February 29, 2012
The Beta Investment Report | US Equity Funds (Broad) | 2.29.12
The world is awash in ETF and mutual fund research, newsletters, and commentary from every conceivable angle. But the world needs one analytical effort in this corner, albeit with a specific focus. What’s been missing is a regular update of low-cost, index fund proxies of the major asset classes. For strategic-minded investors looking to build and manage multi-asset class portfolios, the choices are overwhelming. Yes, there are many, many possibilities for combing through the list. But for those of us who want a short list that cuts to the chase, the menu of options is limited for finding good choices fast. With that in mind, today I’m launching a semi-regular series of updates on the short list of products within a given asset class, beginning with broad-minded U.S. equity funds.
In the table below is a list of index mutual funds and ETFs that are arguably the leading choices for tapping the broad U.S. stock market beta via conventional market-cap weight designs. In a future post, I’ll review funds that weight stocks by alternative rules, i.e., something other than market cap. I’ll also be looking at other asset classes as well, one by one, in the weeks and months to come. In time, I'll peruse the choices in domestic bonds, foreign bonds, commodities, REITs, and so on--one at a time. In addition, I’ll eventually be archiving these fund lists for easy retrieval in one section on this site. Meantime, let’s start by reviewing the products that seek to replicate a broad definition of the U.S. equity market.
The first screen for the chart above is eliminating funds with expense ratios above 20 basis points. I also ignore funds that target something other than a broad, market-cap-weighted U.S. equity index. As such, there are no S&P 500 index funds, for instance, which effectively are large-cap products. In other words, I’m looking only at single-fund solutions that satisfy a core domestic equity position that seeks out an expansive definition of stocks. For mutual funds, initial investment minimums can be no higher than $5,000 and the products must be available to the general public.
My first choice is the Vanguard Total Stock Market ETF (VTI). The combination of a low expense ratio (just 7 basis points) and deep liquidity (2 million-plus shares trade each day on average) make VTI a tough fund to beat as a core holding. The fact that it also posts the highest performance for the past three years among its competitors in the table above doesn’t hurt either.
U.S. equity allocations are likely to be among the single-biggest stake for many domestic investors over the long haul. As such, there’s a strong case for going the extra mile in reducing the drag from fees in this corner of the portfolio. The good news is that the opportunities for minimizing expenses (i.e., raising net return) are second to none in the U.S. equity space. It wasn’t all that long ago that the expense ratios of 10 basis points were available only for large institutional investors. Now, low-cost investing in the extreme is available to everyone.
A low expense ratio by itself, much less in one corner of a multi-asset class portfolio, won’t bring miracle results, of course. On that note, ETF investors should be mindful of funds with low trading volumes. And for ETFs and mutual funds in general, a perennially low asset base may be a warning sign that the product isn’t long for this world.
Meantime, strategic-minded investors will need every benefit they can muster in the years ahead. The tailwind of unusually high beta returns will be rare for the foreseeable future, in my view. One way to keep this modest outlook from biting too deeply is by squeezing costs. Every basis point saved is a basis point earned. It doesn’t mean much for one or two fund choices, but if we remain vigilant on expenses across the portfolio, the net savings will be more than trivial over time. Taking full advantage of low-cost U.S. equity beta is a substantial down payment on exploiting that advantage.
Strategic Briefing | 2.29.12 | Politics & Economic Stimulus
Stimulus Is Maligned, but Options Were Few
The New York Times | Feb 29
Britain — which has its own currency and enjoys low interest rates — offers perhaps the best parallel to the United States. In 2010 the coalition government of David Cameron came into office promising to undo the stimulus policies of its predecessor. It cut spending across the board, asking government departments to slash budgets by 25 to 40 percent. And it shot Britain’s incipient economic recovery in the foot. By the end of last year the British economy was still 4 percent smaller than it was before the recession started four years earlier. And it is expected to contract a little more this year. Even after budget cuts, the government’s debt is bigger, compared with the size of the economy, than when Mr. Cameron took office. By comparison, despite criticism of its size and composition by both the right and the left, the stimulus by the Obama administration did add to jobs and growth. The nonpartisan Congressional Budget Office estimates it will have contributed at least 1.6 million jobs and perhaps as many as 8.4 million by 2013.
Partisans ignoring stimulus’s success
Juan Williams (The Hill) | Feb 27
The upcoming presidential election is likely to be a debate about the value of the stimulus.
Auto Bailout Now Backed, Stimulus Divisive
Pew Research Center | Feb 23
Public support for government loans to major U.S. automakers are viewed more positively today than in the fall of 2009, but there has been less change in opinions about other major economic policies such as the federal loans to banks and financial institutions during the 2008 financial crisis and President Obama's economic stimulus plan.
The stimulus plan that Romney forgot
Salon | Feb 27
As governor, Romney proposed more than $700 million in economic stimulus in a pair of packages over three years to right a sickly state economy that shed thousands of jobs before he took office, including offering to hand employers $30,000 for each worker they hired, even though he now bashes his Republican and Democratic foes over wasteful government spending.
The Secret Romer Stimulus Memo
Jonathan Chait (New York Magazine) | Feb 22
The largest question looming over Barack Obama’s presidency is what would have happened if he tried to push for a larger economic stimulus at the outset. Could he have gotten it passed? Did he think his plan was truly big enough, or just the biggest one he could pass? In answer to that question, Noam Scheiber has acquired a major piece of the puzzle. While reporting his new book, The Escape Artists, which chronicles the administration’s response to the crisis, he got his hands on the fabled original version of Obama's economic team's 2008 memo, sort of the economic policy equivalent of the Blade Runner original cut. In the first version, Romer argues that a $1.8 trillion stimulus would be needed to fill in the anticipated output gap (which, in any case, turned out to be larger than anybody knew at the time.) But Larry Summers considered that figure unrealistically high — they would be laughed at by the political team — so the memo that reached Obama’s desk described an $850 billion stimulus as the largest possible option.
Third-Year Anniversary of $787B Stimulus Scores a Grave Milestone
The New American | Feb 21
Last Friday marked the third-year anniversary of President Obama’s $787-billion economic "stimulus" law — and it scored a rather grim milestone: The unemployment rate held steady above eight percent for 36 months, the longest period since World War II. In fact, according to the Bureau of Labor Statistics, the current 8.3-percent unemployment rate is precisely where it stood three years ago when the legislation, called the American Recovery and Reinvestment Act (ARRA), was signed into law. The previous record for above-8-percent unemployment was 27 months, which transpired in the early 1980s.
Fact-Checking the Fact Checkers: Mitt Romney, President Obama, and the Stimulus
Peter Suderman (Reason) | Feb 21
The Washington Post’s Fact Checker column takes Mitt Romney to task for claiming that “three years ago, a newly elected President Obama told America that if Congress approved his plan to borrow nearly a trillion dollars, he would hold unemployment below 8 percent.” After all, it wasn’t President Obama who said this, but his economic advisers, and they didn’t even know that we actually needed roughly a zillion times more stimulus! Here’s the Post:
Far from being anything that Obama said, the Romney campaign acknowledges that this 8 percent figure comes from a staff-written projection issued Jan. 9, 2009 — before Obama had taken the oath of office.
…Romer, after she left the White House in 2010, said that the estimate of the impact of the stimulus bill was accurate but that the 8 percent “prediction was so far off” because economic conditions were so much worse.
“We, like virtually every other forecaster, failed to anticipate just how violent the recession would be in the absence of policy, and the degree to which the usual relationship between GDP [gross domestic product] and unemployment would break down,” Romer said.
The bottom line? The Bernstein-Romer report “was not an official government assessment or even an analysis of an actual plan that had passed Congress.” Three Pinocchios!
Stimulus and Etiquette
Professor John Cochrane (The Grumpy Economist) | Jan 19
Stimulus still an economically interesting proposition, and there is a great deal of uncertainty about whether, when, and how well it might work. There is a huge academic literature being produced right now, as typically happens after any event makes the news. Here are the facts. Some economic models do predict a fiscal stimulus effect. Some don't. Some of those models have huge holes in them (the standard IS LM model, which even Krugman admits is "ad hoc"). Some don't. The rather mysterious "New Keynesian" stimulus models could use a lot of investigation (More in an upcoming post.) Even if stimulus works, when and for how long? A lot of models give more stimulus when interest rates are stuck at zero. But many advocates, like Krugman and Delong, want more government spending even for times and for countries (Greece) with high interest rates. Surely too much spending eventually leads to debt crises or strangling taxation, but when? (Then, advocates usually want inflation and devaluation, but that has a limit as well.) The facts are far from decisive. The right says: "The government spent like a drunken sailor and we still had an awful recession. Stimulus Failed" The left says "It would have been way worse without the stimulus." History does not paint a clear picture either. GDP rose a lot along with Government spending at the beginning of WWII. GDP didn't fall like a stone at the end of WWII. Economists are producing hundreds of papers and volumes of studies for us to sort through, which I'll review in the future, but cause and effect will always be hard to tease out in economics.
Survey of Economists On Effect Of Stimulus On Unemployment
Booth School of Business at the University of Chicago | Feb 15
February 28, 2012
Durable Goods Orders Dropped Sharply Last Month
New orders for durable goods tumbled in January, falling 4.0%, the U.S. Census Bureau reports. That’s the biggest monthly decline in three years and it’s sure to spark a new round of heated debate about what happens next for the economy. Nonetheless, it’s premature to use today’s numbers to argue that the economy’s destined for the skids. Indeed, the annual trend for new orders is still solidly in the black as is the year-over-year pace for business investment (non-defense capital goods ex-aircraft orders).
It’s true that the annual rate of change for both measures of new orders has been slowing, but that’s not necessarily fatal, at least not yet. It’s debatable if the decelerating pace is part of the economy’s transition from post-recession rebound to something closer to a normal expansion. It was always inevitable that the 15%-to-20% year-over-year increases posted in early 2010 were destined to fall. The question is whether the slower rate of annual growth is signaling trouble ahead? Yes, if the deceleration rolls on. For now, however, the latest numbers—new durable goods orders growing at 8% a year and business investment spending rising by 6%--are still quite strong.
"We see no evidence of underlying slowing in the industrial economy so we look for a rebound in February and the re-emergence of the upward trend over the next couple of months," predicts Ian Shepherdson, chief economist at High Frequency Economics.
But some analysts beg to differ. "What we are seeing is that that the buildup of inventory that made third quarter GDP so strong is beginning to crest," warns FTN Financial's chief economist, Christopher Low. "We are seeing a slowdown in domestic demand for equipment and also slower overseas demand. The three-month average and year-over-year increases are falling due primarily to weaker overseas demand."
If January's durable goods report is a harbinger of darker things to come, we might see additional evidence in the February numbers. But if we're headed for a rougher period of economic updates, it's not obvious in the early clues for this month based on the manufacturing surveys published by the regional Fed banks so far. As I noted earlier today, four reports of regional manufacturing activity reflects ongoing expansion. In addition, the Richmond Fed just released its survey and the news is upbeat here as well: "Manufacturing activity in the central Atlantic region advanced for the third straight month, according to the Richmond Fed's latest survey," the bank reports.
The next reading on February manufacturing activity arrives on Thursday, when the widely watched ISM Manufacturing Index is released. The consensus forecast sees a slight rise for this proxy of national economic activity, according to Briefing.com. Nothing less is required for thinking that the January slump in durable goods orders isn't as ominous as it appears.
Four Regional Fed Banks Report Economic Growth In February
Early clues about February’s economic activity via several regional Federal Reserve banks suggest that growth prevails. Month to date, four regional banks have released manufacturing activity updates for February and in all four cases the numbers show improvement. That suggests that the rest of this week’s economic news on manufacturing will bring more statistical encouragement. Later today, the Richmond Fed will release its update of manufacturing activity and the January summary of durable goods orders for the U.S. arrives. Tomorrow we’ll learn the latest for the ISM-Chicago Business Barometer and on Thursday the ISM Manufacturing Index for February hits the streets, offering the first broad look at the U.S. activity for the month. Meantime, the four regional Fed surveys available at the moment suggest that February overall is shaping up to be another month for expansion. Here’s a brief look at each of the four regional Fed reports released so far based on the accompanying press releases:
Empire State Manufacturing Survey (New York):
The February Empire State Manufacturing Survey indicates that manufacturing activity in New York State expanded for a third consecutive month. The general business conditions index rose six points to 19.5, its highest level in more than a year. The new orders index, at 9.7, was positive but down slightly, and the shipments index was little changed at 22.8. The prices paid index held steady at 25.9, while the prices received index fell eight points to 15.3, suggesting that selling prices rose at a slower pace. Employment indexes were positive and close to last month’s levels, indicating that employment levels and the average workweek continued to rise at a modest pace. Indexes for the six month outlook, while somewhat lower than last month, remained at fairly high levels, signaling considerable optimism about the future.
Philadelphia Fed Survey
Responses from manufacturing firms polled for this month’s Business Outlook Survey suggest that regional manufacturing activity continued to expand in February. The survey’s broad indicators for general activity, new orders, and shipments all increased from their readings in January. Firms reported near‐steady employment levels but an increase in average work hours. More firms reported higher input prices this month, and a sizable share of firms reported price increases for their own manufactured goods. The survey’s broad indicators of future activity fell from levels in recent months but continue to reflect optimism about future manufacturing growth.
Kansas City Fed Manufacturing Index
The Federal Reserve Bank of Kansas City released the February Manufacturing Survey today. According to Chad Wilkerson, vice president and economist at the Federal Reserve Bank of Kansas City, the survey revealed that Tenth District manufacturing activity increased further in February, and expectations also climbed higher. “Factories further ramped up activity in February and – despite a drop off in export orders – were more optimistic about future output and hiring than at any time in the past year,” said Wilkerson.
Dallas Fed Manufacturing Survey
Texas factory activity continued to increase in February, according to business executives responding to the Texas Manufacturing Outlook Survey. The production index, a key measure of state manufacturing conditions, rose from 5.8 to 11.2, suggesting a pickup in the pace of growth. Other measures of current manufacturing conditions also indicated expansion in February. The new orders index was positive for a second month in a row but fell from 9.5 to 5.8. Similarly, the shipments index moved down from 6.1 to 4.2. Capacity utilization increased further in February; the index edged up from 8.5 to 10.
February 27, 2012
In Search Of Smoking Guns
Lakshman Achuthan of the Economic Cycle Research Institute reaffirmed his recession forecast from last September, telling CNBC that “our call stands.” He emphasized that “when you look at the hard data that is used to officially date business cycle recessions, it has been getting worse, not better, despite what the consensus view of an improving economy has been.”
Achuthan emphasizes that several key indicators have been posting slowing annual rates of growth recently. For example, he notes that industrial production’s year-over-year pace was at a 22-month low last month. Personal income growth and the broadest measures of sales are also suffering from declining rates of growth on an annual basis.
He’s right, of course. Disposable personal income’s (DPI) growth has been slowing for nearly two years and the trend surely raising warning flags, as I noted with the update of the December and November data. Industrial production’s slowing growth rate is less pronounced. But as I also wrote earlier this month, after looking at the January report on this series, industrial production increased 3.4% over the previous 12 months, which still compared favorably relative to the rates of growth before the Great Recession hit.
Nonetheless, if the trends in personal income, industrial production, and other crucial economic metrics continue to decelerate, the odds increase that a new recession is approaching. But if that’s fate, it’s not yet an open-and-shut case. There is still an array of strong signals from other corners of the economy, starting with the labor market.
The persistent fall in initial jobless claims, which has pulled the series down to a four-year low as of last week, is a strong signal that the job creation will roll on. History suggests that new recessions don’t begin when new claims are falling by 10% a year, as they have been lately, and private payrolls are advancing by 2%-plus on a year-over-year basis as of last month. This is no trivial issue. If job growth continues to pick up, as it did in January, the trend can help heal the trouble brewing in the personal income data. Indeed, in the chart below, the declining year-over-year percentage change in new claims (green line) looks encouraging and surely represents a strong bit of support for thinking positively.
On the other hand, if the labor market stumbles, recession risk will rise. For the moment, however, the jury’s out, and it still leans toward moderate optimism. Indeed, a broad measure of economic activity via the Chicago Fed National Activity Index isn’t warning of recession. Meanwhile, the Conference Board’s leading index is signaling growth ahead. Maybe it’ll all come apart in the weeks and months ahead, but maybe not. Maybe rising gasoline prices will derail the recovery. Then again, maybe the healing process in the real estate market will throw us a cyclical bone and energy prices will head lower in the months ahead.
Nobody really knows what’s coming. But if there’s truly a recession coming, it’ll soon be clear in the numbers. For now, however, you can still make a case for growth.
February 25, 2012
Book Bits For Saturday: 2.25.2012
● The Oil Curse: How Petroleum Wealth Shapes the Development of Nations
By Michael L. Ross
Summary via publisher, Princeton University Press
Countries that are rich in petroleum have less democracy, less economic stability, and more frequent civil wars than countries without oil. What explains this oil curse? And can it be fixed? In this groundbreaking analysis, Michael L. Ross looks at how developing nations are shaped by their mineral wealth--and how they can turn oil from a curse into a blessing. Ross traces the oil curse to the upheaval of the 1970s, when oil prices soared and governments across the developing world seized control of their countries' oil industries. Before nationalization, the oil-rich countries looked much like the rest of the world; today, they are 50 percent more likely to be ruled by autocrats--and twice as likely to descend into civil war--than countries without oil. The Oil Curse shows why oil wealth typically creates less economic growth than it should; why it produces jobs for men but not women; and why it creates more problems in poor states than in rich ones. It also warns that the global thirst for petroleum is causing companies to drill in increasingly poor nations, which could further spread the oil curse.
● The Wrong Answer Faster: The Inside Story of Making the Machine that Trades Trillions
By Michael Goodkin
Summary via publisher, Wiley
In 1968, Michael Goodkin is about to graduate from Columbia University. While his classmates interview for jobs, he daydreams of seeing the world as a man of independent means. Noticing that there are no computers on Wall Street and drawing on his experiences as a failed teenage investor and successful gambler, he has an epiphany: since no one knows the right price for anything, the only way to beat the market is to make a computer that comes up with the wrong answer faster than the professionals. And thus begins a journey that takes this provincial Midwesterner from nearly broke to opulent Park Avenue. The Wrong Answer Faster is the story of unintended consequences: how a technique originally created to minimize market risk spiraled into a multi-trillion dollar game with unparalleled risks. Having founded and sold a firm that changed the world, Goodkin left New York to travel and play backgammon—only to return to found another groundbreaking firm, Numerix, a software company that substituted computational physics for econometrics to better manage derivative risk.
● The Oxford Handbook of Quantitative Asset Management
Edited by Bernd Scherer and Kenneth Winston
Summary via publisher, Oxford University Press
Quantitative portfolio management has become a highly specialized discipline. Computing power and software improvements have advanced the field to a level that would not have been thinkable when Harry Markowitz began the modern era of quantitative portfolio management in 1952. In addition to raw computing power, major advances in financial economics and econometrics have shaped academia and the financial industry over the last 60 years. While the idea of a general theory of finance is still only a distant hope, asset managers now have tools in the financial engineering kit that address specific problems in their industry. The Oxford Handbook of Quantitative Asset Management consists of seven sections that explore major themes in current theoretical and practical use. These themes span all aspects of a modern quantitative investment organization. Contributions from academics and practitioners working in leading investment management organizations bring together the key theoretical and practical aspects of the field to provide a comprehensive overview of the major developments in the area.
● Encyclopedia of Municipal Bonds: A Reference Guide to Market Events, Structures, Dynamics, and Investment Knowledge
By Joe Mysak
Summary via publisher, Wiley
Until now, there has been no accessible encyclopedia, dictionary, nor guide to the world of municipal bonds. Comprehensive and objective, this groundbreaking volume covers the history and mechanics of the municipal market in clear and understandable terms. It covers all aspects of the market, including pricing, trading, taxation issues and yields, as well as topical events such as the financial crisis, hysteria about defaults and Chapter 9 municipal bankruptcy, fraud, and regulation.
● Fixing the Housing Market: Financial Innovations for the Future
By Franklin Allen, James R. Barth, Glenn Yago
Summary via publisher, FT Press, and interview with authors via Milken Institute
Ever since the ancient Greeks, financial innovation has enabled more people to purchase homes. Today is no different: in fact, responsible financial innovation is now the best tool available for "rebooting" crippled housing markets, improving their efficiency, and making housing more accessible to millions. In Fixing the Housing Market, three leading experts explain how, covering everything decision-makers should know about today’s housing and financial markets.
February 24, 2012
Inflation Expectations & Stocks Still Moving In Lockstep
The new abnormal is alive and well, or so it appears. Exhibit A: the stock market and inflation expectations remain joined at the hip. As the crowd anticipates higher inflation, the stock market rallies, and vice versa. This won’t last forever, and earlier this month I wondered if the new abnormal was on its last legs. But for the moment, at least, reports of this relationship’s demise are premature.
Consider the market’s inflation forecast (the yield spread for the nominal 10-year Treasury less its inflation-indexed counterpart) and prices for the S&P 500. Both have been rising steadily over the past month. The stock market has regained all it lost in last year’s selloff and the 10-year Treasury market’s inflation forecast has climbed to 2.3%, the highest since last August.
It’s anyone’s guess when the positive correlation between inflation and stock prices (a proxy for the economic outlook) will end. My guess is that when the crowd believes that economic growth is sustainable without extraordinary support from the central bank, the new abnormal will fade. At that point, inflation expectations and the stock market will go their separate ways, which is the historical norm. But there’s no sign of a break yet, which implies that investors remain wary of the economic outlook, despite the good news of late.
February 23, 2012
More Awkward Questions For Advocates Of The Gold Standard
“The key point which bears repeating again and again is that under a gold standard, there is no assurance that the value of money will be stable in the absence of action taken by the monetary authorities to maintain its value,” Glasner writes.
If a gold standard were to be restored, I have no idea how the demand for gold would be affected. The value of gold (in the short to intermediate run and perhaps even the long run) depends, more than anything, on the demand for gold. Gold is now a speculative asset; people hold gold now because they for some reason (unfathomable to me) believe that it will appreciate over time. If the value of gold were fixed in nominal terms by way of a gold standard, would people continue to demand gold in anticipation that its price would rise? Perhaps, but I don’t think so. And what do supporters of the gold standard believe that governments and monetary authorities, which now hold about almost 20% of existing gold stocks, believe ought to be done with those reserves? Do they think that governments and public agencies ought to continue to hold gold simply to stabilize the value of gold? Is that how the free market is supposed to determine the value of money?
Jobless Claims Flat Last Week At 4-Year Low
Today’s initial jobless claims report is a yawn with last week’s new filings for unemployment benefits showing no change from the previous week’s total, which was revised upward slightly. But the latest numbers don’t provide any reason to question the persistence in the recent decline for this series. The unchanged 351,000 seasonally adjusted total for new claims last week is still the lowest since early 2008.
As recently as last month, claims were over the 400,000 mark. The fact that the latest update remains lower by 50,000 implies that the labor market will continue growing. In turn, that suggests that growth still has an edge for the broader economy.
"The strength we’ve had in the last few months is continuing," says Guy Berger, an economist at RBS Securities. "Barring any surprises, February looks like another good month for payroll growth." Omer Esiner, a market analyst at Commonwealth Foreign Exchange, agrees, noting that today's claims report is "broadly in line with recent U.S. data showing a gradually improving economic backdrop."
Yesterday's data point on residential real estate offers some fresh support for thinking positively: existing home sales rose last month and housing inventory continued to fall, the National Association of Realtors reports. The news bolsters the case for expecting more from housing in months ahead and pondering the possibility that housing has finally bottomed. Tomorrow's update on new home sales is expected to bring a bit more good news on this front with the consensus forecast calling for another modest rise, according to Briefing.com.
Here's how the economics group at Wells Fargo interprets the latest housing data via its Feb. 22 update:
"Existing Home Sales Remain Strong"
"Inventory Levels Continue to Fall"
No one argues that the housing recovery—if in fact it is it is a genuine recovery—is the answer to all the economy's cyclical ills. But if housing is no longer a dead weight, there's one more reason to think that growth can survive. Some estimates peg housing's contribution to GDP as high as 18%, which implies that if this sector is no longer part of the problem (even if it's not yet part of the solution) the demons of contraction will loosen their grip on the cycle's throat.
The true test, of course, is the labor market, on which so much still depends. Initial jobless claims continue to drop bullish clues, as does the broad trend, as suggested by the moderate revival in the Chicago Fed National Activity Index. The potential for a stronger dose of optimism arrives on March 9 with the scheduled release of the February payrolls data. Meanwhile, steady as she goes.
Granted, Europe's recession is a joker in the deck that could derail the trend. The same can be said for rising energy prices. But Europe's downturn may turn out to be "mild and temporary." As for energy, well, Iran is still the wild card and there's always reason to wonder what comes next.
February 22, 2012
Volatility & Asset Allocation
Earlier this month I wrote about the upcoming launch of two foreign bond index funds from Vanguard—the firm’s first step into the market for international fixed-income products. Foreign bond funds are nothing new these days, although the proposed Vanguard funds are a bit out of the ordinary because the portfolios will hedge foreign exchange risk. Vanguard’s reasoning is that forex hedging dampens volatility, which is true. But as I noted, volatility per se isn’t a problem in the context of a broadly diversified multi-asset class strategy. In fact, volatility can be quite helpful in that case. Although I mentioned this point briefly, the issue deserves more attention vis-a-vis rebalancing.
The basic message is that in order to capture the rebalancing bonus, a certain amount of volatility is necessary. As I noted in my book Dynamic Asset Allocation, a 1988 paper by Andre Perold and Bill Sharpe ("Dynamic Strategies for Asset Allocation," Financial Analysts Journal) outlined the standard framework for thinking about the relationship between volatility and rebalancing. Although you can forecast any outcome you prefer under specific assumptions, market history and the Perold and Sharpe paper imply that we should see volatility as productive within the environment of broad diversification across the major asset classes. Granted, there's no guarantee that rebalancing will produce higher returns vs. the same portfolio that's left untended, but the argument for not rebalancing is hardly a no-brainer either. In my view, a fair reading of the literature, along with a careful review of market history, suggests that some degree of rebalancing is useful if not essential.
A number of researchers have come to similar conclusions over the years, including a monograph (“The Rebalancing Bonus”) by the financial planner William Bernstein, who advised:
The actual return of a rebalanced portfolio usually exceeds the expected return calculated from the weighted sum of the component expected returns. A formula for estimating this excess return is derived and tested. It is demonstrated that assets with high volatility and low correlation with the remainder of the portfolio provide considerable excess return, or "rebalancing bonus."
As a simple test, consider how my proprietary index of all the major asset classes fared in recent history in three forms. One variation is the passive, unmanaged mix that’s initially set to market-value weights as of December 31, 1997 and left to drift with the market’s ebb and flow—the Global Market Index (GMI). The rebalanced version of GMI simply returns the portfolio mix to its 1997 market weights at the close of each year. Finally, the equally weighted GMI starts out with equal weights and resets to that mix at the end of every year. The chart below tracks the results of an initial $100 investment in each strategy from the end of 1997 through December 31, 2011.
It’s clear that the rebalanced and equal-weighted versions of GMI earned substantial premiums over the unmanaged GMI. In both cases, the higher return is due to rebalancing. In this simple example, the rebalancing is annual at the close of each calendar year, although in practice there’s a case for embracing a more opportunistic strategy. Meanwhile, let’s also recognize that the rebalancing bonus is dependent to a degree on volatility. Mindlessly adding assets to capture higher volatility per se isn’t wise, but if there’s an economic rationale for a given set of asset classes, and individually they exhibit relatively high volatility, intelligently managing the mix through time can pay off handsomely.
That brings us back to hedging forex risk. Yes, it’s clear that hedging reduces volatility. That may be beneficial if we’re looking at the assets in isolation, but as part of a broadly diversified portfolio it’s not obvious that keeping the volatility of the individual asset classes to a minimum is beneficial as a general rule. Indeed, depending on how you analyze the possibilities, hedging might end up taking a bite out of the rebalancing premium.
Markowitz long ago told investors that the primary focus should be on designing and managing the portfolio. That’s a message that still resonates and it reminds us not to obsess over the parts if—if—we’re embracing broad, multi-asset class diversification.
Strategic Briefing | 2.22.12 | Eurozone Economics
European shares slip on euro zone recession worries
Reuters | Feb 22
The euro zone's service sector shrank unexpectedly this month, reviving fears that the economy risks sinking into recession, a business survey showed. Markit's Eurozone Services Purchasing Managers' Index (PMI) fell to 49.4 from January's 50.4, missing even the lowest forecast in a Reuters poll. Strategists said several issues remained unresolved after the Greek bailout deal. "There are still some big questions: does Greece have enough money even now after the second bailout? Can they generate the growth required?" asked Henk Potts, equity strategist at Barclays Wealth, though he noted other factors would limit the downside for equities. "In general terms, there has been a more positive feel to markets since the start of the year. The euro zone crisis has been helped by recent measures. The U.S. (economy) is gaining momentum."
Euro-Area Manufacturing, Services Contract
Bloomberg | Feb 22
European services and manufacturing output unexpectedly shrank in February as the euro-area economy struggles to rebound from a contraction in the fourth quarter. A euro-area composite index based on a survey of purchasing managers in both industries dropped to 49.7 from 50.4 in January, London-based Markit Economics said in an initial estimate released by e-mail today. Economists had forecast a reading of 50.5, according to the median of 16 estimates in a Bloomberg News survey. A reading below 50 indicates contraction.
Euro-Zone Business Activity Shrinks Unexpectedly
The Wall Street Journal | Feb 22
"The euro zone is far from out of the economic woods and faces a hard slog to get back to sustained growth," said Howard Archer, economist at IHS Global Insight, a forecasting group. "Indeed, the surveys reinforce our belief that it is more likely than not that the euro zone will suffer a further contraction in the first quarter of 2012 which will put it back into recession," he said. The euro-zone economy shrank by 0.3% in the last three months of 2011. A recession is defined as two straight quarters of falling output.
Europe's debt crisis set to dominate G20 talks
Reuters | Feb 22
Europe's debt crisis will dominate talks between Group of 20 (G20) policymakers this weekend as the rest of the world looks for pledges that the euro zone will boost its crisis safety net. Advanced and developing nations alike are keen for reassurances that the European Union will do whatever it takes to limit fallout from the crisis and convincing answers could help officials inch closer to boosting the firepower of the International Monetary Fund (IMF) so it can better help victims.
Recession has Portugal urging citizens to leave to find work
USA Today | Feb 21
For nearly 600 years, Portugal had one of the greatest colonial empires in Europe, commanding trade centers in Africa, South America and China. Now, laid low by recession, Portugal is telling citizens to head to former colonies where Portuguese is spoken, such as Brazil and Macau, to find work. "Recent graduates should lead a new type of emigration, different from the 1960s, when Europe was the destination," Minister for Parliamentary Affairs Miguel Relvas said recently. "In the past 20 years, Portugal has invested in a generation of people, and now we can't give them what they need: employment."
Greece bailout wards off Europe meltdown
AP | Feb 21
The bailout has saved Europe, for now, but it's unlikely to save Greece. The euro130 billion ($172 billion) rescue - agreed to Tuesday after an all-night summit of European ministers - prevented an uncontrolled bankrupcty and calmed investors worried that a Greek default would have started a chain reaction across Europe. But it left key problems unresolved. Draconian budget cuts could keep Greece mired in recession after five straight years. The deal doesn't directly address the debt problems in other struggling countries in the 17-country zone that uses the euro. Spending cuts could reduce tax revenue and possibly worsen the government's finances. "You can't shrink your way out of a recession," said Mark Weisbrot, co-director of the liberal Center for Economic and Policy Research in Washington. "What they are doing to Greece really makes no economic sense."
February 21, 2012
Chicago Fed Nat'l Activity Index Is Positive For 2nd Straight Month
For the first time in a year, the Chicago Fed National Activity Index (CFNAI)—a broad measure of the U.S. economy—posted a positive reading for the second month in a row. Nonetheless, the pace slowed, with CFNAI slipping to +0.22 for January from December’s +0.54. Meanwhile, the three-month moving average (CFNAI-MA3) rose slightly to +0.14 last month, up from +0.06 in December, which the Chicago Fed advises is a sign "that growth in national economic activity was slightly above its historical trend."
CFNAI is a weighted average of 85 indicators of U.S. economic activity. The Chicago Fed recommends reading its 3-month moving average (CFNAI-MA3) as follows: a value below -0.70 after a period of economic expansion "indicates an increasing likelihood that a recession has begun." By that rule, the January CFNAI-MA3 reading of +0.14 suggests that the economy will continue growing for the foreseeable future.
The bank reports that 50 of the 85 indicators made positive contributions last month, up from 48 positive contributors in December. But with gasoline prices rising, some analysts are warning that January's positive profile may be out of date. In that case, much is riding on Thursday’s weekly update on initial jobless claims (again) for a more timely reflection of economic activity. Last week’s claims number provided a fresh dose of macro optimism, although the consensus forecast doesn’t expect much of a change for Thursday’s release, according to Briefing.com. But with energy related anxiety rising, simply holding on to the recent decline in new claims may be enough to convince the crowd that the economic recovery will survive.
Will Rising Gasoline Prices Derail The Economic Recovery?
Gasoline prices are on the march once again, reaching an average price of $3.52 a gallon in the U.S. for the week of February 13, according to the Energy Information Administration. Prices have been advancing steadily since mid-December and are now at the highest level since last September. Some analysts predict that we'll see $4-a-gallon soon as a national average. If so, will the rally in fuel costs threaten the economic recovery?
“We’re always over-sensitive to the price of gasoline,” economist Chris Kuehl tells the Kansas City Star. “It just provokes consumers into total depression if the price goes up. … It’s just psychological.”
The last time gasoline prices approached the $4-a-gallon range—last April and May— the economy's momentum slowed and recession risk started climbing. Are we headed for a repeat scenario? In search of clues, let's consider how consumer spending stacks up after subtracting purchases of gasoline. The bulk of U.S. GDP is based on consumption and so there may be warning signs for the macro outlook in the trend for retail sales ex-gasoline purchases.
Gasoline station sales as a share of total retail sales were 11.2% in January, up fractionally from December. But as the chart below shows, the monthly share of gasoline sales has been trending lower since the previous peak of nearly 11.7% set last May. Nonetheless, gasoline is taking a relatively high proportion of retail consumption and so this threat to consumption can't be ignored if prices continue to climb. Nonetheless, there's still some wiggle room before we reach a tipping point. As the chart also shows, the rolling 1-year % change in retail sales ex-gasoline remains quite high, advancing 5.6% for the 12 months through January. That's a relatively strong pace, although the worry is that the recent deceleration in growth will roll on if gas prices continue climbing.
Part of the rise in gas prices comes from stronger demand, courtesy of a growing economy. But the Iranian factor is also in play these days. Fears of a temporary supply shortage are also driving up the price of crude oil. Gasoline and oil prices don’t always move in lockstep, but if there’s a new Mideast crisis brewing via Iran, it’s a safe bet that higher crude prices will spill over into gasoline.
“It’s hard to see the oil price decreasing, especially with the Iran situation, which I don’t think is going to go away anytime soon,” says Simon Wardell, senior oil analyst at IHS CERA via CNBC.
How bad will it get? Michael Lynch, president of Strategic Energy & Economic Research and a veteran observer of oil markets, thinks there’s still room for optimism. "When people talk about $5 [per] gallon, that's kind of worst-case scenario," he opines via The Chicago Tribune. "If we don't see [more] cutoffs in Iranian oil supplies, or attacks on oil shipping, we're probably close to a peak now."
February 20, 2012
Research Review | 2.20.2012 | Socially Responsible Investing
Do Socially Responsible Investment Indexes Outperform Conventional Indexes?
Shunsuke Managi (Tohoku University), et al. | Feb 2012
The question of whether more socially responsible (SR) firms outperform or underperform other conventional firms has been debated in the economic literature. In this study, using the socially responsible investment (SRI) indexes and conventional stock indexes in the US, the UK, and Japan, first and second moments of firm performance distributions are estimated based on the Markov switching model. We find two distinct regimes (bear and bull) in the SRI markets as well as the stock markets for all three countries. These regimes occur with the same timing in both types of market. No statistical difference in means and volatilities generated from the SRI indexes and conventional indexes in either region was found. Furthermore, we find strong co-movements between the two indexes in both regimes.
The Many Faces of Socially Responsible Investing - Does the Screening Mechanism Affect the Risk and Return of Mutual Funds?
Jacquelyn Humphrey and David Tan (Australian National University) | Aug 2011
We investigate whether positive or negative screening impacts the performance and risk of socially responsible mutual funds. We mimic the characteristics of mutual funds and bootstrap firm returns to form portfolios which reflect actual mutual fund holdings. We find positive screening results in increased returns, but also increased total risk and beta. We do not find support for the conjecture that positively screened firms have lower unsystematic risk. Return results from negative screening are not as clear, but we do find that increasing the number of stocks excluded from a portfolio may impede the ability to fully diversify.
Green Investment and Related Disclosures Decisions
Patrick Martin and Donald Moser (University of Pittsburgh) | Dec 2011
We use experimental markets to examine whether preferences for societal benefits lead managers to invest in unprofitable green projects, what information they disclose regarding such investments, and how investors react to those disclosures. We find that managers who are also shareholders in their company make green investments even when they know this reduces shareholder value, thereby decreasing their own and other current shareholders’ payoffs. Moreover, managers voluntarily disclose to potential investors that they have made such unprofitable green investments and tend to focus their disclosures on the societal benefits of their green investment rather than on the cost to the company. Finally, potential investors’ bids for the company reward managers and other current shareholders more when managers disclose their green investments than when they do not, and this result is stronger when managers’ disclosures focus on the societal benefits of their investment rather than on the cost to the company. These results are consistent with both managers and potential investors trading off personal wealth for societal benefits and help explain why, given the current voluntary reporting environment, company managers often focus their disclosures of environmental investments on the benefits to society and to the company rather than on the cost to the company. In addition to these specific results, our study demonstrates the benefits of using experiments to study important corporate social responsibility issues that are difficult to address using archival data.
The Performance of Socially Responsible Investment: A review of scholarly studies published 2008‐2010
Emma Sjöström (Stockholm School of Economics) | Oct 2011
This report explores whether socially responsible investment (SRI) generates higher, lower or similar risk adjusted financial return compared with conventional investment. 21 academic studies are reviewed. Seven studies conclude that SRI have similar performance relative to their conventional peers. Five studies report that SRI outperforms conventional investment. Three studies find that SRI generates inferior performance relative to its conventional peers. Finally, six studies report mixed results. We can conclude that results point in all different directions, and that there is no clear link between SRI and financial performance. Our results implicates that it would be unwise to make general statements about the performance of SRI based on only one or a few studies.
Trends in the Literature on Socially Responsible Investment: Looking for the Keys Under the Lamppost
Gunther Capelle-Blancard and Stéphanie Monjon (Université Paris) | Oct 2011
In this paper, we use online search engines and archive collections to examine the popularity of socially responsible investing (SRI) in newspapers and academic journals. A simple content analysis suggests that most of the papers on SRI focus on financial performance. This profusion of research is somewhat puzzling as most of the studies used roughly the same methodology and obtained very similar results. So, why so many studies on SRI financial performance? We argue that the academic literature on SRI is mostly data-driven: the famous “Looking for the Keys Under the Lamppost” syndrome. The question of the financial performance of the SRI funds is certainly relevant, but maybe too much attention has been paid to this issue, whereas more research is needed on a conceptual and theoretical ground, in particular the aspirations of SRI investors, the relationship between regulation and SRI, as well as the assessment of extra-financial performances.
Financial Constraints on Corporate Goodness
Harrison Hong (Princeton University), et al. | Jan 2011
We model the firm's optimal choice of capital and goodness subject to financial constraints. Managers and shareholders derive benefits over profits and social responsibility. Goodness is costly and its marginal benefit is finite; as a result, less-constrained firms spend more on goodness. We verify that less-constrained firms do indeed have higher social responsibility scores. Our empirical analysis addresses identification issues that have long plagued the corporate social responsibility literature, establishing the causality of this relationship using a natural experiment. During the technology bubble, previously constrained firms experienced a temporary relaxation of their constraints and their goodness scores also temporarily increased relative to their previously unconstrained peers. This convergence applies to all components of the goodness scores such as community and employee relations and environmental responsibility but not governance.
Are Red or Blue Companies More Likely to go Green? Politics and Corporate Social Responsibility
Alberta Di Giuli (ISCTE Business School) and Leonard Kostovetsky (University of Rochester) | March 2011
We use political variables to examine how personal preferences of firm stakeholders for socially responsible behavior affect corporate social responsibility (CSR). We find that firms with Democratic CEOs, founders, and directors are more socially responsible, as reflected in higher KLD scores (firm CSR ratings provided by Kinder, Lydenberg, and Domini), than firms with Republican corporate stakeholders. On average, firms with a Democratic CEO have KLD scores that are 0.15 standard deviations higher than firms with a Republican CEO. Firms headquartered in states that lean Democratic are also more socially-responsible than firms in Republican states. Specifically, firms in deep-“blue” states like California have, on average, KLD scores that are 0.22 standard deviations higher than firms in deep-“red” states such as Louisiana. Our tests control for important firm characteristics such as size and financial constraints, CEO characteristics such as the CEO‟s age and gender, and industry effects. We investigate, and find little evidence in favor of, alternative explanations such as reverse causality (CSR leading to more donations to Democrats) and selection (responsible firms hiring more Democratic CEOs or choosing headquarters in Democratic states). The recent growth in the popularity of CSR and socially-responsible investing (SRI) suggests that our results are relevant for corporate finance and asset pricing.
February 18, 2012
Book Bits For Saturday: 2.18.2012
● The Decline in Saving: A Threat to America's Prosperity?
By Barry Bosworth
Summary via publisher, Brookings Institution Press
ongtime Brookings economist and former presidential adviser Barry Bosworth examines why saving rates in the United States have fallen so precipitously over the past quarter century, why the initial consequences were surprisingly benign, and how reduced saving will affect the future well-being of Americans. The saving of American households underwent an astonishing collapse in the years before the financial crisis as consumers engaged in a long-lived spending binge. More recently, however, that saving rate has risen as households attempt to rebuild their wealth in the aftermath of large stock market and housing losses. It was not only consumers who were guilty of overspending; budget deficits grew as the government borrowed huge sums from the rest of the world. Indeed, over the past three decades, the cumulative external deficit has exceeded $7 trillion, leaving the United States as the world’s largest debtor nation.
● Fischer Black and the Revolutionary Idea of Finance
By Perry Mehrling
Summary via publisher, Wiley
Besides revolutionizing finance with the Black-Scholes option pricing model, Fischer Black forever changed Wall Street by developing what is now known as quantitative finance. Fischer Black and the Revolutionary Idea of Finance explores Black's intellectual journey from Harvard to the offices of ADL, from the University of Chicago to MIT, and then to Goldman Sachs. This poignant book tells the story of one man's intellectual adventure at the very center of modern finance, fully describing the birth of quantitative finance and financial engineering along the way.
● Portfolio Representations: A step-by-step guide to representing value, exposure and risk for fixed income, equity, FX and derivatives
By Jem Tugwell
Summary via publisher, Harriman House
This book provides a practical and sophisticated insight into each financial asset type, and how the different risks and exposures they involve should be most accurately combined and represented in a portfolio. The financial issues facing the world since the late 2000s have provided the asset management community with a brutal reminder of the importance of having genuine knowledge of portfolio structures and the risks embedded within them. More so than ever, fund managers need a clear and consistent way of separating value from exposure in their portfolios, allowing a complete 'look-through' to the real risks contained in derivatives and pooled/structured products. Equally, as fund managers are driven to find risk-adjusted rather than just raw returns, it is imperative that risk measures and the understanding derived from them are applied to the entirety of a portfolio, as opposed to just particular asset classes or sections. This book, written by hugely experienced investment expert Jem Tugwell, provides a practical and comprehensive solution. Written in plain English and carefully structured to be easy to use, this is the definitive guide to accurately and quickly representing value in financial portfolios of every complexity. Taking the reader through each asset type in turn, with detailed workings and explanations, it is the most lucid and helpful professional guide yet written on the subject - and something no one working in this area can afford to be without.
● Reckoning with Markets: The Role of Moral Reflection in Economics
By James Halteman and Edd S. Noell
Summary via publisher, Oxford University Press
Undergraduate economics students begin and end their study of economics with the simple claim that economics is value free. Only in a policy role will values and beliefs enter into economic work; there can be little meaningful dialogue by economists about such personal views and opinions. This view, now well over 200 years old, has been challenged by heterodox thinkers in economics, and philosophers and social scientists outside the discipline all along the way. However, much of the debate in modern times has been narrowly focused on philosophical methodological issues on one hand or theological/sectarian concerns on the other. None of this filters down to the typical undergraduate even in advanced courses on the history of economic thought. This book presents the notion that economic thinking cannot escape value judgments at any level and that this understanding has been the dominant view throughout most of history. It shows how, from ancient times, people who thought about economic matters integrated moral reflection into their thinking. Reflecting on the Enlightenment and the birth of economics as a science, Halteman and Noell illustrate the process by which values and beliefs were excluded from economics proper. They also appraise the reader with relevant developments over the last half-century which offer promise of re-integrating moral reflection in economic research.
● Learning From the Global Financial Crisis: Creatively, Reliably, and Sustainably
Edited by Paul Shrivastava and Matt Statler
Summary via publisher, Stanford University Press
This book is motivated by the simple hope that the cloud of the global financial crisis may yet have a silver lining—that political leaders, economists, and management scholars might seize this opportunity to reflect critically on the assumptions, practices, and infrastructures that have precipitated the crisis and to imagine and create new forms of organization that sustainably enhance the well-being of global stakeholders.
● Better Living through Economics
Edited by John J. Siegfried
Summary via publisher, Harvard University Press
Better Living Through Economics consists of twelve case studies that demonstrate how economic research has improved economic and social conditions over the past half century by influencing public policy decisions. Economists were obviously instrumental in revising the consumer price index and in devising auctions for allocating spectrum rights to cell phone providers in the 1990s. But perhaps more surprisingly, economists built the foundation for eliminating the military draft in favor of an all-volunteer army in 1973, for passing the Earned Income Tax Credit in 1975, for deregulating airlines in 1978, for adopting the welfare-to-work reforms during the Clinton administration, and for implementing the Pension Reform Act of 2006 that allowed employers to automatically enroll employees in a 401(k). Other important policy changes resulting from economists’ research include a new approach to monetary policy that resulted in moderated economic fluctuations (at least until 2008!), the reduction of trade impediments that allows countries to better exploit their natural advantages, a revision of antitrust policy to focus on those market characteristics that affect competition, an improved method of placing new physicians in hospital residencies that is more likely to keep married couples in the same city, and the adoption of tradable emissions rights which has improved our environment at minimum cost.
February 17, 2012
Another Month, Another Rise In The Conference Board's Leading Indicator
The economy is poised to continue growing for the foreseeable future, according to the January update of the Conference Board's leading indicator index. "This fourth consecutive gain in the LEI reflected fairly widespread strength among its components, pointing to somewhat more positive economic conditions in early 2012," says Conference Board economist Ataman Ozyildirim in a press release.
There's no shortage of economists who agree. For instance: “There is some pretty good momentum in the economy,” Michael Feroli, chief U.S. economist at JPMorgan Chase, tells Bloomberg.
The rise in the Conference Board's leading indicator coincides with the recent improvement in the U.S. Weekly Leading Index published by the Economic Cycle Research Institute (ECRI). As Doug Short wrote after ECRI updated its index this morning: "This is the fifth consecutive week of improvement (less negative) data for [ECRI's] Growth Index and the highest level (i.e., least negative) since August 26th of last year."
If the revival in leading indicators has convinced ECRI to repeal its recession forecast from last September, the firm hasn't publicly announced a retraction. But if the economic numbers continue to improve--and it's getting harder to ignore the trend--ECRI and a handful of other analysts expecting a recession will be under increasing pressure to revise their dark predictions. Then again, ECRI's homepage continues to feature a Bloomberg TV interview from December, when the firm's Lakshman Achuthan confidently renewed his call that a recession was near. The not-so-subtle message: ECRI's prediction of economic trouble ahead is still in force.
Inflation & The New Abnormal
The trend in headline inflation slowed last month, the Labor Department reports. Consumer prices rose 2.9% for the year through January—a slightly slower pace than the annual 3.0% rise as of December. Meanwhile, core inflation—consumer prices less food and energy—inched higher on an annual basis, advancing 2.3% for the year through last month, or up slightly from December's 2.2% rate. What does it all mean? For the moment, nothing much has changed relative to the previous update. But because we’re still in the new abnormal, higher inflation remains a positive. By that standard, today’s CPI offers a mixed bag of news on the margin.
As a quick bit of background, the new abnormal is a world where higher inflation is greeted enthusiastically by the markets. In the wake of the 2008 financial/economic crisis, higher inflation expectations (defined as the yield spread between nominal Treasuries less their inflation-indexed counterparts) have been accompanied by higher stock prices, and vice versa. That’s abnormal in the grand scheme of U.S. macro history, but it’s been the rule in recent years. It’s debatable if the new abnormal has run its course, as I discussed earlier this week. No one rings a bell when these big-picture regimes start or end, and so definitive answers are available only well after the fact.
Meantime, until the economy has transitioned to a robust and sustainable state of growth, and the crowd recognizes the transition as durable, it's best to assume that the new abnormal rolls on. That means that we should be wary of a persistent round of disinflation. As the market monetarists advise (Scott Sumner and David Beckworth, for instance), the policy prescription of the highest order these days is raising nominal GDP as a tool for juicing the real economy (i.e., real or inflation-adjusted GDP). Explaining this goal in its crude and somewhat misleading form equates with raising, or at least maintaining inflation at a certain level.
With that in mind, we can see in the chart above that the pace of headline inflation has been slowing. “We’ve seen the peak” in inflation, says Jeremy Lawson, a senior U.S. economist at BNP Paribas. “There is still a reasonable amount of slack in the labor market.”
If inflation's pace continues to slow, and if the new abnormal persists, the combination may spell trouble for the economy in the months ahead. One clue that suggests we can't ignore this risk, however marginal, is a slower rate of nominal GDP's growth (real GDP plus inflation) in 2011's fourth quarter: 3.7% on an annualized basis, down from 3.9% in Q3. Yes, the more widely watched real GDP growth rate accelerated to 2.8% in Q4 from 1.8% previously. But the market monetarists tell us that if nominal GDP continues to slow, the trend may take a toll on real GDP in the current climate. As such, lower inflation isn't helpful. One day that will change, but not yet.
Fortunately, recent economic reports suggest that the economy is likely to keep growing, as yesterday's update on initial jobless claims implies, for instance. Meanwhile, core inflation remains in an uptrend, which suggests that falling inflation isn't a danger (i.e., core inflation has a history of providing a more reliable benchmark for measuring pricing trends). Maybe nominal GDP isn't destined to fall after all.
The notion that higher inflation is helpful (still) at this stage confuses some pundits. But recall that falling inflation since 2008 has been accompanied by a deteriorating economic outlook. Fast forward to the present and recent history shows that higher inflation has gone hand in hand with a rising stock market and a revival in the economy's growth prospects. Counterintuitive? Perhaps, but that's par for the course in the new abnormal.
Update: Marcus Nunes notes that the 1.3% one-year-ahead inflation outlook via the Cleveland Fed is roughly equivalent to its 10-year-ahead counterpart. In addition, Nunes provides us with a chart that shows that inflation expectations overall are the lowest since 2009:
Kicking The Tires Of Multi-Asset Class Funds
Actively managed asset allocation products are hot. The supply is growing rapidly and there's a broad variety of strategies to choose from. The product designs range from conservative balanced funds to aggressive trading-oriented strategies and they're available in open-end mutual funds and ETF formats. But some things never change, and so it's still hard to beat a passive benchmark of all the major asset classes. That headwind alone doesn't necessarily mean that you should shun actively managed multi-asset class funds, but it's a reminder that there's no free lunch in this corner of investment products. In other words, all the standard caveats that apply to active single-asset class funds apply here. Your mission, if you choose to accept it, is figuring out if you can overcome the odds.
One of the main hurdles with multi-asset class funds is sorting through the list and figuring out who's offering what and which strategies soar or crash. A recent Morningstar report notes that assets in ETFs that own a mix of other ETFs have grown 43% for the year through January 2012. By Morningstar's reckoning, there are 370 ETF products with $27 billion in assets in this field. The list is much longer if you include open-end mutual funds, which includes the popular target-date funds.
There's also a lot of interest in the sub-category of tactical asset allocation funds, but definitions can get hazy. ”There's much debate over what's tactical and what's not," Michael Herbst of Morningstar writes. "Unfortunately there's not yet an easy, quantitative way to identify tactical funds or classify their strategies." Herbst goes on to advise:
In many cases, you won't be able to tell what a tactical fund is actually doing to pursue its goal. Tactical funds are apt to adjust their holdings quickly and in many cases dramatically, so it's tough to know exactly what the fund owns or is exposed to at any given time. Many adjust their market exposure by taking long and short positions with derivatives such as futures, forwards, and options, as well as interest rate, credit default, and total return swaps. Derivatives themselves aren't necessarily problematic because managers can use them to adjust portfolios more nimbly and cheaply than they could by buying and selling stocks and bonds. But derivatives markets can seize up, and managing long and short positions can be difficult in volatile markets, which is when tactical funds are supposed to shine….
Given the complexity of many tactical strategies, it can be difficult if not impossible to tell how a tactical fund is invested by looking at its portfolio holdings or the conventional asset-allocation data that many managers provide.
The bottom line, Herbst concludes: "Many tactical fund managers employ complex strategies and sport short track records, making it tough to assess how effectively they're plying their strategies."
What is clear is that the vast majority of tactical funds, when lumped in with the various other flavors of actively managed asset allocation products, deliver mediocre results in the aggregate. The reason is that beating the market—broadly defined across multiple asset classes—is difficult. Last month I updated how 1,000-plus multi-asset class mutual funds and ETFs with at least 10 years of history fared against the Global Market Index (GMI), a passive value-weighted mix of the major asset classes. The result is predictable: GMI earned above-average performance over the past 10 years relative to its competitors overall.
What explain's GMI's strong performance? All the advantages that makes single-asset class indexing so compelling apply here as well, starting with low fees. For instance, you can replicate GMI with ETFs for under 50 basis points. By comparison, many actively managed asset allocation products come with much-higher expense ratios, in many cases well north of 100 basis points.
Choosing an actively managed asset allocation fund can be worthwhile if you find a product with a talented manager. But that's not going to be easy. Portfolios that swim in several asset classes employ a broad array of techniques for managing the mix. Apples-to-apples evaluation requires a fair amount of analysis. And there's ongoing monitoring to consider too. Given the complexity of some of these products, and the lag time in portfolio updates, that could be another headache. Still, if you do your homework, you may be able to identify promising funds that match your risk tolerance and investment objectives. But you'll need a high degree of confidence that a given manager is worth a relatively high expense ratio.
If you do wade into these waters, make sure you're clear on what you're looking for. High returns? Risk management? Some of both? The sky's the limit for strategic possibilities. The historical track records, however, are more likely to be grounded in terra firma. Some funds manage to break free of the crowd and deliver impressive results. But figuring out who'll be in that rarefied club next year—and for years after—is one of the tougher challenges in investment research, and the burden falls on you (or your advisor).
February 16, 2012
Jobless Claims Fall Again...To A New Four-Year Low
Initial jobless claims dropped again last week, slipping 13,000 to a seasonally adjusted 348,000, the Labor Department reports. That’s the lowest number of new filings for unemployment benefits since March 2008. The trend, in other words, is still sending a strong signal that the labor market recovery—and economic growth—will roll on.
The jobless claims indicator has predicting recovery for months now and the embedded prediction in today’s update is the strongest yet that the economy will expand for the foreseeable future. You have to ignore quite a lot of cyclical history with this data series to dismiss its record as a leading indicator. As economist Ed Yardeni reminds, the encouraging outlook via claims follows a clear pattern and so pessimists should think twice before rejecting the implied forecast.
Skepticism would be a lot more compelling if other economic reports were screaming danger. But that’s not the case either. Indeed, today’s update on housing starts and newly issued building permits for January reminds that this sector remains on the mend. It’s premature to argue that there’s a robust recovery underway for housing, but at least it’s no longer a negative for the economy, and perhaps it’ll soon be contributing to growth to a more meaningful degree. Meantime, the trend looks favorable. The year-over-year change in housing starts has been positive for five straight months and new permits have been advancing over year-earlier levels since last May. With other economic reports also hinting at continued growth—including the all-important labor market with some support from manufacturing—it’s getting harder to ignore the writing on the macro trend’s wall.
Granted, nothing’s guaranteed when it comes to reading the economy’s tea leaves in the dark art of looking ahead; rather, it’s a game of estimating odds for growth vs. contraction by reviewing numerous reports. But the odds have been looking better for growth since last autumn and today’s numbers—particularly new jobless claims—strengthens this view. As I’ve noted all along, if there’s a new recession brewing the clues will become obvious in the economic data in a meaningful way. So far, those clues of high risk haven’t materialized, at least not to my eyes. For example, late last month I looked at a range of data points and asked if December's economic momentum (as indicated by several indicators at the time) would survive? There was reason for thinking positively then and more of the same is in order today. Sure, there’s always room for debate about where we go from here, especially these days. But the various economic reports aren’t issuing clear and persistent warnings.
"The job market is getting better and that's really key," says Kevin Caron, market strategist at Stifel, Nicolaus & Co. "We're still in the early innings of this but I'm glad to see another data point that adds to the picture of an improving economy."
The drop in claims is "clearly reflecting a rapidly improving labor market, signaling further declines in the jobless rate," advises Sal Guatieri, a senior economist at BMO Capital Markets, via Bloomberg. "It’s good news for consumers, meaning stronger income growth and likely rising confidence that will support spending."
It could all come apart if energy prices—gasoline in particular—keep rising, or the European recession turns especially nasty, or geopolitical risk goes off the deep end because of Iran. You can come up with numerous scenarios that alter the outlook dramatically. But given the current set of economic numbers these days, predicting modest growth is still the higher-probability scenario. As always, the outlook for the future arrives one number at a time. So far, so good.
Expecting More From Housing
Last week I wondered if the housing sector had finally hit bottom. There's a good case for arguing "yes," although the bigger question is whether housing will be a contributor to overall economic growth? That's still a mystery in terms of timing, but the odds are looking better for the optimistic outlook is increasingly relevant. Perhaps we'll find some fresh clues in the update for January's housing starts, scheduled for release later this morning. The consensus forecast calls for a moderate increase over December, according to Briefing.com.
The continued rise in home builder confidence, via yesterday's update on the NAHB/Wells Fargo Housing Market Index (HMI), suggests that we should expect a recovery in housing starts. “Builder confidence has doubled since September as measured by the HMI,” says NAHB chairman Barry Rutenberg, a home builder, in a press release. “Given the recent improvements in new home starts and the increasing number of markets included in the NAHB/First American Improving Markets Index, this consistency suggests that the housing market is moving toward more sustainable growth.”
A graph from Calculated Risk implies that the sharp rise in HMI will soon lead to a jump in housing starts.
Economist Scott Grannis is inclined to see better days ahead on the housing front:
This index of homebuilders' sentiment is still at miserably low levels, but the improvement in recent months is striking. Things have really improved on the margin, and that is what is most important—not the level, but the change on the margin. This also suggests that housing starts, which rose 25% last year, are likely to continue to pick up.
Housing's contribution to economic growth (GDP) can be as high as 18%, according to NAHB. The opposite effect is possible too, and we've had a long stretch of that in recent years. But the negative influence has recently faded to something approximating a neutral state. If housing is now set to become a sustained force for growth, even at a modest level, that's just what the economy needs to keep the recovery going at this stage.
"The story here is that pent-up demand is being freed by much easier mortgage conditions, low rates and rising employment," says Ian Shepherdson, chief U.S. economist for High Frequency Economics. "It's real."
The stock market seems to agree. As CNBC reports: "There’s an awful lot of optimism that housing is going to turn around. The iShares Home Construction Index is up 50 percent since October. Builders like Ryland, Lennar, and PulteGroup are at new highs. Not a lot of room for error!"
Indeed, housing may be on the mend, but confidence is thin that all's well. Energy prices are rising, in part thanks to the Iran factor, and a "European recession could have American consequences." But if housing is set to become a net contributor to expansion, there's one more reason for thinking that the U.S. can weather another macro storm.
February 15, 2012
Is Gold Really An Inflation Hedge?
Earlier today I wrote that macro history raises serious questions about returning the monetary system to a gold standard, a goal that some pundits (and a few Republican candidates for president) advocate. Looking to gold as a cure for economic volatility rests partly on the assumption that the metal is a reliable inflation hedge through time. But as it turns out, gold's inflation-hedging attributes may not be as durable as conventional wisdom claims. As The Free Exchange at Economist.com notes, there's a "gold puzzle" in them 'thar hills.
Because of gold's finite supply and long history as a medium of exchange, Free Exchange reminds, "it’s often cited as a good inflation hedge." Not necessarily:
The thinking goes that if a central bank prints too much money, unleashing rampant inflation, gold will retain its value. Or imagine the mother of all tail events: if civilisation collapses we can still barter with gold. I don’t have any evidence concerning whether or not gold will hold up in the latter scenario. But when it comes to the former claim, London Business School authors Elroy Dimson, Paul Marsh and Mike Staunton, in collaboration with the Credit Suisse Research Institute, recently published a report which shows that gold was not such a great hedge over the last 111 years.
If it were gold's value would be fairly stable over time and realised inflation. The figure below demonstrates that's not the case.
Its price may be correlated with expected inflation, but if you're looking for a hedge, gold's relationship with realised inflation is what's important. Gold’s real value usually does not decrease during bouts of inflation. But what strikes me, other than by historical standards how overpriced gold looks, is how volatile it is. In finance volatile assets are considered risky; it’s baffling that gold is considered a safe haven for anything. If an investor is looking to speculate in the commodities market, investing in gold may be a fine idea. But if you’re looking for safety, inflation-linked bonds, or even equity, is probably a better way to go.
Gold, it seems, may not always glitter.
Industrial Production Was Flat In January
Industrial production was basically unchanged last month, the Federal Reserve reports. Economists were expecting a substantial rise and so today’s update was a negative surprise. Is that a sign of trouble for the economy? No, not really, at least not yet. Industrial production alone isn’t all that valuable as a forward-looking measure of the business cycle, although it does tend to confirm other warning signs when recession risk is rising. By that standard, there’s not much going on here since the annual pace of industrial production is still growing at a healthy clip. If you're looking for a smoking gun that tells us the economy's set to tumble, you won't find it here. Sure, it could be the start of something worrisome, but it might just as easily turn out to be noise, and so the net result at the moment is that today's data point is more or less a wash.
Even after last month’s flat performance, industrial production rose 3.4% over the past 12 months. As the chart below shows, that’s a fairly high rate relative to the pre-recession economy. It’s down from post-recession rebound rates of 2010, but those elevations weren’t sustainable once the economy moved closer to something approximating normality.
Meanwhile, even though industrial production overall was flat, there was growth in certain sectors, notably: business equipment-related manufacturing, which popped 1.8% last month, building on a strong 1.4% rise in December. This was offset in construction and materials sectors, and a slight dip in consumer-related production. Then again, one month doesn’t mean much—rather, it’s the trend that’s crucial, and as the chart above reminds there’s nothing particularly problematic in the numbers on that score. Growth, in short, is still the path of least resistance.
As David Sloan of IFR Economics explains via Reuters:
January industrial production with an unchanged headline fell well short of expectations for a 0.7% increase, but the disappointing headline conceals positive details in the breakdown. Manufacturing saw a healthy 0.7% increase, though over half of this came from autos, with the overall number restrained by weakness in utilities (-2.5%, a second straight steep fall due to a mild winter) and a less easy to explain 1.8% fall in mining. What are however most notable are unusually sharp upward back month revisions. December is now seen as up 1.0% rather than 0.4% with December manufacturing output up 1.5% rather than 0.9%. With November also revised up December's net revisions total +0.8% for overall industrial production and +0.7% for manufacturing. Despite the weaker than expected headline, this report is showing a significant recent acceleration in manufacturing output.
Papering Over The Gold Standard's Flaws
Pushing for a return to the gold standard as a cure for economic volatility is the new new thing in populist circles these days. Holding out the promise of a kinder, gentler business cycle needs no introduction. Several Republican presidential candidates have embraced the idea, and there's no shortage of pundits jumping on gold's bandwagon, including former Wall Street Journal editor George Melloan, who proclaims: "Let's return to the gold standard" in The American Spectator. Alas, the cure is an illusion, and one that's based on a misreading of economic history. Hard money talk can whip up a crowd, but a sober reading of the past on this topic leaves lots of questions--questions that Melloan and others of his persuasion rarely address.
The attacks on gold as the foundation of a monetary system, Melloan writes, arise from a "disinformation campaign." He argues:
The left has blamed the "gold standard"—with breathtaking over-simplification—for the 1929 Crash, saying it starved the economy of money. The causes of the Crash were far more complex, and if anything, quite the opposite. First of all, the classical gold standard didn't exist in the 1920s, but had been replaced by a far looser "gold exchange" standard, which allowed greater manipulation of monetary policy by the Fed. The central bank at that time had been in business only 16 years and badly mismanaged its new experiments in controlling the money supply.
But as students of monetary history know, the primary source of the so-called left wing attack on the gold standard starts with one Milton Friedman, who laid bare the destructive forces of binding the monetary system to gold in A Monetary History of the United States, 1867-1960.
Melloan's brief for the metal conveniently ignores all the subsequent economic analysis of the gold standard in recent decades and instead cites John Maynard Keynes and finds an obscure quote that purportedly demonstrates that the economist was actually in favor of the metal. Melloan also asserts that the "real gold standard" that prevailed between 1879 and 1914 is the ideal to which we should aspire. "Far from being a restriction on real economic growth, the gold standard was a boon," he opines.
Yet Melloan provides no analysis of the many financial panics that plagued the U.S. economy during 1879-1914. But any serious discussion of the gold standard can't ignore history and the fact that under these presumed idyllic monetary conditions there was a steady stream of deep financial crises in the late-19th and early 20th centuries. What's more, these crises arose before the creation of the Federal Reserve in 1913. It was The Panic of 1907 that laid the groundwork for creating a central bank. As economist James Hamilton writes,
The pre-Fed era was characterized by frequent episodes such as the Panic of 1857, Panic of 1873, Panic of 1893, Panic of 1896, and Panic of 1907 in which even the safest borrowers would suddenly find themselves needing to pay a very high rate of interest. Those events were associated with significant financial failures and business contraction….
The pre-Fed financial panics were also accompanied by long contractions in overall economic activity
Even a casual review of NBER's cycle dates suggests that the era of the gold standard was unusually volatile. When the mother of all crises hit in the early 1930s, the nation had had enough. In other words, there was a reason why the gold standard was abandoned: it was choking recovery in the 1930s. This is old news, and convincingly documented in numerous studies through the years, including Barry Eichengreen's research that shows that the earlier a nation left the gold standard in the 1930s, the sooner its economy began to heal from the deleveraging crisis:
Romanticizing the gold standard is one thing, but a fair debate about the metal's limits as a monetary system raises lots of awkward subjects for the hard money folks. Gold bugs rarely talk about gold's dark side in monetary history, preferring instead to focus on its inflation-fighting credentials. Keeping a lid on inflation is crucial, of course, but we could just as easily tie the dollar's value to a basket of commodities or adopt an inflation targeting regime and produce similar results. Ah, say the gold bugs, you can't trust the Fed to keep inflation low. Perhaps not, but somebody would have to oversee a gold standard, and as Melloan himself points out that oversight was bungled by the Fed in the 1930s.
Still, if you think gold is the better way to go, fine, let's have at it. Economic history tells us to be skeptical. But gold bugs don't want to discuss the metal's failures as a comprehensive solution for promoting growth, controlling inflation and keeping a lid on crises. History suggests that gold only provides one out of three, and that's not good enough. A full and complete review of gold's monetary history leaves plenty of room for doubt for seeing gold as a silver bullet.
February 14, 2012
A January Thaw For Retail Sales
Retail sales rose 0.4% last month, the government reports. That’s below what many economists were forecasting, but predictions aside there’s nothing particularly troubling with the latest numbers. Indeed, the revival in January’s retail sales growth after December’s sluggish pace is welcome news.
But there’s always something to worry about, of course, especially these days, and one potential dark cloud is the slowdown in the year-over-year trend in consumption. Granted, the annual rise in retail sales is still quite robust, but it continues to decelerate. On the other hand, looking at January’s numbers suggests that the American consumer remains willing and able to buy. If we consider the latest retail sales update with other economic reports of late—the surge in transport activity, for instance, as Ed Yardeni notes—the case for expecting moderate economic growth in the foreseeable future remains intact, or at least plausible. That said, the ongoing descent in the rate of annual growth in retail sales, which mirrors the slowdown in disposable personal income growth, is worrisome, if only at the margins at this stage.
As for last month’s retail sales, consumption rose 0.4% on a seasonally adjusted basis, the best month since last October. Meantime, after excluding the volatile auto sector, retail sales were up in January by a healthy 0.7%--the strongest month for retail ex-auto since last March.
More importantly, the annual pace of retail sales overall continues to rise on a year-over-year basis by a robust 5.8% as of last month. If the annual rate stayed in this neighborhood, we could rest easy. But there’s reason to wonder how the months ahead will play out for consumption. Indeed, the annual rate of growth has been slipping for four months straight and we’re well below the 9% pace from a year ago. True, deceleration was always fate from the high levels in the recent past. A mature economy like the U.S. can’t maintain retail sales growth above 7% for very long. The question is whether the trend will continue to sink? The decline in the personal income growth rate raises some doubts about what comes next, although the ongoing strength in the labor market keeps hope alive.
Indeed, if there’s an argument for thinking that the slowdown in the annual growth rates of consumption and income will soon stabilize, the optimism is directly related to the economy’s ability to mint new jobs at a reasonably healthy pace. So far, so good, as the latest nonfarm payrolls report suggests, supported by the ongoing decline in initial jobless claims. And if last month’s pop in retail sales is an indication, an argument in favor of the virtuous cycle rolling on is convincing.
"I don't think there's anything here [for retail sales] that really brings into question the fact that the economy has been improving," Wayne Kaufman, chief market analyst at John Thomas Financial,tells Reuters. Pierre Ellis, an economist at Decision Economics, is inclined to agree. "The good news is that the strong January gain establishes that the consumer trend is not folding," says Ellis via AP.
The Forecast File: US Retail Sales For January
Retail Sales in U.S. Probably Rose by the Most in Four Months
Bloomberg | Feb 14
Sales at U.S. retailers probably rose in January by the most in four months, led by growing demand for autos, economists said before a report today. The projected 0.8 percent increase would follow a 0.1 percent December advance, according to the median forecast of 82 economists surveyed by Bloomberg News.
Retail sales key to U.S. economic recovery
MarketWatch | Feb 12
Economists surveyed by MarketWatch predict retail sales jumped a sharp 1% last month, which would mark the biggest increase since September. Retail spending minus the auto sector, whose sales have been surging, is expected to rise 0.7%.
Retail Sales Rose in January: U.S. Economy Preview
International Business Times | Feb 13
Sales at U.S. retailers probably climbed in January as Americans bought more new cars and shoppers took advantage of post-holiday promotions, a sign that the U.S. economy is recovering, economists said before a report this week.The projected 0.7 percent gain in purchases would follow a 0.1 percent increase in December, according to the median forecast of economists survey by Thomson Reuters.
Week ahead February 13-17
Handelsbanken Capital Markets | Feb 13
We expect retail sales in current prices to increase m-o-m by 0.5 percent in January,
versus 0.1 percent in December. Consensus forecasts an increase of 0.7 percent for the month of January. Our forecast is that retail sales ex autos in current prices likely increased by 0.4 percent in January, versus a decline of 0.2 percent in December. Consensus forecasts an ex auto reading of 0.5 percent in January.
What to Expect From the U.S. Retail Sales Report
FX Street | Feb 14
A few leading consumer spending reports also hint that retail sales were up during the month. For instance, according to the International Council of Shopping Centers, retail stores that have been open for more than a year (excluding Wal-Mart stores) saw a 4.8% jump in sales following the 3.5% increase in December. Thomson Reuters also reported that same-store sales grew by 4.2% during the month, more than double the 2.0% forecast. The surge in car sales has also gotten market junkies giddy. Autodata, publisher of technical charts for automotive professionals, reported that purchases of light trucks and cars reached an annualized amount of 14.1 million in January. FYI, this is the biggest amount we've seen since August 2009. Last but not the least, the need to replenish inventories during the month also must have gotten businesses spending. Business inventories rose by 0.4% and topped the 0.3% increase we saw in December. Now before you get too excited, you should know that the retail sales report has missed expectations in the last couple of months. Yikes! Looking at the past two releases, it's also noteworthy to point out that the report had a direct correlation with the U.S. dollar, at least within the first few minutes after the release.
Economic & Financial Commentary
Wells Fargo | Feb 10
On Tuesday we get retail sales for the month of January and the expectation is for a relatively strong recovery compared to the 0.1 percent growth rate recorded in December. In fact, we are expecting growth to have been 1.1 percent compared to a consensus expectation of only 0.6 percent and the highest since the 1.3 percent growth rate reported in September 2011.
Excluding autos, we are also above consensus, which expects a 0.5 percent increase, at 0.8 percent after a drop of 0.2 percent for December. Thus, we are expecting the year to have started on a very positive note for retail sales. The only caveat for retail sales is that the strength may also be related to the same weather phenomenon that has affected other indicators early in the year, as the winter season has been one of the warmest in many decades in the United States.
February 13, 2012
Is The New Abnormal On Its Last Legs?
The recent rise in the stock market has been accompanied by an increase in inflation expectations. That’s a healthy sign while we’re trapped in the new abnormal. One day the stock market and inflation expectations will go their separate ways, but not yet. Meantime, the economy's still struggling to break free of post-crisis gravity and so it still requires the assistance from higher inflation expectations.
As the chart below shows, the S&P 500 and the market's inflation outlook (10-year Treasury yield less its inflation-indexed counterpart) remain tightly correlated. They've been joined at the hip for several years now. That's abnormal in the long run, but for now it's still reality. The dance will end once stronger economic growth returns, and the crowd believes something approximating a normal business cycle has revived. Meanwhile, inflation and the stock market (a proxy for the overall economic outlook) are entwined.
Ed Yardeni recognizes the new abnormal in a blog post from last week:
In the past, the market’s valuation multiple tended to rise when bond yields decreased, and vice versa. In the past, rising inflationary expectations often were negative for equity valuations, while falling ones were positive. There relationships have turned topsy-turvy since early 2007, when falling yields and inflation rates started to be associated with falling rather than rising P/Es. That’s because yields and inflation rates are so low that investors fear that they may be harbingers of deflation and depression.
So why haven’t bond yields risen along with the P/E since late last year? The Fed’s Operation Twist has clearly distorted the bond market. Without it, yields would have undoubtedly risen. They still could if the program is terminated on schedule at the end of June. Meanwhile, the expected inflation rate embodied in the 10-year TIPS market has risen from a low of 1.7% on October 3 to 2.2% in early February. So far, that's been bullish for the P/E.
Scott Grannis looks at the relationship between stocks and Treasury yields directly (without adjusting for the inflation-indexed yield) and wonders if something's about to give. He's referring to the equity market's strong rise in recent months while Treasury yields have remained flat. Grannis observes:
It just doesn't make sense for the economy to be doing better while bond yields languish near all-time lows. My money is on higher yields, since the evidence of continued economic improvement is pervasive.
Higher yields would be a sign that the crowd thinks the new abnormal is ending. If so, that would constitute progress, although at what point will higher inflation expectations become the enemy? The transition could be rocky.
Meantime, this week's is scheduled to bring some fresh clues on where we stand on progress, starting with the update on retail sales for January. The consensus forecast is looking for some improvement, with a 0.8% gain last month vs. December's meager 0.1% increase, according to Briefing.com. If that forecast turns out to be accurate, it'll be tempting to think that the days of the new abnormal are numbered. Then again, we've been here before only to have the rug pulled out from under our reviving expectations. As such, it's still one data point at a time. Yes, it's a still a recover... if we can keep it.
February 11, 2012
Book Bits For Saturday: 2.11.2012
● Coming Apart: The State of White America, 1960-2010
By Charles Murray
Review via LA Times
Charles Murray's new book is hardly the bombshell that placed him on the Politically Incorrect Ten Most Wanted list 18 years ago when he co-wrote "The Bell Curve" with Richard J. Herrnstein in 1994. But by providing a data-driven argument for inequality's cultural and sociological roots, "Coming Apart: The State of White America, 1960-2010" arrives just in time for the central political and policy debate in the 2012 elections: What is the nature of the widening gap between the rich and everyone else — and what can, or should, be done about it?
● The World America Made
By Robert Kagan
Excerpt via The New Republic
Is the United States in decline, as so many seem to believe these days? Or are Americans in danger of committing pre-emptive superpower suicide out of a misplaced fear of their own declining power? A great deal depends on the answer to these questions. The present world order—characterized by an unprecedented number of democratic nations; a greater global prosperity, even with the current crisis, than the world has ever known; and a long peace among great powers—reflects American principles and preferences, and was built and preserved by American power in all its political, economic, and military dimensions. If American power declines, this world order will decline with it. It will be replaced by some other kind of order, reflecting the desires and the qualities of other world powers. Or perhaps it will simply collapse, as the European world order collapsed in the first half of the twentieth century. The belief, held by many, that even with diminished American power “the underlying foundations of the liberal international order will survive and thrive,” as the political scientist G. John Ikenberry has argued, is a pleasant illusion. American decline, if it is real, will mean a different world for everyone.
● The Prosperity of Vice: A Worried View of Economics
By Daniel Cohen
Summary via publisher, MIT Press
What happened yesterday in the West is today being repeated on a global scale. Industrial society is replacing rural society: millions of peasants in China, India, and elsewhere are leaving the countryside and going to the city. New powers are emerging and rivalries are exacerbated as competition increases for control of raw materials. Contrary to what believers in the “clash of civilizations” maintain, the great risk of the twenty-first century is not a confrontation between cultures but a repetition of history. In The Prosperity of Vice, the influential French economist Daniel Cohen shows that violence, rather than peace, has been the historical accompaniment to prosperity. Peace in Europe came only after the barbaric wars of the twentieth century, not as the outcome of economic growth. What will happen this time for today’s eagerly Westernizing emerging nations? Cohen guides us through history, describing the European discovery of the “philosopher’s stone”: the possibility of perpetual growth. But the consequences of addiction to growth are dire in an era of globalization. If a billion Chinese consume a billion cars, the future of the planet is threatened. But, Cohen points out, there is another kind of globalization: the immaterial globalization enabled by the Internet. It is still possible, he argues, that the cyber-world will create a new awareness of global solidarity. It even may help us accomplish a formidable cognitive task, as immense as that realized during the Industrial Revolution--one that would allow us learn to live within the limits of a solitary planet.
● Sovereign Wealth Funds: The New Intersection of Money and Politics
By Christopher Balding
Summary via publisher, Oxford University Press
Sovereign wealth funds are a growing and dynamic force in international finance. The shifting international economic relations from capital rich states gives them new power in influencing the global agenda. Despite controlling trillions of dollars in the biggest companies in the world, little is known about the opaque funds of oil rich and non-democratic governments. This is the first book to compile a history of sovereign wealth funds recounting the Abu Dhabi Investment Authority's involvement with the scandal-plagued BCCI bank and Chinese arms exports to Iran. By constructing a history within the proper context of oil-driven surpluses and large inflationary pressures with no international investment framework, this book explains the development and growth of sovereign wealth funds. The economics of capital surplus countries and investment strategies are examined in order to better understand sovereign wealth fund creation and growth. In a straightforward and accessible style, the author examines the complex and amazing growth of an unknown group of investors controlling trillions of dollars worldwide.
● Beyond the Resource Curse
Edited by Brenda Shaffer and Taleh Ziyadov
Summary via publisher, University of Pennsylvania Press
When countries discover that they possess large deposits of oil and natural gas, the news is usually welcome. Yet, paradoxically, if they rely on their wealth of natural resources, they often set down a path of poor economic performance and governance challenges. Only a few resource-rich countries have managed to develop their economies fully and provide a better and sustainable standard of living for large segments of their populations. This phenomenon, known as the resource curse, is a core challenge for energy-exporting states. Beyond the Resource Curse focuses on this relationship between natural wealth and economic security, discussing the particular pitfalls and consistent perils facing oil- and gas-exporting states.
February 10, 2012
Consumer Sentiment Dips. A Sign Of Trouble, Or Just A Temporary Setback?
Regular readers of The Capital Spectator know that the still positive but decelerating trend in personal income and spending has been a concern on these pages for some time. Among the risks to worry about when it comes to the key economic reports and the potential blowback for the business cycle, this is near the top of my list. Today’s update on consumer sentiment suggests that the crowd is also worried.
Americans turned less optimistic about the economy in early February on worries about falling income even as their outlook on the jobs market rose to a record high, a survey released on Friday showed. The Thomson Reuters/University of Michigan overall index of consumer sentiment fell to 72.5 in early February from January's 75.0, which was the highest level since February 2011. The latest figure fell short of the median forecast of 74.5 among economists polled by Reuters.
Even so, the latest drop is still a blip in the context of the recent revival in consumer sentiment. Yes, today’s dip could be a sign of things to come. But much depends on what happens next with personal income—disposable personal income (DPI) in particular. The latest update on DPI was a sign that falling rate of annual increases may soon stabilize... maybe. Indeed, DPI jumped 0.4% in December, the biggest monthly rise since last March and a dramatic turnaround from November’s slightly decline. Alas, we won't know if there's fresh momentum until March 1, when the next update on income and spending hits the streets.
It’s unclear if more good news for DPI is coming, but if there is it’ll surely be closely linked with the ebb and flow of the labor market. On that front, the respectable rise in private nonfarm payrolls for January is encouraging (as is the positive year-over-year change in payrolls without a seasonal adjustment). Will February’s payrolls report also bring good news? Yesterday’s update on initial jobless claims suggests we should be optimistic.
"Bottom line, confidence gave back half the jump seen in January, but at 72.5 is still the 2nd best reading dating back to last May as the labor market has shown signs of continued improvement," says Peter Boockvar, Miller Tabak’s equity strategist.
Deciding if the slip in consumer sentiment has broader import for macro may become easier next week with the scheduled updates for several economic numbers, including retail sales (Tues, Feb 14), industrial production (Wed., Feb 15), housing starts and initial jobless claims (both on Thurs., Feb 16). Meantime, there's a small crack in the rebound to consider. It may turn out to be nothing, but the recovery is still fragile enough to keep everyone guessing for the foreseeable future.
Been Down So Long--Has Housing Finally Bottomed?
The economy may be poised for better days, but we’re still a long way from a genuine boom. Indeed, some folks remain skeptical generally and warn that the economy is more likely to contract than grow in the foreseeable future. A higher level of confidence that we’ll sidestep macro trouble is in order. But how? Job growth seems to be perking up, but it could use some help. Maybe we’ll catch a break with residential real estate in the months ahead too. Yes, real estate.
Granted, that’s a tall order, or so the last several years suggest. It’s been a long time since housing was a positive contributor to economic momentum. Meantime, predictions of recovery have come and gone for, well, years. But while it’s easy to remain gloomy about residential real estate, there has been progress, albeit primarily as a sector that’s no longer contracting. Unfortunately, it’s not necessarily growing either. But after three years of treading water in housing starts and newly issued building permits, for instance (see chart below), are we finally at the stage for something approximating an authentic expansion? Even if--a big if--we're at a turning point, any expansion is likely to be mild at best. But if you’re willing to entertain an optimist outlook, the numbers suggest that there could be some light trickling into this tunnel.
Housing starts and new building permits are inching higher. Meantime, housing inventories have fallen to 2005 levels, notes Bill McBride at Calculated Risk. The drop inspires Slate's Matthew Yglesias to think on the bright side and write: lower inventory "obviously doesn't mean that we're primed for a return to full boom levels of residential investment and construction employment, but it does mean that we should be primed for a return to something like long-term average levels of residential investment and construction employment."
Perhaps it's no surprise to find that a housing industry economist is expecting better times, but David Crowe of the National Association of Home Builders argues that 2012 will be an improvement over last year. "I'm looking at 2012 as sort of a ramping event to get a much more solid recovery in 2013," he tells AP. If so, maybe we'll see some supporting evidence in next week's scheduled updates for housing starts and building permits for January.
Housing's contribution to the economy is estimated to be as high as 18%, and so even modest growth for this sector could be just the thing that's needed to keep the expansion going.
The housing market is "improving," says Crowe, "but it is not going to be great. We are so far down we almost have to see some improvement.”
Residential property investment is poised to increase at more than twice the rate of GDP this year, predicts Bank of America Merrill Lynch, reports HousingWire. According to the analysts, even a modest revival "will help reduce the stubbornly high bucket of long-term unemployment and underpin confidence. A virtuous cycle can start to develop, but it will be gradual."
If so, we may see some clues in next week's housing reports. Hope springs eternal for this sector… again.
And for good measure, there's a new deal to help sort out the foreclosure mess. Perhaps it's no surprise that homebuilder shares have popped recently. "Anything that helps resolve the issue is bullish for homebuilder stocks," says Thomas Lawler of Lawler Economic and Housing Consulting. "It’s good for builders that are well-capitalized and don’t need to go to the bank to get a loan, and those are basically the publicly traded builders."
February 9, 2012
Still No Sign Of Recession Risk In Latest Jobless Claims Data
Never say never in macroeconomics, especially when it’s based on one economic indicator. But the longer that initial jobless claims zig zag lower, the harder it’ll be to maintain a recession forecast. One thing is sure: either the revival in the labor market in recent months is one giant head fake, or the handful of analysts telling us (still) that a new recession is imminent will soon cry “uncle.” Meanwhile, the data continues to give the forces of growth the edge, and today’s weekly update on new filings for unemployment benefits only strengthens the case. Indeed, new claims dropped last week by a healthy 15,000 to a seasonally adjusted 358,000. That’s the second-lowest reading since early 2008 (the lowest reading was for a week last month). More importantly, the latest numbers strongly suggest that the downward trend is intact. That's a crucial factor for this leading indicator, which has a good record of telling us when the economy is weakening.
Maybe this time is different, but history shows that every recession since the 1970s has started with rising levels of jobless claims. And not merely a subtle increases, but clear and distinct pops. By contrast, the trend of late is exactly the opposite. There’s simply no way to misread this indicator: it’s signaling that the labor market will continue growing, perhaps at a moderately faster pace than what we’ve seen so far, but growing nonetheless. Yes, the claims numbers could be wrong, but it would be the first false signal since the government started publishing this data in the late-1960s.
What’s more, the descent in jobless claims isn’t an artifact of seasonal adjustment. As the second chart shows, unadjusted claims have been dropping consistently on a year-over-year basis since last spring, and nothing's changed as of last week.
The claims numbers would be a lot less compelling if there was lots of conflicting evidence that the economy is crumbling. But you don’t have to look too hard to find sources of optimism elsewhere. As I noted last month, the December numbers generally looked pretty good, or at least good enough to debate the forecast that a new downturn was coming. In the subsequent weeks, the updates have continued to offer encouragement. Examples include the surprisingly strong rise in private payrolls for January, which, by the way, still looks good even without the seasonal factor; and manufacturing activity continued to perk up last month. I’m still worried about consumer spending and income, but if jobs creation can remain positive this risk may fade too. A more potent problem is the higher recession risk in the eurozone and the UK. Will those threats infect the internal dynamics of the U.S.? Stay tuned.
Meantime, there’s a danger of obsessing over the labor market as the key factor for anticipating the health of the business cycle. Monitoring and evaluating a wide array of indicators is essential. But it’s also clear that there if there’s any hope of skirting a new recession, the odds for success are closely tied with the ebb and flow of the jobs market—more so than ever.
"It does look like with these [jobless claims] numbers that the labor market is on a positive footing, which is good to see,” Sean Incremona, an economist at 4CAST, tells Reuters. “Job creation is probably going to be what keeps this recovery alive. Things do seem to be holding up somewhat better than we had expected.”
Millan Mulraine, a strategist at TD Securities, agrees: “The recent positive momentum over the past two months is being sustained. If we stay within this range, then we should see employment growth pick up.”
There’s no guarantee, of course, but if deterioration is brewing that will take down the broad trend, it’ll soon be obvious for all to see. For now, however, the odds of new recession look fairly low based on the latest set of numbers for new claims and a range of other indicators.
Vanguard's Forex-Hedged Foreign Bond ETFs
Vanguard will soon be launching its first foreign-bond funds, although the roll-out date has been delayed, the firm reports. The proposed set of ETFs and index mutual funds will target a broad definition of foreign bonds as well as products for emerging markets. But unlike most of the existing foreign bond ETFs, such as SPDR Barclays International Treasury ETF (BWX) and Van Eck Market Vectors Emerging Market Local Currency Bond ETF (EMLC), the new Vanguard funds will hedge currency exposure from a U.S.-dollar-investor perspective. Vanguard argues that this is a superior approach for U.S. investors investing in foreign bonds because it will dampen volatility. True, but it's not clear that this is a better way to manage a foreign bond fund.
The general case for holding foreign bonds as part of a broad asset allocation strategy is widely accepted. Indeed, unless you’re intentionally making a strong tactical bet, sidestepping such a large slice of the world’s capital markets is misguided as a strategy matter. The literature on this point is well established. The main question is deciding if you should hedge the currency exposure or not?
A relevant point in this debate is recognizing that the currency factor tends to be a wash in the long run. In the short run, of course, forex is quite volatile. But unless you plan on making lots of short-term tactical trades based on currency volatility, it's not clear that this is a crucial issue. For example, consider that the Trade-Weighted US Dollar Index for the world’s major currencies posted an average one-year change of -0.9% for the past 30 years, or relatively close to zero. In other words, the fluctuations bounce around a zero mean. That’s another way of saying that there’s relatively no trending behavior. For comparison, the U.S. stock market (S&P 500) has a clear history of trending, as suggested by its average one-year change of 9.4% for 1981-2011.
Of course, if volatility is a short-term concern, hedging has appeal. Vanguard advises that “unhedged bonds add a level of volatility more similar to equities than to bonds and can therefore offset any diversification benefit of international bonds.” That’s true, but as part of a broad asset allocation strategy using the major asset classes it’s not obvious that the extra volatility is detrimental. Depending on the time period, the extra vol may even be productive. In fact, as I recently reported, a passive mix of the major asset classes (including unhedged foreign equity and bond positions) has proven to be competitive with actively managed asset allocation funds over the past decade.
Consider too that a U.S. investor is well advised to diversify her currency exposure beyond greenbacks. In a globalized economy, betting the house on one currency--even if it's the world's reserve currency--looks extreme. Unless you have some definite views on the dollar, particularly in the short and medium terms, there’s a compelling case for holding at least some of your assets in non-dollar-denominated assets. It's tempting to forecast that the dollar will strengthen, or weaken, over some future time horizon, but accuracy is notoriously scarce in forex predictions, even by the standards of equity investing.
Keep in mind too that currency hedging is expensive as a long-term proposition. That said, Vanguard’s new foreign bond ETFs will carry relatively low expense ratios of 0.30% for the broad fund, and 0.35% for the emerging markets product. Those levels are at the bottom end relative to the existing product lineup. But if Vanguard didn’t plan on hedging currency risk, it’s reasonable to assume that the expense ratios would be even lower.
In the long run, currency hedging almost certainly comes at a price. This point is quite clear in the newly published Credit Suisse Global Investment Returns Yearbook 2012. Hedging can help soften return volatility in the short run, the study notes, but over longer-term horizons the strategy takes a bite. “Typically, the benefits fall the longer the horizon, and rapidly turn negative,” according to the yearbook’s authors (including Elroy Dimson of the London Business School). “Rather than lowering risk, hedging by longer term investors raises risk.”
The currency factor is, of course, a source of risk. In isolation, this risk can be dangerous, particularly for the average investor. Indeed, as the Credit Suisse study reminds, predicting currency returns is quite difficult, perhaps even more so than for stocks and bonds. But holding a portfolio of different and relatively uncorrelated risks can be beneficial, especially if you have a long-term investment horizon.
Then again, generic prescriptions only go so far. Much depends on your specific asset allocation. Keep in mind that if you own foreign stock funds, you probably already have a fair amount of forex exposure--most non-U.S. equity funds don’t hedge, or do so minimally.
Meantime, let’s no dismiss Vanguard’s argument for hedging completely. Forex volatility may be a wash in the long run, but in the short term it can radically help or hurt returns. Since bond returns are generally modest compared with stocks, an unhedged foreign bond allocation can be quite volatile. But volatility for a given asset class isn’t necessarily troublesome if it’s part of a broadly diversified mix.
Nonetheless, the larger question is whether you want exposure to a currency other than the U.S. dollar? For most investors, there’s a good argument for answering “yes,” albeit in moderation. But if you disagree, or prefer to access forex risk through something other than the fixed-income channel, Vanguard will soon offer a competitive alternative. For sophisticated investors, the prospect of using the Vanguard product and making a separate allocation to forex with, say, one or more currency ETFs is another possibility.
Any way you slice it, forex is a big deal when venturing into foreign markets. Indeed, the forex factor is likely to be the overwhelming driver of returns for foreign bond allocations, for good or ill, in the short and medium terms. The problem is that it's quite difficult to figure out in advance if this influence will help or hurt. That inspires opting for the unhedged allocations and looking for risk management tools elsewhere, starting with broad diversification across asset classes. There are many ways to manage risk, but some are more compelling (and less costly) than others.
Update: A bit of long-run forex perspective from a new research report from Andrew Smithers, who writes: "France and the US have grown at almost exactly the same pace over the past 110 years and their real exchange rates today are also almost exactly the same as they were at the end of 1900."
February 8, 2012
Job Openings On The Rise
Job openings in the U.S. rose to 3.4 million on the last business day of December, up from 3.1 million a month earlier, the Labor Department reports. “Although the number of job openings remained below the 4.4 million openings when the recession began in December 2007, the number of job openings has increased 39 percent since the end of the recession in June 2009,” according to the accompanying press release.
The job openings data is a relatively new addition to the government’s employment analysis tool set and the history only dates to 2000. (Here’s a background paper on the data.) Intuition tells us that this series will track the business cycle and offer additional context for confirming or denying major turning points in the economy. The continued rise in job openings certainly paints an encouraging picture for thinking that the economy is expanding.
The rising trend in job openings wouldn’t mean much if other labor market indicators presented conflicting information. But the news for jobs creation has been relatively encouraging lately. The labor market in January was perky, even without the seasonal adjustment, and the falling trend in initial jobless claims implies that there’s more good news down the road.
Will tomorrow’s weekly update on new filings for unemployment benefits bring more of the same? The outlook is a bit cloudy, with the consensus forecast anticipating a small rise for weekly claims, according to Briefing.com.
February 7, 2012
Quantifying Economic Policy Uncertainty
Is economic policy muddled? Some economists argue that confusion on the outlook for a range of policy fronts, such as regulation and tax policy, has been weighing on the economy. But how does one define policy uncertainty? A Stanford economist (Nicholas Bloom) and a Ph.D. candidate (Scott Baker) offer a possible solution with an attempt to quantify the concept in a new benchmark: Index of Economic Policy Uncertainty (EPU). According to the index’s latest data through January, U.S. policy uncertainty has fallen sharply.
Alongside the sudden drop in policy uncertainty, economic prospects in the US appear to have improved considerably. Last Friday’s announcement of a 250,000 drop in unemployment led to a surging stock market as investors began to believe the recovery had finally begun. Our research suggests this has been aided by the calming of policy uncertainty.
Unfortunately, policy uncertainty still appears extremely high in Europe with the Eurozone crisis. When this finally calms down, European growth should then have additional impetus to recover.
Compared with the pre-2008 era, however, policy uncertainty remains elevated, as the chart below shows. Nonetheless, the recent decline is pronounced, suggesting that the future is considerably less murky these days vs. last year’s second half. Last October, Baker and Bloom warned that “Policy Uncertainty Is Choking Recovery.”
The EPU index is calculated from a mix of policy related references in news stories and other data, such as the number of tax laws expiring in the near-term future and predictions of government spending. For the details and the data, along with a new white paper on the index, visit the EPU’s web page: www.policyuncertainty.com/Home.html
Strategic Briefing | 2.7.2012 | Europe & Recession Risk
What's next for Europe?
CNN | Feb 6
The European Central Bank has thrown cold water on the sovereign debt crisis by injecting billions of euros into the banking system, but the embers of the crisis are still smoldering. S&P says the eurozone has a 40% chance of entering a severe recession this year, with the economy projected to shrink by as much as 2%. Unless comprehensive reform creates a much tighter fiscal union, uncertainty will continue to cast a dark cloud over Europe's economic future.
German Manufacturing Orders Rise
The Wall Street Journal | Feb 7
German manufacturing orders rose more than expected in December, driven by a surge in demand from outside the euro zone, in the latest sign that Europe's largest economy may yet avoid recession despite the euro zone's debt crisis. New orders rose 1.7% on the month in adjusted terms, after slumping by a downwardly revised 4.9% in November, data from the economics ministry showed Monday.... While German orders data are "very volatile", the latest figures "seem to suggest that factory activity has not collapsed," even after German economic growth moderated in the fourth quarter "as demand from abroad was hit by the global slowdown," said Annalisa Piazza, a strategist at Newedge in London. "If anything, a slight pick-up is expected in the first quarter of 2012," she said.
Falling Unemployment In Germany
Bloomberg | Feb 6
German unemployment dropped to a two-decade low in January, bolstering economic growth as the sovereign-debt crisis prompted companies from Spain to Greece to cut jobs. Germany’s economic expansion has helped soften a slowdown across the region as companies boost output and hiring. Still, Europe’s largest economy is cooling as slower global growth and weaker demand from debt-stricken euro-area neighbors erode sales. Siemens said last month that meeting targets for this year has become harder and predicted that Europe will slip into recession.
German Industrial Production Unexpectedly Dropped in December
Bloomberg | Feb 7
German industrial output unexpectedly dropped the most in three years in December as Europe’s debt crisis weighed on confidence and the global economic slowdown damped demand.... While the German economy probably shrank 0.25 percent in the final three months of last year, data this year suggest it may avoid recession, which is commonly defined as two consecutive quarterly contractions. Business sentiment jumped to a five-month high in January and factory orders gained 1.7 percent in December, driven by demand from outside the 17-nation euro area. “It appears that factory orders are stabilizing and a turning point may have been reached,” said Jens Sondergaard, senior European economist at Nomura International Plc in London. “We are becoming slightly more optimistic on the German business cycle, especially if we get a little more clarity on how the Greek situation is going to evolve.”
Germany, France and EC increase pressure on Greece
The Telegraph | Feb 7
Germany and France have told Greece there will be no €130bn bailout unless it agrees harsh new austerity cuts and reforms, while the European Commission warned the deadline for a deal "has already passed".
Euro crisis could almost halve China's growth, IMF says
BBC | Feb 6
A eurozone recession could almost halve Chinese growth this year, according to the International Monetary Fund (IMF). The IMF forecasts China's economy will grow by 8.2% this year - but warns that a recession in the eurozone could cut this to 4.2%. It said Beijing should get ready to inject billions of dollars into the economy to fend off any downturn.
Second (UK) recession fears grow as small business confidence plummets
The Guardian | Feb 5
The beleaguered state of the UK economy has been underlined by three separate reports revealing that Britain's one million small and medium-sized businesses were facing their most difficult year since the recession of 2009. Sharp declines in bank lending to smaller firms, and a collapse in confidence across the sector outlined in the reports will add to concerns that the economy is about to enter a second recession in three years, analysts said. The gloomy reports will also put pressure on the Bank of England to pump an extra £50bn into the economy when it meets on Thursday.
Fears of recession return as (UK) retail sales fall
Yorkshire Post | Feb 7
Retail sales fell last month, making it the second-worst January since 1995 and raising fears that Britain is poised to return to recession. According to the latest British Retail Consortium (BRC) data, only January 2010 was worse after food sales slowed sharply following a boost over Christmas.
February 6, 2012
The Seasonal Factor & January's Encouraging Employment Report
January’s payrolls report looks convincingly strong to many economists, but some skeptics warn that the seasonal adjustment in the first month of the year is usually quite hefty and so there's less good news in the numbers than we've been told. That inspires looking at the unadjusted data on a year-over-year basis in search of clarity. But here too the results are encouraging.
As of last month, private payrolls sans seasonal adjustment are higher by 2.1% vs. the year-earlier figure. That’s the fastest rate of growth since May 2006. Let’s also note that the trend is strengthening. As recently as a year ago, this definition of the private labor market was growing by just 1.2% a year.
History suggests that when the trend in labor market growth is at a ~2% pace on an unadjusted basis--and rising--the odds of a new recession are relatively low. The qualifier that the pace of annual job growth must be rising is crucial. Job creation at or above the 2% mark alone doesn’t say much—unless the rate of increase has been strengthening, which is clearly the case. Short of a sudden and dramatic deterioration, it's hard to see the trend in nonfarm payrolls as something less than productive for the economic outlook.
But could the trend in nonfarm payrolls be a quirk? If so, we should be able to find some conflicting numbers elsewhere in the labor market. One possibility is the weekly jobless claims data, which has a reasonably good record in dropping clues about the major turning points in the economy. But here too the trend has been our friend recently, as the second chart below shows. The unadjusted 12-month percentage change in weekly claims in January was -12.2%, based on monthly average numbers. That’s a relatively robust decline rate. If there was a new recession brewing, we’d likely see unadjusted claims rising on a year-over-year basis. So far, so good.
Two data series that post encouraging trend lines are hardly definitive proof. On the other hand, it’s far from irrelevant that these two measures are signaling continued expansion for the labor market and, by extension, the broader economy. Yes, there are plenty of risks to worry about, including the deteriorating trend in personal income and spending. But with the labor market rebounding, the healing process seems set to continue. But if jobs creation can stay positive, the odds increase that spending and income will stabilize.
The bottom line: much depends on the labor market. That's usually true, of course, but the stakes are especially high these days. For the moment, however, the numbers are encouraging.
February 4, 2012
Book Bits For Saturday: 2.4.2012
● The People's Money: How Voters Will Balance the Budget and Eliminate the Federal Debt
By Scott Rasmussen
Interview with author via Newsmax
Independent pollster and political analyst Scott Rasmussen tells Newsmax that the real federal debt is $120 trillion — and he has a new book with proposals that could save the government more than $100 trillion over the coming decade.
● The End of Money: Counterfeiters, Preachers, Techies, Dreamers--and the Coming Cashless Society
By David Wolman
Review via Kirkus Reviews
Alternating between in-depth reporting and personal rumination, Wired contributing editor Wolman (Righting the Mother Tongue: From Olde English to Email, the Tangled Story of English Spelling, 2008, etc.) tries to figure out what a cashless society would mean and whether it is an idea whose time has come. The author decided to live without spending cash for a year, but he does not develop that portion of the saga at length. Mostly he focuses on visionaries who are hoping, for a variety of reasons, to eliminate paper money and coins. Some of the advocates believe a cashless society would function more smoothly and reduce deficit spending. Others are more politically oriented, wanting to remove governments from printing/coining what has come to be called "money."
● Why Capitalism?
By Alan Meltzer
Summary via publisher, Oxford University Press
A review of the headlines of the past decade seems to show that disasters are often part of capitalist systems: the high-tech bubble, the Enron fraud, the Madoff Ponzi scheme, the great housing bubble, massive lay-offs, and a widening income gap. Disenchantment with the market economy has reached the point that many even question capitalism itself. Allan H. Meltzer disagrees, passionately and persuasively. Drawing on deep expertise as a financial historian and authority on economic theory, he provides a resounding answer to the question, "why capitalism?" Only capitalism, he writes, maximizes both growth and individual freedom. Unlike socialism, capitalism is adaptive, not rigid--private ownership of the means of production flourishes wherever it takes root, regardless of culture. Laws intended to tamper with its fundamental dynamics, such as those that redistribute wealth, fail. European countries boasting extensive welfare programs have not surpassed the more market-oriented United States.
● The Complete Guide to Portfolio Construction and Management
By Lukasz Snopek
Summary via publisher, Wiley
In the wake of the recent financial crisis, many will agree that it is time for a fresh approach to portfolio management. The Complete Guide to Portfolio Construction and Management provides practical investment advice for building a robust, diversified portfolio. Written by a high-profile investment adviser, this book reveals a practical portfolio management framework and new approach to portfolio construction based on four key market forces: macro, fundamental, technical, and behavioural. It is an insight that takes the focus off numbers, looking instead at the role of risk and behavior in finance.
● New Perspectives on Asset Price Bubbles
Edited by Douglas D. Evanoff, George G. Kaufman and A. G. Malliaris
Summary via publisher, Oxford University Press
This volume critically re-examines the profession's understanding of asset bubbles in light of the global financial crisis of 2007-09. It is well known that bubbles have occurred in the past, with the October 1929 crash as the most demonstrative example. However, the remarkably well-behaved performance of the US economy from 1945 to 2006, and, in particular during the Great Moderation period of 1984 to 2006, assured the economics profession and monetary policymakers that asset bubbles could be effectively managed with little or no real economic impact. The recent financial crisis has now triggered a debate about the emergence of a sequence of repeated bubbles in the Nasdaq market, housing market, credit market, and commodity markets.
February 3, 2012
Private Payrolls Post A Surprisingly Strong Gain In January
Today's employment report from the U.S. Labor Department delivered a hefty blow against the idea that recession risk is high for the immediate future. Private nonfarm payrolls rose by a net 257,000 in January (total nonfarm payrolls rose by a slightly lower 243,000 because of a 14,000 decrease in the government's workforce). That's the strongest monthly increase for the private sector since last April and a tidy increase over December's revised gain of 220,000. Economists overall had been expecting a considerably lower increase of well under 200,000 for private payrolls for January. But with today's update in hand, it appears that job creation is accelerating in corporate America. Is this surprising? Not really. As I've been discussing for months, the falling trend in new weekly jobless claims has been signaling for some time that the labor market would continue to heal and perhaps grow at a moderately faster pace. Today's jobs report certainly lends persuasive support for that view.
Thanks to January's rise in jobs, the unemployment rate last month fell to 8.3% from 8.5% in December. That's the lowest jobless rate in nearly three years. It's still high, but at least it's moving in the right direction, and perhaps with some momentum. Indeed, as recently as last September the jobless rate was 9.0%. Even better, the growth in private-sector employment last month was broadly based. The cyclically sensitive goods-producing sector, for instance, posted a net 81,000 rise in January, up from December's encouraging 71,000 increase. Meanwhile, the all-important service sector, which represents the lion's share of the nation's labor force, enjoyed a robust net gain of 176,000 positions last month, building on December's 149,000 pop.
In short, it's hard to see the latest government figures for nonfarm payrolls as anything other than good news for expecting that the economy will continue to grow. In addition, it looks like the leading indicator of weekly jobless claims remains a reliable barometer of things to come. The persistent decline in new claims in last year's second half was too striking to ignore. And when claims dropped to a 3-1/2 year low in mid-December, that was an especially strong clue that there was momentum in the labor market, and it was one reason why I wrote at the end of last year that "the risk of a new economic recession in the U.S. looks low." And last week, a broad review of the major economic indicators offered confirmation that the business cycle was in no imminent danger of falling off a cliff.
Granted, there's still plenty to worry about, starting with the falling trend in personal income and spending. This danger sign is on the top of my list of developments that could spoil the party later this year, assuming it rolls on. But if the labor market can keep growing at 200k-plus a month, that will go a long way toward slowing and perhaps even reversing the deceleration in consumption and income growth.
"The report was much better than expected in terms of indicating fundamental strength in the economy, and the strength is in the most important place in terms of contributing to momentum," advises Pierre Ellis, senior economist at Decision Economics, via Reuters. "There was a strong increase in private sector employment, widely spread. The expected demerit from the big boost in messenger/courier jobs in December did not appear. The combination of December and January shows a big jump in the usage of labor hours, signifying real growth in the economy. Income growth is moving up almost accordingly, which means an increase in cash flow to consumers."
February 2, 2012
Jobless Claims Continue To Trend Lower
Reading this morning's latest weekly update on jobless claims inspires the question: When will we see evidence that a new recession is here, or lurking in the near future? The answer: Not today. If there's a clear sign that the economy's set to tumble, it's not obvious in last week's new applications for unemployment benefits. In fact, this leading indicator continues to tell us that the labor market is slowly improving. New claims dropped by 12,000 to a seasonally adjusted 367,000 last week. One number doesn't tell us much, of course, but it's hard to dismiss the trend.
As the chart below shows, new jobless claims have been zig-zagging lower for months. As of last week, claims are near a four-year low. You can't rely on any one indicator for business cycle analysis, but jobless claims have a fairly good record over the last four decades of providing an early warning sign of recessions. The fact that the new-claims trend shows no sign of rising can't be accepted as the last word on what comes next, but this indicator surely increases the pressure on economists who argue that there's a recession in our midst.
Some analysts say flat out that we should dismiss initial claims because of seasonal factors. But that view isn't convincing. The year-over-year change in unadjusted claims supports the seasonally adjusted figures. Indeed, as the second chart below reminds, new claims have been routinely falling by around 10% a year since last spring before adding a seasonal adjustment.
Perhaps the debate should focus on whether jobless claims are fundamentally delivering the mother of all misleading signals for reasons that go behind technical issues. Has this indicator's relationship with the business cycle changed? There are precious few absolutes in macro and so we need to keep an open mind. As the saying goes, this is economics, not physics. But the argument that jobless claims are no longer relevant at this point would be stronger if they were a lone signal of optimism. But as we learned yesterday, manufacturing seems to be improving too in the new year. A big part of the improvement is related to higher auto sales. As Bloomberg reports: "Automakers sold new cars and trucks in January at the fastest pace since the 2009 'cash for clunkers' program without resorting to profit-sapping discounts, signaling demand returned to pre-recession levels."
True, job growth is still sluggish, as yesterday's ADP Employment Report advises. But the labor market has been sluggish for several years and the economy has still managed to expand, albeit modestly and in fits and starts. Has something changed? Maybe, but you won't find a smoking gun for that view in today's jobless claims numbers.
"It certainly suggests we will continue to see job growth at the higher end of the recent range (which has been between) 100,000 to 200,000," says Christopher Low, an economist at FTN Financial. "If claims continue to drop then we should see job growth stronger than that."
But if the claims data is wrong this time, and there's a recession approaching, as a handful of economists warn, there will be clear signs of a downturn in the labor market. Employment trends aren't considered a leading indicator, but at some point there'll be a clear break from the recent trend of modest job growth to something more ominous. Perhaps we'll find some clarity in tomorrow's payrolls report for January. For what it's worth, the crowd's expecting more of a gray area rather a decisive number one way or another. The consensus forecast anticipates a net rise of 168,000 for private nonfarm workers, according to Briefing.com. That's not high enough to put the recession fears to rest, although it's not low enough to give the recession forecasters a victory either. If 168k turns out to be accurate, what it will do is keep the debate alive about the next phase for the business cycle.
"This is a mild positive, but with the market at these lofty levels, you need to have continued good news for the market to sustain its gains," says Beth Ann Bovino, senior economist at S&P. "This is not a particularly meaningful data point, but it is more good than bad."
Gold Tricks In A New Bottle
Brett Arends of MarketWatch delivers a gentle profile of James Grant and his long-standing support for a return to the gold standard. Grant, who pens the newsletter Grant's Interest Rate Observer, is among the metal's leading promoters. He's even been cited as a possible candidate to run the Federal Reserve. In that unlikely outcome, we certainly know how Grant would act. Arends quotes Grant as saying that the dollar's value should be stable and unchanging, with the not-so-subtle implication that future crises would be averted with this policy.
But the article only hints at the historical record, which shows that gold standard is actually no stranger to economic turmoil. According to Arends:
In his ideal world, says Grant, he would lay out a three-year program to convert back to the gold standard, probably at around $2,500 per ounce of gold. He adds that he would take great care to avoid the notorious blunder made by Winston Churchill and the British back in 1925, when they went back on the gold standard at too high a price, and imposed brutal deflation on the economy. Alas, he admits, this would need an act of Congress.
Curiously, there's no mention of U.S. deflation in the 1930s, or what would happen in the 21st century when money demand surges (as it inevitably does from time to time) and what that would mean for the economy that's tethered to a currency with an inflexible value. We know the result from the last experiment with gold during a time when money demand skyrocketed. Indeed, we know that when demand for liquidity rose sharply, the supply constraint imposed by the gold standard delivered a devastating blow to the economy. This is actually old news, available in any number of studies, starting with Milton Friedman and Anna Schwartz's A Monetary History of the United States, 1867-1960 and Barry Eichengreen's Golden Fetters: The Gold Standard and the Great Depression, 1919-1939. For a popular history of what went wrong by linking the currency to gold, Liaquat Ahamed's Lords of Finance: The Bankers Who Broke the World delivers a powerful reminder that the precious metal's history is disturbingly problematic. Even when the U.S. had no central bank and the gold standard reigned supreme, financial crises were quite common, such as The Panic of 1907. Is it any wonder that the sooner that nations abandoned the gold standard in the early 1930s, the sooner their economies began to recover? No, not really.
If the proponents of the gold standard want to convince the wider world that their views have merit, it seems to me that they must confront the metal's troubling history in those historical episodes of soaring money demand. It's easy (if you'll pardon the phrase) to paper over these serious economic questions, but it's hard to take the gold bugs seriously when this fundamental issue is ignored. Then again, it's not surprising that you'd minimize the fatal flaw in your policy prescription.
Sure, the present system is far from perfect. Indeed, there are lots of challenges that come with central banking, and it's clear that mistakes have been made. Perfection and macroeconomics are two words that should never be used in the same sentence, except as a warning that the twain shall never meet. Meantime, the first question that the hard money folks should address is telling us why a gold standard would be better this time around. That's going to be tough, to say the least. A fair reading of economic history strongly suggests that we should remain skeptical for thinking that barbarous relic is the solution we've been waiting for. It failed before, which is why the Fed was created in the first place. A central bank is the lesser of evils, but that's the nature of economics.
February 1, 2012
Continued Improvement For Manufacturing Activity In January
January looked a bit better through the prism of the ISM manufacturing index, which rose again last month to 54.1 from December's 53.1. That's the third monthly increase in a row. Readings above 50 are generally interpreted as a sign that the economy is growing. It's hardly a knock-out blow against analysts warning of high recession risk these days, but it's clearly a step in the right direction. At this critical juncture for the global economy, anything that doesn't bite us is a big help.
Components of the ISM survey reflected growth as well. "Manufacturing is starting out the year on a positive note, with new orders, production and employment all growing in January," says Bradley Holcomb, chair of the Institute for Supply Management manufacturing business survey committee, in a press release.
For some context, here's how the ISM manufacturing index compares with the latest data on rolling 12-month percentage changes for the stock market, new orders for durable goods, and industrial production:
Based on the recent upturn in durable goods orders, it's not terribly surprising to see manufacturing activity rising. But with the stock market's annual return doing all it can to stay above zero, and with industrial production's pace slipping, the big picture is still mixed. All the more so after learning that ADP's estimate of job growth in January slowed by more than a trivial degree.
Will the economic outlook become any clearer after tomorrow's update on weekly jobless claims? Don't count on it, according to the consensus forecast from economists via Briefing.com. The crowd expects that new filings for unemployment benefits last week totaled 375,000. If true, that's just a slight drop from the previous week. That's mildly encouraging, but it won't be enough to still the debate about recession risk. Unless, of course, there's a big downside surprise for jobless claims, which would inspire a fresh round of thinking optimistically.
Major Asset Classes | Jan 31, 2012 | Performance Update
Last month was kind to risky assets. Indeed, there was no red ink in January for our broadly defined benchmarks of stocks, bonds, REITs and commodities. Ironically, cash (3-month T-bills) retreated ever so slightly on a monthly basis. Otherwise, the overall performance in this year's first month was the best since last October, with the Global Market Index (a passive, market-value weighted mix of all the major asset classes) rising a robust 4.0% last month.
The big winner was emerging market stocks: the MSCI EM Index popped a hefty 11.3% in January. The relative loser: U.S. bonds, which reported a 0.9% gain last month. Even so, that's a fairly healthy rise for this asset class in the context of its history. For the moment, the bond bubble that many have predicted has yet to show its teeth.
If your investment strategy didn't turn a tidy profit last month, you're either overweighted in cash or you're doing something wrong. We don't often see months like January, when returns are healthy and far flung. Rest assured, the easy money won't last. But for a brief, fleeting moment, at least, recent history makes everyone look like a genius.
ADP: Job Growth Slows In January
Job growth slowed in January, according to ADP. It wasn't a cataclysmic slowdown, but it's enough to keep the debate about recession risk bubbling. U.S. nonfarm private sector employment increased by a seasonally adjusted 170,000 last month, according to the ADP Employment Report. That's down from the 292,000 gain in December. It's clear that the labor market is still expanding, and that's one more favorable trend for the optimists. But the magnitude of the downshift is hardly a clear signal of hope about the future. At the very least, the outlook for the business cycle is a bit more hazy in the wake of this report.
As the chart below shows, today's ADP update implies that the Labor Department's official estimate of nonfarm payrolls for January will also deliver mildly disappointing news. The consensus forecast for Friday's update from the government for private payrolls anticipates a mild 168,000 rise vs. 212,000 reported for December, according to Briefing.com.
For the moment, at least, it's tempting to see the latest numbers as confirmation that the sluggish but still-positive revival in the labor market rolls on. “The job market continues to grow at a moderate pace,” says Jonathan Basile, a senior economist at Credit Suisse. “We’re on a gradually improving path for the labor market.”
By that reasoning, nothing much has changed for payrolls. The pace still isn't great, but an economy that's minting 170,000 jobs a month is high enough to cast some doubt on the idea that a recession is imminent if not here already. But analysts who think that a downturn is now a high risk can also point to history in search of support. Using the Labor Department's private nonfarm payrolls database as a guide, net job growth above 150,000 isn't usually associated with the onset of a recession. But "usually" leaves room for debate, especially these days. Indeed, in December 1969, for example, when the business cycle peaked, private nonfarm payrolls rose by 123,000. And at the peak in November 1973, on the eve of the worst recession since the 1930s, private job creation was a robust 246,000. Of course, the fall of 1973 witnessed the start of the Arab-Israeli war and the arrival of an oil embargo, an event that pushed the U.S. economy into recession. History doesn't repeat, but sometimes it rhymes. Is the trouble in the Middle East these days a worrisome trend? And there's always the festering crisis in Europe to consider. Lots of potential risk factors hang in the air as the U.S. appears to muddle through.
If there's another recession lurking, job creation will soon falter. We'll also see signs of trouble in other economic indicators. For the moment, however, there's enough a statistical support to argue both sides of this probability coin. Someone is wrong, of course, and it's likely that the data will soon tell us who's misreading the trends.