserve and depository institution credit, the Federal Reserve would have the added benefit of guidance with regard to its “exit” strategy.
As depository institutions become able to create more credit, the Federal Reserve would begin to scale back its purchases or engage in sales of securities so as to not exceed its target growth rate of combined Federal Reserve and depository institution credit.
The bottom line: "In the face of weak and/or contracting growth in depository institution credit and the absence of quantitative easing, what otherwise might be the case could be declines in goods/services and/or asset prices, similar to what occurred in the early 1930s." Is this doomed to bring uncontrollable inflation that wrecks the economy? No, Kasriel explains:
If the Federal Reserve conducts its quantitative monetary policy so as to achieve a rate of growth in combined Federal Reserve and depository institution credit consistent with some moderate rate of growth in nominal domestic demand, say 5%, then there will not be excessive sustained increases in the prices of goods and services nor will there be asset-price bubbles.
Kasriel's view might be easily dismissed if he were a long voice in the wilderness. In fact, it's easy to find like-minded dismal scientists espousing similar views. True, this group is in the minority, but the collective influence of voices like Scott Sumner, Marcus Nunes, David Beckworth, and others seems to be rising... maybe.
Talk is still cheap, of course, and skepticism remains high as to what the Fed could do, or will do. But the stakes are clear, even to some within the Federal Reserve system. As Charles Evans, president of the Chicago Fed, explained earlier this week:
Suppose we faced a very different economic environment: Imagine that inflation was running at 5% against our inflation objective of 2%. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn’t any doubt. They would be acting as if their hair was on fire. We should be similarly energized about improving conditions in the labor market.
In the United States, the Federal Reserve Act charges us with maintaining monetary and financial conditions that support maximum employment and price stability. This is referred to as the Fed’s dual mandate and it has the force of law behind it.
The most reasonable interpretation of our maximum employment objective is an unemployment rate near its natural rate, and a fairly conservative estimate of that natural rate is 6%. So, when unemployment stands at 9%, we’re missing on our employment mandate by 3 full percentage points. That’s just as bad as 5% inflation versus a 2% target. So, if 5% inflation would have our hair on fire, so should 9% unemployment.
September 8, 2011
The Chronic Pain Of Jobless Claims
The risk of a new recession is higher, but it’s not obvious that it’s at the tipping point. A number of traditional indicators that have an encouraging history of dispensing early warning signs are still in the growth column, if only slightly. But there’s also a set of deteriorating numbers that counteract the positives, as today’s update on new jobless claims reminds. No wonder that some analysts say there's a 50/50 chance of a downturn.
The latest data point is hardly a reason to think otherwise. New filings for unemployment benefits inched higher last week by 2,000 to a seasonally adjusted 414,000. At the very least, we’re stuck in an elevated range, which offers little hope that the labor market will pull out of its slump in the near future. Even worse, there are signs that the trend may be set to rise. The four-week moving average of claims, which is quite volatile on a weekly basis, increased to nearly 415,000 last week, the highest since mid-July.
Equally worrisome is the year-over-year percentage decline for the unadjusted numbers, as shown in the second chart below. New claims are still falling vs. the year-earlier period, but the margin of safety is shrinking again. Rising claims on an annual basis for this series (if it comes to that) alone wouldn't necessarily predict a new recession. But further deterioration here would be troubling, given the general weakness in job creation these days.
For now, the message is more of the same: the labor market is stuck in a rut. There’s minimal job creation in the private sector and today’s jobless claims report implies that we'll see more of this in the weeks ahead. "It's suggesting sluggishness rather than a dramatic new weakening," says Jim O'Sullivan, chief economist at MF Global. "Recessions are associated with claims shooting up and so far that hasn't happened."
Optimism has been defined down in recent weeks. You're in the glass-is-half-full group if you're expecting that the economy will avoid a recession while suffering little or no job growth. In that case, we’re transitioning from what was a low-job-growth recovery to a true jobless recovery.
"Jobless claims numbers have been stabilizing in recent weeks,” advises Gary Thayer, chief macro strategist at Wells Fargo Advisors. “We're probably seeing an economy that's just growing slowly.”
The problem is that an economy that grows slowly and produces minimal jobs is an economy that's at an elevated risk. “When the growth rate gets low enough, certain factors may kick in, nonlinearly,” explains economist Menzie Chinn, co-author of newly published Lost Decades: The Making of America's Debt Crisis and the Long Recovery.
And as David Leonhardt of The New York Times notes today:
…the main significance of the recent slowdown is that the economy may not merely be going through a weak phase that will soon pass, as many policy makers hope. Instead, history seems to suggest that the situation will probably get worse before it gets better.
In a recent research paper, Jeremy J. Nalewaik, a Federal Reserve economist, described this concept as “stall speed”: once the economy slows markedly, it often continues to do so. (He did not make a forecast.) In the other two severe downturns of the last 80 years — in the 1930s and the early 1980s — the economy suffered just such a stall and fell into a second recession not long after the first.
So while the jobless claims numbers aren't soaring, they're not falling either. Eventually, the distinction may not matter much, and for all the wrong reasons.
September 7, 2011
The Power Of Two Simple Investing Ideas
In theory, the recent increase in market volatility opens the door for superior results from active management. In practice, it’s still hard to beat relevant benchmarks. You wouldn’t know it from the promises from the usual suspects, but the numbers suggest another reality.
Every few months I like to review how my proprietary benchmark that passively weights all the major asset classes—the Global Market Index (GMI)—fares vs. a broad swath of actively managed multi-asset class funds. Once again, the results are typical: GMI delivered a competitive above-average return relative to the competition.
For example, consider GMI’s track record over the last 10 years through the end of this past July. This unmanaged, market-valued weighted index posted an annualized total return of 6.5% over that decade-long stretch. That translates into well-above average performance relative to more than 1,000 actively managed mutual funds and ETFs toiling away with a multi-asset class mandate of one form or another.
Using Morningstar Principia software, I screened for funds with at least 10 years of history in the following Morningstar categories: conservative, moderate, aggressive and world allocations, along with balanced funds. I looked only at distinctive portfolios to throw out various share classes of the same funds. The result was a hodge-podge of funds in excess of 1,000 products. A handful delivered stellar results. In fact, the leading fund has been nothing less than amazing (see black line in chart above). Maybe it’ll deliver equally strong results in the decade ahead. Then again, maybe not. GMI, on the other hand, is likey to remain an average, perhaps an above-average performer.
Presumably, high expectations also accompanied investors in the worst performing fund over the last decade (red line in chart above). This unfortunate product somehow managed to suffer an annualized loss of 1.3% over the past 10 years.
The bulk of the funds did much better, of course, although the results are fairly mediocre. The fund in the 75th percentile—i.e., the fund that outperformed three-fourths of its competition—earned 5.2% a year. Not bad, although GMI did moderately better.
In fact, if you mindlessly rebalanced GMI, you could have enjoyed an even higher return for virtually no extra risk. Returning GMI’s asset allocation back to its year-earlier mix every December 31 (GMI-R) boosted results to roughly 7.3% a year (see red line in the second chart below). Meantime, a "model-free" allocation plan of equally weighting the major asset classes (and returning the mix to equal weighting at the end of each year) fared even better (GMI-E), delivering a 9.6% annualized total return (gray line in chart below) vs. 6.5% for the unmanaged, unrebalanced GMI.
Ah-ha! you say. GMI and its counterparts are theoretical indices. What about real world results? Well, you can replicate GMI with ETFs for less than 50 basis points. That compares with expense ratios that are typically higher in the 1,000-plus-fund universe noted above. In fact, it’s not uncommon to see funds in this niche charge 100 or even 200 basis points or more. That’s a performance drag that weighs heavily on results as the years go by, and so you need to be one extraordinary manager to overcome this headwind. As the first chart above reminds, most managers fall short of the challenge.
Granted, none of this is terribly surprising. It’s hard to beat a broadly diversified asset mix over time. Meantime, the idea that you can earn a premium with little or no risk by rebalancing a broad array of asset classes isn’t radical either, at least not in some circles. Judged by where investors end up putting their money, however, all of this seems to fall on deaf ears.
Don’t misunderstand: the analysis above isn’t an argument for investing in GMI, although you could do a lot worse. Rather, the point here is simply a reminder that diversifying across asset classes and keeping the mix from going to extremes is competitive and easy to do, and therefore you shouldn’t pay too much for the service. But simple ideas that have a history of working don’t always attract a crowd in finance.
Another Look At Volatility Hedging
Can market volatility be tamed? Sure, but it comes at a price, usually in the form of reduced return. The real question is whether you can tame volatility without materially lowering expected return. Analysts have been dissecting this problem for years, although interest in the topic has exploded lately for obvious reasons. One of the more intriguing strategies is available through a new breed of hedging strategies designed by several large investment banks. A number of financial planners are using the products, which have been stress-tested during the recent market turmoil. How do these strategies hold up upon closer inspection? For some perspective, take a look at my article in the September issue of Financial Advisor.
Strategic Briefing | 9.7.2011 | The Crisis In Europe
In Euro Zone, Banking Fear Feeds on Itself
The New York Times | Sep 7
“This crisis has the potential to be a lot worse than Lehman Brothers,” said George Soros, the hedge fund investor, citing the lack of an authoritative pan-European body to handle a banking crisis of this severity. “That is why the problem is so serious. You need a crisis to create the political will for Europe to create such an authority, but there is still no understanding as to what the authority will do.”
German court gives MPs bigger say in euro bailouts
Reuters | Sep 7
Germany's highest court said parliament must have a bigger say in euro zone rescue packages, a landmark ruling that may make it more difficult for Europe to respond swiftly in delivering aid to crisis-hit member states.
EU parliamentarians fear debt crisis damage to Europe
Deutsche Welle | Sep 7
The next act in the Greek debt tragedy, regarding the declining eurozone and its nascent rescue, is upon us: It now seems that Greece may not be able to fulfill the requisite conditions to qualify for further financial aid from Europe. This has stirred much ire within the German government. Some, few lawmakers are calling for Greece to be ejected from the single currency zone.
German austerity drive risks Euro-slump
The Telegraph | Sep 6
German finance minister Wolfgang Schäuble has vowed to halt rescue payments to Greece unless the country complies totally with the EU-IMF demands, brushing aside warnings that a Greek collapse would set off a disastrous chain reaction and a global banking crisis.
Finland May Quit Second Greek Rescue If Collateral Denied, Katainen Says
Bloomberg | Sep 7
Finnish Prime Minister Jyrki Katainen said his country may not contribute to a second Greek bailout package if demands for collateral in exchange for new loans aren’t met. Such an outcome “remains a possibility,” Katainen told reporters after delivering a speech in Helsinki today. “It depends on the collateral issue.” Finland is at the center of a collateral dispute that threatens to stall Greece’s second rescue package and exacerbate Europe’s debt crisis. Katainen had earlier this month pledged to find a model that satisfies the AAA rated nation’s insistence on extra assurances its bailout funds be repaid without putting other euro members or creditors at a disadvantage.
Greece 'to speed up cost-cutting work'
BBC | Sep 7
The Greek finance minister has pledged to speed up reforms to cut public spending and reduce the size of the state, saying his privatisation plans would start "immediately".
Italy austerity plan faces Senate confidence vote
Reuters | Sep 7
Italian Prime Minister Silvio Berlusconi faces a confidence vote in the Senate on Wednesday following the latest changes to a widely criticised austerity package aimed at staving off financial crisis... Italy, the euro zone's third largest economy, has been at the centre of the debt crisis since the start of July when markets began to doubt its commitment to cutting its 1.9 trillion debt mountain. Only intervention by the European Central Bank to buy Italian bonds has kept its borrowing costs from soaring out of control and destabilising the entire euro zone. But the ECB has warned that its support could not be taken for granted. Berlusconi's centre-right coalition has been deeply split over whether to raise taxes or hit pensions with Economy Minister Giulio Tremonti, once seen as the guarantor of financial stability, appearing increasingly isolated.
September 6, 2011
A Bit Of Good News For The Services Sector
The U.S. services sector grew at a moderately faster pace in August, but the crowd’s not paying attention. The better-than-expected rise in the ISM’s non-manufacturing index is taking a back seat to Friday’s news of flat job growth and renewed fears of mounting economic challenges in Europe and the Continent's ongoing push for fiscal and monetary austerity. Focusing on the negative isn’t surprising, but today’s ISM report keeps hope alive, if only slightly, that the problems in the U.S. will bring a mixed bag of macro results rather than an outright recession.
The news from the Institute for Supply Management is no silver bullet, but it’s hardly irrelevant. Why? It could have been worse. The fact that the numbers were ok is enouraging because the services sector is where the action is for the U.S. economy. Something on the order of four of every five workers draw paychecks from companies in the services economy. The manufacturing sector may generate all the buzz in economic analysis, but in terms of dollars and jobs the real story resides elsewhere.
The ISM’s composite services index was 53.3 in August, up from 52.7 in July, the 25th consecutive month of growth. For the moment, that's meaningless in the markets, where risk aversion is the only game in town once again. Perhaps everyone’s noticing that the employment index component in the services report slipped last month for the second month running. The optimistic interpretation is that we’re facing a jobless recovery. Cynics will argue that we’ve suffered no less all along.
In fact, we’ve been in a recovery with below-average job growth. Will that be replaced by a true period of jobless growth? Maybe the better question is deciding how much more of a slowdown the economy can endure without tipping over into an explicit recession? Assuming, of course, such razor-thin distinctions are even possible or relevant.
The Trouble With Tax Cuts
Job growth stalled in August, manufacturing activity isn’t faring much better, the demand for liquidity and safety is on the march again, and the trend for U.S. exports may face new headwinds if economic growth in emerging markets suffers, as some analysts predict. What's a politician to do these days? Lean on the tried-and-true policy response, of course.
The latest round of gloom is raising the profile of tax cuts once more as a potential solution. But is this policy tool up to the job this time? President Obama seems to think so. He’s ready to roll out a new round of tax cut proposals in his scheduled speech to Congress this Thursday.
The president "is focusing on cuts targeted at middle-income Americans to spur consumer spending, which accounts for 70 percent of the economy," Bloomberg reports. The article goes on to quote Peter Orszag, former director of Obama’s Office of Management Budget, who reminds that with the unemployment rate stuck at the elevated 9% "the economy desperately needs help." Presumably that's one of the few uncontroversial notions in Washington these days. But how to respond is as tricky as ever.
Weighing the nexus of political reality and economic need, Orszag says that the president “will probably have to lean heavily on tax cuts if it’s going to have a serious chance of being enacted."
If Obama has any hope of re-election, he certainly needs to do something, or at least project the appearance of action on the jobs front. For the moment, he has his work cut out for him. More than half of Americans disapprove of how the president's managing his job, and the subject of the economy is an especially sore point with the public, according to a new poll via Politico.
The question is whether fresh tax cuts will bring any relief, and by relief we're talking jobs. Andrew Ross Sorkin recommends that we curb our enthusiasm:
…temporary tax cuts rarely result in new jobs and always result in less tax revenue.
“Tax policy is not a great lever for adjusting short-term growth,” explained Howard Gleckman, a resident fellow at the Tax Policy Center , who has reviewed dozens of studies on the subject. Most temporary tax holidays “reward people for what they are going to do anyway,” he said, adding that “the bang for the buck is very low — you’re subsidizing companies that were already going to hire.”
Sorkin also reports:
“If Congress enacts a second tax holiday, rational corporate executives will conclude that more tax holidays are likely in the future,” Chuck Marr and Brian Highsmith of the Center on Budget and Policy Priorities recently wrote. “That will make corporations more inclined to shift income into tax havens and less likely to make investments in the United States.”
Unfortunately, other job-creation plans aren't considered quick fixes for job growth either. But the economy demands action, and cutting taxes, effective or not for our current problems, is easy for the Beltway crowd.
Even if you sign on to the tax-cuts-will-help view, there's still plenty of room for debate. Consider that House Majority Eric Cantor, a Republican from Virginia, reportedly supports a 20% tax deduction for income of small business owners. As Roll Call notes, "Obama and Cantor favor tax cuts aimed at businesses, but there is still a significant gap between how they want to design their tax cuts." Details, details...
Democrats prefer the payroll tax cut because it benefits millions of Americans whose incomes wouldn’t benefit from cuts to the income tax rate.
They also say money in the pockets of those in lower-income brackets is likely to be spent more quickly.
Republicans say that because the payroll tax cut is explicitly temporary, job creators don’t plan and make hiring decisions based off of it like they would a change to tax rates.
Not just any tax cut will do, depending on the talking head. But will any tax cut suffice for the problems du jour?
September 3, 2011
Book Bits For Saturday: 9.3.2011
● The Arrogance Cycle: Think You Can't Lose, Think Again
By Michael K. Farr and Edward Claflin
Summary via publisher, Lyons Press
What is the arrogance cycle? We've just lived through it. As market bubbles build, our confidence level rises (dis)proportionately. Everyone wants in on the action. We want to believe Wall Street, and once we do, the inevitable happens. The only problem was that it was all artificial. In The Arrogance Cycle, Farr examines the forces at work on individuals and markets and explains in clear, concise layman terms how we got to where we are.
● Buy and Hedge: The 5 Iron Rules for Investing Over the Long Term
By Jay Pestrichelli, Wayne Ferbert
Summary via publisher, FT Press
If you're trying to build wealth, sharp market downturns are your worst enemy. And nowadays, they're happening far more often: in the last 18 years, the S&P 500 has experienced sixteen violent declines. Institutions and professional investors have mastered powerful hedging techniques for dramatically reducing the risks of market volatility. Now, you can do it, too--and you can't afford not to. In Buy and Hedge, two leading investment experts show how to apply hedging as part of a long-term program for growing and preserving your assets. CNBC Fast Money guest Jay Pestrichelli and seasoned financial industry veteran Wayne Ferbert show how to systematically protect yourself against violent downward moves while giving your portfolio maximum room to run in upward markets.
● The Smartest Portfolio You'll Ever Own: A Do-It-Yourself Breakthrough Strategy
By Dan Solin
Summary via publisher, Perigree|Penguin
Bestselling author and financial blogger, Dan Solin, provides real do-it-yourself investors the means to create a dynamic-and safe- portfolio that mimics those constructed for some of the major institutional and trust investors in the country. Readers can maintain complete control over their money-and not sacrifice precious points to an advisor or broker. Using a strategy that minimizes volatility and maximizes returns, Solin makes investing according to the principles of the most sophisticated financial models accessible to individuals in a way that has never been possible before.
● Drinking from the Fire Hose: Making Smarter Decisions Without Drowning in Information
Review via Brain Drain
What Frank and Magnone offer in Drinking from the Fire Hose is a straightforward framework for making sense of data. It begins by asking what is the most important thing you need to know in order to move forward. the rest flows from there: finding out what really matters to your customers, putting short-term data into context, asking why data reveals the results it reveals, zeroing in on the most relevant data and what that tells us about our business, and identifying who the silent majority are that we can convert into loyal customers. Or in short: Get the data, sift through what's relevant, and take action.
● Erotic Capital: The Power of Attraction in the Boardroom and the Bedroom
By Catherine Hakim
Excerpt via The Wall Street Journal
Beauty is not limited to supermodels and A-list celebrities. It can be achieved by wearing flattering styles, getting in shape, improving posture and putting some effort into choosing clothing and hairstyles.
And erotic capital is not just about physical attractiveness. It also encompasses personality, charm, liveliness, social energy and the ability to make people feel at ease and want to know you. It is not about flaunting your sexuality at the office by showing more cleavage and wearing tight pants.
Researchers have consistently found that attractive people of both sexes are perceived to be more competent and intelligent. Attractive adults are noticed more and treated more favorably, and they are more often welcomed into social networks, where they receive more cooperation and help from others. They are more persuasive and sell ideas and products more successfully.
Erotic capital also translates into income. A number of studies show that, in the U.S. and Britain, there is a 10% to 20% "beauty premium" in earnings across the workforce. In jobs that involve contact with customers or clients, the returns can be even greater, adding up to hundreds of thousands of dollars in additional income over the course of a career. Fifteen years after graduating from a prestigious law school, an attractive lawyer in private practice, for instance, earns over $20,000 per year more than an unattractive lawyer, holding other relevant factors constant.
● Portfolio Decision Analysis: Improved Methods for Resource Allocation
Summary via publisher, Springer
Portfolio Decision Analysis: Improved Methods for Resource Allocation provides an extensive, up-to-date coverage of decision analytic methods which help firms and public organizations allocate resources to 'lumpy' investment opportunities while explicitly recognizing relevant financial and non-financial evaluation criteria and the presence of alternative investment opportunities. In particular, it discusses the evolution of these methods, presents new methodological advances and illustrates their use across several application domains.
September 2, 2011
Job Growth Takes A Dive In August
Today’s employment report is dismal. It may not be fatal, but it’s the most discouraging update for jobs from the Labor Department since the Great Recession was formally declared dead and buried as of June 2009.
Let’s start the grim work of digging through the numbers by focusing first on total nonfarm payrolls, which includes government employment. The net change is exactly zero for August, which means that last month was the worst for jobs creation since the 29,000 loss for September 2010. No wonder that the unemployment rate stayed at an elevate 9.1%.
The main trouble in this widely cited number is that the government continues to shed jobs. The loss was relatively mild in August, with government jobs retreating by only 17,000--down from a 71,000 loss in July. But the decline has been virtually non-stop for more than a year, and last month was no exception.
The trend looks better with private-sector job creation, but not by much. A mere 17,000 new positions were created in corporate America in August, a nearly complete fade from July’s 156,000 gain. We haven’t seen numbers this low since February 2010’s decline of 21,000 private-sector jobs. The one bright spot: the healthcare and social assistance category, which popped by 36,000, up a bit from July’s 33,000 rise. But there’s no way to soft pedal the hard fact that the service sector—the main employment engine in the economy—suffered a huge downshift, adding just 20,000 new jobs on a net basis vs. 104,000 in July. Add that slowdown to the slight loss for jobs in the goods-producing sector (which posted a strong 52,000 increase previously) and it’s easy to see why the jobs machine has all but rolled to a stop.
The pessimistic view is that we’ve come full circle in the "recovery." The revival of the labor market that began in the spring of 2010 has dried up. It was a weak rebound, but now even that modest healing process is over. If you subscribe to this view, the future looks dark. Whatever burdens weigh on the economy (and there are plenty), the load becomes quite a bit heavier without job growth. And let’s not even consider what might happen if the labor market begins contracting. That’s already happening in the government sector, but at least the corporate world has been a net contributor to employment, if only slightly as of August.
Is that thin reed about to end? No one really knows, of course, although you can’t blame anyone from worrying. “This is further evidence that the economy is very close to stalling if not having stalled,” warns Nariman Behravesh, chief economist at IHS. “Businesses continue to be super, super cautious.”
But before we give up hope, let’s recall that August was a tough month on a number of fronts. From the politically inane budget debate to S&P’s downgrade of Treasuries to wars and economic turmoil elsewhere in the world, there’s been no shortage of excuses to delay hiring. There was also the temporary loss of 45,000 jobs due to the Verizon strike weighing on the statistics. Meanwhile, the fact that the trend in jobless claims isn't anywhere near as dark as today's jobs report offers some support for thinking September's numbers will be better. Of course, if jobless claims start to rise again in the weeks ahead, that would be quite a different ball game.
For now, the question is whether August was bedeviled with a tsunami of one-time events, or does it marks a new wave of trouble? We’ll know the answer soon. Meantime, there’s not much to celebrate as the Labor Day weekend arrives.
September 1, 2011
Manufacturing Growth Weakens In August
The first major economic report for August offers no comfort for thinking that we'll break free of the economy's sluggish growth phase any time soon. Today's update on the ISM Manufacturing Index reflects an expansion in the sector, but only slightly. The index slipped to 50.6 last month, down from 50.9 in July. A reading above 50 indicates expansion, but with the index declining to its lowest level in more than two years there's nothing dazzling here.
Yes, it could have been worse, and a number of analysts thought it would be. The Bloomberg News survey advises that the median forecast from economists anticipated that ISM would drop to 48.5. By that standard, we're doing ok, but that's like saying you expected to drive off a cliff and instead you only had a flat tire. Sure, it's better, but no one's going to celebrate the relative improvement.
But let's not get too worked up over ISM. This index has a history of going to extremes, but the frequent peaks and troughs (relative to the neutral 50 level) don't routinely coincide with major turning points in the business cycle, as defined by NBER. No indicator is perfect, of course, but if you're looking for clues about the next recession, there are more productive benchmarks to consider. Since 1990, the ISM Manufacturing Index has slipped under the 50 mark at least eight times, even though there have been only three formal recessions during that stretch. By comparison, monitoring the 12-month percentage change for the U.S. stock market (S&P 500) has been a far more reliable early warning system of a new recession, to cite one example. Indeed, there are a number of other metrics with stronger records of anticipating the cycle vs. ISM Manufacturing. But that's a story for another day.
Don't misunderstand: the ISM Manufacturing Index deserves routine monitoring. Manufacturing is still a critical component, albeit one of diminishing influence as the economy evolves. As economist Richard Yamarone explains in The Trader's Guide to Key Economic Indicators:
From the 1940s through the 1970s, manufacturing activity was a much greater influence on the total U.S. economy than during the 1980s, when the economy became less industrialized and more services oriented. So, in earlier times when manufacturing fell into a slump, it dragged the entire economy in recession. Today, manufacturing accounts for only 20 percent or so of total economic output. As a result, declines in manufacturing don't always result in macroeconomic recessions.
That doesn't mean that a dip below the 50 level for the ISM index would be irrelevant. In the old days, that almost surely would have been a nail in the cyclical coffin. But we'd need to see a fair amount of corroboration from other indicators to make the ISM warning persuasive in 2011. For some perspective, let's compare the 12-month percentage changes for the ISM index with U.S. stocks, new orders for durable goods, and industrial production. As the chart below suggests, ISM looks considerably weaker vs. the other three metrics. Of course, durable goods orders and industrial production are only updated through July. But based on the numbers in hand, there's still room for debate about the implication of the ISM's recent descent.
None of this changes the fact that the economy continues to struggle, regardless of what the ISM report suggests, or doesn't suggest. You can make a statistical case that the odds of a new recession are still minimal, but we're still stuck with a weak recovery that is vulnerable to macroeconomic things that go bump in the night.
The true antidote for all this anxiety is a stronger labor market. But expectations remain muted on that front. Net private-sector job growth is expected to be in the neighborhood of 100,000 via tomorrow's update from the Labor Department. That may be enough to keep us out of another downturn, but no one will confuse it with economic strength.
Jobless Claims Fell Last Week, But So What?
New jobless claims fell by a seasonally adjusted 12,000 last week to settle at 409,000, but no one’s going to see that as much more than another round of statistical noise. This leading indicator of economic activity has been stuck in a rut for months and it’s going to take more than one sizable downshift to convince the crowd that something’s changed. It doesn't help that there's another one-time event in the mix. Some of the drop is reportedly due to the end of the Verizon strike, which pushed new claims higher in early August. But the same factor in reverse had the opposite effect a few weeks back. Round and round we go.
Temporary factors aside, not much has changed with claims. Going nowhere isn’t encouraging for growth, but it could be worse. New claims could be trending higher, but they’re not, at least not recently. There was a disturbing pop higher earlier in the year, but that was an early warning of the current rough patch that’s afflicting the economy. As I noted back in April, when the previous rise in jobless claims was unfolding, “the bigger risk for now is that the economy’s rebound moderates rather than evaporates.” That’s still a good guess, in part because jobless claims, while still elevated, have fallen since the spring. We'd be in much deeper trouble if new claims had continued rising all along.
Meantime, consider the unadjusted data for year-over-year changes in jobless claims, as illustrated in the second chart below. As of last week, new claims were lower by nearly 13% vs. a year ago. That’s encouraging, if only because it suggests that the labor market will meander along. Unfortunately, job creation is weak, as yesterday’s ADP Employment Report reminds. But low growth is still better than no growth. And if the annual trend in jobless claims has any relevance, and I think it does, we’re probably in for more of the same.
“Businesses are putting off hiring plans for the time being rather than going to layoffs,” Ellen Zentner, a senior U.S. economist at Nomura International Securities, tells Bloomberg. “Businesses are holding to the status quo while they await certainty on the economic outlook.”
By that reasoning, it’s best to remind ourselves that we’re still facing a long and slow recovery. That’s old news, of course, but what's old is new again... and again, and again.
Major Asset Classes | August 31, 2011 Performance Update
The summer from hell may be history, but the wounds still smart as stocks took another beating in August. For the fourth straight month, equity markets around the world tumbled. U.S. stocks (Russell 3000) were down by a hefty 6.0%, the deepest monthly decline since May 2010. Foreign equities in unhedged dollar terms fared even worse, with developed markets (MSCI EAFE) off by 9% and emerging markets (MSCI EM) down by 8.9%. In other words, it's been close to non-stop selling for stocks since May.
Bonds, by contrast, continue to benefit from the rush to safe havens. The Barclays Aggregate Bond Index soared again by nearly 1.5%. Foreign government bonds in developed markets (Citigroup WGBI ex-US) did even better with a gain of 1.8% last month.
But the rise of fixed-income wasn't able to offset the deep across-the-board losses in equities. As a result, our passive, value-weighted benchmark of all the major asset classes took another hit. The Capital Spectator’s Global Market Index (GMI) sunk 3.8% in August, its biggest monthly decline in more than a year. True to form, the equal-weighted version of our benchmark (GMI-E) suffered less, dropping by a lesser 2.4%
For the year so far through the end of August, GMI and its counterparts are still posting gains, but just barely. Compared to stocks, however, that looks pretty good. Over the last three years, the unmanaged GMI still earned 3.4% a year.
Four consecutive months of red ink for stocks isn’t unprecedented, but it’s sufficiently rare to inspire hope that September will offer something better. If so, it may be time for bonds to share some of the burden.