November 30, 2011
ADP Says Job Creation Accelerated In November
Job creation rolls on, today’s ADP Employment Report advises. The preliminary update for November shows a net gain of 206,000 private sector jobs on a seasonally adjusted basis. That’s the highest monthly advance for this series since December 2010. If there’s a recession brewing in the U.S., it’s not obvious in these numbers.
Never say never, but history strongly suggests that new recessions don't arrive with this level of job creation. Granted, there’s always a contingency these days, and it starts with the euro crisis. With Europe widely expected to dip into a recession, if it’s not there already, the strength in U.S. job growth could evaporate quickly. Even so, the revival in private sector jobs provides an additional buffer against future troubles.
More immediately, the ADP news raises confidence for anticipating that the U.S. Labor Department’s estimate of job growth (scheduled for release this Friday) will be comfortably in the black. Not surprisingly, there’s a high correlation through time between the monthly change in the ADP number and the Labor Department's summary of private-sector fluctuations.
For the 10 years through October, the correlation between the two series is roughly 0.95. In the short term, however, there's relatively wide divergence. Consider recent history in the graph below, which compares the monthly changes for the ADP and Labor Department statistics. Note that the pair trade places from time to time in terms of one exceeding the other. That’s a sign that the current gap will soon reverse, as it always has in the past. The latest ADP data point is unusually high relative to the last number from the government. Given today’s relatively strong ADP report, the statistical implication is that Friday’s Labor Department update will at least bring news of stronger private sector job growth in November vs. October. Of course, the alternative view is that the gap will close with a future downward revision in the ADP number. If so, we'll likely see a weaker-than-expected update on Friday. Stay tuned.
Meantime, progress is visible once again on the jobs front, if only for the moment. If somehow the euro crisis and the budget troubles in Washington could magically disappear, I suspect that the economic momentum would be even stronger. But we live in interesting times and so we have to settle for a resilient labor market that’s facing down lots of uncertainty and risk. Impressive. There’s still no silver bullet in today’s ADP report, but it’s clear that the economy isn’t succumbing to the darker side of the business cycle, at least not yet.
“Things are getting better for the economy,” says Robert Brusca, chief economist at Fact & Opinion Economics. “It means the news we have on Christmas shopping and on an increase in consumer confidence may have some validity.”
But there's always the catch to any good news in this climate, as William Larkin of Cabot Money Management reminds: "The ADP is a pretty good number, but it will put a lot of weight on Friday's data, especially coming off of yesterday's consumer confidence number. However this news puts us on the path of stronger equities."
What's needed to dispatch the recession talk once and for all is clear follow through in support of today's number. An encouraging number in tomorrow's weekly update on jobless claims would be a good start, as would a strong number in Friday's Labor Department report. The real test is how the economic numbers play out in the weeks ahead. If the U.S. economy can hold its ground even as Europe shudders, there's still hope.
We are, it seems, at a critical juncture, albeit with a bit of a tailwind in today's labor market news. No wonder, then, that the world's major central banks today launched "coordinated action to shore up the global financial system…" Strike while the iron is hot.
The battle to keep growth alive rages on. Score one for the labor market on that front. The war's outcome is still undecided, but the troops can at least rally behind another assault against the debt deflation enemy. Alas, there are still many more battles yet to come.
Stressed Out & Up
To say that the global economy is stressed is to state the obvious these days. The potential for implosion in one of the world's major currencies is no trivial development. The great mystery is whether the rising stress on the system will unleash a new recession. That looks like a done deal in Europe by some accounts, although there's still a lively debate about where the U.S. economy is headed. This much, however, is clear: the financial system is under pressure and so the threat of an economic contraction in the U.S. is higher these days. But tipping points are only obvious in hindsight, particularly during delicate periods such as the one currently blowing through the global economy.
One measure of the elevated risk is the St. Louis Fed's Financial Stress Index, which has recently increased to the highest levels since 2009. The level of systemic stress is one factor. More ominously is the trend. In 2009, stress was declining. By contrast, stress was rising in 2008, a trend that coincided with a recession. The fact that this metric is now at elevated levels and increasing raises warning signs for the business cycle.
Financial stress alone isn't enough to push an economy over a cliff. Much depends on the broader context. At the moment, there are mixed messages. Although some economists are predicting a new downturn for the U.S., many analysts expect the economy will avoid a contraction. One reason for thinking optimistically is stock market, which remains on the fence when it comes to discounting the future. Equities tend to fall on a year-over-year basis either just ahead of a new recession or during its early stages. At the moment, the S&P 500's price change is roughly flat vs. a year ago.
But there's a danger at looking at any one, or even a handful of numbers at such a precarious time. Any one factor can be flawed. But if you rank the various cyclical indicators at the moment you end up with a mixed bag. That leaves us looking to each new data update in search of the marginal change that may bring clarity, one way or the other. This Friday's update on November employment surely falls into that category.
The consensus forecast for private nonfarm payrolls calls for a net gain of 141,000, according to Briefing.com. If the prediction holds, it will represent an improvement over October's 110,000 rise. As a preview of what Friday's report may hold, later today we'll see the ADP Employment Report for this month. Forecasts for this number are bubbly as well. Reuters reports that today's ADP update "is expected to show its best reading since April and the third consecutive gain greater than 110,000."
Art Hogan of Lazard Capital Markets clearly falls into the optimistic camp. He tells CNBC: Anticipating good news in Friday's Labor Department report, he predicts that it'll be "a better jobs reporting week than we've had in the past. The weekly jobless claims have been under 400,000 for a couple weeks, so the jobs number we get on Friday is probably going to have an upside surprise to it."
If so, we may be poised to dodge the euro bullet. Recessions and expanding labor markets (even weakly expanding ones) aren't natural allies. Every recession in the last 50 years has been accompanied by an annual decline in private sector nonfarm payrolls. As of October, we're higher by 1.7% vs. a year earlier on that score. If November's numbers maintain or improve on that pace, the recession talk will fade, at least for a few days.
November 29, 2011
Will October's Economic Momentum Last?
Consumer confidence rebounded strongly in November, the Conference Board reports. David Semmens, an economist at Standard Chartered Bank, opines that "the improvement in the labor market must be offering greater comfort to consumers." The question, of course, is whether the labor market's "improvement" can survive the sentiment attack blowing through the global economy via the euro crisis. Today's rise in the Conference Board's consumer benchmark provides fresh encouragement for thinking positively, but this is still mostly guesswork until the major economic reports for November arrive. For the moment, it's still a blank slate.
The good news is that October's numbers are clearly in the growth camp, as the table below reminds. Other than housing starts and new durable goods orders, the tide was rising across the board last month. Even better, the year-over-year trend is largely in the black too. A good tailwind never hurts, but as the OECD reminds, there's no shortage of risks for the global economy. It's debatable how much relevance the recent past has for the immediate future, but we'll all find out soon enough... one economic report at a time.
This much is clear: the deepening euro crisis and the deadlock over budget negotiations in Washington are still threatening. It's unclear how, or if, those twin threats will play out in the weeks and months to come, but it's easy to take a dim view of waiting (hoping) for policy makers to engineer salvation. Optimists in the U.S. counter that the recent revival in the economic numbers will overcome any obstacles in Europe and Washington. Maybe, but events are still too fluid to muster much confidence that the worst has passed.
The first big test for the November economic trend arrives this Friday with the update on nonfarm payrolls. October's report wasn't all that impressive, although the 104,000 net gain in private-sector job creation was enough to keep the recession forecasters on the defensive. Brian Wesbury and his team at First Trust are expecting that November will deliver another month of growth, although they're hedging their bets. First Trust projects a rise of 95,000 private sector jobs for this month, just south of October's number.
That's quite a bit lower than the consensus forecast of 141,000, according to Briefing.com. Brewin Dolphin in London reminds that "the economy has been re-gaining momentum recently and the weekly jobless claims have improved thus pointing to better employment prospects and possibly a surprise that might be on the upside." RBC also cites the declining jobless claims numbers in recent weeks as a rationale for predicting a stronger pace with November private sector payrolls. RBC predicts a relatively strong gain of 120,000 in Friday's report.
It's a safe bet that any downside surprises for the foreseeable future will go over like a lead balloon in the current climate. But for the moment, we're off to a good start with today's Conference Board report. Then again, it's going to take sustained strength in the U.S. economy to offset what's shaping up to be a "fairly deep recession" in Europe, which looks set to take a toll on the Japanese economy.
November 28, 2011
The euro crisis is a tragedy—or a farce? Whatever it is, it's bit less so today, or one could reason by way of today's rally in U.S. stocks. But how did we get here? Everyone has an opinion.
"The main cause of the debt crisis is that incomes are not growing fast enough to generate enough free cash flow to pay off the fixed nominal obligations incurred by the insolvent, nearly insolvent, or potentially insolvent Eurozone countries," argues David Glasner.
It doesn't help that Germany isn't quite the rich uncle that some assume. Scott Sumner explains:
Many people seem to be under the illusion that Germany is a rich country. It isn’t. It’s a thrifty country. German per capita income (PPP) is more than 20% below US levels, below the level of Alabama and Arkansas. If you consider those states to be "rich," then by all means go on calling Germany a rich country. The Germans know they aren’t rich, and they certainly aren’t going to be willing to throw away their hard earned money on another failed EU experiment. That’s not to say the current debt crisis won’t end up costing the German taxpayers. That’s now almost unavoidable, given the inevitable Greek default. But they should not and will not commit to an open-ended fiscal union, i.e. to “taxation without representation."
The departing European Central Bank economist Juergen Stark is focused on "responsibility," which leads him to certain conclusions (via Edward Harrison), which implies a particular fate:
There must be a clear separation of functions between central banks and governments. The central bank has to deliver price stability. And it is the responsibility of governments to ensure adequate conditions for the financing of government expenditures. That markets have been more sensitive to the high indebtedness of states for some time and therefore require higher interest rate is not a situation for the central bank to correct… "Money printing" as you call it, is in no way used for the reduction of public debt. We are fulfilling our mandate to ensure price stability now and into the future.
Responsibility and mandate fulfillment, however defined, are moving toward an end game, which may or may not work. The Wall Street Journal reports:
Euro-zone countries are weighing a new plan to accelerate the integration of their fiscal policies, people familiar with the matter said, as Europe's leaders race to convince investors they can resolve the region's debt crisis and keep the currency area from fracturing.
Under the proposed plan, national governments would seal bilateral agreements that wouldn't take as long as a cumbersome change to European Union treaties, according to people familiar with the matter. Some German and French officials fear that an EU treaty change could take far too long. That has prompted the search for a faster option.
The plan, which hasn't been finalized, would allow the euro zone to announce a speedy change to its governance. European authorities would gain tough new powers to enforce fiscal discipline in the 17 countries that make up the euro zone, the people said. EU treaty changes could then follow at a later stage.
For good or ill, this is how it ends (or revives?). Fiscal integration, or something approximating it, may succeed. But the details will be messy. They already are. A tighter fiscal integration for 17 economies would be an enormous challenge under a multi-year plan. The question is how the crowd reacts over the next several weeks. Even before we begin, we're "one too many mornings and a thousand miles behind."
Tactical ETF Review: 11.28.2011
The capital markets and the global economy are caught between the rock and the hard place. Misguided policy choices in Europe and deadlocked budget negotiations in Washington are threatening to crush the meager economic growth in the developed world. The toxic environment is starting to infect emerging markets too. For contrarian investors with a long-term view, the possibilities may be looking up. But earning higher risk premiums than the crowd isn’t going to come easily. Turbulence looks like a safe bet for the near term, and perhaps longer. Everything else is open for debate as the world sorts through the mystery of how we get from here to there without (hopefully) shooting ourselves in the head. The thankless job of discounting the unknown unknowns is now job one. The blunt response is now roiling markets, as you’ll see in the following review of the major asset classes via our usual list of ETF proxies…
US STOCKS • Vanguard Total Market (VTI) • Benchmark: MSCI US Broad Market Index
The bounce didn't last...
FOREIGN DEVELOPED MARKET STOCKS • Vanguard Europe Pacific (VEA) • Benchmark: MSCI EAFE
Foreign developed stocks are sinking even faster...
EMERGING MARKET STOCKS • Vanguard Emerging Markets (VWO) • Benchmark: MSCI Emerging Market
Emerging market equities are no longer immune to the developed world's ills...
US BONDS • Vanguard Total Bond Market (BND) • Benchmark: Barclays US Aggregate
The safe-haven trade is stuck in neutral...
INFLATION-INDEXED US TREASURIES • iShares Barclays TIPS Bond (TIP) • Benchmark: Barclays US TIPS
Inflation-indexed Treasuries are treading water too...
HIGH YIELD BONDS • SPDR Barclays High Yield Bond (JNK) • Benchmark: Barclays High Yield Very Liquid
Gravity takes a toll on junk...
COMMODITIES • iPath Dow Jones-UBS Commodity (DJP) • Benchmark: DJ-UBS Commodity
Commodities are trending lower too...
REAL ESTATE INVESTMENT TRUSTS • Vanguard REIT (VNQ) • Benchmark: MSCI US REIT
REITs are no longer a port in a storm ...
FOREIGN DEVELOPED MARKET GOVERNMENT BONDS • SPDR Barclays Int’l Treasury (BWX) •
Benchmark: Barclays Global Treasury ex-US Capped
The euro crisis has knocked the stuffing out of foreign developed market government bonds...
EMERGING MARKET GOVERNMENT BONDS • Van Eck Market Vectors Emg Mkt Local Currency Bond (EMLC) •
Benchmark: J.P. Morgan GBI-EMG Core
Emerging market bonds are now suffering as well...
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 are retreating...
FOREIGN CORPORATE BONDS • PowerShares International Corporate Bond (PICB) •
Benchmark: S&P International Corporate Bond
And there's no safety in foreign corporate bonds either...
Charts courtesy of StockCharts.com
November 26, 2011
Book Bits For Saturday: 11.26.2011
● Zombie Banks: How Broken Banks and Debtor Nations Are Crippling the Global Economy
By Yalman Onaran
Q&A with author via PLFNews
Everyone is afraid that the world economy is about to go into a second recession. Why are we heading in that direction?
That’s because we haven’t fixed the problems that had caused the one in 2008. Leaders in the U.S. and Europe patched up the troubled spots, printed lots of money and avoided the underlying issues. Especially the banking system, which blew up to bring the world economy down a few years ago, is still fragile, too wounded to support a recovery and filled with even more risk. That’s why I call the banks zombies. They will make the next blowup more spectacular.
● Against Thrift: Why Consumer Culture is Good for the Economy, the Environment, and Your Soul
By James Livingston
Review via Bloomberg
Livingston is a lively, argumentative writer. He assails the “pathetic” thinking of Republicans, Democrats, economists, philosophers, and journalists while sounding like the guy at a dinner party who dominates the salad, entrée, and dessert conversation with a stubborn will to prove everyone but him is bananas. Which does not necessarily mean he’s wrong. Livingston reserves his harshest abuse for the “new Puritans” among economists, government leaders, and commentators who regularly admonish us to stop being slaves to consumerism and recommend practicing austerity on an individual level. Though others have made similar arguments, Livingston modestly compares his theory to Galileo’s heresies in 1610. “Practically speaking,” Livingston writes, “the facts and figures I will cite to demonstrate my case are invisible to most economists, just as invisible as the moons and phases Galileo measured were to most mathematicians and physicists of his time. They’re invisible because in theory, they’re preposterous, even impossible.”
● Pricing the Future: Finance, Physics, and the 300-year Journey to the Black-Scholes Equation
By George G. Szpiro
Summary via publisher, Basic Books
Options have been traded for hundreds of years, but investment decisions were based on gut feelings until the Nobel Prize–winning discovery of the Black-Scholes options pricing model in 1973 ushered in the era of the “quants.” Wall Street would never be the same. In Pricing the Future, financial economist George G. Szpiro tells the fascinating stories of the pioneers of mathematical finance who conducted the search for the elusive options pricing formula. From the broker’s assistant who published the first mathematical explanation of financial markets to Albert Einstein and other scientists who looked for a way to explain the movement of atoms and molecules, Pricing the Future retraces the historical and intellectual developments that ultimately led to the widespread use of mathematical models to drive investment strategies on Wall Street.
● Race Against The Machine: How the Digital Revolution is Accelerating Innovation, Driving Productivity, and Irreversibly Transforming Employment and the Economy
By Erik Brynjolfsson and Andrew McAfee
Review via Kurzweil AI
In Race Against the Machine, Brynjolfsson and McAfee bring together a range of statistics, examples, and arguments to show that technological progress is accelerating, and that this trend has deep consequences for skills, wages, and jobs. The book makes the case that employment prospects are grim for many today not because there’s been technology has stagnated, but instead because we humans and our organizations aren’t keeping up.
● The Moral Foundation of Economic Behavior
By David C. Rose
Summary via publisher, Oxford University Press
his book explains why moral beliefs can and likely do play an important role in the development and operation of market economies. It provides new arguments for why it is important that people genuinely trust others-even those whom they know don't particularly care about them-because in key circumstances institutions are incapable of combating opportunism. It then identifies specific characteristics that moral beliefs must have for the people who possess them to be regarded as trustworthy. When such moral beliefs are held with sufficient conviction by a sufficiently high proportion of the population, a high trust society emerges that supports maximum cooperation and creativity while permitting honest competition at the same time. Such moral beliefs are not tied to any particular religion and have nothing to do with moral earnestness or the set of moral values-what matters is how they affect the way people think about morality. Such moral beliefs are based on abstract ideas that must be learned so they are matters of culture, not genes, and are therefore able to explain differences in economic performance across societies.
November 25, 2011
Playing With Fire
The only thing worse than an economy headed for a recession is an economy headed for recession with rising interest rates. That appears to be Europe's fate, and it's a fate that increasingly looks like a self-inflicted wound. The stakes could hardly be higher. The blowback from Europe threaten the feeble growth in the U.S., which in turn carries dire implications for the global economy, starting with China. But, hey, the political "leadership" in Germany, which in many ways is directing this horror show, doesn't see any reason to change its plans.
Chancellor Angela Merkel yesterday reminded the world that her rigid embrace of Austerity Now remains intact. She continues to reject a bigger role for the European Central Bank as a tool for lowering the Continent's rising interest rates. Centuries of precedent in central banking during financial panics are effectively dismissed in favor of what Ambrose Evans-Pritchard correctly labels as "reactionary policies being imposed on two thirds of the eurozone by Germany’s Wolfgang Schauble and the northern neo-Calvinists – with input from 1930s liquidationists at the ECB." Indeed, the newly installed head of the ECB, Mario Draghi, is embracing this ill-fated plan, insuring a united front in short-circuiting any hope for monetary relief.
Germany's position is all about insuring that the spendthrift countries suffering high debts and low growth should be forced onto the straight and narrow path to fiscal rectitude. This is a solution in the long run, but it's a disaster in the short run. Unless and until the central bank steps in to lower bond rates, the potential for crushing economic pain looks inevitable. Those who disagree argue that ramping up the ECB's lender-of-last-resort role risks unleashing higher inflation. That's a concern, but it's a risk that's surely several years away as the European economy slows, with negative consequences for China, which relies on the European Union for roughly one-fifth of its exports.
“The damaging effects of the eurozone’s ongoing debt crisis are likely to push the region’s economy back into a deep and protracted recession,” warns Jonathan Loynes of Capital Economics. The high odds for this negative shock far outweigh the potential for inflation at the moment.
Until the ECB recognizes this risk and acts accordingly, economic conditions in Europe look set to deteriorate for the foreseeable future. The immediate cause: the slow strangulation that accompanies higher rates in a time of slowing growth. Indeed, Italy is "forced to pay record rates" at its latest bond auction. It's the same narrative in Spain, Greece, and throughout Europe. Even Germany may no longer be immune to higher rates.
Granted, the lender-of-last resort solution is no free lunch and so it should be used with eyes wide open. This is a game of choosing the least-worst option from a set of awful choices. Like every decision in macroeconomics this one comes with tradeoffs. That includes the recognition that it's easier to minimize macro risk vs. engineering economic growth. But even that policy decision is being artificially dismissed. That doesn't change the fact that we're at a point where the debt-deflation risk dominates. Germany will bend to reality eventually. There may no longer be a euro to save at that point, but economic pressures can't be denied indefinitely. History is quite clear on the end game. Only the timing and costs are debatable. Meantime, there will be blood.
November 24, 2011
Let's Talk Turkey
Happy Thanksgiving to everyone. As a brief interlude from the usual fare, here are some worthy passages to promote the holiday spirit. Enjoy. All the best to you and yours!
November 23, 2011
A Mixed Bag Of Economic News For October
Because of the Thanksgiving holiday tomorrow, the government released three major economic reports today: income & spending, initial jobless claims, and new orders for durable goods. Overall, the numbers show an economy that continues to struggle. There's just enough growth in the latest data points to keep the debate open about what happens next, but the macro trend still looks precarious no matter how you spin the numbers.
The strongest number is disposable personal income (DPI), which rose 0.3% in October—its highest monthly increase since March. The engine here is the stronger growth in private sector wages over the last two months. That’s certainly good news, but more of the same is needed in the months ahead to reverse the slowing growth in the year-over-year change. There’s still a relatively wide divergence between the growth rates of income and spending, as the chart below shows. Even worse, both series are slowing vs. their respective year-earlier figures. The downshift is especially severe for DPI. Today’s news on income takes the worries down a notch, but it remains to be seen if the revival can withstand the blowback from the deepening euro crisis and the budget wrangling in Washington.
Alas, there’s no assistance today with initial jobless claims, which rose a slight 2,000 last week to a seasonally adjusted 393,000. That's not horrible, but we're at a critical juncture (again) with new claims. The burning question: Is the recent downtrend signaling better times ahead for the labor market? Today's report doesn't tell us much one way or the other.
The charitable view is that weekly claims numbers leave room for optimism, but the year-over-year change in the unadjusted series of new filings for unemployment benefits is looking worrisome as the trend drifts higher.
Another problem is the latest dip in new orders for durable goods, which slipped 0.7% in October on a seasonally adjusted basis—the second monthly decline in a row. The broader trend appears to be grinding lower as well.
Keep in mind too that October’s reports don’t fully reflect the deeper troubles in Europe or the stalemate in Washington over budget cuts, both of which took a turn for the worse in November. If the economic numbers for October are a mixed bag, it’s hard to see how November’s updates will fare any better and offer clarity on the side of growth. Instead, it seems as though we're in for a rough stretch of economic news as the year winds down.
Research Review | 11.23.2011 | Managing Asset Allocation
Testing Rebalancing Strategies for Stock-Bond Portfolios: Where is the Value Added of a Rebalancing Strategy?
Hubert Dichtl (Alpha Portfolio Advisors), et al. | September 15, 2011
This study addresses the question why institutional investors prefer rebalancing even though these strategies require the selling of a fraction of the better-performing assets and investing the proceeds in the less-performing assets. Analyzing the value added of rebalancing strategies for investors, we document that the return effect is negligible, and hence it is primarily a risk management argument which justifies the widespread use of these strategies. Minimizing risk (defined as return volatility) with respect to a given asset allocation seems to be the primary objective of any rebalancing strategy.
Recessions and balanced portfolio returns
Joseph Davis and Daniel Piquet (Vanguard) | October 2011
Given the rising risk of a renewed U.S. recession, investors may wonder about the merits of a more “defensive” posture for their broad portfolio. To provide perspective, we calculated the historical returns of a balanced 50% equity/50% bond portfolio under two distinct U.S. business cycle regimes: recessions and expansions. We show that the average real returns of such a portfolio since 1926 have been statistically equivalent regardless of whether the U.S. economy was in or out of recession. Although it may seem counterintuitive, this similarity in average real returns has occurred because of two typical market patterns: first, the tendency for bonds to outperform stocks during the initial period of economic weakness (a “flight-to-safety” effect), and second, the tendency for stock prices to decline before a recession officially occurs and to rise before it officially ends (a “leading indicator” effect). While a recession is always unwelcome, our results support the utility of an investment program focused on a diversified, long-term strategic asset allocation, and should give considerable pause to those who recommend a more tactical or reactive approach to investing.
Investing for the Long Run
Andrew Ang (Columbia Business School) and Knut Kjaer | November 11, 2011
Long‐horizon investors have an edge. They can ride out short‐term fluctuations in risk premiums, profit from periods of elevated risk aversions and short‐term mispricing, and they can pursue illiquid investment opportunities. The turmoil we have seen in the capital markets over the last decade has increased the competitive advantage of a long investment horizon. Unfortunately, the two biggest mistakes of long‐horizon investors - procyclical investments and misalignments between asset owners and managers - negate the long‐horizon advantage. Long‐horizon investors should harvest many sources of factor risk premiums, be actively contrarian, and align all stakeholders so that long‐horizon strategies can be successfully implemented. Illiquid assets can, but do not necessarily, play a role for long-horizon investors, but investors should demand high premiums to compensate for bearing illiquidity risk and agency issues... To take advantage of the long‐run advantage, investors should first institutionalize contrarian behavior by adopting a rebalancing rule. Avoiding procyclicality also requires redefining the concept of risk away from just volatility. Low volatility often coincides with low expected risk premiums, which are a more relevant concept of risk for the long‐run investor who can withstand short‐term fluctuations. Investors should practice factor investing and build robust factor portfolios. Long‐term investors can harvest many sources of factor risk premiums. They should go beyond asset classes and use the underlying factor risk premium drivers as the basis for portfolio construction.
Paired-Switching for Tactical Portfolio Allocation
Akhilesh Maewal and Joel Bock (Scalaton) | August 22, 2011
Paired-switching refers to investing in one of a pair of negatively correlated equities/ETFs/Funds and periodic switching of the position on the basis of either the relative performance of the two equities/ETFs/Funds over a period immediately prior to the switching or some other criterion... It is based upon the idea that if the returns of two equities are negatively correlated, overlapping of the periods during which the equities individually yield returns greater than their respective mean values will be infrequent. Consequently, if the criterion for switching is even minimally accurate in its ability to identify the boundaries of such periods, there is a possibility of improving the performance of the portfolio consisting of the two equities over the portfolio wherein the two equities are statically weighted on the basis of traditional methods such as, for example, variance minimization. Trading based on paired-switching is fundamentally distinct from paired-trading, which seeks enhanced returns by attempting to exploit the departure of the behavior of the time series of the actual returns from the prediction of a model based upon historical data and implements a market neutral strategy on the assumption that the prices will ultimately move to conform with the model. In contrast, paired switching embraces the model – which is just the fact that the returns are negatively correlated - and tries to ride it out. When applied to each equity in a portfolio, paired-switching provides an alternative means of dynamic or tactical portfolio allocation. Some results of back testing shown below suggest that some very simple criteria for paired-switching can lead to lower volatility without any significant penalty in terms of lower returns.
On the Equity and Interest Rate Predictability for Balanced Portfolios and Coverage Ratios for Pension Plans
Foort Hamelink (Lombard Odier & Cie and University Amsterdam) | October 17, 2011
The purpose of this study is twofold. On one hand we derive an optimal allocation framework between stocks and bonds, with and without a momentum factor, taking into account a regime-switching model based on monthly equity and interest rate data since 1870. On the other, we investigate the optimal portfolio construction for the manager of a pension plan, where the pension’s liabilities are valued in present value terms. Assuming such a pension plan is exposed to two risk factors only, an equity factor and an interest rate factor, the manager needs to decide on the exposure to equities (the beta to equities measured at the level of the total portfolio), and the level of exposure to interest rates, relative to the benchmark defined by the liabilities. Using over 140 years of monthly data pertaining to US equities and 10-year yields, I show that combining a momentum factor with a Markov regime switching approach provides a very robust framework with optimal allocations to stocks and bonds in each regime for the traditional manager, and a well defined equities (beta) exposure and interest rate hedge policy for the manager of the pension plan.
Tactical Commodity Allocation and the Theory of Storage
Pierre Six (Rouen Business School) | September 15, 2011
This article examines the benefit of adding commodity futures and/or spot commodity to a portfolio of bonds and equity. We find that an investor, who optimally considers the information conveyed by the whole term structure of commodity futures, greatly improves the wealth certainty equivalent of his/her strategy. However, this strategy results in extreme positions on the term structure of commodity futures. We show nevertheless that a suboptimal strategy that consists of the spot commodity only, also significantly improves the bond-stock mix performance. Our two key results justify the investment on commodity markets through single commodity indexes as regularly released by the Commodity Futures Trading Commission (CFTC).
November 22, 2011
Will The Barricades Fall?
The Treasury market's inflation forecast is slipping… again. If the descent rolls on, it'll be a dark sign of things to come, just as it has been in the post-crisis mire of recent years. The battle isn't lost yet, but the forces of inflation and deflation are clearly locked in a new round of conflict. For the moment, it's unclear which side will win if we're looking solely at the yield spread between the nominal less inflation-indexed 10-year Treasuries. But in a world once again flush with deflationary instincts, confidence is low that that defenders of prices can hold the line.
The good news is that the inflation forecast, which has been a harbinger of sentiment and markets in the New Abnormal, is above previous interim troughs. But as the euro crisis deepens and the odds rise for austerity via automatic budget cuts in the U.S., faith that we'll pull away from the brink is growing thin.
Yesterday's 1.8% drop in the stock market surely hasn't inspired hope. Equities never recovered from the summer's momentum loss and so the technicals remain grim. The S&P 500 is under its 200-day moving average again and the 200-day moving average has been under its 50-day average since August.
The only real support for the forces of growth has been the recent strength in economic reports, starting with the declines in new jobless claims in recent weeks. The question is whether the renewed strength in the American economy, albeit relative to the summer slump, will hold up in the face of Europe's woes and Washington budget-linked political paralysis.
Perhaps the answer lies with deciding if the Austerity Now folks win the political debates. They're certainly not giving up the battle. And perhaps they're on a roll. The barricades—the last defense in Europe—seem to be crumbling.
Will they succumb? Recent economic news from last month seems to be of limited value because sentiment has changed in the last week or two. Will the numbers follow? The answer arrives one data point at a time starting... now.
November 21, 2011
Draghi Isn't Ready For His Closeup
Mario Draghi, the recently installed head of the European Central Bank, is in no mood for monetary salvation. Instead, it's price stability all the way—inflation fighting, in other words. “Gaining credibility is a long and laborious process,” he says. “But losing credibility can happen quickly — and history shows that regaining it has huge economic and social costs.”
The credibility to which he refers is the ECB's inflation-fighting credentials. But there are other types of credibility, and some are more pressing than others at certain junctures in history. To wit, the financial crisis that threatens to turn the eurozone into a macro morass. That, says Draghi, is a fiscal issue and one that only politicians can address. The notion of the ECB embracing its inner lender-of-last-resort muse is off the table, at least for now. As for Europe's suffering that has nothing to do with inflation, let them eat cake, is the ECB's effective response.
Perhaps someone should explain to Mr. Draghi that the quixotic pursuit of inflation credibility won't mean much if the euro goes the way of the dodo. The currency—the entire edifice of the eurozone—is fighting for its life. Survival is a tricky affair in the wake of debt-deflation blowback. There are no easy solutions, but it's easy to make it worse, and the newly installed ECB chief seems to be moving down that path, and thumbing his nose at the lessons of economic history in the process.
Let's be clear: the rising yields in Europe outside of Germany are slowly strangling the European economy, and the odds for the euro's survival. A new recession appears to be a given on the Continent, and without a central bank-led effort to lower those yields by purchasing bonds the pain is set to get worse, perhaps much worse.
The last stand in this battle may be French government bond yields. Surging spreads over German bonds has already victimized Greece, Ireland, Spain, Italy and Portugal and now the disease seems to be attacking France. Earlier today, French yields rose to just over 3.5% and more of the same may be coming. It's not clear what happens next if France tips over to the dark side, but does Mr. Draghi really want to find out?
Maintaining a credible inflation target has its place—and time, but none of that applies to Europe now. A long, clear history of central banking during financial and economic crises tells us so. And there's no guarantee that Germany won't be afflicted in time either.
The great irony (and tragedy) is that Draghi's plans for saving the euro threaten to undermine it and perhaps destroy it. Mario knows this, but paralysis reigns supreme. There will be a heavy price to pay if it rolls on.
November 19, 2011
Book Bits For Saturday: 11.19.2011
● Money in a Free Society: Keynes, Friedman, and the New Crisis in Capitalism
By Tim Congdon
Summary via publisher, Encounter Books
In the fifteen years leading to mid-2007 the world economy enjoyed unparalleled stability, with steady growth and low inflation. But the Great Recession has seen the worst economic turmoil since the 1930s. A dramatic plunge in trade, output, and employment in late 2008 and 2009 has been followed by an agonizingly weak recovery. What explains this crisis? What are the intellectual origins of the policy mistakes that led to the Great Recession? Which ideas on economic policy have proved right? And which have been wrong? Money in a Free Society contains eighteen provocative essays on these questions from Tim Congdon, an influential economic adviser to the Thatcher government in the UK and one of the world’s leading monetary commentators. Congdon argues that academic economists and policy-makers have betrayed the intellectual legacy of both John Maynard Keynes and Milton Friedman.
● Beyond Our Means: Why America Spends While the World Saves
By Sheldon Garon
Excerpt via publisher, Princeton University Press
When I began researching this book several years ago, saving money was not the sexiest of topics—certainly not in America. Policymakers here have long emphasized consumption as the driver of the economy, while historians prefer to write about the rise of our vibrant consumer culture. But recently the issue of saving has become maybe too exciting. Despite a booming economy, household saving rates sank to near-zero levels by 2005. Three years later, the U.S. economy experienced a housing and financial meltdown from which we have yet to recover. Americans now contend with massive credit card debt, declining home prices, and shaky financial institutions. It has become painfully clear that millions lack the savings to protect themselves against foreclosures, unemployment, medical emergencies, and impoverished retirements.
● The United States and the Global Economy: From Bretton Woods to the Current Crisis
By Frederick S. Weaver
Summary via publisher, Roman & Littlefield
Financial collapse. Global recession. The revival of free-market policies. Massive and increasing inequalities. Housing bubbles and record foreclosures. Severe strain in the European Union. Emergence of China and other major players on the international economic scene. Every day, media outlets bombard us with news and possible explanations for the financial, economic, and political crises. In The United States and the Global Economy, Frederick S. Weaver gives readers a concise introduction to the patterns of change in international financial and trade regimes since World War II in order to clarify recent global economic turmoil. Weaver has compiled a clear chronology of major events in the international economy to show how they have reflected and shaped changes in the domestic economy of the United States. Although U.S. dominance over the world economy is not as complete as it once was, U.S. domestic economic processes continue to have profound effects on global economic affairs.
● Back to Work: Why We Need Smart Government for a Strong Economy
By Bill Clinton
Review via The Economist
Mr Clinton says he was prompted to write by the success in the 2010 mid-term elections of what he calls the “antigovernment” movement, which has prevented much of the action that is necessary to tackle joblessness. He bemoans the end of an era when Republicans and Democrats in Washington, DC, could disagree on policies but essentially share a common set of facts and the view that, one way or another, government was there to help.
● What Works on Wall Street, Fourth Edition: The Classic Guide to the Best-Performing Investment Strategies of All Time
By James P. O’Shaughnessy
Summary via publisher, McGraw-Hill
Containing all new data, What Works on Wall Street, Fourth Edition, is the only investing guide that lets you see today’s market in its proper context— as part of the historical ebb and flow of the stock market. And when you see the data, you’ll see there is no argument: Stocks work. Now in its second decade of helping investors succeed with stocks, What Works on Wall Street continues to provide the most effective investing strategies, presenting incontrovertible data on what works and what doesn’t. Updated with current statistics and brand-new features, What Works on Wall Street offers data on almost 90 years of market performance....
● The Price of Fish: A New Approach to Wicked Economics and Better Decisions
By Michael Mainelli and Ian Harris
Review via SalterBaxter Blog
The world today is faced with a series of huge difficulties among which are unstable financial markets, depletion of natural resources, a rapidly growing population and unstable political environment. The world is full of ‘wicked problems’ that are not easy to solve in the neat, theoretical ways. The Price of Fish, by Professor Michael Mainelli and Ian Harris, sets out a powerful new approach to making better decisions, beyond economics alone. Diminishing fish stocks are an example of a wicked problem – the price of fish cannot be right when there is over-fishing, hunger and ruined seas. Getting to the right price will require a blend of different answers. Mainelli and Harris explore possible answers to over-fishing, as well as other wicked problems. The Price of Fish takes the reader on a journey through areas of knowledge, including choice architecture, systems and evolution that need to be understood to explain how the world really works.
November 18, 2011
If you’re feeling whipsawed lately, there’s a good reason. Make that a lot of good reasons. Everywhere you look there seems to be an surplus of contradiction in economics and finance. The trend in consumption, for intance, is encouraging while income growth is slowing. Meanwhile, the labor market is showing signs of renewal recently just as the euro crisis threatens to deepen.
What does Mr. Market think? If we look at the widely watched mix of 50- and 200-day moving averages for the S&P 500, the signals are rather grim. For most of the past three months, the S&P has been trading under its 200-day moving average, a slump that continues at the moment. Additional discouragement comes by way of the 50-day average, which slipped under the 200-day average back in August with no sign of imminent change on the horizon. As any market technician will tell you, those are dark signals for the market outlook and perhaps the economy too.
But if the market’s telling us to beware, the trend in industrial production is sending a brighter message. The rolling one-year percentage increase in industrial production is 3.9% through last month—the best annual growth rate since April. Mr. Market, however, is distinctly unimpressed, even on a rolling 12-month basis through yesterday.
Industrial production’s strength is hardly an outlier. Retail sales, for instance, are bubbling higher these days. Meantime, the economy is expected to grow in the fourth quarter at its fastest pace in 18 months. And the Conference Board reported today that its leading economic indicator index (LEI) for October jumped sharply. "The October rebound of the LEI — largely due to the sharp pick-up in housing permits — suggests that the risk of an economic downturn has receded," says Ataman Ozyildirim, an economist at The Conference Board.
Why isn’t the stock market reacting in kind? Perhaps the potential for deep trouble from the euro crisis is weighing on the crowd's sentiment. Or maybe the threat of another government shut-down in the next phase of the U.S. budget debate is spooking investors.
Whatever the reason, it's clear that we're suffering from an excess of disconnects. True for the numbers, and true on the streets, as represented by the Occupy Wall Street protesters yesterday as they marched through New York's financial district.
Welcome to the Great Divergence. A fair amount of encouraging good news (relatively speaking) is evident in recent economic reports. But there's widespread debate about what it means for the economy. Heck, there's at least 9% of the workforce that begs to differ when it comes to thinking positively.
This will go on until it doesn't. There's a head fake lurking out there somewhere. The question is whether we're set to be disabused of pessimism or optimism? Depending on your perspective, you can make a compelling case for either side.
Strategic Briefing | 11.18.2011 | The ECB's Last Stand?
European Rift on Bank’s Role in Debt Relief
The New York Times | Nov 17
The financial stability of Europe has come down to one institution, the European Central Bank, which is now under heavy new pressure to rescue the euro — or possibly see it collapse.... “There is no solution to the crisis without the E.C.B.,” said Charles Wyplosz, a professor at the Graduate Institute in Geneva and co-author of a standard textbook on European integration. “The amounts we are talking about are too big for anybody but the E.C.B.”
Euro Rescue Plan Falling Short Renews Franco-German ECB Spat
Bloomberg | Nov 18
The failure of European leaders to end the debt crisis with their broadest effort yet has revived a Franco-German dispute over the European Central Bank’s role and fueled investor concerns over policy makers’ economic impotence. ECB chief Mario Draghi today slammed governments for failing to implement policy commitments as holders of Greek debt began talks in Athens on structuring a 50 percent writeoff that was the cornerstone of a deal pieced together last month at an all-night summit. Officials in Berlin and Paris yesterday swapped barbs and European borrowing costs outside of Germany rose to euro-era records.
European Central Bank may start printing money to tackle debt crisis
Economic Times | Nov 18
The European Central Bank could soon bow to pressure to print money to prevent a further escalation of the euro zone's debt crisis, with respondents in a Reuters poll giving an even probability the ECB would adopt a policy of quantitative easing. The poll of 50 bond strategists across Europe and the United States conducted this week gave a median 48 percent probability that the ECB will be forced to conduct outright quantitative easing (QE).
Bundesbank chief Weidmann says don't overstretch ECB
Reuters | Nov 18
Decisions taken by European leaders so far have not fully addressed the core of the European debt crisis but this does not justify stretching the role of the European Central Bank, ECB Governing Council member Jens Weidmann said on Friday.... "The lack of success in containing the crisis does not justify overstretching the mandate of the central bank and making it responsible for solving the crisis," Weidmann, who also heads the German Bundesbank, said in a speech prepared for delivery at the European Banking Congress in Frankfurt.
Asian powers spurn German debt on EMU chaos
The Telegraph | Nov 17
Andrew Roberts, rates chief at Royal Bank of Scotland, said Asia's exodus marks a dangerous inflexion point in the unfolding drama. "Japanese and Asian investors are for the first time looking at the euro project and saying `I don't like what I see at all' and fleeing the whole region. "The question on everybody's mind in the debt markets is whether it is time to get out Germany. The European Central Bank has a €2 trillion balance sheet and if the eurozone slides into the abyss, Germany is going to be left holding the baby. We are very close to the point where markets take a close look at this, though we are there yet," he said. Jean-Claude Juncker, Eurogroup chief, fueled the fire by warning that Germany is no longer a sound credit with debt of 82pc of GDP. "I think the level of German debt is worrying. Germany has higher debts than Spain," he said.
Higher bond rates stoke fears of a spread of the eurozone debt crisis
Deutsche Welle | Nov 16
“Investors aren't confident about the eurozone's ability to solve its problems. So they are looking for the safest place to put their money. That means Germany - and so everyone else suffers,” Elwin de Groot, an analyst with the Rabobank in the Netherlands told the Reuters news agency. While Germany pays an interest rate of just 1.77 percent on 10-year bonds, France's rate is currently double that - and the gap between the two continues to grow. “This can't be maintained in the long term,” Verhofstadt told the European Parliament.
The Bundesbank’s chief and the ECB’s Italian president have much in common
The Economist | Nov 19
When Mario Draghi took over as president of the European Central Bank at the beginning of this month, it was felt that he had to prove his credentials in Germany. That task is made harder by calls on the ECB to act as backstop to troubled Italy, Mr Draghi’s home country, and to contain a sovereign-debt crisis that is raising borrowing costs for most euro-zone countries, while driving them down in Germany. This week Jens Weidmann, the head of the Bundesbank, Germany’s central bank, raised the bond-market pressure on Italy and on Mr Draghi by saying that central-bank support for government finances would be illegal. Mr Weidmann told the Financial Times that the ECB could not act as a lender of last resort for countries, because in doing so it would transgress EU treaties banning direct financing of states. It would be counter-productive as well, argued Mr Weidmann. The roots of the euro-zone crisis lay with governments, and providing them with cheap financing would only reduce pressure for reform.
The ECB's internal contradictions
Worthwhile Canadian Initiative (Nick Rowe) | Nov 17
The Eurozone news is really depressing. I think things are going to be very bad very soon. I don't have much to say that I haven't already said in previous posts. But thought I would add this anyway, FWIW [for what it's worth]. The ECB doesn't like inflation uncertainty; it wants to keep inflation predictable and just below 2%. The ECB doesn't like buying the bonds of Eurozone governments. The ECB, presumably, wants to preserve the Euro and preserve its own existence. Everything the ECB is currently doing seems almost designed to lead to the exact opposite of what it wants. The ECB is currently buying limited quantities of Eurozone government bonds. But it has made no public commitment, conditional or otherwise, to do so in future. It doesn't want to buy more.
The ECB’s Battle against Central Banking
Project Syndicate (Brad DeLong) | Oct 31
Perhaps the most astonishing thing about the ECB’s monochromatic price-stability mission and utter disregard for financial stability – much less for the welfare of the workers and businesses that make up the economy – is its radical departure from the central-banking tradition. Modern central banking got its start in the collapse of the British canal boom of the early 1820’s. During the financial crisis and recession of 1825-1826, a central bank – the Bank of England – intervened in the interest of financial stability as the irrational exuberance of the boom turned into the remorseful pessimism of the bust.
November 17, 2011
Jobless Claims Fall Again As Euro Risk Festers
If the euro crisis represents a threat to the U.S. economy (and it does), it’s not putting upward pressure on new jobless claims--at least not yet. New filings for unemployment benefits dipped again last week to a seven-month low of 388,000 on a seasonally adjusted basis. We’re still not at the post-recession low reached in this cycle (375,000 in late-February), but the old trough is now within shouting distance.
Will the troubles in Europe derail this progress? It’s premature to say for sure. Much depends on what policy makers do next. But here in the states, there’s a fresh data point that promotes cautious optimism that maybe, just maybe, the labor market in the U.S. is headed for sustained if only moderate healing. Assuming, of course, that the euro debacle doesn’t explode (and that’s by no means a given). The coming days and weeks will surely be critical for deciding if this glass is half full or cracked and leaking.
"The U.S. economy continues to show signs of strong momentum," says Millan Mulraine, a senior macro strategist at TD Securities. "The improvement in claims underscores that the gains in labor market activity over the past few months are being sustained."
I'm reluctant to say that jobless claims are now on a sustained downtrend, but the odds certainly seem to improving for this long-awaited virtuous cycle. It's been clear for the last month or so that the economic activity in the U.S. has revived after moving close to stall speed in September. Deciding how much of the recent pop is due to stronger growth vs. pulling away from the edge is still debatable. Even if the euro crisis could somehow be solved tomorrow, the old problem of minting jobs is still with us.
"Layoffs have eased, which is a great sign," says Omair Sharif, an economist at RBS Securities. "The other side of the equation, however, is that firms are still very hesitant to hire. You’re getting a very gradual improvement in the labor market."
Gradual progress is obviously better than a shrinking labor market, but we're still a long way from creating jobs at a rate that will pull the economy out of its mediocrity. Yet job growth is essential at this stage for repairing another potential trouble spot: the mismatch between growth rates in consumption and income. The cure is fatter payrolls. Today's jobless claims report suggests we might actually see more improvement on this front, assuming the European Central Bank keeps the euro contagion from spreading. But as I wrote earlier, that's still a big if.
Europe's Central Banking Crisis
The optimists expect that the European Central Bank will do the right thing… eventually. Perhaps, but would a philosophy transplant at this late date make a difference? Year-over-year growth in euro monetary aggregates is growing at a snail's pace of around 3%. That hardly comes close to what's needed for an economy that's suffering from a banking crisis, high unemployment (10% plus), rising bond yields, and the likelihood that the Continent is dipping into a new recession. The austerity-now movement is courting disaster.
Europe is suffering from policies that are a defacto gold standard, albeit imposed by way of fiat currency. The euro region's broad M3 monetary aggregate rose a mere 3.1% for the year through September. With a recession looming for Europe, monetary policy is effectively throwing gasoline on a simmering fire. The dysfunction is obvious when you see government bond yields rising amid heightened recession risk. Normally, capital would be flowing into bonds on the expectation that the central bank would favor an easier monetary policy. But this is Europe, where the concept of promoting financial stability is a radical idea and certain government bonds aren't quite what they appear to be.
For perspective, broad money supply is rising at a considerably higher rate in the U.S. M2 is advancing by around 10% a year and the narrow M1 is up by 20% vs. year-earlier figures. By these standards, the ECB is imposing a stern dosage of passive tightening on a faltering economy when exactly the opposite is needed.
The austerity crowd may have reasoned that the trouble was limited to the southern tier of euro countries—Italy, Spain and Greece. But French government bond yields are now taking flight too, trading at a 2-percentage point premium over German bonds for the first time since the euro was launched. The not-so-subtle implication: the infection caused by tight money in the wake of debt-deflation blowback is spreading.
No wonder that there's a growing breach on policy matters between the euro's two largest economies. Bloomberg explains:
French Finance Minister Francois Baroin risked re-opening a clash with Germany over using the European Central Bank as a backstop, saying that ECB support for Europe’s recue fund is the best way to counter the debt crisis.
Baroin’s comments underscore French unease as the debt crisis moves to the euro region’s second-largest economy. The extra yielded demanded by investors to hold French 10-year bonds over German bunds widened to a euro-era high today.
“We consider that the best way to avoid contagion is to have a solid firewall” by giving the fund a bank license, Baroin said in a speech in Paris late yesterday. “We haven’t won the argument. We won’t make it a casus belli, but naturally we continue to think it would be the best way to bring stability to Europe.”
As global leaders step up calls on Europe to find a fix to the crisis now entering its third year, the French stance is again running into resistance from German Chancellor Angela Merkel’s government, which opposes enlisting further support from the ECB.
As Brad DeLong recently noted, "The ECB continues to believe that financial stability is not part of its core business." The question is when (or if?) the ECB will undergo an attitude adjustment? It's not too late, but the stakes are high and time is running short.
* * *
Update: The Economist's Buttonwood summarizes the strange state of affairs unleashed by Europe's misguided monetary policy:
"You might think that high yields in the peripheral euro zone countries would attract bargain hunters but it doesn't seem to be the case. Cesar Perez of JP Morgan Private bank (himself a Spaniard) gave me a clue earlier this week; fund managers he talked to were unwilling to buy peripheral bonds of yields or 7-8% but they would buy at 4-5% The reason for this paradox is that, at yields of 7-8%, the finances of Spain and Italy look unsustainable (the same would be true of most developed countries). A fall in yields to 4-5% would, in contrast, be a sign that the crisis was over and an indication that both countries could get their fiscal houses in order."
November 16, 2011
The Ebb & Flow Of Style Analysis
Knowing what you own in order to get a handle on expected risk and return is essential for successful investing in the long run. No one accidentally generates attractive risk-adjusted results through time (well, almost no one). There are many ingredients for minimizing the mystery of what's driving results, but for equity portfolios the capitalization factor is probably the first factor to review. Small stocks tend to behave differently than large caps. A close second, and perhaps the dominant factor at times is the value/growth distinction. Numerous studies remind that companies with low valuations have different expected return and risk characteristics compared with their highly valued counterparts. What's more, the relationship is far from constant. That's old news, of course, as are the implications for number crunching, a.k.a. style analysis. The details, however, can get messy, as a recent essay by investment consultant Ron Surz of PPCA, Inc. reminds.
As a bit of background, Surz calculates a proprietary set of style indices—Surz Pure Style benchmarks—that he argues are superior to the usual suspects because they're "mutually exclusive and exhaustive, and they include a style in between value and growth that we call 'core'". Long ago and far away I profiled Surz and his efforts at building style indices. In any case, he continues to argue that benchmarks without a core "are like Oreo cookies without the filling." To be fair, his enlightened view of benchmarking styles is no longer an outlier. But few have been on this bandwagon longer, or have a deeper understanding of the issues.
Surz's reasoning for measuring a core style is that in order to capture the value or growth factors cleanly it's necessary to maximize each factor's distinct profile. That means excluding the securities that only exhibit mild value or growth readings. This is a topical issue of late because, as Surz explains, of a widening divergence between so-called pure measures of value and growth compared with more popular style benchmarks:
A lot has happened in the past year, including movement toward agreement. Surz Style Pure classifications agreed with Russell and S&P prior to the 2008 meltdown, but have not agreed for the past 4 years as you can see in the following performance report. We disagree primarily because of financials.
Indeed, the unusual upheaval in banking and related industries means that certain financial stocks that were ranked as growth have migrated to core and perhaps value, and vice versa. Capitalization rankings have shifted too. The restless rotation rolls on, only more so in the wake of the Great Recession.
As such, the argument for keeping an eye on how your equity portfolio's profile has evolved has never been more pressing. What you thought was growth may have taken on more of a value flavor, for instance. Or maybe the reverse is true. And then there's the benchmark aspect. "In many economic environments it doesn’t matter much whose style definition you use, but that has not been the case in this economic crisis," Surz advises.
Perhaps the main challenge with style analysis is that there's much debate about what constitutes reliable benchmarks. No wonder that analysts are continually revisiting the subject, such as this recent study—"Returns Based Style Groups and Benchmarking"--that reviews "the suitability of two methods of returns based style analysis for classification of investment styles for a single asset class, US Diversified Equity Funds."
The task of monitoring and maintaining a style strategy is harder if you hold individual securities. Alternatively, style- and capitalization-focused ETFs can ease the burden, assuming you pick intelligently designed products. The argument for building equity portfolios one security at a time is that you can add value over a relevant benchmark, intelligently crafted or otherwise. Maybe, but you'll have to keep the guesswork about your style allocation to a minimum. Fortunately, there's no shortage of resources on the web to help clear away some of the fog for how a given portfolio of stocks has evolved. As a starting point, you can give Surz's Style Scan tool a run. Plug in the tickers and portfolio weights and compare how the results stack up against various benchmarks.
The key message is that rhetorically labeling portfolios "growth" or "value" is one thing, but quantitative analysis may beg to differ. None of this would matter if there wasn't much difference in ex ante risk and return among styles. The truth, of course, is more complicated.
November 15, 2011
Higher Retails Sales Inspire Cautious Optimism
The September surge in retail sales slowed in October, but there's still no sign of recession in U.S. consumer spending. Total retail spending rose 0.5% last month on a seasonally adjusted basis. That's a substantial deceleration from September's 1.1% pop. But ignoring September's unusual and unsustainable gain, October retail sales continue growing at a respectable clip. You can't read too much into any one data point (or data series), but if you're looking for clear-and-present signs of trouble for the business cycle you won't find it here, at least not today.
Consumption decelerated in October, but it was the second-best month for growth since March. Even better, most corners of retail posted gains last month. That includes the cyclically sensitive realm of auto sales, which managed to rise 0.5%.
The annual pace of retail sales softened slightly last month to roughly 7.1%. Nonetheless, that's still comfortably in territory that's historically linked with economic expansions.
"The data are uniformly positive," says Eric Green, chief U.S. economist at TD Securities. Today's update on consumer spending "is more than enough to keep the economy going. They continue to push back the recession fears that began this summer."
With the holiday shopping season here, there's reason to think that consumption can continue to push higher. But if there's a glitch in this happy scenario, it's the recognition that October's economic data doesn't fully reflect the latest round of trouble in Europe via the deepening euro crisis.
The hope is that Europe's troubles won't infect the modest recovery in the U.S. Today's retail sales report bolsters the case for this outlook. There's certainly a tailwind in consumption in recent months, which will come in handy if the ill winds from Europe blow harder across these United States.
Dallas Fed President Richard Fisher sounds as if he's discounting the possibility that Europe represents a new hurdle for the U.S. "We’re poised for growth,” he tells Bloomberg, opining that the odds of a new recession are "negligible." He predicts GDP will rise 2.5% to 3% in the fourth quarter and "gradually" rise from there.
Was the late-September recession call by the Economic Cycle Research Institute premature? The latest data from ECRI seems to be leaning in that direction, although the consultancy hasn't officially changed its forecast.
Reasonable minds can still differ on what comes next. As the San Francisco Fed warns, it's still too early to dismiss the recession risk if you consider the worst-case scenario:
Gathering storms across the Atlantic threaten a U.S. economy not yet recovered from the last recession… Prudence suggests that the fragile state of the U.S. economy would not easily withstand turbulence coming across the Atlantic. A European sovereign debt default may well sink the United States back into recession. However, if we navigate the storm through the second half of 2012, it appears that danger will recede rapidly in 2013.
So, yes, there's some good news in today's retail sales figures. But optimism still has a short shelf life these days as we remain dependent on the kindness of the next update.
The Triumph Of Austerity (And Its Consequences)
Europe's slowing economy is a wake-up call for the austerity-now folks. Industrial production in the euro-zone fell 2% in September, a sharp drop from August's 1.4% rise, EuroStat reports. The annual pace is still positive, but a slowdown is evident here as well with September's year-over-year rise of 2.2% vs. 6.0% in August. Germany is still the exception these days, enjoying far stronger growth than its neighbors. What accounts for the divergence? There's no single answer, but an obvious place to start: interest rates. The high and rising rates outside of Germany are conspicuous, whereas German rates are low and falling.
As The Wall Street Journal reports:
Bonds issued by highly indebted euro-zone countries came under renewed pressure Tuesday, with traders demanding the highest yield premiums since the inception of the euro to hold French, Spanish and Belgian bonds instead of safe-haven German bunds, as they fretted over the ability of policy makers to push through tough austerity measures without choking growth.
Italian bonds also slumped, with the yield on the 10-year bond nudging closer to the 7% mark that in the past tripped Greece, Ireland and Portugal and forced these countries into seeking external assistance.
The U.S. economy is arguably in better shape, or so it appears, than the ex-German eurozone profile. But the slow-growth burden afflicts America too and so confidence is middling at best that the U.S. will avoid another recession. All of which suggests that calls in some circles for the Federal Reserve to switch to a hawkish monetary policy are misguided, to put it mildly. With economic growth still weak, unemployment high, and rising fears that Europe's troubles will spill over into the U.S., the prescription for tighter money looks like the wrong policy prescription at the wrong time, at least for now.
Higher rates are ultimately the goal, but the path to tighter money is crucial. Ideally, higher rates should come as a byproduct of economic growth as opposed to premature central bank tightening. Europe's currency crisis is effectively imposing a tighter monetary policy on the Continent outside of Germany with predictable results these days. Would higher rates in the U.S. bring a different outcome? Unlikely.
As for Europe, the austere German central bank isn't helping alleviate the pressure, as the FT reports:
The president of Germany’s powerful Bundesbank has firmly rebuffed international demands for decisive intervention in the bond markets by the European Central Bank to combat the eurozone debt crisis, warning that such steps would add to instability by violating European law.
Bundesbank president Jens Weidmann told the Financial Times that only politicians could resolve the crisis, and he rejected the idea of using the ECB as “lender of last resort” to governments.
We've seen this movie before. Higher rates after a severe debt-deflation recession are burdensome, perhaps economically fatal. Hiding behind the excuse that we must fight inflation NOW requires a grand dismissal of economic history. There are times to impose austerity and don the hawkish posture, but there are times when that's exactly wrong. This is one of those times, particularly for Europe.
Old lessons, it seems, must be re-discovered in the dismal science… again and again. As professor Roger Backhouse explains (and asks) in a recent book, this is The Puzzle of Modern Economics: Science or Ideology?.
November 14, 2011
The Forecast File: US Retail Sales For October
The next major clue about the state of the U.S. economy arrives on Tuesday with the October update for retail sales. When we lasted checked in with this metric, consumption had rebounded sharply in September, chasing away a fair amount of the recession blues. The year-over-year pace in retail sales remained encouraging as well, suggesting that the business cycle wasn't set to take a tumble. But income growth hasn't kept pace, which raises questions about spending's staying power. Meantime, the European currency crisis has deepened, casting a shadow over expectations here and abroad.
Nonetheless, analysts remain optimistic that October retail sales will post modest gains after September's strong rise. Briefing.com reports that the consensus forecast anticipates a 0.4% rise in retail sales last month vs. The latest Bloomberg survey also reflects expectations of higher consumption:
Retail sales probably rose in October and U.S. manufacturing accelerated, helping give the world’s biggest economy a boost entering the final months of 2011, economists said before reports this week The 0.3 percent rise in purchases would follow a 1.1 percent gain that was the most in seven months, according to the median forecast in a Bloomberg News survey ahead of Commerce Department figures on Nov. 15.
"The message I want to give you here today is that I think the consumer fundamentals are improving," says Alan Gayle, senior investment strategist at RidgeWorth Investments, via the Richmond Times-Dispatch. Perhaps, but other analysts are warning that tomorrow's update could come perilously close to zero. UniCredit's forecast, for instance, calls for a razor thin rise of just 0.1%.
The burning question is whether the ongoing euro crisis is spilling over into the U.S. by putting a dent in consumer sentiment? The answer remains unclear for the moment. Nonetheless, the accelerating trouble in Europe "seems to be coming to a head right at the time the U.S. economy is at its most vulnerable," observes Mark Vitner, a Wells Fargo economist.
But the holiday shopping season is upon us and perhaps that's the economy's salvation. Tomorrow's data point will provide a critical preview, for good or ill.
November 12, 2011
Book Bits For Saturday: 11.12.2011
● The End of the Euro: The Uneasy Future of the European Union
By Johan Van Overtveldt
Summary via publisher, Agate B2
Van Overtveldt makes a convincing case that the end-scenario of Germany’s retraction from the euro and a general dissolution of the entire European monetary union, is more likely than a solution in which EU policymakers develop a plan that would preclude the death of the euro. The implications for the future of the world economy—and theeconomies of different countries across Europe—are dramatic.
● Capitalist Revolutionary: John Maynard Keynes
By Roger E. Backhouse and Bradley W. Bateman
Review via The Deal
This is not a technical economic tract; this is a book for someone who wants to understand how Keynes' ideas and habits of thought fit together (it includes a useful bibliographic essay to the Keynes industry at the end). While it deals with the broad outline of Keynes' economic ideas, particularly in the '30s when he published his masterpiece, "The General Theory of Employment, Interest and Money," it also tackles the philosophical contexts that shaped his thinking and what the authors call "Keynes' ambiguous revolution," that is, how those ideas were revised and reshaped after World War II into a kind of orthodoxy, then rejected in the stagflation '70s, then embraced, debated and reinterpreted up to our own deeply confusing era. This is extremely useful, particularly in an age where we are once again hearing from movements like Occupy Wall Street that capitalism needs to be renovated or eliminated, or when, in a time of often-vicious partisanship, Keynes and Keynesianism is tossed around as a term of blackest opprobrium or unassailable wisdom.
● Exile on Wall Street: One Analyst's Fight to Save the Big Banks from Themselves
By Mike Mayo
Excerpt via The Wall Street Journal
Over the years, I have pointed out certain problems in the banking sector—things like excessive risk, outsized compensation for bankers, more aggressive lending—and as a result been yelled at, conspicuously ignored, threatened with legal action and mocked by banking executives, all with the intent of persuading me to soften my stance.
Looking inside the world of finance—with its pressures to conform and stay quiet—may offer some insight into why so many others have fudged. And it may offer some answers as to how crisis after crisis has hit the economy over the past decade, taking the markets by surprise, despite what should have been plentiful warning signs.
● The Economics of the Financial Crisis: Lessons and New Threats (Finance and Capital Markets)
By Marco Annunziata
Summary via publisher, Palgrave Macmillan
Through the tools of economics, Annunziata's vivid and gripping book shows how the global financial crisis was caused by a failure of leadership and common sense in which we all played a role. The insights of this clear and compelling analysis are essential for learning the right lessons from the crisis, and seeing new threats around the corner.
● Currency Wars: The Making of the Next Global Crisis
By James Rickards
Summary via publisher, Penguin/Portfolio
Currency wars have happened before--twice in the last century alone--and they always end badly. Time and again, paper currencies have collapsed, assets have been frozen, gold has been confiscated, and capital controls have been imposed. And the next crash is overdue. Recent headlines about the debasement of the dollar, bailouts in Greece and Ireland, and Chinese currency manipulation are all indicators of the growing conflict. As James Rickards argues in Currency Wars, this is more than just a concern for economists and investors. The United States is facing serious threats to its national security, from clandestine gold purchases by China to the hidden agendas of sovereign wealth funds. Greater than any single threat is the very real danger of the collapse of the dollar itself.
November 11, 2011
A Precarious Optimism
The euro crisis is no garden variety hazard for the financial system, or even the global economy, but market sentiment in the U.S. seems to be holding up quite well in the face of the latest round of the ill winds via Italy.Yesterday's rally in stocks is one inspiring data point. Another is the staying power of inflation expectations via the yield spread on the 10-year Treasury less its inflation-indexed counterpart. It could all evaporate in the twinkling of an eye, but for now there's a view that the glass is still half full in these United States.
This inflation forecast, when it falls precipitously for a stretch, has been an early warning sign of trouble in recent years. Disinflation/deflation is the enemy in the current climate and so this Treasury metric is one way to evaluate the slippery concept of pricing expectations. The fact that the implied Treasury outlook on inflation is holding steady offers a glimmer of hope that the Italian edition of the euro disaster won't bite the U.S. Or perhaps it's safer to say that the crowd is currently anticipating that the bite will only be skin deep.
The guidebook here is that the abnormal connection of late between inflation expectations and the stock market suggests that falling inflation expectations are a harbinger of darkness. Accordingly, the ability of the Treasury market's to hold the line at 2%-plus in recent days is encouraging, albeit in a close-to-the-edge-anything-could-happen-tomorrow sort of way.
It doesn't hurt that the St. Louis Fed's Financial Stress Index has fallen modestly this month, or that yesterday's encouraging update on initial jobless claims suggests that the labor market is standing tough too.
But any optimism is a precarious creature these days, subject to adjustment on the news from the next economic report. I may be going out on a limb here, but it's hard to imagine that the crowd has much tolerance for disappointment. Anxiety over Europe (and perhaps even China) suggests that the margin for error is virtually nil. More than ever, the U.S. economic updates must avoid disappointment. That's a high hurdle. But for the moment, the crowd seems to hold out the hope that America can continue to struggle forward.
November 10, 2011
A Round Trip For Euro Yields
Ed Yardeni has a great graph of European sovereign yield history. It's interesting to note that yields have basically rebounded to levels that prevailed before the euro was launched. Of course, some of the rebounding has moved faster and climbed higher in certain countries.
The main exception is Germany, the undisputed benchmark for "risk free" yield in euroland. Accordingly, German yields have dropped given in the current debt-deflation climate. Otherwise, it's up, up, and away with current yields. The irrational exuberance over the euro from the pre-launch era has evaporated. What's old is new. The big outlier--Greece--is now at yields that were the norm in the early '90s. If you pulled a Rip Van Winkle over the last 20 years you might wonder what all the excitement's about. Nothing's changed, at least from a yield perspective. Interim details, of course, can alter one's perspective (and hit you over the head).
US Jobless Claims Drop To 390k As Euro Crisis Deepens
The drop of 10,000 in new jobless claims last week to a seasonally adjusted 390,000 provides a bit of a shock absorber for sentiment in the wake of the new wave of euro turmoil via Italy. Yes, even last week's numbers may be out of date as the Continent's woes worsen. But for the moment, at least, we know that the labor market was continuing to heal on the margins, as suggested by other metrics, such as the Monster Employment Index or the payrolls report for October. The progress has been slow, but at least there's been some progress. The optimistic view with the number du jour is that the tepid installment of the latest virtuous cycle is spilling over into November. The big mystery is whether the tenuous revival will survive the new bout of euro darkness? Questions, questions, always fresh questions.
Mysteries aside, last week's jobless claims tally is another installment on the new new downward trend of the last two months--and the best yet! Weekly filings for unemployment benefits touched the lowest levels since early April. There's a bit of symbolic significance in retesting the previous lows, and perhaps some economic import as well. April, you may recall, was the month when the previous round of encouraging economic momentum came apart. In terms of initial jobless claims, we've come full circle. Normally, that would be a bullish sign worthy of celebration. But with the Italian version of the euro crisis kicking up, I'm keeping my options for expectations open.
“Today’s report is a positive sign for the state of the labor market in the fourth quarter,” says John Herrmann, a bond strategist at State Street Global Markets, via Bloomberg today. “The economy remains very exposed to potential turbulence in the euro zone, but at least the economy is growing at a decent clip. Job retention is pretty high. Businesses have been very carefully managing their headcount.”
I still think the U.S. economy will avoid a recession, or at least has the capacity to dodge a macro bullet. But the edge for growth may be tested in the weeks ahead… again. Just when you thought there was some positive momentum it turns out that there's another demon jumping out of macro's shadows and shouting boo. The acid test is watching how the economic numbers hold up (or don't) in the days and weeks ahead.
The next data point is tomorrow's Reuter's/University of Michigan's consumer sentiment index. The consensus forecast anticipates a slight rise, according to Briefing.com.
More substantial updates arrive next week with the retail sales report (Nov 15) and industrial production (Nov 16), for instance. Even if they deliver encouraging results, those updates still reflect October's activity and so it's going to take time to assess how much has changed (or not) in the wake of the news on Italy. Perhaps the crowd will take it all in stride, as this morning's sharp rebound in U.S. equity prices implies. But a lot can change in a week (or a day). There's simply too much uncertainty hanging over Europe to assume that we're finally on a sustained, if modest road to economic recovery. Indeed, that rosy notion was suspect before the Italian troubles went ballistic. Expecting it to fade away by next Tuesday is simply asking too much. The euro crisis may wax and wane, but it's going to be with us for some time, along with all the other familiar macro baggage.
The possibility, perhaps the likelihood of a "a deep and prolonged recession" in Europe looms. The U.S. economy is arguably in somewhat better shape to withstand any blowback compared with conditions in, say, August. Nonetheless, that's a thin reed for confidence, assuming it even holds up.
"We have positive momentum to carry us through to the early part of next year, but the headwinds are still going to cap the pace of growth," says Scott Brown, chief economist at Raymond James. The fear is that today's cap becomes tomorrow's weight that drags us down. Figuring out if fear is fate will take another month or so of new numbers.
Meantime, expect plenty of volatility in sentiment and prices. Overall, same old same old, but with a somewhat darker tone.
The Italy Factor Gets Ugly
Is the euro Toast? Maybe not, but if you thought the currency was under pressure before, well, you ain't seen nothin' yet.
The immediate issue is that the Italian problem has forced the European Central Bank into a put-up or shut-up moment. Bloomberg explains:
Italy is forcing Europe to choose between increased bond buying by the European Central Bank or a possible breakup of the euro.
Italian 10-year yields have breached the 7 percent level that locked Greece, Portugal and Ireland out of the capital markets and forced them to seek aid. With debt of 1.9 trillion euros ($2.6 trillion), more than those three countries combined, Italy has to refinance about 200 billion euros of maturing bonds next year and more than 100 billion euros of bills.
With so much uncertainty amid higher stakes, it's no wonder that Italy's government bond yields are rising, jumping north of 7%. The cost of financing Italy's debt burden is soaring, and eventually those chickens will come home to roost. By comparison, the 10-year Treasury Note yields around 2%. That's a hell of a spread for one of the planet's largest economies.
The next phase of the euro crisis is underway as Italy, Europe's third-largest economy, struggles to pull itself out of a political/fiscal crisis. The euro will almost certainly survive, but it's not going to be the same currency in the future.
Perhaps there'll be fewer members. Surely the rules for membership will change. Figuring out what it means to be a euro member is headed for a dramatic attitude adjustment. Meantime, it's a sign of the times when economists are offering detailed tips for exiting the euro. Stergios Skaperdas, an economics professor at University of California, Irvine, outlines a roadmap for Greece's departure, assuming it comes to that, which is no longer beyond the pale:
To minimize the number of days banks would need to be closed, the decision to move to the new drachma should be made on a Friday. Bank deposits and domestic debt would be immediately converted to new drachmas at the initial exchange rate. It would fall to the Greek courts to determine whether pre-2010 public debt would follow suit, but there is no reason to think they would treat it any differently from domestic debt.
But Greece is peanuts compared with Italy, and Kelly Evans recommends that we put the threat into perspective. "The risk of a serious hit to the global financial system from a European default is suddenly a clear and present danger, due to Italy," she reminds in today's Wall Street Journal. That country is the third-largest government debt market in the world, with about $2.1 trillion of securities outstanding as of March, according to the Bank for International Settlements."
The first question with the elevated euro mess is deciding if there's a blowback effect that will push America into a new recession? It's hard to model uncertainty, and the euro crisis comes with a lot of unknowns. But you don't have to be an economics wizard to recognize that there's a sizable risk here, perhaps the biggest yet since the Continent's troubles began several years back. Simply put, Italy's woes, given the country's size, represent a much larger threat vs. Greece. The danger of an outright implosion may be slight, but there's no getting around the fact that the best case scenario isn't all that appetizing either. Of course, it's a mistake to look at Italy in isolation. The main problem (still) is debt. A trio of IMF economists summarize the challenge for Italy, Europe and the rest of the developed world:
The global financial crisis has caused government debt to soar in the advanced economies. Public concern is rising and debates rage on how to fix the problem.
* In advanced economies, the average debt-to-GDP ratio is approaching 100% – higher than at any time since World War II, and set to increase further.
* The required fiscal adjustment is historically unprecedented.
It will take many years of chipping away at public debt to bring it back to more prudent levels.
We already knew that, but it seems that a fresher course via Italy is on the table. "If governments like Greece can’t reduce their debt through inflation, then a default where bondholders take a sizeable haircut on their debt becomes a more likely option, with all of the attendant costs in terms of lost output and higher unemployment," NYU economists David Backus and Thomas Cooley advise.
There's no easy way out. The only mystery is how the crowd reacts in the weeks and months ahead. It seems that we're on yet another precarious macro perch. Recent U.S. economic data hasn't been great, but it looked sufficiently buoyant to keep us from tipping over into a new recession, if only just barely. But even that modest bit of optimism is open for debate (again). The economic numbers of September and October are ancient history. Job One is looking for signs that the euro mess is infecting the slight revival in the U.S. macro trend. The margin for digesting trouble was already razor thin. Can it get even thinner without pushing us over the cliff?
The answer dribbles forth one economic number at a time. The next clue arrives later this morning with the update on initial jobless claims. Stay tuned…
November 9, 2011
Will Slowing Income Growth Spoil The Party?
Job openings on the last business day of September rose to 3.4 million, the Labor Department reports. That's up from 3.1 million in August. Here's one more statistic for thinking that the U.S. economy continues to grow. Coupled with moderately positive job creation in the private sector for October,, one might reason that the recession risk is falling. The higher "churn" rate in the job market echoes the sentiment, Catherine Rampell explains. But let's not forget that there are still plenty of risks lurking, including the disconnect in consumer spending and income.
Tim Duy observes a "nagging" divergence in consumer confidence vs. consumer spending:
While confidence is at recession levels, real personal consumption expenditures continue to grow at a reasonable clip. Should confidence numbers be totally dismissed, or do they signal an underlying fragility among households that should not be ignored? Some hints at an answer may be found in the September income and spending report. Notably, real personal disposable income looks to have rolled over
Last month I noted the fading in the year-over-year change in personal income in the September data, pointing to this chart:
Duy adds that the higher consumer spending appears to be funded at the expense of a falling household savings rate. "It looks like households are struggling to hold onto the even meager spending gains achieved since the recession ended, and that struggle may be what is reflected in the consumer confidence numbers," he writes. "Overall, this suggests to me that consumer spending is much more fragile than commonly believed."
The optimistic outlook is that the continued growth in the labor market will keep consumption bubbling. That argument carries a bit more weight after yesterday's news from the Federal Reserve that consumer borrowing revived in September after slumping in August. Meanwhile, American Express anticipates that holiday shoppers will spend 17% more this year.
The job market and consumer spending are tightly linked over the medium and long run. In the short term, well, stuff happens. For the moment, both seem to be in a mildly positive trend. The question is whether the falling pace of consumer income is poised to disrupt this virtuous cycle?
November 8, 2011
Predicting GDP With ARIMA Forecasts
Is the U.S. economy headed for a new recession? The risk is clearly elevated these days, in part because the euro crisis rolls on. The sluggish growth rate in the U.S. isn’t helping either. But with ongoing job growth, albeit at a slow rate, it's not yet clear that we've reached a tipping point. Given all the mixed signals, however, forecasting is unusually tough at the moment. It’s never easy, of course, but it’s always necessary just the same. But how to proceed? The possibilities are endless, but one useful way to begin is with so-called autoregressive integrated moving averages (ARIMA). It sounds rather intimidating, but the basic calculation is straightforward and it's easily performed in a spreadsheet, which helps explain why ARIMA models are so popular in econometrics. A more compelling reason for this technique's widespread use: a number of studies report that ARIMA models have a history of making relatively accurate forecasts compared with the more sophisticated competition.
As a simple example of the power of ARIMA forecasting, let’s consider what this statistical tool is telling us about the next quarterly change in nominal GDP for the U.S. Making a few reasonable assumptions (discussed below), a basic ARIMA forecasting model predicts that fourth quarter 2011 nominal GDP will rise 4.7% at a seasonally adjusted annual rate. For comparison, that’s slightly lower than the government’s initial estimate of 5.0% growth for the third quarter. (Remember, we’re talking here of nominal GDP growth vs. real growth, which strips out inflation. Real GDP is the more popularly quoted series.)
For perspective, let's compare the history of my ARIMA forecast with GDP predictions via the Survey of Professional Forecasters (SPF). SPF data is available on the Philadelphia Fed's web site and in this case I focus on nominal GDP. To cut to the chase, ARIMA has a history of dispatching superior forecasts compared with SPF. To be precise, I'm comparing ARIMA forecasts with the mean quarter-ahead prediction of economists surveyed quarterly in the SPF reports.
Ok, let's take a closer look at some of the finer points by reviewing a few basic ARIMA concepts. Keep in mind that in the interest of brevity I'm glossing over the details. For a complete discussion of ARIMA, an introductory econometrics text will suffice. One of many examples: Peter Kennedy's A Guide to Econometrics. Meanwhile, the main point with ARIMA forecasting is that it's a tool for using a time series' history to make a forecast. Yes, it's naïve, but the fact that ARIMA's errors tend to be low relative to many if not most other forecasting techniques makes this approach worthwhile. It's not a crystal ball, of course, and so ARIMA forecasts should be considered in context with other predictions using alternative models.
As for ARIMA, the first step is taking the data series (in this case the historical quarterly nominal GDP numbers) and regressing them against a lagged set of the same data. For the analysis here, I'm regressing each quarterly GDP number against 1) the previous quarter; 2) two quarters previous; and 3) four quarters previous. Next, I ran a multi-regression analysis on this set of lagged data to estimate the parameters, which tell us how to weight each lagged variable in the formula that spits out the forecast. To check the accuracy of the parameter estimates, I also ran a maximum likelihood procedure. (As a quick aside, all of this analysis can be easily done in Excel, although more sophisticated software packages are available, such as Matlab and EViews.)
ARIMA's forecasts are naïve, of course, but based on history it does fairly well compared with SPF. The in-sample forecasting errors (residuals, as statisticians call them) for ARIMA's average deviation from the actual reported GDP number is a slight 0.0049% since 1970. That's a mere fraction of SPF's 3.06% residual over the past 30 years. There are several additional error tests we can run, but the simple evaluations above offer a general sense of how a naïve ARIMA model can provide competitive forecasts vs. the expectations of professional economists.
Alas, like all econometric techniques that look backward as a means of looking ahead there's the risk that sharp and sudden turning points in the trend will surprise an ARIMA model. That's clear by looking at recent history, as shown in the chart below. Note that when the actual level of nominal GDP turned down in 2008 as the Great Recession unfolded, ARIMA's forecasting error rate increased. But ARIMA fared no worse than the mean SPF predictions. In fact, you can argue that ARIMA did slightly better than SPF, as implied by tallying up the errors for each during 2008 and comparing one to another.
Errors are inevitable in forecasting. The goal is to keep them to a minimum, a task that ARIMA does quite well. But that assumes a certain amount of trial-and-error testing for building and adjusting ARIMA models. Still, the future's always uncertain. But the errors can help improve ARIMA forecasts. By modeling the errors and incorporating their history into ARIMA's regressions, there's a possibility that we can reduce the error in out-of-sample forecasts going forward. That's because if you design an ARIMA model correctly, the errors should be randomly distributed around a mean of zero. In other words, errors through time should cancel each other out. In that case, past error terms can be useful for enhancing ARIMA's forecasting powers, i.e., reduce the magnitude of the errors in the future.
Yes, we still need an understanding of economic theory to adjust, interpret and design ARIMA models for predicting GDP and other economic and financial data series. But considering the simplicity and relative reliability of this econometric technique, ARIMA forecasting is a no-brainer. At the very least, it provides a good benchmark for evaluating other forecasts.
Looking For Bubbles
Bubble talk is a hardy perennial. The latest installment comes in a recent column by Jason Zweig, who provocatively inquires: "Can you spot a bubble?"
It's a loaded question, of course. If the answer is "no," well, then you're a chump. If it's "yes," then the natural follow-up is to ask how you've profited by spotting bubbles? Did you sell in late-2007/early 2008? Did you then jump back in at some point in, say, January 2009?
The assumption is that the persistence of bubbles lays the foundation for easy profits. "Bubbles always implode, since by definition they involve non-sustainable increases in the indebtedness of a group of borrowers or non- sustainable increases in the prices of stocks," Charles Kindleberger advised in Manias, Panics, and Crashes. That leads to the idea that a savvy investor can always profit from the event by looking for signs of excess before the crowd catches on.
It's a reasonable assumption, in part because there's a sea of research that tells us that expected return fluctuates. Some of the fluctuation, perhaps most of it, is bound up with fundamentals, such as dividend yields for stocks and credit spreads for bonds. In other words, highly valued securities imply low or negative expected returns, and vice versa. The details vary, of course, but the general concept is widely recognized. And for good reason. For instance, the link between current yield and future return in the equity market is conspicuous through time (see, for instance, the first chart in this post)
But if bubbles are so prevalent, and there's ample techniques for indentifying bubbles, why do so many investors (and institutions) have such a hard time cashing in? There's no single answer, but surely one of the challenges is distinguishing between recognizing bubbles in real time and deciding when (or if) it's timely to act. Bubbles may be obvious, but that's only half the battle. The bigger question: Is the bubble poised to pop? There's a lot more uncertainty hanging over the second question. The market, as Keynes warned, can remain irrational for longer than you can stay solvent.
No wonder that a broadly diversified mix of the major asset classes has been a resilient competitor over the long haul. You can earn decent if unspectacular returns over time by holding a proxy for "the market"—i.e., a portfolio that holds all the major asset classes. But don't bubbles pose a risk? Yes, of course. But the first line of defense is to ignore bubble talk per se and focus on risk management with a systematic rebalancing strategy.
Simple, mindless rebalancing has a history of modestly boosting return with little if any additional risk (volatility). Consider my Global Market Index (GMI), a passive, unmanaged mix of all the asset classes. Over the last three years through the end of last month, GMI earned 11.6% a year. Rebalancing the index every December 31 to the previous year's weights added 100 basis points to performance. And if you equally weighted the mix (and rebalanced back to equal weights at the end of each year) the annualized total return jumps nearly 400 basis points.
Yes, these are benchmarks and so they're not necessarily appropriate for any one investor. But they provide a sample of the opportunities that are available through a) diversifying across asset classes and b) exploiting price volatility and the tendency for mean reversion in asset pricing.
By contrast, the game of trying to identify bubbles in real time and deciding if it's timely to act (or not) is a misguided way of thinking about money management for most folks and institutions. Instead, your time is better spent in designing a dynamic asset allocation framework and letting relative changes in the asset mix guide your portfolio management decisions. You can and should design this framework to reflect your particular risk preferences, expectations, and financial circumstances. In addition, you can and should stick with ETFs and ETNs to build your asset allocation.
Successful investing is closely related to seeing money management as a financial engineering challenge. It's easy to get caught up in chatter about when and where the next bubble will pop, but there are more productive ways to oversee assets. Broad diversification, rebalancing and maintaining a contrarian mindset are a powerful mix. Let someone else decide if there's another bubble lurking. And if they insist on telling you otherwise, ask to see their (audited) performance results that present returns in a risk-adjusted context.
November 7, 2011
Research Review | 11.7.2011 | Asset Allocation
Strategic Allocation to Premiums in the Equity Market
David Blitz (Robeco Asset Management) | Oct 2011
Investors tend to focus on harvesting the risk premiums offered by traditional asset classes when making their strategic investment decisions. Some recent papers, however, argue that investors should also consider various other premiums for possible inclusion in the strategic asset allocation. Examples of such premiums that have been documented for the equity market are the size, value, momentum and low-volatility effects. In this paper we show that the theoretically optimal strategic allocation to these premiums is sizable, even when using highly conservative assumptions regarding their future expected magnitudes. We also discuss the pros and cons of two ways of obtaining the implied exposures in practice, specifically passively managed index funds versus actively managed quant funds.
(R)Evolution of Asset Allocation
Fabian Dori (Wegelin & Co.), et al. | Oct 2011
Asset allocation is at the heart of every portfolio construction process and crucial to its success. Though as diverse as they are innovative, the approaches used to pinpoint the optimal mix of assets mostly have common roots. In the following paper, we address this commonality in depth. First, we outline the portfolio construction process and highlight empirically the importance of asset allocation with respect to a portfolio's return. Second, the evolution of portfolio theory is put into a historical perspective. Third, we present a unified optimization framework for asset allocation and show that most well-known asset allocation techniques fit exactly in that framework. Finally, an illustrative example brings to light the similarities and differences of three prevalent approaches and highlights implications for practitioners.
Dynamic Versus Static Asset Allocation: From Theory (Halfway) to Practice
Didier Maillard (Conservatoire National des Arts et Métiers) | March 2011
The aim of this paper is to assess, with parameter values as reasonable as possible, the order of magnitude of the extent by which the dynamic optimisation process dominates the static optimisation process; and to gauge whether the existence of transaction costs changes significantly the assessment… The main results are that for high risk adverse investors, the improvement provided by dynamic versus static optimisation is moderate; it may be huge for low risk adverse investors, but this comes principally from the fact that dynamic optimisation leads to a huge leverage, which is normally prohibited in a static framework. Reasonable values for transaction costs do not jeopardise the superiority of dynamic asset allocation.
Investors Care About Risk, But Can't Cope with Volatility
Christian Ehm (University of Mannheim), et al. | October 2011
Following the classical portfolio theory all an investor has to do for an optimal investment is to determine his risk attitude. This allows him to find his point on the capital market line by combining a risk-free asset with the market portfolio. We investigate the following research questions in an experimental set-up: Do private investors see a relationship between risk attitude and the amount invested risky at all and do they adjust their investments if provided with different risk levels of the risky asset? To answer these questions we ask subjects in a between subject design to allocate a certain amount between a risky and a risk-free asset. Risky assets differ between conditions, but can be transformed into each other by combining them with the risk-free asset. We find that mainly investors risk attitude, but also their risk perception, and the investment horizon are strong predictors for risk taking. Indeed, investors do not appear to be naïve, but they do something sensitive. Nevertheless, we observe a strong framing effect: investors choose almost the same allocation to the risky asset independently of changes in its risk-return profile thus ending up with significantly different volatilities. Feedback does not mitigate the framing effect. The effect is somewhat smaller for investors with a high financial literacy. Overall, people seem to use two mental accounts, one for the risk-free and one for the risky investment with the risk attitude determining the percentage allocation to the risky asset and not the chosen portfolio volatility.
Choice Proliferation, Simplicity Seeking, and Asset Allocation
S. Iyengar (Columbia Business School) and E. Kamenica (University of Chicago) | March 2010
In settings such as investing for retirement or choosing a drug plan, individuals typically face a large number of options. In this paper, we analyze how the size of the choice set influences which alternative is selected. We present both laboratory experiments and field data that suggest larger choice sets induce a stronger preference for simple, easy-to-understand options. The first experiment demonstrates that, in seeming violation of the weak axiom of revealed preference, subjects are more likely to select a given sure bet over non-degenerate gambles when choosing from a set of 11 options than when choosing from a subset of 3. The second experiment clarifies that large choice sets induce a preference for simpler, rather than less risky, options. Lastly, using records of more than 500,000 employees from 638 institutions, we demonstrate that the presence of more funds in an individual's 401(k) plan is associated with a greater allocation to money market and bond funds at the expense of equity funds.
Seasonal Asset Allocation: Evidence from Mutual Fund Flows
Mark J. Kamstra (York University), et al. | August 2011
This paper explores U.S. mutual fund flows, finding strong evidence of seasonal reallocation across funds based on fund exposure to risk. We show that substantial money moves from U.S. equity to U.S. money market and government bond mutual funds in the fall, then back to equity funds in the spring, controlling for the influence of past performance, advertising, liquidity needs, capital gains overhang, and year-end influences on fund flows. We find a strong correlation between mutual fund net flows (and within-fund-family exchanges) and the onset of and recovery from seasonal depression, consistent with the hypothesis that investor risk aversion varies with the seasons. Further, we find stronger seasonality in Canadian fund flows (a more northerly location relative to the U.S., where seasonal depression is more severe), and a reverse seasonality in fund flows for Australia (where the seasons are reversed). While prior evidence regarding the influence of seasonal depression on financial markets relies on seasonal patterns in asset returns, we provide the first direct trade-related evidence.
November 5, 2011
Book Bits For Saturday: 11.5.2011
● Beyond the Keynesian Endpoint: Crushed by Credit and Deceived by Debt — How to Revive the Global Economy
By Tony Crescenzi
Summary via publisher, FT Press
Since the 1930s, governments have overcome recessions by borrowing and spending to temporarily replace lost consumer and business spending. What happens when they can't do it anymore? In Beyond the Keynesian Endpoint, PIMCO Executive VP Tony Crescenzi offers a sobering tour of today's unprecedented global sovereign debt crisis. Crescenzi shows how exhausted national balance sheets have stripped policymakers of their ability to bolster growth… how investors are finding it increasingly difficult to navigate debt-ridden markets... how increased spending intended to cure the financial crisis is instead worsening it. He dissects each scenario for the future, and reveals the crisis' profound long-term implications for governments, investors, and the global economy.
● Great by Choice: Uncertainty, Chaos, and Luck--Why Some Thrive Despite Them All
By Jim Collins and Morten T. Hansen
Summary via publisher, HarperCollins
Ten years after the worldwide bestseller Good to Great, Jim Collins returns with another groundbreaking work, this time to ask: why do some companies thrive in uncertainty, even chaos, and others do not? Based on nine years of research, buttressed by rigorous analysis and infused with engaging stories, Collins and his colleague Morten Hansen enumerate the principles for building a truly great enterprise in unpredictable, tumultuous and fast-moving times. This book is classic Collins: contrarian, data-driven and uplifting.
● Borderless Economics: Chinese Sea Turtles, Indian Fridges and the New Fruits of Global Capitalism
By Robert Guest
Review via Foreign Affairs
In this highly readable and personal account built on interviews with emigrants from many countries, Guest, business editor of The Economist, contends that voluntary emigration almost always benefits the emigrants and usually benefits their countries of origin and destination, too. In recent decades, Chinese and Indian overseas diasporas have played a crucial role in generating rapid growth in their home countries, as their members have created businesses and opened foreign marketing channels. To be sure, international migration also has a dark side, in the form of criminal organizations and terrorist networks that exploit open borders. But Guest argues that immigration is an especially important source of vitality for the United States, which does a remarkably good job of providing a hospitable and productive home for immigrants and their children, compared with other developed countries.
● The High-Beta Rich: How the Manic Wealthy Will Take Us to the Next Boom, Bubble, and Bust
By Robert Frank
Review via Publishers Weekly
While the recession continues to wreak havoc in the economic lives of the nation’s middle- and low-income population, Frank provides a cogent explanation of how megabillionaires have contributed to today’s economic conditions and heightened economic inequities. Furthermore, he shows that few are genuinely interested in job creation or the long-term prosperity of others. Frank’s readers are left with a depressing sense of an economic order where the average American family will continue to see a decline in its standard of living with few solutions in sight.
● The Great Recession
Edited by David Grusky, Bruce Western, and Christopher Wimer
Summary via publisher, Russell Sage Foundation Publications
Officially over in 2009, the Great Recession is now generally acknowledged to be the most devastating global economic crisis since the Great Depression. As a result of the crisis, the United States lost more than 7.5 million jobs, and the unemployment rate doubled—peaking at more than 10 percent. The collapse of the housing market and subsequent equity market fluctuations delivered a one-two punch that destroyed trillions of dollars in personal wealth and made many Americans far less financially secure. Still reeling from these early shocks, the U.S. economy will undoubtedly take years to recover. Less clear, however, are the social effects of such economic hardship on a U.S. population accustomed to long periods of prosperity. How are Americans responding to these hard times? The Great Recession is the first authoritative assessment of how the aftershocks of the recession are affecting individuals and families, jobs, earnings and poverty, political and social attitudes, lifestyle and consumption practices, and charitable giving.Focused on individual-level effects rather than institutional causes, The Great Recession turns to leading experts to examine whether the economic aftermath caused by the recession is transforming how Americans live their lives, what they believe in, and the institutions they rely on.
● Pension Finance: Putting the Risks and Costs of Defined Benefit Plans Back Under Your Control (Wiley Finance)
By M. Barton Waring
Excerpt via publisher, Wiley
Defined benefit (DB) pension plans in the United States are in a state of crisis, a crisis that is measured in the trillions of dollars of value and a crisis that has not been sufficiently acknowledged or fully recognized. Yet, serious students of pension finance have known of this problem for years; it is as if we have an early-warning system but are ignoring the alarm. We needed such advance warning before Enron Corporation’s collapse or before AIG’s or Lehman Brothers’ failures but did not have it. So, we are lucky to have such warning. Will we pay attention to it in time, or is it human nature to deny a crisis until it is simply too late?
November 4, 2011
Sluggish Job Growth Prevails... Again
There's (relatively) good news and (more of the same) bad news in today's employment report. First the good news, such as it is. Private-sector job creation continues to chug along at a mediocre pace. Last month witnessed a net gain of 104,000 for private nonfarm payrolls, the Labor Department reports. That's nothing to get excited about, but it's obviously better than a loss and so it offers yet another bit of statistical evidence for thinking that the economy isn't poised to slip into a new recession. There's also encouraging news in the latest batch of revisions to previous payroll reports. In particular, September's initial estimate of a 137,000 net rise in private payrolls has been substantially revised higher to 191,000. Even August's originally dismal rise has been revised higher to a slightly less dismal gain of 42,000 vs. the earlier 30,000 advance.
Now the bad news: the labor market is still growing at a sluggish pace. The pace is somewhat less sluggish than it appeared, say, yesterday, but nothing much has changed. In fact, October's growth represents a downshift from September's gain. The broader message is that the economy still needs a much higher level of job creation to make a significant dent in the unemployment rate, which explains why the jobless rate slipped by the smallest of margins last month to 9.0% from September's 9.1%. Yup, sluggish growth is still an accurate description of macro conditions. It may be enough to keep us from crashing, but it's not likely to do much more any time soon.
Of course, if you look at the top line number of payrolls, which includes government employment, the sluggish trend looks worse. Government workers were lighter by 24,000 last month, adding to September's 33,000 drop. As a result, total nonfarm payrolls (the number that receives most of the media attention) rose by only 80,000 in October.
“We’re making progress at a very slow pace,” says John Silvia, chief economist at Wells Fargo Securities. “It indicates continued consumer spending, getting a little better over time. The labor market is consistent with moderate economic growth.”
The potential for danger, however, is more than trivial if there's serious blowback from the euro crisis in the weeks and months ahead. Confidence is vulnerable these days, presumably for a myriad of reasons that need no explanation at this late date. It's certainly helpful to see job creation moving ahead, albeit slowly. But it wouldn't take much to crack the thin veneer of upward momentum if the Continent's crisis goes into a death spiral. Granted, that may be a low-probability event, but no one is dismissing fat-tail risks these days.
"It's not a game-changer but when you take into account the upward revision [in U.S. employment] to prior months and the drop in the unemployment rate, it's a step in the right direction," opines John Canally, economic strategist at LPL Financial. "It's about in line with the growth you're seeing in the economy but it's not enough to break us out of the range we're in."
One Small Cut In Interest Rates, One Giant Step For Macro Perspective
The newly installed head of the European Central Bank, Mario Draghi, broke with his predecessor and cut the benchmark interest rate to 1.25% from 1.5%. In one fell swoop Jean-Claude Trichet's misguided austerity policy has evaporated. And not a moment too soon, given the signs of rising recession risk for the Continent. But there's more to the story than just another rate cut.
Scott Sumner offers some context as he distills the macro lessons by reviewing the "Trichet debacle"...
Thank God Trichet is finally gone. Now let’s see what we can learn from recent policy moves by the Bank of Japan and the ECB.
Start with the fact that both are ultra-conservative institutions. Then consider the following moves:
1. The BOJ tightens in 2000 by raising rates, despite no inflation. Soon after the economy turns down and the BOJ is forced into an embarrassing about face, rates are cut back to zero.
2. The BOJ tightens in 2006 by raising rates, despite no inflation. Soon after the economy turns down and the BOJ is forced into an embarrassing about face, rates are cut back to zero.
3. The ECB tightens policy by raising rates in mid-2008, just as a severe debt crisis is leading to a rush for liquidity, and threatening to plunge the world into recession. A few months later the economy turns down and the ECB is forced into an embarrassing about face, rates are cut sharply.
4. The ECB tightens policy by raising rates in mid-2011, just as a severe debt crisis is leading to a rush for liquidity, and threatening to plunge Europe into recession. Today the ECB was forced into another embarrassing about face, and cut rates by 1/4 point.
All of which reminds once again that wisdom in economics is cyclical, not cumulative, or so it appears in some corners. Fortunately, that's a rare condition outside of the dismal science, such as medicine and aerospace engineering. Otherwise, we'd all be visiting witch doctors and limiting our travels to transport via terra firma.
Analyzing Obama's Economic/Political Troubles
Nate Silver, a new breed of statistically oriented political analysts, boils down President's Obama's macro baggage in an article for this weekend's edition of The New York Times Magazine. Silver's impressive record in forecasting elections puts him on the short list of must-reads in political calculus circles these days and his latest foray into the dark art of looking ahead doesn't disappoint for intriguing evaluations of the national political mindset. Think politics in a Moneyball framework.
In any case, Silver reports that the President has no shortage of troubles as a candidate, and much of it comes down to the economy. Here's the bottom line (or one facet of it), according to Silver, along with some thoughts on how to crunch the political numbers going forward:
• First, many of us understand that Barack Obama inherited a terrible predicament. We have a degree of sympathy for the man. But we have concerns, which have been growing over time, about whether he’s up to the job.
• Second, most of us are gravely concerned about the economy. We’re not certain what should be done about it, but we’re frustrated.
• Third, enough of us are prepared to vote against Obama that he could easily lose. It doesn’t mean we will, but we might if the Republican represents a credible alternative and fits within the broad political mainstream.
Each of these factors, in turn, can be quantified.
• The first factor, Americans’ performance reviews of Obama, can be measured through his approval ratings.
• The second factor, economic performance, can be measured through statistics like G.D.P.
• The third factor — essentially, the ideological positioning of the Republican candidate — is sometimes thought of as an “intangible.” But it can be measured too, and it matters a great deal.
As we get closer to the election and more data become available, we can indulge — even encourage! — greater complexity in the analysis. Figuring out how Obama is performing in individual states and how this translates to the Electoral College, for instance, requires a fair amount of attention to detail. But it is premature to do that now. Instead we should think big, and focus on the three fundamentals.
November 3, 2011
Jobless Claims Drop Below 400k
Initial jobless claims dipped below the 400,000 mark last week, signaling that the odds of a new recession aren't rising and may very well be falling. New claims for unemployment benefits dipped to a seasonally adjusted 397,000 last week. That's the lowest since touching 395,000 for the week through September 24. Yes, we've seen this movie before only to get burned with letting optimism carry us away. But a bit of good news never hurts these days and so we'll take a bit of statistical sunshine wherever (and whenever) we can get it.
The key takeaway with today's update is recognizing that recessions don't usually arrive with falling levels of initial claims, which is one of the more reliable leading indicators of the business. Yes, such statements come with all the usual caveats and so no one can fully dismiss the possibility that it's different this time. Leaving that hazard aside, however, leaves plenty of room for thinking that initial claims are again moving toward a healthier trend. It's all the more compelling when we look at claims in context with several other economic trends, such as the persistent strength in retail sales on a year-over-year basis.
Nonetheless, let's also be mindful of the noise that muddies the numbers for initial claims in the short run. That inspires looking at the annual pace, which allows us to dispense with the seasonal adjustment. Reviewing the trend through that prism reveals that the discouraging upward bias of late has taken a breather. It's too soon to say if we'll see more of it, but the possibility certainly looks somewhat stronger today. Plugging in last week's update into the chart below shows a healthy drop in the annual change of fresh claims. An encouraging sign, but one that needs more time to evolve. This, after all, may be yet another head fake.
But if the annual pace of new claims continues to recede, so too do the estimated odds that we'll suffer a new recession in the near term. But it's debatable if in fact that's a reasonable view at this point. The best we can say for sure at the moment is that the annual change in new claims is no longer rising. Perhaps the next few weeks will offer stronger evidence for arguing that the trend is falling. Last week's update seems to be leaning in that direction. Yesterday's ADP Employment Report for October hints at no less, which suggests that tomorrow's employment report from the Labor Department will offer another batch of moderately satisfying numbers.
“The trend remains very constructive,” opines Eric Green, chief market economist at TD Securities. “It’s back below 400,000, which seems to be the pivot point in terms of a strengthening labor market as opposed to a weakening one.”
The Federal Reserve yesterday told us what we already suspected was coming. Economic growth will remain sluggish, according to the Fed's new core projection. Real GDP for all of 2011 will rise by 1.6% to 1.7%, the central bank predicts, down from its June estimate of 2.7% to 2.9%. Next year's real GDP is expected to deliver slightly better results in the 2.5% to 2.9% range, but that estimate has also been trimmed from June's 3.3% to 3.7% guess.
The dysfunction of the U.S. economy, in other words, will be with us for the foreseeable future, If there's anyone left who doesn't understand this discouraging outlook, Bernanke set the record straight once again in yesterday's post-FOMC press conference.
True to form in these troubled times, the Treasury market's inflation outlook still waxes and wanes with the crowd's expectations for the macro trend. Or does the causality flow the other way? In any case, it's no surprise that the recent rally in the stock market coincided with a pop in the market's inflation expectations, as implied by the yield spread on the nominal 10-year Treasury Note less its inflation-indexed counterpart. (For some background on why inflation expectations and the stock market are joined at the hip these days, see my post here.) As of yesterday, Treasuries' inflation prediction settled at just over 2.0%, up from the recent low of 1.72% on September 22. Since that date, the stock market (S&P 500) has rallied 9.6% through yesterday. The prospects of higher inflation remain tightly linked with expectations for growth. That's abnormal, but for the foreseeable future it's likely that this abnormality has legs.
It's also a relationship that offers some empirical support for the market monetarists and their recommendation for targeting higher levels of nominal GDP as a better mandate for monetary policy. But if the Federal Reserve is entertaining the concept, it wasn't obvious in Bernanke's press conference yesterday. Then again, maybe an artful reading between the lines suggests otherwise. "Bernanke’s no idiot," writes Scott Sumner, an unofficial leader of the market monetarist camp. "I have to assume he privately favors more stimulus, and is considering options for December or January. And I think he’s counting down the days until the new crop of regional Fed presidents comes on to the FOMC, and wondering why Obama left 2 Board seats empty."
Perhaps, but talk is cheap. Expectations, on the other hand, remain dominant, and for compelling reasons, as economist David Beckworth recently discussed. By that standard, the outlook remains precarious. The 10-year Note's inflation outlook is higher, but just barely. For the moment, it's easier to make the case that gravity is still in control of the trend this year for inflation expectations. Perhaps the recent pop in expectations heralds a new era, but that looks unlikely with the 10-year TIPS yield turning slightly negative in recent days.
Once you factor in the ongoing turmoil in Europe, well, it requires a potent strain of optimism to see a material change on the upside for growth and a fall in the forces of disinflation/deflation. Meantime, Bernanke stands at the ready. "We are prepared to take further action," he said yesterday. "We've already taken quite a bit of action but we are prepared to do more and we have the tools to do more if that's appropriate."
By some accounts, it's appropriate NOW. But this is by no means a universal view. If inflation expectations take another tumble, however, Bernanke's hand may be forced no matter the political repercussions.
November 2, 2011
Every monthly employment report is crucial these days, but Friday's update may be the first among equals. When we last checked in with the nation's payrolls report, there was a collective sigh of relief that private-sector job creation avoided a descent into darkness in August. A repeat performance is essential if there's any hope for sidestepping a new recession.
Some argue that an economy that's merely bumbling along is at higher risk stalling. But one could just as easily argue that when you're already on your knees, you're closer to the ground and so the chances of falling are diminished, or that the fall (should it come) will be mild. For those who agree, the diminished state of housing is a key factor. Residential real estate isn't helping the forces of recovery, but no longer is it a threat to dragging us over the cliff.
One hint of things to come on Friday suggests that there's still forward momentum in the labor market, but just barely. Job creation is still sluggish among small companies, according to the latest update from the Intuit Small Business Employment Index. The latest readings imply a sluggish annual growth rate of 1.7% for October. Or is that a rounding error?
Later today comes word of the ADP Employment Report for October. The consensus forecast via Briefing.com calls for a modest rise of 100,000 new jobs, or slightly higher than last 91,000 gain, which is roughly what economists overall are expecting for Friday's employment update from the government.
If that forecast holds up, it's just enough to keep hope alive that a new recession can be avoided. But that's about as far as it goes. There's not much confidence that the economy will break free of its sluggish state any time soon. Radical optimists have been reduced to thinking the fourth quarter won't suffer the start of a new recession. On Friday we'll have a better reading on whether such notions are the stuff of dreams.
Update: Private-sector employment rose 110,000 last month vs. September, according to today's ADP Employment Report for October. That's roughly in line with expectations, although it represents a small dip from September's upwardly revised 116,000 gain. Nonetheless, here's one more data point for thinking that Friday's jobs report from the Labor Department will deliver more of the same: a modest dose of job creation. One dark spot, however, is that today's ADP report shows that all of last month's rise in private sector employment came from the services sector. Manufacturing employment slipped last month, as it did in September.
November 1, 2011
The Pessimism Of Economics Bloggers
"Economics bloggers seem the most pessimistic in their outlook on the U.S. economy so far for 2011," according to the Kauffman Foundation's latest quarterly survey of 200 economics bloggers, including the views of yours truly. According to the report, 96% of the bloggers polled think overall economic conditions are "mixed, facing recession, or in recession."
Taking a closer look at the numbers, those in the mixed camp constitute 55% of the respondents, with another 25% saying that the economy is facing a new recession and another 16% predicting the economy is weak and already in a downturn. Suffice to say, economics bloggers are in a dour mood.
Now for the $64,000 question: Is this pessimism a contrarian indicator? Stay tuned for the answer...
Major Asset Classes | Oct 31, 2011 | Performance Update
October was a month of renewal. After sharp losses virtually across the board in September, last month witnessed a healthy dose of the opposite. But in a sign of the times, the last day of October suffered a heavy bout of selling in risky assets amid new fears that the crisis in Europe rolls on. The red ink is spilling anew this morning as I write. For a brief, shining moment, however, it looked like there was a light at the end of the tunnel. But last month is suddenly so yesterday.
As for October, the numbers were certainly encouraging, with REITs leading the way on a 14.4% surge—the best month for the MSCI REIT Index since April 2009. There was no shortage of potent gains elsewhere. U.S. stocks (Russell 3000), for instance, soared 11.5%, delivering the best monthly return since 1987. Surprised? The rebound in stocks shouldn't come as a total shock. As I noted in the September review of asset class returns, equities had been down for five months straight at that point and there was only minimal precedent for six consecutive months of losses.
But ours is still a world struggling with debt and sluggish growth and so no one has much confidence that yesterday is a prelude to tomorrow. Volatility seems to be the only constant for the moment. In short, more of the same. October's stellar returns are already old news. It's anyone's guess what November will bring. Of course, we'll always have Paris (and October 2011).
Australia Rethinks Inflation Worries
Bloomberg reports: "Australia’s central bank lowered its benchmark interest rate today for the first time since April 2009 as inflation eases and weaker global growth threatens to slow the nation’s resource-driven economy." The Reserve Bank of Australia cut its benchmark rate by 25 basis points to 4.5%.
Recall that Australia was among the first central banks to start raising interest rates after the financial crisis of 2008. The country still has one of the highest rates in the developed world. But at a time when the rich world is struggling with debt and sluggish growth, inflation fears aren't nearly as strong as the hawks predicted. The Reserve Bank of Australia explains:Trade performance, however, is starting to see some effects of a significant slowing in economic activity in Europe, where the prospects are for economic weakness to continue. Commodity prices, while still at high levels, have generally declined over recent months... After underlying inflation started to pick up in the first half of the year, recent information suggests the subdued demand conditions and the high exchange rate have contained inflation more recently