November 30, 2012
Is October's Weak Spending & Income Report Another Victim Of Sandy?
Personal income and spending in October was sluggish, and that's the charitable interpretation. But any talk of weak growth these days is quickly followed by the word "hurricane," along with the excuse that the devastating storm that struck the Northeast U.S. in late-October took a bite out of what would have been a more favorable profile for the month. There's a lot of debate about how much to blame on the weather, if at all. The Bureau of Economic Analysis notes in its income and spending report today that the storm was a factor in some degree that reduced wages and salaries. The implication, of course, is that what nature has taken away the economy will replace down the line. As such, the weather factor is an issue for the future, for good or ill. Meantime, on to the numbers as reported this morning.
Disposable personal income (DPI) was flat last month, posting the weakest reading since November 2011's decline. Personal consumption expenditures (PCE) fared even worse, retreating 0.2% in October—the first monthly decrease since June and the steepest drop since May. In short, today's numbers aren't encouraging by any stretch of the imagination. Given the general climate, between the fiscal cliff risk in Washington and recession in Europe, no one will be comforted by today's data dump. But the numbers aren't overwhelmingly awful either when considered in a longer-term context.
The next chart shows the year-over-year percentage changes for DPI and PCE, which reminds that growth is modest but relatively stable, at least for now. Income and spending are rising at around 3% each in nominal terms. That's not impressive, but that's only slightly below the previous month's annual rate and so we don't yet have a clear and unambiguous signal that these two metrics are collapsing.
The year-over-year trends for income and spending continue to support the slow-growth narrative that's prevailed for the economy overall this year. The support is wearing thin, particularly if the one-time hurricane excuse doesn't pan out. If the annual pace slips further in the months ahead, it'll be time to reassess. Certainly the trend doesn't look encouraging for thinking that growth will accelerate. The question is whether the annual rate will decelerate in any large degree?
One reason to remain cautious on expecting a favorable outcome is the ongoing deceleration in private-sector wages, as shown in the next chart below. Wages represent about half of personal income and so this slice of the pie can't be ignored. As of last month, private-sector wages increased 2.8% vs. a year ago. Not great, but we haven't yet crossed a red line yet either. Would the numbers have looked better without the hurricane? Probably, but it'll take another month or two to decide what to believe, or not.
“When all is said and done, consumers are not performing robustly, but they have a few things in their favor. Gas prices have fallen and the housing market is showing some traction,” says IHS Global Insight economist Chris Christopher.
Some folks will jump on today's income and spending numbers as proof positive that the economy is crumbling. They may be right, but it's still hard to make that claim based on the data du jour. A broader review of the indicators also suggests that slow growth is still with us. Can we count on more of the same with the incoming numbers in the days and weeks ahead? Let's just say that the potential for trouble is higher than it has been in several months. But it's still premature to put a fork in this turkey and declare that the expansion is cooked.
It's never wise to wait one day longer than necessary to declare that a new recession is fate. But it's equally risky to proclaim that we've slipped over to the dark side before the numbers present a convincing case on multiple fronts. To some ears, this sounds like prevarication. On the contrary, it's simply recognizing reality. It's tempting to fill in the missing pieces with speculation about what's coming, or not, and that's fine, up to a point and assuming it's done intelligently. But the future is still full of tricks, and not all of them lead down the rabbit hole.
There's Another Recession Out There Somewhere... Now & Forever
Lakshman Achuthan of Economic Cycle Research Institute toured the TV circuit again yesterday to revive and defend his firm's long-standing forecast that recession risk is high (see interviews on Bloomberg, and Yahoo Finance). He asserted that the recession started several months ago, noting that this past July marks the peak in the current business cycle for the U.S. The supporting evidence for this analysis, he explained, is patently clear in the behavior of three indicators. It all sounds plausible, but there's plenty of room for doubt too. The main problem is the ambiguity of the model, as it was outlined. Transparency and clarity regarding the underlying process are essential in business cycle analysis, particularly if you're arguing in no uncertain terms that the forecast is a virtual certainty. Essential, that is, if you're trying to evaluate the legitimacy of the prediction. Unfortunately, those features were in short supply in yesterday warnings.
It doesn't help Achuthan's position that ECRI's recession forecast has been kicking around since September 2011, when the firm warned that "the U.S. economy is indeed tipping into a new recession" and "if you think this is a bad economy, you haven’t seen anything yet." By most accounts, the recession has yet to arrive. But Achuthan begs to differ and says the proof is now visible in three indicators: industrial production, personal income, and sales (manufacturing, wholesale and retail). As an accompanying ECRI essay published yesterday explains:
Reviewing the indicators used to officially decide U.S. recession dates, it looks like the recession began around July 2012. This is because, in retrospect, three of those four coincident indicators – the broad measures of production, income, employment and sales – saw their high points in July (vertical red line in chart), with only employment still rising.
The "tell-tale chart," according to ECRI, is as plain as the nose on your face. Judge for yourself:
Note that employment isn't signaling a recession, as Achuthan readily concedes. But the other three indicators have peaked, he says, and so the writing is on the wall. July 2012 was the turning point.
The problem is that it's not obvious how ECRI came up with this analysis. Yes, it appears that industrial production, income and sales have peaked. But if you spend any time looking at the historical records of economic indicators you know that peaks in the data come and go fairly regularly without the start of recessions. How can we filter the numbers to elicit clearer signals? There are several methodologies that can enhance clarity, even though nothing is flawless. We can also remain skeptical of what's likely to lead us astray, starting with the shaky notion that looking at indicators in recent history, without benefit of crunching numbers for relative changes, is a short cut to clarity.
Note that the data presented above in ECRI's chart is the actual values of the indicators and not changes. Evaluating data series this way in search of business cycle insight is problematic for several reasons. Unfiltered data of this nature often looks menacing when it isn't. For example, consider industrial production's 10-year history. As you can see, there were several times when it looked like this indicator was rolling over only to resume its upward bias. To further complicate matters, industrial production was trending higher in late-2007, just as the last recession commenced.
This challenge is endemic to most, if not all economic and financial indicators. One way to filter out some of the noise is by looking at year-over-year changes. Let's take another look at industrial production on a rolling one-year-percentage-change basis. In the next graph below, industrial production seems to show a cleaner signal around and below the zero mark in connection with recessions.
The signal is a bit clearer, but there's still the issue of timeliness. What to do? Plugging a carefully selected array of indicators into a diffusion index and tracking the broad trend—primarily on a year-over-year basis, albeit with some exceptions—enhances the aggregate signal a bit more in terms of clarity and timing. It's still a lagging signal, but only marginally so if you do the analysis correctly. The tradeoff is that you have a higher level of confidence in the data analysis. In fact, this approach is a regular feature on these pages via the updates of The Capital Spectator Economic Trend Index (CS-ETI), with a recent update published here.
CS-ETI is no silver bullet, although it offers a solid starting point for deeper analysis—a baseline, if you will, for business cycle research and evaluating the risk of recession. Even so, bit of humility helps.
One of the big problems in the grand scheme of economic predictions is the assumption that recessions are always predictable events well in advance. If we're looking out a few months, there's a reasonable argument that risk can be assessed with some degree of confidence. For example, I run a number of econometric applications that analyze the economic trend from several angles for clues about where the data's probably headed in the next one to three months. This is useful as an exercise for assessing risk, particularly if you track and analyze the inevitable errors.
But what you can't do is look ahead six months, 12 months, 18 months down the road and reasonably argue that the economy will peak, or not. There are simply too many unknowns when you're gazing that far into the future.
In fact, it's really, really hard to call business cycle peaks with a high level of confidence before there's confirming data to back up your claim. Many have tried, and failed. The record on this front is quite clear, as many studies remind. The next best thing is looking for high confidence signals as early as possible that the economy has recently peaked. This type of analysis can be supplemented to a degree with econometric applications that assess the near-term future.
The dirty little secret in business cycle analysis is that the risk of missing the start of a recession is no less threatening than crying wolf far in advance. Both of these extremes tend to come with a high price in opportunity costs. The good news is that a compromise between these two extremes is practical and, in many respects, the only game in town. It takes quite a lot of work, however, and the analysis doesn't lend itself to dramatic headlines. But if you're looking for genuine perspective on how the big picture's unfolding, that's a small price to pay.
So, yes, ECRI's latest warning that the recession is underway may prove accurate. It's clear that the economy is vulnerable on several fronts. But that was also true in September 2011. Has the beast finally arrived? Possibly, although the econometric evidence isn't compelling, at least not yet. When it is, you'll read about it here.
November 29, 2012
Q3 GDP Revised Up, Jobless Claims Down
One up, one down. That's a good thing when it comes to the latest macro data points. GDP in the third quarter increased at a faster pace than initially reported and jobless claims continue to fall in the wake of the storm-related surge that drove new filings skyrocketing earlier in the month. The GDP news is a convincing sign that the economy continues to roll along in a slow-growth mode. The post-hurricane decline in jobless claims is also a positive, although the rate is a bit sluggish. What does it all mean? Let's take a closer look, starting with today's update on initial claims.
New filings for unemployment benefits dropped 23,000 last week to a seasonally adjusted 393,000. That's the second decline in as many weeks and another clue for thinking that the surge in claims for the week through November 10 was a one-time event that was driven by havoc unleashed by Hurricane Sandy. I said as much two weeks ago and the numbers published since offer support for this view.
That said, I remain a bit anxious because the rate of decline is modest relative to the surge. Last week's drop slowed to 23,000 vs. the previous week's decline of 35,000. And while new claims are again below the 400,000 mark, we're still well above the 360,000 range that prevailed before the storm hit. Another reason to wonder about the post-surge retreat is the modest rate of descent in the year-over-year unadjusted figures, as shown in the next chart.
An annual decline in jobless claims before seasonal adjustment is usually a strong signal that the labor market is creating new jobs on a net basis, which of course is critical for keeping the economy moving forward. The fact that new claims generally have been falling for the better part of the past two years speaks for itself. Accordingly, it's encouraging to see that claims are again falling relative to year-earlier levels. But today's update also shows that unadjusted claims dropped a light 4% vs. a year ago. Anything below zero is good, of course, but a 4% rate of decline is soft relative to pre-hurricane history and it's also quite a bit slower than the previous week's 8% annual decrease. Is this a warning sign of labor market troubles or just noise from the lingering effects of Sandy? Too early to say for sure, but suffice to say I'll be keeping a close eye on the incoming data in the weeks ahead and report the results here.
As for today's revised Q3 GDP, the 2.7% increase is quite a bit stronger than the previously reported 1.3%. The higher growth in the third quarter isn't a total surprise. Recall that The Capital Spectator's GDP nowcast, published right before the initial estimate from the government was released, anticipated a decent level of improvement over Q2's sluggish growth. I received a number of emails from folks at the time who said an improved outlook for Q3 vs. Q2 couldn't be right because the economy was weakening. But the nowcast said differently, drawing support from the relatively upbeat numbers via The Capital Spectator Economic Trend Index (CS-ETI) as of mid-October.
Meantime, Q4 growth currently looks set for a slower pace, as I noted in the latest GDP nowcast and CS-ETI updates from earlier this month. But for the moment, a broad review of the numbers continues to suggest that slow growth remains a convincing forecast for the near term. All the more so if the fiscal cliff issue is resolved, which may be a possibility if not a likelihood.
The economy is still vulnerable, of course, and a 2.7% pace for GDP is still modest at best. Overall, there's still plenty to worry about. But that's been the case all along. When there's a real danger sign that shows up in the numbers in a meaningful way, you'll read about it here. Meantime, as Societe Generale economist Brian Jones tells Bloomberg: “We’re just muddling through.”
November 28, 2012
Managing Expectations & Expected Returns
One of the most influential lines of research in financial economics over the past generation has been the "discovery" that asset returns are predictable. The predictability, as documented in the literature, isn't much help to day traders. Instead, numerous studies lay out the empirical case for arguing that a) expected returns fluctuate, and b) they fluctuate with some degree of recurring patterns relative to various factors, such as dividend yield and price-to-earnings ratio across medium- and long-term horizons in the equity market, for instance. This news surprised a lot of economists, including several who have helped lay the groundwork for indexing, which is widely favored by investors who think that forecasting generally is bunk. So far, so good, although it's easy abuse this discovery, as a recent research paper from Vanguard reminds.
"We find that many commonly cited signals have had very weak and erratic correlations with actual subsequent returns, even at long investment horizons," advise the authors of "Forecasting stock returns: What signals matter, and what do they say now?" Doesn't that evidence conflict with much of the research published in the last several decades? Not necessarily, although the Vanguard paper reminds us what's too often forgotten: the signals that provide assistance in developing robust forecasts for asset returns are often murky in real time, and always less than flawless. As the authors explain,
We confirm that valuation metrics such as price/earnings ratios, or P/Es, have had an inverse or mean-reverting relationship with future stock market returns, although it has only been meaningful at long horizons and, even then, P/E ratios have “explained” only about 40% of the time variation in net-of-inflation returns. Our results are similar whether or not trailing earnings are smoothed or cyclically adjusted (as is done in Robert Shiller’s popular P/E10 ratio).
Consider, for instance, one of the paper's graphs, which compares several predictors in terms of how they stack up in history relative to future equity market returns:
The best track record goes to P/E ratios based on trailing 10-year earnings (P/E 10). According to Vanguard, 43% of the variance of 10-year future real stock returns is "explained" by P/E 10 across time (1926-2011). That's a relatively high reading, compared with most other metrics. But if 43% of future returns are explained by P/E 10, it follows that 57% of the variance is effectively noise. The record is even less encouraging for shorter-term horizons. Vanguard notes that P/E 10 for the year-ahead perspective is around 10%, and generally speaking "the estimated historical correlations of most metrics with the 1-year-ahead return were close to zero."
Does that mean we should ignore predictors and give up trying to develop informed estimates of expected return? No, absolutely not. As Antti Ilmanen persuasively outlines in his invaluable reference work, Expected Returns: An Investor's Guide to Harvesting Market Rewards, "investing involves both art and science; a solid background in the science can improve the artist."
That includes familiarizing yourself with the pros and cons of the various predictors of risk premia that have been identified by financial economists over the years. Unless you're truly a long-term investor, and have no plans to modify your portfolio, understanding the finer points of generating expected return estimates is critical. Why? Because producing a reasonable forecast of risk premia requires that we focus on risk. Obvious, perhaps, but too often ignored. There's a reason why it's called a risk premium.
Quite a lot of the troubles that investors suffered in recent years could have been minimized to a large degree if they'd been forecasting returns through a risk-management framework. Several asset classes were priced for perfection ahead of the market crash in late-2008. The preference at the time was to overlook the warning signs and assume that the rules had changed. Big mistake, and for a number of reasons that weren't a secret then, or now.
Even under the best of circumstances, of course, quite a lot of the future will remain obscure, uncertain, and otherwise unknowable. What should we do? The Vanguard paper suggests that we start by thinking in probabilistic terms rather than coming up with point forecasts for expected returns. Agreed. If you're crunching the numbers and deciding that stocks have a real expected return of 6%, you should understand the applicable prediction interval, as one example.
You should also have a solid understanding of the methodology that created the forecast. Even better, use several methodologies to cross check the predictions, and make a habit of forecasting regularly. Predictions are almost always wrong, but you can learn a lot from the process, particularly if you analyze how your forecasts fared vs. the actual data.
Favor a multi-asset class strategy too. The Vanguard paper's conclusion that more than half of the stock market's variance is unrelated to P/E10 implies that owning stocks will take you on a bumpy ride for reasons that are hard if not impossible to fathom at times. But volatility, understood or not, also presents opportunity, especially in the context of asset allocation.
As I explain in some detail in my book, Dynamic Asset Allocation, is the "natural extension of asset allocation" because it's a relatively reliable tool for harvesting risk premia via price volatility. The combination of diversifying across asset classes and rebalancing the weights back to some pre-determined mix has an encouraging history of minimizing risk, modestly boosting return, or a bit of both.
If you also keep an eye out for falling rocks, including dark turns in the business cycle, you can improve the odds that you won't be blind-sided by shocks. The infamous unknown unknowns are always lurking, of course, but you can do quite a lot with a plain vanilla risk-management strategy.
What's the catch? You've got to do your homework, or hire someone who'll do it for you. What you can't do, at least not without suffering large doses of unnecessary hazards, is ignore history. Earning a reasonable risk premium doesn't require a Ph.D. or a team of securities analysts. In fact, you can do quite well by simply holding a broad asset allocation that's comprised of the major asset classes and rebalancing the mix every year or two. But you can't get blood out of stone or beat the mathematics of finance for very long. Every investor who beats the market does so because another investor has fallen short of the benchmark.
That brings us back to investing 101, as explained by the Vanguard paper. "Forming reasonable long-run return expectations for stocks and other asset classes can be important in devising a strategic asset allocation. But what precisely are “reasonable” expectations in the current environment, and how should they be formed?" The answer begins by recognizing that there are no silver bullets.
If you're skeptical, take a hard look at investors with a verifiable track record that's above average, vs. a relevant benchmark and for 10 years or more. What you're sure to find is an individual, or team of individuals, who are well versed in developing intelligent forecasts of return and risk.
November 27, 2012
The Trend For Durable Goods Orders Remains Weak
New orders for durable goods were flat last month, the Census Bureau reports. That follows a strong 9.2% gain in September. Stripping out the volatile transport sector, however, reveals that new orders jumped a respectable 1.5% in October. Meantime, business investment gained some ground last month, with new orders for non-defense capital goods ex-aircraft rising 1.7%--the best month since May. Corporate America's willingness to invest isn't dead yet. Even so, new orders for big-ticket items overall remains sluggish. Today's report suggests that the bottom isn't falling out on this leading indicator, at least not yet, but the numbers are still well short of offering robust confidence for arguing that demand is strong.
Still, today's modest bit of good news is a surprise for economists, who expected that the October report would post a sizable retreat. “Demand for durable goods has stabilized,” Ryan Wang, an economist with HSBC Securities, tells Bloomberg. “It’s a positive sign.”
Fair enough, but it's a positive sign that's also precarious in the current climate. Looking at the year-over-year trend in durable goods orders reminds that this indicator certainly isn't impressing the bulls. The headline number is generally treading water these days while business investment continues to fall relative to year-earlier levels. October's revival is welcome, but one month is weak tea against the recent trend.
The good news is that durable goods orders are still a weak player in a field of generally positive indicators, when measured on an annual basis. That's a sign that the business cycle isn't caving, as noted in last week's update of The Capital Spectator Economic Trend Index. It's clear that the monthly comparisons for October suffered setbacks, although it's debatable how much of this is due to weather-related distortions vs. deeper problems for the business cycle overall. A mix of the two explanations is probably a safe bet.
Nonetheless, today's durable goods report, encouraging as it is relative to the much darker expectations that preceded the release, is a reminder that the economy is vulnerable and growing at a slower rate these days. Is the recent slowdown enough to push us into recession? Not yet, or at least not yet based on a broad read of the numbers. But there's nothing in today's durable goods update to wipe this possibility from our minds and so it's on to the next batch of reports for additional perspective.
Next up is tomorrow's weekly update on jobless claims. The consensus forecast expects another modest decline that will chip away at the storm-related surge of two weeks ago. Another drop constitutes progress, although anything less than a big decline in tomorrow's claims data will keep debate open about where we go from here.
November 26, 2012
Chicago Fed: Slower Economic Activity In October
The economy’s momentum weakened last month, according to today’s update of the Chicago Fed National Activity Index (CFNAI). The slowdown isn’t surprising, given the monthly declines cited in several reports for October data—retail sales and industrial production, for instance. The question remains if Hurricane Sandy distorted the data? That's a possibility, although it's not clear how much we can blame on weather for last month's deceleration. Meantime, with the fiscal cliff approaching, today's CFNAI report will surely promote worries that the economy is headed for rough seas.
Nonetheless, it's still premature to pull the plug on the outlook for growth. CFNAI's three-month average for October is -0.56, or slightly above the tipping point level of -0.70, below which is considered a signal of "an increasing likelihood
that a recession has begun," according to the Chicago Fed. That doesn't leave much room for comfort, but if we've learned anything in the last few years when it comes to business cycle analysis it's that early and impulsive cries that a new recession has started without sufficient data has a dismal track record.
My own analysis supports the case for reserving judgment on what comes next. Last week's update of The Capital Spectator Economic Trend Index (CS-ETI) reminds that a broad review of economic numbers continues to suggest that recession risk is low. Since CS-ETI's update, we've learned that housing starts and new permits in October continue to look encouraging and so the incoming data isn't uniformly dark. Meantime, Friday's nowcast of GDP on these pages for the fourth quarter, although weaker than the reported 2.0% increase for Q3, is still comfortably in positive territory.
The point here isn't to white wash the signs of trouble on the macro landscape, but to remind that it's still too early to issue a high-confidence warning that the economy has taken a fatal and unavoidable turn for the worse. That may yet be the business cycle's fate, but jumping on that bandwagon of pessimism still requires quite a lot of speculation about what comes next and ignoring the genuinely positive signs in the economic data overall.
That includes assuming that the threat arising from the fiscal cliff will be allowed to roil the economy. The potential from self-inflicted wounds via the Beltway crowd can't be ignored, but there's still time to tame this beast.
Nonetheless, we're at a perilous stage once more for the business cycle. The good news: a surplus of clear signs that growth has taken a holiday remains elusive in terms of the broad trend. Yes, the defenses are weakening on some fronts and so it's critical to monitor the data closely, day by day. If we slip over the edge in convincing terms, you'll read about it here. Meantime, cautious optimism, although running lighter these days, is still recommended.
Tactical ETF Review: 11.26.2012
If investors are worried about the threat from the fiscal cliff, it's not obvious in the recent price trends for the major asset classes. Our ETF proxies for the primary slices of the world's capital and commodity markets remain in the black for the year through November 23. For the month so far, only foreign developed-market bonds and REITs are suffering from the red ink disease, albeit in moderate doses, while the U.S. stock market overall is near the tipping point.
It's a strange, almost surreal environment. Depending on the analyst, the forecast if the fiscal cliff's tax hikes and spending cuts are allowed to kick in come January ranges from a minor blip to deep economic recession. There are also those who dismiss the danger entirely, arguing that it's a media-hyped event for the political class, with little or no real consequence for the economy or markets. Given the generally positive returns across the major asset classes, one might wonder if the crowd leans toward the latter view. December's market action, no doubt, will sort it all out. Meanwhile, here's how the horse race stacks up so far:
US STOCKS • Vanguard Total Market (VTI) • Benchmark: MSCI US Broad Market Index
FOREIGN DEVELOPED MARKET STOCKS • Vanguard Europe Pacific (VEA) • Benchmark: MSCI EAFE
EMERGING MARKET STOCKS • Vanguard Emerging Markets (VWO) • Benchmark: MSCI Emerging Market
US BONDS • Vanguard Total Bond Market (BND) • Benchmark: Barclays US Aggregate
INFLATION-INDEXED US TREASURIES • iShares Barclays TIPS Bond (TIP) • Benchmark: Barclays US TIPS
HIGH YIELD BONDS • SPDR Barclays High Yield Bond (JNK) • Benchmark: Barclays High Yield Very Liquid
COMMODITIES • iPath Dow Jones-UBS Commodity (DJP) • Benchmark: DJ-UBS Commodity
REAL ESTATE INVESTMENT TRUSTS • Vanguard REIT (VNQ) • Benchmark: MSCI US REIT
FOREIGN DEVELOPED MARKET GOVERNMENT BONDS • SPDR Barclays Int’l Treasury (BWX) •
Benchmark: Barclays Global Treasury ex-US Capped
EMERGING MARKET GOVERNMENT BONDS • Van Eck Market Vectors Emg Mkt Local Currency Bond (EMLC) •
Benchmark: J.P. Morgan GBI-EMG Core
FOREIGN GOVERNMENT INFLATION-LINKED BONDS • SPDR DB International Inflation-Protected Bond (WIP) •
Benchmark: DB Global Government ex-US Inflation-Linked Bond Capped
FOREIGN CORPORATE BONDS • PowerShares International Corporate Bond (PICB) •
Benchmark: S&P International Corporate Bond
Charts courtesy of StockCharts.com
November 24, 2012
Book Bits | 11.24.12
● Antifragile: Things That Gain from Disorder
By Nassim Nicholas Taleb
Summary via publisher, Random House
Nassim Nicholas Taleb, the bestselling author of The Black Swan and one of the foremost thinkers of our time, reveals how to thrive in an uncertain world. Just as human bones get stronger when subjected to stress and tension, and rumors or riots intensify when someone tries to repress them, many things in life benefit from stress, disorder, volatility, and turmoil. What Taleb has identified and calls “antifragile” is that category of things that not only gain from chaos but need it in order to survive and flourish. In The Black Swan, Taleb showed us that highly improbable and unpredictable events underlie almost everything about our world. In Antifragile, Taleb stands uncertainty on its head, making it desirable, even necessary, and proposes that things be built in an antifragile manner.
● Taxes in America: What Everyone Needs to Know
By Leonard Burman and Joel Slemrod
Q&A with authors via Washington Independent Review of Books
Q: A chapter on taxes and the economy tackles some of the questions involved in the contentious issue of tax cuts versus spending cuts. You note that conventional economic wisdom argues for directing tax cuts to lower-income individuals since their marginal propensity to consume (MPC) — that is, the immediate need to spend any additional income, including tax cuts — will be higher than for the wealthy. But you point out that recent evidence has called this conventional wisdom into question. So, is the evidence about MPC credible and are we looking at arguments based on economic principles, or is it all just politics?
A: There’s certainly a lot of politics, but economic evidence is certainly relevant. The fact is that some tax cuts intended to help get the economy out of a recession often have proven disappointing. Policymakers hope that when they cut taxes for individuals, they will go out and spend the money, which will create new demand for products and services and induce companies to hire and invest more. The problem is that, especially in recent years, consumers often put their tax rebates in the bank or use them to pay down credit-card debt, which is good for the taxpayers but doesn’t do much to get the economy going.
● Tap Dancing to Work: Warren Buffett on Practically Everything, 1966-2012: A Fortune Magazine Book
By Carol J. Loomis
Review via Kirkus Reviews
"In 1966 he was the proprietor of an unfamous hedge fund, Buffett Partnership Ltd., and the controlling shareowner and de facto CEO of a small New England textile company, Berkshire Hathaway, with $49 million in annual revenues," writes Fortune senior editor at large Loomis, as she discusses more than 80 articles covering the investing history of Warren Buffett. “By 2011, Berkshire was No. 7 in the Fortune 500, with $144 billion in revenues.” Serious investors as well as those interested in the history of Berkshire Hathaway and the philanthropic ideas of Buffett will enjoy these revealing pieces extracted from the Fortune archives. Having written many of the original articles herself, Loomis offers new insights into the various phases and actions of her close personal friend. Chronologically arranged, the commentaries begin in 1966, when Buffett was first mentioned in Fortune (an article in which his name was misspelled) and move through his latest thoughts and actions on philanthropy based on a dinner held for the uber-rich in 2010.
● Trading with Intermarket Analysis: A Visual Approach to Beating the Financial Markets Using Exchange-Traded Funds
By John J. Murphy
Summary via publisher, Wiley
With global markets and asset classes growing even more interconnected, intermarket analysis—the analysis of related asset classes or financial markets to determine their strengths and weaknesses—has become an essential part of any trader's due diligence. In Trading with Intermarket Analysis, John J. Murphy, former technical analyst for CNBC, lays out the technical and intermarket tools needed to understand global markets and illustrates how they help traders profit in volatile climates using exchange-traded funds.
● Deficits, Debt, and the New Politics of Tax Policy
By Dennis S. Ippolito
Summary via publisher, Cambridge University Press
The Constitution grants Congress the power "to lay and collect taxes, duties, imposts, and excises." From the First Congress until today, conflicts over the size, role, and taxing power of government have been at the heart of national politics. This book provides a comprehensive historical account of federal tax policy that emphasizes the relationship between taxes and other components of the budget. It explains how wars, changing conceptions of the domestic role of government, and beliefs about deficits and debt have shaped the modern tax system. The contemporary focus of this book is the partisan battle over budget policy that began in the 1960s and triggered the disconnect between taxes and spending that has plagued the budget ever since. With the federal government now facing its most serious deficit and debt challenge in the modern era, partisan debate over taxation is almost completely divorced from fiscal realities. Continuing to indulge the public about the true costs of government has served the electoral interests of the parties, but it precludes honest debate about the urgent task of reconnecting taxes and budgets.
● Business Cycles: Part I
● Business Cycles: Part II
By F.A. Hayek
Summary via publisher, Routledge
In the years following its publication, F. A. Hayek's pioneering work on business cycles was regarded as an important challenge to what was later known as Keynesian macroeconomics. Today, as debates rage on over the monetary origins of the current economic and financial crisis, economists are once again paying heed to Hayek's thoughts on the repercussions of excessive central bank interventions. The latest editions in Routledge's ongoing series The Collected Works of F. A. Hayek, these volumes bring together Hayek's work on what causes periods of boom and bust in the economy. Moving away from the classical emphasis on equilibrium, Hayek demonstrates that business cycles are generated by the adaptation of the structure of production to changes in relative demand. Thus, when central banks artificially lower interest rates, the result is a misallocation of capital and the creation of asset bubbles and additional instability. Business Cycles: Part I contains Hayek's two major monographs on the topic: Monetary Theory and the Trade Cycle and Prices and Production. Reproducing the text of the original 1933 translation of the former, this edition also draws on the original German, as well as more recent translations. For Prices and Production, a variorum edition is presented, incorporating the 1931 first edition and its 1935 revision. Business Cycles: Part II assembles a series of Hayek's shorter papers on the topic, ranging from the 1920s to 1981.
November 23, 2012
Q4:2012 U.S. GDP Nowcast Update | 11.23.2012
The post-Hurricane Sandy economic updates have taken a slight toll on the GDP outlook for the fourth quarter. Since our previous Q4:2012 nowcast on November 5, the average estimate for real GDP growth has slipped to 1.2% from 1.7% previously, based on five econometric methodologies (see list below). That compares with the actual 2.0% increase for Q3, according to the government’s announcement last month. (All percentage changes cited based on quarter-over-quarter data in annualized terms). Keep in mind that there’s still a long way to go until the release of the initial estimate of Q4 GDP on January 30, 2013 from the Bureau of Economic Analysis. Meantime, if the data favors us with a degree of post-hurricane bounce back, the nowcasts will rise in the weeks ahead. Turning back to the present, let's take a closer look at how The Capital Spectator’s current nowcasts stack up.
Today's estimates of Q4 GDP growth rates are below those in recent survey forecasts from The Wall Street Journal (WSJ) and the Philadelphia Fed’s Survey of Professional Forecasters (SPF). Our average 1.2% nowcast is well under the 1.8% predictions published by WSJ and SPF earlier this month.
The decline in today’s nowcasts vs. the November 5 estimates reflects the weak incoming data for October, namely: industrial production and retail sales, which is used as a proxy for the consumer sector until the personal consumption expenditures report for October is published next week.
For now, the latest numbers suggest that we should moderate our expectations for Q4 GDP vs. the previous quarter. There’s a reasonable argument that the updates in the weeks ahead will improve, at least for those of us who think that the hurricane distorted the numbers. Even if that assumption proves overly optimistic, our average 1.2% nowcast implies that slow growth is still the path of least resistance--assuming that the fiscal cliff threat is defused. The mildly optimistic average GDP nowcast also draws support from the latest update for the The Capital Spectator Economic Trend Index, which estimates that recession risk remains low for the moment. All of this is based on reported numbers and using the data to project the near-term outlook. Political factors arising from self-inflicted macro pain via our representatives in Washington, in other words, isn’t part of the statistical analysis. Some hazards for the business cycle can’t be quantified, even if they’re staring us in the face.
As for the numbers in hand, here’s a brief review of how they’re sliced and diced to generate The Capital Spectator’s GDP nowcasts:
4-Factor Nowcast. This estimate is based on a multiple regression of quarterly GDP in history relative to quarterly changes for four key economic indicators: real personal consumption expenditures, real personal income less government transfers, industrial production, and private non-farm payrolls. This model compares the data on a quarterly basis, looking for relationships with GDP within each quarter from the early 1970s to the present. The four independent variables are updated monthly and so the nowcast is revised as new data is published. In effect, this model is telling us what the data trends in the current quarter imply for the quarter's GDP growth.
10-Factor Nowcast. This model also uses a multiple regression framework based on historical data from the early 1970s onward and updates the estimates as new numbers arrive. The methodology here is identical to the 4-factor model except that it uses additional factors—10 in all. In addition to the data quartet in the 4-factor model, the 10-factor nowcast also incorporates the following series:
• ISM Manufacturing PMI Composite Index
• housing starts
• initial jobless claims
• the stock market (S&P 500)
• crude oil prices (spot price for West Texas Intermediate)
• the Treasury yield curve spread (10-year Note less 3-month T-bill)
ARIMA Nowcast. The econometric engine for this nowcast is known as an autoregressive integrated moving average. The technique is using only real GDP's history, dating from the early 1970s onward, for anticipating the current quarter's change. As the most recent quarterly GDP number is revised, so too is the ARIMA nowcast, which is calculated in R software via Professor Rob Hyndman’s “forecast” package, which optimizes the prediction model based on the data set's historical record.
ARIMA 4 Nowcast. This model is similar to the ARIMA technique above in terms of the econometric technique, but with a key difference. Instead of using GDP's historical data as a lone input, the ARIMA 4 model analyzes four historical data sets to predict GDP: real personal consumption expenditures, real personal income less government transfers, industrial production, and private non-farm payrolls.
VAR Nowcast. The vector autoregression model looks to several data series in search of interdependent relationships for estimating GDP. The historical data sets in the 4-factor and ARIMA 4 models above are also used to generate VAR nowcasts of GDP. As new data is published, so too is the VAR nowcast. The basic idea here is to let the data specify the model's parameters. The data sets are based on historical records from the early 1970s, using the "vars" package for R to crunch the numbers.
November 22, 2012
A day to relax, reflect--and give thanks. An autumn feast that's inspired by the first banquet shared by the Plymouth colonists and Wampanoag Indians in 1621 is right as rain for your editor at this moment. After playing catch-up in the wake of Hurricane Sandy, it's been a long month and so the opportunity to reconsider all that's been won, and lost, in America is a welcome break from the routine. As one of the "classic" Thanksgiving essays republished in The Wall Street Journal over the years observes: "We can remind ourselves that for all our social discord we yet remain the longest enduring society of free men governing themselves without benefit of kings or dictators. Being so, we are the marvel and the mystery of the world, for that enduring liberty is no less a blessing than the abundance of the earth."
November 21, 2012
Jobless Claims Fell Sharply Last Week
The ranks of the newly unemployed tumbled last week, as expected. The previous update on weekly filings for jobless benefits reported a dramatic surge, but many analysts--including yours truly--argued that the spike was weather related and so it probably wasn't a sign that the business cycle was slipping over the edge. Today's news provides some statistical support for that relatively optimistic perspective.
New claims dropped 41,000 to a seasonally adjusted 410,000 for the week through November 17. That's still high, and uncomfortably so, especially as it relates to recent history. But for the moment, it's reasonable to assume that the return to "normal" is underway, even though it will take time to rid the data of the distorting effects from Hurricane Sandy. Indeed, the storm-battered states of New Jersey and New York reported a huge combined increase in new claims of 75,000 last week. No one confused these two states as ground zero for strong economic growth prior to the hurricane. Yet it's unconvincing to argue that the ranks of the unemployed in NJ and NY would be taking flight to this degree if the skies had remained sunny all along. Short of the arrival of economic Armageddon in the days ahead, it's a fairly safe bet that NY and NJ won't be reporting new claims of 75,000 per week going forward, which implies that there's room for expecting further declines in the national numbers. In fact, one could argue that it's impressive that claims overall fell last week amid such a huge gain in these two states.
Speculation about what it all means for a broader read on the economy will wander near and far, of course. But a stronger case for thinking that the hurricane is largely to blame for the recent spike in claims can be found by looking at the unadjusted data on a year-over-year basis. As the next chart shows, the annual pace of new filings last week fell back to the trend that's prevailed over the past year: a decline of roughly 10% vs. the same week of 12 months previous. That's a signal that the labor market didn't collapse recently, and that more modest growth is coming.
Even so, there are still plenty of hazards to consider as the year winds down and so forecasts generally are more precarious than usual. Yes, the fiscal cliff factor remains an issue, which may bring trouble for the labor market and other corners of the economy, perhaps with devastating effects. But considering that raw claims data is again falling by roughly 10% a year suggests that the jobs market, while still struggling with slow growth, didn't suffer a death blow in the recent past.
Hurricane Sandy's lingering effects remains a “temporary setback for the job market,” advises Ryan Sweet, a senior economist at Moody’s Analytics, via Bloomberg. Looking ahead, “the job market is still very weak and it’s going to remain that way until we get some fiscal clarity,” he says.
Fiscal clarity, alas, may remain a rare species in the land of the Beltway follies, thanks to the risk known by the "worst metaphor" of the year. But no matter what you call the political nonsense in Washington, the potential for economic pain is quite real. What's more, the macro fallout, if it arrives, may linger a lot longer compared with the temporary torture from Sandy.
"The Congress and the Administration will need to protect the economy from the full brunt of the severe fiscal tightening at the beginning of next year that is built into current law--the so-called fiscal cliff," Fed chairman Ben Bernanke warned in yesterday's testimony in Congress via his prepared remarks. "The realization of all of the automatic tax increases and spending cuts that make up the fiscal cliff, absent offsetting changes, would pose a substantial threat to the recovery--indeed, by the reckoning of the Congressional Budget Office (CBO) and that of many outside observers, a fiscal shock of that size would send the economy toppling back into recession."
The labor market, in other words, may be facing a new round of suffering after all. But for the moment, there's no smoking gun for arguing that the suffering has already started for fundamental economic reasons. Political factors are another matter since our representatives in Washington insist on playing with loaded fiscal weapons.
A Perverse Relationship: Equity Prices & Inflation Expectations
The stock market and the market's implied inflation forecast are still a perverse couple. That's no surprise, given the anxiety over the fiscal cliff, the economic outlook, the Middle East, and all the rest. The new abnormal, in short, is still with us and probably will be for the foreseeable future. That's no surprise, even if this reality shocks some observers who continue to consider inflation from a pre-2008 perspective.
Oh, well. Big changes in macro conditions can take a toll on some folks' ability to grasp the obvious. But recognized or not, the stock market and the market's inflation forecast (the yield spread for the 10-year Treasury less it's inflation-indexed counterpart) continue to move with a relatively high degree of positive correlation.
Over the past two months or so, for instance, the stock market has trended lower, and so has the yield spread for nominal less inflation-indexed 10-year Treasuries. What does it mean? For starters, the crowd still considers higher inflation as a positive. That's nothing new by the standard of the past four years. It's abnormal in the grand sweep of market history, of course, but it remains front and center in the current climate. (For a formal explanation of this relationship, see David Glasner's paper: The Fisher Effect under Deflationary Expectations.)
It's a safe bet that inflation expectations will diminish further if the folks in Washington allow the economy to move closer to the fiscal cliff. In that case, one should expect the stock market to follow. Yes, the new abnormal will end one day, and inflation will again be considered with a wary eye from the vantage of equities. But that day still seems like a distant prospect until the macro uncertainty is sorted out. Meantime, abnormality remains the new new thing in the dance between risky assets and inflation. Same as it ever was.
November 20, 2012
The Housing Recovery Rolls On
The housing sector continues to revive, according to this morning's update on housing starts and newly issued residential building permits. Residential construction increased 3.6% in October over the previous month, the Census Bureau advises. Last month's permits total total slipped 2.7%, but that's not a worry at this point because this metric, which offers a clue about future construction activity, is still advancing at a robust pace generally.
Improvement is also the message in the latest read on existing home sales, which rose 2.1% last month and are higher by nearly 11% vs. a year ago, according to the National Association of Realtors. Home builders are feeling more optimistic about their industry as well: confidence in this sector rose this month rose to its highest level in six years, the National Association of Home Builders reported yesterday. Improving conditions are also reflected in today's update on starts and permits, even though permits backtracked a bit.
The crucial perspective on starts and permits as it relates to the business cycle analysis is watching how these indicators perform on a year-over-year basis, and on that front the trend remains convincingly positive. Both series are rising at well over 20% a year, a strong signal that the housing sector is expanding at a healthy pace. In absolute terms the rate of construction is still well below the levels reached before the housing bust circa 2006. But at this stage the most important factor is the growth rate. An expanding housing sector, even from a low base, is critical on a number of levels for the macro picture these days. The good news is that the trend continues to be our friend.
The housing market's recovery is timely for the economy overall. Housing at times can represent nearly one-fifth of GDP, according to some estimates, and so the news that this arena is no longer a drag on growth but is a net positive again is significant. All the more so at a time when concerns are rising about the fiscal cliff and its potential for creating headwinds for the economy. A housing recovery, in other words, is no longer a sideshow for the business cycle; instead, it's probably an essential source of growth if there's any chance of falling into a new recession. Housing probably won't save us if the worst-case scenario for the fiscal cliff arrives, but for now let's just say that the rebound in residential real estate couldn't come at a better time.
“Housing is absolutely going in the right direction,” says Harm Bandholz, chief U.S. economist at UniCredit Group. “Excess supply has been wound down and there’s a steady increase in demand. That’s good for construction.”
It's also good for the big picture. In yesterday's update of The Capital Spectator Economic Trend Index (CS-ETI), new building permits for October was one of the few missing pieces of data for last month's profile. With today's update, there's another data point that falls into the positive column. Even before this morning's housing news, CS-ETI was telling us that recession risk was low, based on the available data through October. The analysis is even more compelling now.
If the fiscal cliff hazard could be defused, the economy might really take off. That leaves us with a crucial question, as posed by the LA Times today: "Can the bozos who created the 'fiscal cliff' save us from it?" The business cycle, it seems, is at the mercy of the clown factor.
Strategic Briefing | 11.20.12 | Housing & The Economy
Steady US housing recovery is boosting economy
Associated Press | Nov 19
The housing market’s recovery still has a long way to go. But for now, it’s helping prop up an economy that’s being squeezed by a global slowdown and looming spending cuts and tax increases. Joseph LaVorgna, an economist at Deutsche Bank, estimates that the housing recovery could boost U.S. economic growth by a full percentage point next year. That’s because a stronger housing market would mean more jobs, especially in industries like construction, and more consumer spending.
Housing recovery gains traction
Reuters | Nov 19
"The housing market is continuing to improve. It's probably improving more than most economists were projecting earlier this year," said Patrick Newport, an economist at IHS Global Insight in Lexington, Massachusetts.
Home sales up, inventory down: good for home prices and for builders
Christian Science Monitor | Nov 19
"The improvement in existing home sales ... is being driven by the very favorable level of housing valuations and affordability," says Paul Diggle, a housing expert at Capital Economics in London, in a report Monday. "Supply conditions in the existing homes market are even tighter than we had previously thought." A wild card, for the months ahead, is whether and how politicians resolve the "fiscal cliff" of tax hikes and federal spending cuts that are scheduled to take effect in January. The cliff could send the US economy into recession (and thus derail a housing recovery), but most economists expect that Congress and President Obama will cut a deal in time to avert the worst effects.
Existing-Home Sales Rise in October with Ongoing Price and Equity Gains
Nat'l Assoc of Realtors | Nov 19
Sales of existing homes increased in October, even with some regional impact from Hurricane Sandy, while home prices continued to rise due to lower levels of inventory supply, according to the National Association of Realtors. Total existing-home sales1, which are completed transactions that include single-family homes, townhomes, condominiums and co-ops, rose 2.1 percent to a seasonally adjusted annual rate of 4.79 million in October from a downwardly revised 4.69 million in September, and are 10.9 percent above the 4.32 million-unit level in October 2011. Lawrence Yun , NAR chief economist, said there was some impact from Hurricane Sandy. "Home sales continue to trend up and most October transactions were completed by the time the storm hit, but the growing demand with limited inventory is pressuring home prices in much of the country," he said. "We expect an impact on Northeastern home sales in the coming months from a pause and delays in storm-impacted regions."
Builder Confidence Rises Five Points in November
Nat'l Assoc of Home Builders | Nov 19
Builder confidence in the market for newly built, single-family homes posted a solid, five-point gain to 46 on the National Association of Home Builders/Wells Fargo Housing Market Index (HMI) for November, released today. This marks the seventh consecutive monthly gain in the confidence gauge and brings it to its highest point since May of 2006.
Record-low mortgage rates may lift housing
Dallas Morning News | Nov 18
Demand for residential real estate is also being propelled by more affordable properties, progress in the labor market and improving consumer sentiment. The data underscore what Federal Reserve Chairman Ben Bernanke called “signs of improvement” in the market, which is helping fuel the expansion as manufacturing cools. “Housing has definitely become a bright spot in the economy, while all the international-facing sectors are doing much worse,” said Yelena Shulyatyeva, U.S. economist at BNP Paribas in New York. The economy should sustain a “modest recovery” through year-end, she said.
Housing’s comeback looks real
MarketWatch | Nov 16
More than 100 economists polled by Pulsenomics for the real estate website Zillow expect the good times to roll. They foresee home price increases of around 2.3% this year, but also think residential real estate will continue recovering for the next four years.
Housing Dynamics over the Business Cycle
Finn E. Kydland, et al. | Aug 26, 2012
A well known feature of the U.S. business cycle is that residential investment leads and nonresidential investment lags GDP. We document that in most other developed economies both types of investment are, more or less, coincident with GDP. There is much more uniformity across countries, however, when residential construction activity is measured by housing starts: almost all countries in our sample exhibit housing starts leading GDP. In contrast, a strong internal mechanism present in most business cycle models produces residential investment occurring only after an increase in GDP, once enough business capital has been built up. Our empirical analysis points to mortgage finance as a potential reason why actual economies exhibit the opposite dynamics.
November 19, 2012
U.S. Economic Trend Update | 11.19.12
Will the fiscal cliff drag us over the edge? Is the festering crisis in Europe going to explode with severe repercussions for the U.S. economy? Do the wars in the Middle East pose a threat too? All of these risk factors are at the top of the list of things to worry about. The good news is that the economy has, or had, a tailwind, based on the current lineup of economic and financial indicators. That's no guarantee that economic growth will survive in an increasingly risky world. But hasty decisions about the economy can take a heavy toll as well.
It's certainly not getting any easier to evaluate the state of the business cycle as 2012 winds down. But if there's any chance of accurately deciding what's likely to come next, it's essential to start the analysis with a broad review of the data. Was the economy deteriorating in recent months? Or was it holding up fairly well? The numbers suggest the latter, as shown in today's update of the indicators in The Capital Spectator Economic Trend Index (CS-ETI):
Plugging the numbers into a diffusion index tells us that recession risk is still minimal, according to the latest data, as the next chart below shows. In other words, the majority of indicators are still trending positive through October, albeit based on 11 of the 14 indicators in CS-ETI for last month. Yes, the incoming numbers may change the profile from light to dark fairly quickly, although October's final profile is all but assured to remain relatively encouraging. November and beyond are where the primary mystery begins. If the tide turns for the worse, CS-ETI will lose altitude, and perhaps quickly. But based on what we know at the moment, the bias toward growth is, or at least was, substantial.
The quality and depth of the growth is another matter—a topic that CS-ETI doesn't address. Rather, the focus here is on quantifying the trend via a wide spectrum of economic and financial indicators in search of one of the more elusive reads in macro: the business cycle, the mother of all latent variables in economics.
Translating CS-ETI's time series into probabilities across time via a probit model also suggests that recession risk is negligible as of October. But the various risks noted above aren't necessarily reflected in the current probability estimate. Given the precarious state of affairs at the moment, it's not clear how much persistence to assume for the trend in the months to come.
Looking ahead is always a murky affair and perhaps more so these days. But with eyes wide open, let's consider what the data's implying for the near-term future via a sophisticated econometric technique that's applied in a relatively straightforward way. In particular, I've generated forecasts for each of CS-ETI's indicators, independently of one another, using an ARIMA model. I then aggregate the results to estimate CS-ETI for the next several months.1 The process starts by filling in the handful of missing numbers for October and then estimating each of the data sets for November and December. It's safe to assume a fair amount of error for any one of these forecasts, although aggregating the individual estimates can minimize the risk a bit if some of the errors cancel each other out.
As usual, the further out we look, the higher the potential for error generally. That said, the basic message is that CS-ETI isn't set to tumble, or so the estimated data for the next few months suggest. A similar set of forecasts for CS-ETI using a vector autoregression technique dispenses a similar set of estimates.
We can't take these forecasts as gospel, of course, but neither we should we dismiss them since the ARIMA estimates for CS-ETI have been encouraging recently. For instance, the chart above shows that the ARIMA estimates of September 28 turned out to be fairly accurate for anticipating August and September's profile—at a time when there was still a fair amount of uncertainty about how those month profiles would fare, particularly for September.
So, what's the risk with all of this? The big one is that all the trouble swirling about isn't reflected in the current data and the potential for a negative shock is growing. For example, the news that investment spending in corporate America continues to fall is a dark sign.
The upbeat estimates for CS-ETI through the end of the year, in other words, may be victimized by new events that aren't yet reflected in the latest economic reports. That's always a risk factor, of course, although the potential for negative surprises is probably higher than average at the moment.
Even so, it's premature to assume that the business cycle for the U.S. is doomed. Yes, the numbers above look counterintuitive compared with how we may "feel" about the economy at the moment, or how the outlook appears by focusing on a relative handful of reports. If we are, in fact, at a turning point that unleashes a new recession there'll be clear signs of the change via a broad set of the numbers, and soon. Yes, you could assume the worst now and start making decisions accordingly. But that's a risk factor too, and a rather large and costly one when considered across time.
It's inevitable that calling major turning points in the business is destined for inaccuracy in real time. There are too many factors working against us to expect a high degree of accuracy at any one moment. The question is how we'd prefer to be wrong as a general proposition? Is it preferable to make premature recession calls? Or are we better served in trying to recognize those times when cycle has turned down after the fact—as early as possible?
My research tells me that the latter is the way to go. Why? Many reasons, including the compelling statistical and econometric evidence that the odds of success are considerably higher for accurately calling the start of new downturns shortly after they've begun vs. trying to anticipate these events before they've started and/or based on minimal evidence for making such assumptions. That doesn't mean we can be nonchalant about rising risks that could push us over the edge. But history teaches that the vast majority of error in business cycle analysis is bound up trying to assume too much about what may happen in the months ahead. That's certainly been a problem during the last several years, which is overflowing with examples of premature warnings of a new recession that, so far, never arrived.
November 17, 2012
Book Bits | 11.17.12
● Post Modern Investment: Facts and Fallacies of Growing Wealth in a Multi-Asset World
By Garry Crowder, Thomas Schneeweis, and Hossein Kazemi
Summary via publisher, Wiley
There have been a lot of big changes in the investment world over the past decade, and many long-cherished beliefs about the structures and performance of various investments no longer apply. Unfortunately the news seems not to have reached many thought leaders and investment professionals who persist in trying, and failing, to apply 20th-century thinking to 21st-century portfolio management. Nowhere is this more true than when it comes to the subject of alternative investments. Written by an all-star team of investment management experts, this book debunks common myths and misconceptions about most classes of alternative investments and offers valuable advice on how to develop investment management and asset allocation strategies consistent with the new realities of the ever-changing world of alternative investments.
● The IMF and Global Financial Crises: Phoenix Rising?
By Joseph P. Joyce
Excerpt via publisher, Cambridge University Press
Among the many surprising features of the global financial crisis of 2008–9 was the emergence of the International Monetary Fund (IMF) as a leading player in the response to what has become known as the “Great Recession.” The news that the IMF was “back in business” was remarkable in view of the deterioration of the IMF’s reputation after the crises of the late 1990s and the decline in its lending activities in the succeeding decade. The IMF had been widely blamed for indirectly contributing to the earlier crises by advocating the premature removal of controls on capital flows, and then imposing harsh and inappropriate measures on the countries that were forced to borrow from it. The number of new lending arrangements approved by the IMF had fallen from twenty-six in 2001 to twelve in 2007 (Figure A.2), and all but two of the latter went to the IMF’s poorest members, which had little access to private sources of finance.
● The Rise of China vs. the Logic of Strategy
By Edward Luttwak
Summary via publisher, Belknap Press/Harvard University Press
As the rest of the world worries about what a future might look like under Chinese supremacy, Edward N. Luttwak worries about China’s own future prospects. Applying the logic of strategy for which he is well known, Luttwak argues that the most populous nation on Earth—and its second largest economy—may be headed for a fall. For any country whose rising strength cannot go unnoticed, the universal logic of strategy allows only military or economic growth. But China is pursuing both goals simultaneously. Its military buildup and assertive foreign policy have already stirred up resistance among its neighbors, just three of whom—India, Japan, and Vietnam—together exceed China in population and wealth. Unless China’s leaders check their own ambitions, a host of countries, which are already forming tacit military coalitions, will start to impose economic restrictions as well.
● Pricing the Planet's Future: The Economics of Discounting in an Uncertain World
By Christian Gollier
Excerpt via publisher, Princeton University Press
Nearly fifty years ago, in 1968, William Baumol commented that “few topics in our discipline rival the social rate of discount as a subject exhibiting simultaneously a very considerable degree of knowledge and a very substantial level of ignorance.” This book aims to reduce the level of ignorance about the social discount rate, presenting recent advances in the field. Ultimately, the objective is to help build a consensus around the way society should value the future.
● The Carbon Crunch: How We're Getting Climate Change Wrong--and How to Fix It
By Dieter Helm
Review via The Economist
For many people, the great problem of climate change has been a failure of regulation and political will. If only, they say, the obligations of the Kyoto accord had been more comprehensive, the regulations stricter, or if more money had gone into renewables. Then the world might have reined in the temperature rise and the public would not have become so sceptical about climate change.
Not so, says Dieter Helm of Oxford University. It is not the failure of the regulations that is the problem but their basic design. They have caused people to focus on the most expensive ways of mitigating climate change, rather than the cheapest, imposing high costs for little gain. Moreover, by concentrating on their own carbon production, and how to reduce it, Europeans have ignored the impact of their continued demand for goods made using carbon- intensive processes. Since Chinese and Indian manufacturing is usually dirtier than Europe’s, the real upshot of Europe’s choices has been an increase in global emissions. The regulatory approach, argues Mr Helm, has got the worst of all worlds. It is expensive, it has not cut emissions and its treaties are unworkable. No wonder the public is growing sceptical.
● Managing Uncertainty: Strategies for Surviving and Thriving in Turbulent Times
Summary via publisher, Wiley
By Michel Syrett and Marion Devine
Managing uncertainty has become a new business imperative. Technological discontinuities, regulatory upheavals, geopolitical shocks, abrupt shifts in consumer tastes or behavior, and many other factors have emerged or intensified in recent years and together conspire to undermine even the most carefully constructed business strategies. Managing Uncertainty: Strategies for Surviving and Thriving in Turbulent Times addresses these new challenges, assessing the sources of business turbulence, how to classify uncertainty, and the different ways in which uncertainty can be embraced to allow greater innovation and growth. Drawing on examples from around the world, the book presents the most recent ideas on what it means to manage uncertainty, from practitioners, academics, and consultants.
● Market Liquidity: Asset Pricing, Risk, and Crises
By Yakov Amihud, et al.
Summary via publisher, Cambridge University Press
This book presents the theory and evidence on the effect of market liquidity and liquidity risk on asset prices and on overall securities market performance. Illiquidity means incurring a high transaction cost, which includes a large price impact when trading and facing a long time to unload a large position. Liquidity risk is higher if a security becomes more illiquid when it needs to be traded in the future, which will raise trading cost. The book shows that higher illiquidity and greater liquidity risk reduce securities prices and raise the expected return that investors require as compensation. Aggregate market liquidity is linked to funding liquidity, which affects the provision of liquidity services. When these become constrained, there is a liquidity crisis which leads to downward price and liquidity spiral. Overall, the volume demonstrates the important role of liquidity in asset pricing.
November 16, 2012
Is Industrial Production's October Slide Another Storm-Related Victim?
Industrial production slumped last month, and the official blame again points to Hurricane Sandy. That's the third time this week that weak economic data has reportedly been assaulted by the recent storm that tore through the Northeast U.S. Earlier in the week we were told that retail sales were victimized by the big blow, and the same was said of yesterday's awful news on initial jobless claims. Is the hurricane narrative just a convenient excuse to minimize a weakening economy? Maybe, but it's hard to say for sure until we see more data that's free and clear of any weather-related mischief.
Meanwhile, today's industrial production report for October is clearly discouraging, regardless of the reason. Output dropped 0.4% last month, and September's initially reported 0.4% increase was revised down by half to 0.2%.
The cyclically sensitive manufacturing sector led the slide last month, dropping 0.9% in October. “Manufacturing is still not the source of economic energy that it was earlier in the year,” observes Ward McCarthy, chief financial economist of Jefferies & Co. “It’s a sluggish story on manufacturing. It’s not where it was.”
The recent weakness is taking a toll on the year-over-year percentage change in industrial production. The annual pace is still positive, but it retreated to a 1.7% gain in October vs. 12 months ago. That's down sharply from September's 2.8% pace. Industrial production is growing at the slowest rate in more than two years. The margin for comfort is now dangerously thin. If blaming Sandy turns out to be a head fake, there'll be hell to pay.
The decelerating trend is the main concern. As recently as this past April, industrial production was expanding at a 5% annual pace. It's been downshifting ever since. That's a dark sign—if it continues. The 1.7% rate in and of itself isn't all that troubling, if we can keep it. The average annual growth rate for industrial production for the five years before the Great Recession began is 2.3%. Considering how much has changed in recent years on the macro front, expecting a repeat performance any time soon is ignoring reality. A 1.7% rate, however, isn't terrible, if it holds.
That leads us back to Hurricane Sandy. The storm "held down production in the Northeast region at the end of October [and] is estimated to have reduced the rate of change in total output by nearly 1 percentage point," the Federal Reserve advises. No doubt there are many skeptics, but for now the jury's still out until we see the next update. The manufacturing community seems to have expected better, based on the relatively upbeat ISM index reading for October. Still, no one should dismiss the potential for more trouble, especially with the fiscal cliff problems brewing. But it's still premature to declare another recession a done deal, even if the odds are rising.
History is littered with excessively early recession predictions as well as analysts who missed the warning signals until well after the fact. Studying the vintage data across a broad spectrum of indicators suggests that a high-confidence evaluation that a recession is fate tends to avail itself about three to four months after the slump has started. That's still early relative to when the crowd usually recognizes reality. With a bit of prudent econometric probing, it's possible to shorten the timing a bit more. I'll have some fresh numbers on this topic early next week with an update of The Capital Spectator Economic Trend Index.
Meantime, it's too early to yell fire in the theater. But make no mistake: the data updates to come in the days and weeks ahead carry more import for assessing the business cycle. That includes next week's housing updates—existing home sales on Monday (Nov 19) and housing starts on Tuesday (Nov 20), followed by an early release, due to Thanksgiving, on jobless claims on Wednesday (Nov 21). There's a turkey to deal with on Thursday, of course. The question is whether the gobbler will have fowl company in the preceding days on the economic front?
Mr. Market Smells A Rat
Anxiety is on the rise in assuming that the fiscal cliff will bring trouble for the economy if the $500 billion in scheduled tax hikes and spending cuts is allowed to kick in come January. But guess what? The pain has already started, courtesy of the forward-looking focus of the capital markets.
The stock market in particular is adjusting accordingly amid the self-inflicted pain that Washington seems intent on dispatching to the country. The S&P 500 is down about 7% since mid-October and the slide will probably roll on without progress on defusing the fiscal-cliff threat.
"I see very little to be optimistic about right now until we get some more clarity on these pressing issues," Randy Frederick, managing director of active trading and derivatives at Charles Schwab & Co., tells the LA Times.
The crowd is inclined to agree, a view that's reverberating throughout the markets. The benchmark 10-year Treasury yield has been falling consistently for the past month, dipping to 1.58% yesterday—the lowest since the end of August. The market's implied inflation forecast is fading too. The yield spread on the nominal 10-year Treasury less its inflation-indexed counterpart yesterday inched down to 2.38%, or the lowest since September. The preference for safety isn't a good sign. The fact that investors are willing--still--to chase Treasuries at such painfully low rates says a lot about sentiment these days.
None of this is surprising. Risky assets taking it on the chin and a new round of disinflation/deflationary winds are blowing. There's still time to short-circuit this train wreck, but time is running short. The truly sad part is that the economic data has been decent lately, and if the fiscal cliff was a non issue it wouldn't be hard to imagine that the prospects for growth would be fairly encouraging right about now. But that's all on hold because of you know what.
The economy for the moment is at the mercy of politics in Washington. Not surprisingly, the results are ugly. What skill set might get us out of this mess? A flair for herding cats comes to mind.
November 15, 2012
Stormy Statistical Subterfuge & Jobless Claims
It looks like a macro disaster, but it's not. It's still unnerving to see last week's jobless claims soar, but the aftershock of Hurricane Sandy is probably the cause. That implies that new filings for jobless benefits will drop sharply in the weeks ahead and return to levels associated with the slow-growth trend that was interrupted by the weather earlier this month.
Meantime, claims exploded skyward by 78,000 last week to a seasonally adjusted 439,000. If this was a genuine signal of shifting economic conditions, well, we'd be cooked. But there's no confirming data elsewhere to suggest that the economy fell off a cliff earlier this month. The source for the statistical mischief, in other words, strongly points to Sandy.
Indeed, last week's unadjusted year-over-year claims total suddenly roared higher with a nearly 30% surge vs. its year-earlier level. The bears may think that they've been handed an early Christmas present, but it's an empty box. The notion that the trend just went from recent history's modest progress of 10% annual declines for new claims to a collapsing labor market is too far-fetched, even by the standards of an overbaked Hollywood script. Recall that it was just two weeks ago that we were told that private-sector employed had its best month of growth last month since February. There's still plenty to worry about, but this isn't September 2008 all over again, at least not yet.
On that note, it's not surprising that in Florida, where Hurricane Sandy's roar was relatively muted compared with the Northeast, the jobless claims update for last week looks decent, with new claims falling to the lowest since 2008 in the Sunshine State. Florida isn't a bellwether for the U.S. labor market; rather, I bring up this data tidbit merely to remind that if you didn't get caught in Sandy's path of destruction, there's a pretty good chance that not much changed in macro terms last week.
But something did change in New York and New Jersey, for instance. “At least a few state labor offices were shut in the prior week so it’s almost as if you have two weeks of claims in one,” explains Ryan Wang, an economist at HSBC Securities. “You have a double whammy this week, where people were filing claims they were unable to previously and individuals unable to work for the storm were filing additional claims.”
"Stepping back from the storm distortions, the economy is growing at about 2 percent," estimates Ryan Sweet, senior economist at Moody's Analytics. "We will likely see a step back in job growth ... because of Sandy. The economy is just muddling along."
How soon will claims data return to something appropriate for reflecting the slow-growth climate that still dominates? Hard to say. A week? Two weeks? Or longer? A new storm, remember, is brewing in Washington from the debate over the fiscal cliff. Forecasting faces better odds of success for anticipating the path of meteorological disturbances compared with assessing the potential for self-inflicted macro wounds via the Beltway crowd. For now, however, pay no attention to the latest data point behind the curtain.
November 14, 2012
Did Superstorm Sandy Sandbag October's Retail Sales?
Retail sales took a modest dive last month, but the prevailing explanation places the blame on Hurricane Sandy. That’s a plausible excuse for October's consumption retreat, although it'll take time to confirm, which means that it's not immediately obvious that we can dismiss today's news as a one-off event.
For now, the only thing we know for sure is that retail sales slumped 0.3% in October, the first monthly drop in four months. Quite a bit of the fall is due to weak auto sales, which sank 1.5%. Retail sales ex-autos were flat last month. “There’s probably some hurricane impact, but when consumers are cautious they tend to spend more on staples than discretionary items, and that’s exactly what happened this month,” Neil Dutta, head of U.S. economics at Renaissance Macro Research, tells Bloomberg. “The broad story is that consumers remain cautious.”
The October fade put a dent in the year-over-year trend too. The annual pace of retail sales remains in the black, rising 3.8% for the 12 months through October. But that's slowest rate of increase since June. Of course, the holiday shopping season is upon us and so the notion of a revival in spending seems like a reasonable view.
In other words, there's some wiggle room to consider and so we shouldn't be in a rush to take today's numbers at face value. But even if retail sales were boom, it's short-sighted to ignore the fiscal cliff worries or the other hazards that continue to lurk.
Nonetheless, October data so far on balance doesn't look awful, and some of it looks rather encouraging, including last month's pop in private-sector payrolls, which rose the most since February. The strength in the ISM Manufacturing Index and consumer sentiment of late are positives as well.
Cautious optimism for the U.S. economy isn't dead yet, but the next few weeks of data releases will be critical for deciding if today's retail sales report is a harbinger of things to come. Some analysts are already preparing for trouble.
Steven Ricchiuto, chief economist at Mizuho Securities, advises that "the weakness in the sales report was not enough to confirm that it was not simply a weather-related dip, but the components suggest that there was more going on than just Sandy."
That sounds a bit too dark at this point, given the positives across a broad set of economic and financial indicators. On that note, I'll soon have an update of The Capital Spectator Economic Trend Index, which looked fairly strong a few weeks back. After this week's economic dates are published, including Friday's read on industrial production for October, I'll update CS-ETI for a formal review of where we stand vis-a-vis the business cycle.
Next up is tomorrow's weekly jobless claims report, although new filings for jobless benefits are also expected to suffer from the delayed reaction to Hurricane Sandy. In terms of the data, it may still get worse before it gets better.
Strategic Briefing | 11.14.12 | The Revival Of US Energy Production
North America leads shift in global energy balance, IEA says in latest World Energy Outlook
Int'l Energy Agency | Nov 12
The World Energy Outlook finds that the extraordinary growth in oil and natural gas output in the United States will mean a sea-change in global energy flows. In the New Policies Scenario, the WEO’s central scenario, the United States becomes a net exporter of natural gas by 2020 and is almost self-sufficient in energy, in net terms, by 2035. North America emerges as a net oil exporter, accelerating the switch in direction of international oil trade, with almost 90% of Middle Eastern oil exports being drawn to Asia by 2035.
U.S. to become world's largest oil producer by 2020, report says
The Los Angeles Times | Nov 12
U.S. oil production peaked in 1970 at slightly more than 9.63 million barrels a day. Except for a modest recovery to fewer than 9 million barrels a day in 1985, U.S. crude production had been on a precipitous decline until 2008, when it bottomed out at 5 million barrels a day, seeming to validate the "peak oil" theory that output would continue falling. That was also the year that oil reached a record price of $147.27 a barrel.
But those oil prices spurred important technological developments that enabled those looking for oil to essentially see through the bottom of rock as though it were transparent, said Philip K. Verleger Jr., a visiting fellow at the Peterson Institute for International Economics.
Energy Independence in the United States? Don’t Pop the Cork Yet
The New York Times | Nov 13
Even if the United States were no longer dependent on oil from the tumultuous Middle East and North Africa, vital American trading partners like China, India, Japan and Europe would continue to import increasing amounts of oil from the region. Future price shocks at the pump would still be likely as long as the world depended on unsteady producing nations like Venezuela, Nigeria, Iraq, Libya and Iran, where politics often mixes inharmoniously with crude.
“This isn’t the end of history,” said Michael Makovsky, a Pentagon official in the George W. Bush administration. “If we are going to be a consumer of oil, it’s better that it be our oil rather than from the Middle East. But the oil market is still global, and the North American oil market will still be greatly impacted by developments in the Middle East.”
Despite oil boost, U.S. not in clear yet
The Houston Chronicle | Nov 14
Some energy company executives already are questioning the forecast. David Roberts, the chief executive of Marathon Oil, which has extensive domestic drilling operations, told investors on a webcast Tuesday that IEA's findings might be too optimistic.
“I don't see it, in terms of this country matching Saudi Arabia,” he said.
What's more, being the biggest producer would mean little to U.S. consumers. We won't be paying less at the pump because, as the IEA notes, “no country is an energy ‘island' and prices for all fuel sources are increasingly global.”
Newfound U.S. Oil Wealth Won't Lower Gas Prices
MIT Technology Review | Nov 13
Although the report says the U.S. will be “all but self-sufficient” by 2035, that doesn’t necessarily mean prices will go down. Because oil is easy to ship around the world, the price for oil is set by global demand, and demand in places such as India and China is expected to keep growing. That’s in part because of subsidies for fossil fuels, which rose 30 percent between 2010 and 2011 to reach $523 billion, the report says. (Many governments around the world are likely to reduce fossil fuel subsidies as they become increasingly expensive.)
2012 World Energy Outlook from the International Energy Agency
Econbrowser (Prof. James Hamilton) | Nov 13
None of this is to deny that U.S. production of oil and gas from tight formations is going to bring significant economic benefits to the United States, nor that the geologic potential for a remarkable transformation in Iraq could well be there. But I think anyone who concludes from this report that we are about to return to the kind of world we inhabited in 1970 may be in for an unpleasant surprise.
Historical and projected US Oil & Gas Production
Source: IEA World Energy Outlook 2012
November 13, 2012
History Lessons & Financial Crises
Professor Gary Gorton’s new book is mandatory reading for anyone who wants to understand why financial crises are a recurring feature across time and distance for capitalism. There are no secret solutions on the pages of Misunderstanding Financial Crises: Why We Don't See Them Coming for the simple reason that none exist. Instead, the book offers an explanation, relatively short and to the point. Considering how so many people misread cause and effect with financial crises, the book is an important contribution for peeling away the confusion.
The subject, of course, has attracted a deep and wide pool of analysis in recent years. But it would be wrong to assume that the events of late-2008 are now broadly viewed through an objective lens with an analyst’s eye for identifying the source--the true source--of the trouble. Gorton sets the record straight with this brief, readable treatment on what should be obvious at this late date. Unfortunately, financial crises remain mysterious for many in the grand scheme of punditry. The good news: the Yale professor leads us out of the darkness, drawing on history to clarify the essential points that are so often ignored or overlooked.
His primary message is that there are no illusions about the 2008 financial crisis, or its many predecessors, both in the U.S. and abroad over the years. “Financial crises are about bank debt,” he writes.
Banks and bank debt were at the root of every one of the 124 systemic crises around the world from 1970 to 2007 (some also involved currency crises in which the value of the domestic currency decline precipitously). Indeed, there cannot be systemic crises without bank debt. But bank debt is needed for conducting transactions and is necessary for an economy to function.
There's a long history in the private sector of trying to create bank debt that captures the unquestioned acceptance of sovereign debt—a 3-month Treasury bill, for instance. If you sell me a truckload of widgets in exchange for a relevant amount of T-bills, satisfaction is guaranteed because the means of payment is trustworthy. (Inflation is the perennial enemy that threatens government debt, of course, but that's another story.)
There is no need to determine the provenance of a U.S. Treasury bill—its value is known by all. Bank debt attempts to privately create this property of a Treasury bill, and this property is called liquidity.
The problem is that the private sector has a hard time replicating T-bills, currency, gold and other perfect or near-perfect mediums of exchange. Clever financial engineers can minimize this imperfection, which inspires overlooking the rough edges of bank debt when money and profits are flush and assets are priced for perfection. But there’s always a fly in the ointment, and every once in a while the crowd discovers that disaster has been lurking just outside the door.
Markets are liquid when all parties to a transaction know that there are probably not any secrets to be known: no one knows anything about the collateral value and everyone knows that no one knows anything. In that situation it is very easy to transact. The situation where there is nothing to know or nothing worth knowing—no secrets—is desirable and allows for efficient transactions.
That ideal situation, of course, goes on holiday every now and again, and that’s when the trouble begins. The best way to describe it is to call it what it is: a bank run. Everyone understands the basic concept, but this is also where many people become confused about the implosion in 2008. In the popular imagination, bank runs are events like the one depicted in the movie It’s a Wonderful Life. In that famous scene, which is burned into the public’s collective memory bank, everyone wants to withdraw their savings at the same time, which, of course, is impossible. No bank can survive a complete and total request for liquidity at a single point in time. The inherent conflict in banking is that the institution is expected to satisfy liquidity demands of depositors while simultaneously providing credit to borrowers—borrowers who agree to repay the loan, with interest, through time. That means that all depositors can’t be made whole at the same time.
No amount of banking regulation can change this fundamental conflict, short of requiring banks to remain liquid to the degree that they can repay all depositors at all times. Of course, that would mean that banks couldn’t lend at all, which defeats the purpose of setting up a bank in the first place.
Okay, but what’s that got to do with the financial crisis that exploded in late-2008? Wasn’t that a new strain of crisis? No, Gorton explains. The details were new, but the fundamental issue didn't change. Although conventional bank runs weren’t the primary trigger of the 2008 crisis, there was a surge in liquidity demand within the shadow banking world and its victims were institutional investors rather than John and Jane Smith. At the center of this run: exotic forms of bank debt.
The commonality of crises is one of the points that the Panic of 2007-2008 should have made clear—the crisis mechanism was the same. In the Panic of 2007-8, it was sale and repurchase agreements (repo), commercial paper, and prime broker balances that were run on. This panic was not observable to most people because it involved whole markets where firms ran on other firms.
Observable or not, the result was typical when the demand for liquidity surged: a frantic rush to withdraw deposits, aka a banking panic. Like every other financial crisis, this one faced a familiar foe in the form of an inability to satisfy the demand for cash. In that scenario, there are two basic choices: liquidate the banks (or quasi banking firms) or bail them out. For what should be obvious reasons, bailing out the banks is the usual and preferable response. It's never politically popular, but a sober review of the macro implications usually leads to the same conclusion: allowing banks to die is economic suicide. It's the one industry that deserves a different treatment than all others.
It’s always tempting to argue otherwise, and for what are sensible reasons. Moral hazard, after all, can’t be dismissed, at least not entirely. But liquidating banks is a dangerous route due to all the interdependent links that tie various corners of the economy together through bank debt. When a bank fails—truly fails and its debt holders are left with nothing—there are deep and wide repercussions throughout the economy. Consider the recent real-world example when just one bank was allowed to go under and its assets were partially liquidated: Lehman Brothers in September 2008.
How did we reach that point? Hadn’t we abolished all the errors of the past? Well, not entirely. “An important misunderstanding revealed by the crisis is that regulators and economists did not know what firms were banks, or what debt was ‘money.’ They thought that banks were only the firms that had bank charters, and that money was only in currency and demand deposits.”
Allowing the shadow banking sector to remain unregulated was a big mistake. But that was a moot point when the run began. We may do better next time by improving the regulatory framework, but rest assured that another financial crises will strike one day and the same set of questions will come up.
The form of the bank debt doesn’t matter so much. The issues and challenges that were front and center during the National Banking Era of the 19th century and beyond are still with us. What is relevant is if there’s widespread use of the debt. If many individuals and/or institutions hold the debt, the potential for trouble is always just around the corner, even if the risk has been dormant for long stretches.
Better regulation can help, but Gorton reminds that raising capital requirements, for example, is no silver bullet. “The global financial crisis that began in the United States in the summer of 2007 was triggered by a bank run, just like those of 1837, 1857, 1873, 1893, 1907 and 1933.” In other words, crises are liquidity events, which is why central banks are necessary evils. That alone doesn’t wipe away the potential for financial crises, or the potential for poor policy choices. But central banks can at least keep a recurring problem from turning into an economic catastrophe.
From an investment perspective, there are important lessons here as well. “Financial crises are often preceded by credit booms, extended periods during which the amount of credit granted-through loans, bond issuance, and mortgages—rises.” And it's hardly atypical that that the previous crisis arrived near a business cycle peak.
Gorton’s book is a powerful reminder that we ignore financial history at considerable peril. If we have any chance of learning from the past, we must first understand it. Easier said than done. The cries to liquidate banks when they stumble, for example, has a wide fan base these days… still. History’s financial lessons, it seems, don’t come easy.
And the basic challenges are as thorny as ever. "To design a bank regulatory environment that addresses the vulnerability of bank debt and fosters economic growth is possible in principle," he writes. "But because of the paradox of financial crises, it might not be possible in practice."
November 12, 2012
Another Civics Lesson… The Hard Way
There's always another recession out there somewhere, although the catalysts keep changing. Here's a new one: feckless politicians who provide the raw material for the next downswing in the business cycle by driving us over the fiscal cliff. Your tax dollars at work...Not! If this diaster hits (and there's no reason it should), it would be the first time that Washington knowingly, willingly, without any illusions, delivers the macro equivalent of suicide. Political dysfunction at its worst.
Yes, I think we can call this a new low if we don't pull back from the brink before the year is out. The only mystery: Why isn't the public mad as hell and unwilling to take it anymore? Maybe it's because we just went through a tiring election that was overloaded with all the usual rhetorical twaddle and then some. And our prize for enduring this nonsense, er, election campaign? The growing threat that the White House and Congress will passively, by inaction, permit a dramatic sharp rise in automatic tax hikes and deep spending cuts, which will unleash a projected 0.5% drop in GDP next year and a rise in unemployment to 9.1% from the current 7.9% jobless rate, according to the CBO.
Yes, anyone who spends five minutes with the details will be angry. No one wants a recession, much less one packaged and delivered to your doorstep by your representatives in Washington—no extra charge. Weeks from now, if this fiscal version of the denouement in "Thelma and Louise" (sans the kissing) is still barreling toward us, one might expect that there will be protests in the streets, dissent from coast to coast, and a general recognition that our government has become incompetent in the extreme. We might call it the Occupy The-Political-Insanity-In-Washington Movement. Sign me up!
Then again, maybe we'll avert crisis... at the last minute? Gee, thanks. But that's better than a kick in the head. But perhaps the Republicans and Democrats can find a way to avoid bringing economic havoc to the people who elected them in a timely manner. Hey, it's a thought. But don't hold your breath, the pundits warn. At this late date, surely nobody is.
That leaves the unpleasant task of measuring the degree of darkness that advances over the economy, one economic report at a time. The tragedy is that the numbers published to date don't look terrible, and perhaps even set us up for a bit of progress for economic growth. But that’s all set to evaporate if our buddies in D.C. don't schedule an appointment for an attitude adjustment..
This republic deserves the government it elects--even one that provides its constituency with a slow-motion train wreck. And, yes, all this reflects as badly on us as it does on them.
Tactical Macro And So Much More...
Today marks the start of a new gig for The Capital Spectator. In addition to the usual commentary here, I'll be publishing my two cents regularly on Saxo Bank's 3 Numbers To Watch blog on its TradingFloor.com site. The focus is on the trading day ahead as seen through the prism of what's on the docket for economic news. As you'll see, I'm in good company over there. I recommend taking some time to explore the analytical flavors that range from forex to technical analysis to macro. On that note, a shameless plug: you can start with my debut post on 3 Numbers To Watch for the fiscal cliff risk: the 10-year Treasury yield, gold prices, and the US$/euro exchange rate.
November 10, 2012
A New Fed Flick
The Federal Reserve is the 800-pound gorilla when it comes to factors affecting the economy and the capital markets. That's generally understood, if not routinely respected. Yet this goliath remains a mysterious entity for most Americans. A new film attempts to peel away some of the inscrutability with what is ultimately a fascinating story of the power, glory, and failures of the Fed. Money For Nothing: Inside the Federal Reserve is a self-proclaimed "independent, non-partisan documentary film that examines America's central bank from the inside out--in a critical yet balanced way," according to the movie's website.
Produced by several acclaimed filmmakers, this soon-to-be-released documentary takes us on an intriguing tour of the banker's bank. Depending on your perspective, the Fed is either a savior or the enemy in the pursuit of a well-functioning economy. But no matter your view, this central bank is too big to ignore. I, for one, am eager to see what this investigative documentary will reveal.
When the filmmakers contacted me recently to ask for a promotional plug, I initially balked. But after looking at the trailer, I'm persuaded that Money For Nothing has the potential to be an important contribution to the public's understanding and awareness of the most-important institution that's way off the radar for the average citizen. It doesn't hurt that it all unfolds with a bit of dramatic flair. This is a movie, after all. Although I haven't seen the complete film yet, it's on my short list when it opens in theaters and/or released on DVD. I'll be looking for insights into a number of aspects of Fed policy, including: How has the definition of the central bank's "independence" changed or is likely to change going forward. As Allan Meltzer reminds in volume 2 of A History of the Federal Reserve his sweeping history of what is arguably (still) the single-most important financial institution on the planet:
The Federal Reserve is said to be an independent central bank. The meaning of independence changed several times [through the course of its history].
Has it changed recently? Is it likely to change in the near-term future? What are the implications?
Talk, of course, is cheap when it comes to films, and so it's time to take a peek at the coming attractions....
Book Bits | 11.10.12
● Market Sense and Nonsense: How the Markets Really Work (and How They Don't)
By Jack Schwager
Excerpt via publisher, Wiley
Many investors seek guidance from the advice of financial experts available through both broadcast and print media. Is this advice beneficial? In this chapter, we have examined three cases of financial expert advice, ranging from the recommendation-based record of a popular financial program host to an index based on the directional calls of 10 market experts and finally to the financial newsletter industry. Although this limited sample does not rise to the level of a persuasive proof, the results are entirely consistent with the available academic research on the subject. The general conclusion appears to be that the advice of the financial experts may sometimes trigger an immediate price move as the public responds to their recommendations (a price move that is impossible to capture), but no longer-term net benefit. My advice to equity investors is either buy an index fund (but not after a period of extreme gains—see Chapter 3) or, if you have sufficient interest and motivation, devote the time and energy to develop your own investment or trading methodology. Neither of these approaches involves listening to the recommendations of the experts.
● Who's the Fairest of Them All?: The Truth about Opportunity, Taxes, and Wealth in America
By Stephen Moore
Review via The Washington Times
Stephen Moore’s latest book, “Who’s the Fairest of Them All?: The Truth About Opportunity, Taxes, and Wealth in America,” fairly sets our liberal friends straight on the issue that seems to be confusing President Obama and the general American public a lot — economics and, in particular, tax policy. Mr. Moore, the senior economics writer for the Wall Street Journal’s editorial page, formerly president of the Club for Growth and a fellow of the Cato Institute and Heritage Foundation, has an encyclopedic knowledge of the tax fights of the 1980s. He condenses that nearly three decades in public policy in a slim 119-page volume that is an accessible and thorough guide to understanding economic growth. He understands that if we don’t learn the lessons of the past, we’re bound to repeat the follies, and so he has taken aim squarely at their chief originator, President Obama. While Mr. Obama may think of himself as Snow White — “the fairest of them all” — when it comes to taxing, he’s really Dopey, treating the world as if the Laffer Curve didn’t exist, as if food stamps and unemployment insurance actually grow the economy.
● Diary of a Hedgehog: Biggs' Final Words on the Markets
Summary via publisher, Wiley
Barton Biggs was a Wall Street legend, trusted by investors around the globe. Now, in his last book, Biggs offers savvy insights into the innermost workings of the markets—today and for the years to come. Packed with keen insights, global experiences, and opinionated stances on investing, Diary of a Hedgehog: Biggs’ Final Words on the Markets explores the ongoing downward economic spiral and where it's headed, to help readers keep their money safe and secure. Offering a unique look at the current state of the markets, why they continue to be depressed, and where we can go from here, Diary of a Hedgehog: Biggs’ Final Words on the Markets is the ultimate guide to how investors—and the general public—should be handling their finances.
● The Cycle of the Gift: Family Wealth and Wisdom
By James E. Hughes, Jr., Susan Massenzio, and Keith Whitaker
Summary via publisher, Bloomberg/Wiley
Giving is at the core of family life--and with current law allowing up to $5,120,000 in tax-free gifts, at least through December 2012, the ultra-affluent are faced with the task of giving at perhaps largest scale in history. Beyond the tax saving and wealth management implications, giving to family members opens up a slew of thorny questions, the biggest of which is, "How do I prepare recipients of such large gifts?" With that question and others in mind, Hughes, Massenzio, and Whitaker have written The Cycle of the Gift in three main parts: "The Who of Giving," "The How of Giving," and "The What and Why of Giving." The first part focuses on the people most deeply involved in family giving, especially the recipients and givers (parents, grandparents, spouses, trustees). The second part, "The How of Giving," addresses the delicate balance of givers who want to maintain some level of control and recipients who want some level of freedom in accepting and growing their gifts. The final part, "The What and Why of Giving" describes various types of gifts, from money to business interests to values and rituals.
● Why Has China Grown So Fast For So Long?
By Khalid Malik
Summary via publisher, Oxford University Press
For analysts China presents a conundrum. It is clear that China has made rapid progress, and the landscape of the world is changing due to China's unique position. Yet for decades, many have questioned this phenomenon, showing concern about cooked data, asset bubbles about to burst, and so on. Yet the Chinese economy has kept growing at a blistering pace, 9-10 per cent annually, and more at times, over a span of almost three decades. Analysing the last 30 years of reforms, this book helps us understand the Chinese growth success, the factors that made this possible, and the lessons that can be distilled from this experience for other developing countries. Arguing that traditional explanations are inadequate, the author applies the "development as transformation" thesis to provide answers to a wide range of questions
● Risk Assessment and Decision Analysis with Bayesian Networks
By Norman Fenton and Martin Neil
Summary via publisher, CRC Press
Although many Bayesian Network (BN) applications are now in everyday use, BNs have not yet achieved mainstream penetration. Focusing on practical real-world problem solving and model building, as opposed to algorithms and theory, Risk Assessment and Decision Analysis with Bayesian Networks explains how to incorporate knowledge with data to develop and use (Bayesian) causal models of risk that provide powerful insights and better decision making. The book first establishes the basics of probability, risk, and building and using BN models, then goes into the detailed applications. The underlying BN algorithms appear in appendices rather than the main text since there is no need to understand them to build and use BN models. Keeping the body of the text free of intimidating mathematics, the book provides pragmatic advice about model building to ensure models are built efficiently.
November 9, 2012
Has Krugman Gone Too Far This Time?
If you're looking for fresh insight into the dysfunctional thinking that impairs policy debates in the U.S., which in turns gums up the machine for doing the right thing on the federal budget in a timely manner, read Paul Krugman's column today. The title says it all: Let’s Not Make a Deal.
I'm shocked, frankly, that one of the most influential economists on the macro scene—and a Nobel-prize winner at that—is recommending that the President of the United States put politics over policy at a vulnerable moment with the economy hanging in the balance. Krugman's advice for Obama comes down to this:
So President Obama has to make a decision, almost immediately, about how to deal with continuing Republican obstruction. How far should he go in accommodating the G.O.P.’s demands?
My answer is, not far at all. Mr. Obama should hang tough, declaring himself willing, if necessary, to hold his ground even at the cost of letting his opponents inflict damage on a still-shaky economy. And this is definitely no time to negotiate a “grand bargain” on the budget that snatches defeat from the jaws of victory.
It's no secret that Krugman is, well, shall we say, a Democratic partisan in the extreme. I say "extreme" in the sense that the Princeton professor isn't shy about mixing his political views with his policy recommendations, as his latest column makes clear in no uncertain terms. That's fine, and everyone's entitled to their opinions. But advocating a political strategy that risks throwing the economy into a nasty recession, at a time when we've never really recovered from the 2007-2009 contraction, is ill-advised, to say the least.
Normally, this wouldn't be worth writing about, but these aren't normal times, at least as far as the economy goes. Let's be clear: the risks are substantial. As a new report from the Congressional Budge Office reminds, the fiscal-cliff risk that's fast approaching will dramatically raise the odds of a new recession if the politicians in Washington don’t defuse this ticking time bomb. The CBO projects that "the significant tax increases and spending cuts that are due to occur in January will probably cause the economy to fall back into a recession next year…."
Many economists agree. For example, Mark Zandi, chief economist at Moody's Analytics, told CBS News yesterday that "if you tote up all of the things that will happen on January 1st -- all the tax increases, all the spending cuts, everything -- it actually totes up to $728 billion in calendar year 2013." If these cuts and tax hikes are allowed to strike in January, "it's very, very likely that we suffer a very deep recession, and I don't think that's the way we want to go here."
Krugman recognizes the risk and that there will be a price to pay if this scenario plays out. As he admits,
I don’t mean to minimize the very real economic dangers posed by the so-called fiscal cliff that is looming at the end of this year if the two parties can’t reach a deal. Both the Bush-era tax cuts and the Obama administration’s payroll tax cut are set to expire, even as automatic spending cuts in defense and elsewhere kick in thanks to the deal struck after the 2011 confrontation over the debt ceiling. And the looming combination of tax increases and spending cuts looks easily large enough to push America back into recession.
Nobody wants to see that happen. Yet it may happen all the same, and Mr. Obama has to be willing to let it happen if necessary.
If necessary? It's hard to imagine a "necessary" rationale for allowing the economy to slide into a new recession, particularly if you had to explain the reasoning face-to-face with the average working man or woman on the street. The reasoning that Krugman offers amounts to an argument for teaching the Republicans in the House a lesson. Sorry, professor, that's not good enough.
We can have a healthy debate about who's to blame for all the gridlock. From my perspective, there's plenty of blame to go around. But the election is over, and it's time to negotiate on behalf of the American public, even if that means giving up cherished political goals of the moment. Recommending more intransigence may play well to a political base, but there's simply too much at stake to let political considerations dominate the days and weeks ahead. And, yes, the same advice goes for the Republicans, who should be willing to bend a little more. News flash to the GOP: Obama was re-elected--act accordingly.
I'm guessing that anyone of modest means, who relies on economic growth for their livelihoods, will agree. Maybe it's me, but it seems that one of the leading voices in the dismal science can do better than recommend politics as usual—before the negations between Republicans and the White House have really started. That's a plan that's dead on arrival. It's also the type of thinking that brought us to the brink in the first place, and staying on this course is sure to push us over the edge. Can't we at least try to imagine another roadmap? If only for our economic survival? Or are we really a nation that's so short-sighted, so caught up in the political debates du jour, that we can't see the forest for the trees? I guess we'll find out soon enough.
It may be naïve on my part to assume that productive negotiations in Washington are possible, but we can still ask—demand—no less. If not now, when? The bottom line: this is a time for leadership, true leadership, as opposed to the flimsy fair-weather notions of leadership that too often are thrown about in political brochures. This much is clear: if Washington fails to avert this crisis, and the economy does sink into a self-inflicted recession, there will be a price to pay, in both economic and political terms. Call me crazy, but it seems that now is the time to promote genuine political compromise. Advocating political warfare, which will fall most heavily on the working poor in terms of the price paid, seems like an incredibly poor choice at this moment.
November 8, 2012
Another Jobless Claims Report, Another Reason To Wonder
Did Hurricane Sandy distort last week's jobless claims data? Possibly. One argument is that the storm kept people away from the unemployment offices and so last week's decline in new filings for unemployment benefits dispensed an artificially low number. "Extreme weather can hold down filings initially, with people initially preoccupied," says Jim O'Sullivan, chief U.S. economist at High Frequency Economics. "Claims are likely to be boosted in the next few weeks by hurricane-related job losses."
It's a reasonable point, but it seems that there's always a new reason to dismiss the fall in claims. The reality is that new filings for jobless benefits have been trending lower for well over a year. It could be all over next week, but it's premature to say that the jig is up, even in the wake of one of the worst hurricanes in decades.
“When you see bad weather, there’s usually a drop in claims, and then you typically see a rebound in the next few weeks,” observes Scott Brown, chief economist at Raymond James & Associates. “Underneath the surface, job destruction has been trending very low. Layoffs aren’t the problem -- it’s the relatively weak pace of job creation.”
That's a fair point as well, and probably closer to the truth. But the potential for Sandy-related blowback can't be ruled out. "You'll undoubtedly get a spike in unemployment claims that has not hit yet; it did not hit in the numbers ... because everybody was still in the midst of the aftermath of the storm, but, you know, expect the next several weeks to show a significant spike," predicts Liz Ann Sonders, Charles Schwab's chief investment strategist.
Perhaps, but no matter what next week's report says, let's not read too much into one data point, especially the seasonally adjusted one. A better way to look at the data is to compare the unadjusted numbers on a year-over-year basis, and through time. By that standard it's not obvious that the modest pace of decline has run its course. New filings are still falling at roughly 10% a year before seasonal adjustment. Last week's nearly 12% year-over-year drop may be an anomaly; if it is, we'll see the payback in the weeks ahead. But then comes the question of whether the declining trend will resume. No doubt there'll be another distorting factor to consider by then.
Meantime, let's not forget that payrolls data for October perked up a bit, and the manufacturing and services sectors (via the surveys published by the Institute for Supply Management) imply that there's a decent amount of momentum in the economy.
Is it all a head fake? Never say never, but Rome wasn't built in a day and periods of economic growth—even relatively weak recoveries—don't evaporate while you step out for coffee. Let's see what next week's reports tell us, including the October updates on retail sales (Wednesday, Nov 14) and industrial production (Friday, Nov 16).
Meantime, there are plenty of talking points to go around. The good news is that the same can be said for mildly encouraging economic data--assuming we can believe it.
New Filings For Jobless Benefits Continue To Decline
Jobless claims dropped again last week, offering more evidence for thinking that the October pop in new filings for unemployment benefits wasn’t a statistical harbinger of cyclical doom after all. Once again the lesson is clear for poking through this data set: remain wary of the latest update and instead focus on the longer-term trend. By that standard, the numbers suggest that modest healing in the labor market continues, a trend that's been in force for most of the past 18 months.
New claims fell 8,000 last week to a seasonally adjusted 355,000. That’s near the lowest level since the recession ended in mid-2009.
A stronger signal that the labor market is still moving forward, if only moderately: unadjusted claims tumbled last week by nearly 12% vs. the same week a year ago. As the chart below shows, that pace of decline is in line with the trend that’s prevailed for more than a year, save for the occasional interruption. As such, the year-over-year trend in the claims numbers before seasonal adjustment tells us that nothing much has changed, and that’s a good thing. In sum: fewer workers are applying for unemployment benefits as the weeks and months pass. No explanation required for why that's more than a trivial plus.
Today’s update on new claims delivers another positive data point for the October economic profile. Earlier this week we learned that the services sector is still biased towards growth as of last month, and a similar story applies to the manufacturing sector in October. In addition, the initial estimate for October payrolls shows the highest monthly gain (+184,000) for private sector jobs since February.
Is the stage set for stronger growth overall? It might be, if the fiscal cliff wasn't threatening and Europe's economy wasn't still reeling. Alas, reality is somewhat different. Of course, the potential for defusing the fiscal cliff risk is plausible if not exactly probable. Much depends on whether the folks in Washington can get their act together. For what should be obvious reasons at this late date, your editor is skeptical, albeit in a hopeful sort of way, if such a thing is possible.
The latest comments from Republicans and Democrats in the wake of the election are certainly encouraging for thinking that the Beltway crowd can finally work together and keep us from falling over the edge. Then again, talk is especially cheap in Washington and the only thing that matters is action—action that in this case must come soon. We're talking weeks, not months, given the fact that automatic tax hikes and spending cuts are set to roll in the new year.
Europe, meanwhile, is a tougher problem, given the deteriorating economic news for Germany, the Continent's largest economy. "Europe is going through a difficult process of macroeconomic rebalancing and adjustment, which will last for some time still," says Olli Rehn, the EU's economic and monetary affairs commissioner. "Market stress has been reduced but there is certainly no room for complacency."
Back in the U.S., however, the economy seems to be holding up... so far. That was certainly true through September and the third quarter generally. The October updates so far suggest that the positive momentum has a decent chance of rolling on, although it's still early and the majority of last month's numbers are yet to come. For now, however, let's recognize that recession risk in the U.S. still looks low, based on the incoming numbers. When and if that changes, the data trend will change. Meantime, cautious optimism on the U.S. is still a reasonable outlook.
Beware Of Zombie Recession Forecasts
With the election behind us and the fiscal cliff approaching, recession forecasting is in full swing again, and so it's time once more to roll out the standard caveat—not all predictions are created equal. In fact, quite a lot of the opinions are of poor quality, largely because one or more of the following applies: 1) the predictions are driven by emotion; 2) the analysis relies on cherry-picking the data; 3) the analyst is generally misreading and abusing the economic signals and models; 4) the analysis is overly focused on recent data that's probably infected with short-term/seasonal distortion; 5) the analyst has another agenda to promote that conflicts with objective macro analysis.
For example, some pundits claim that there's a clean, direct link between the business cycle and policy debates in Washington related to decisions that may or may not happen in the future. For example, Steve Forbes predicted yesterday that "we will have a recession." Yes, that's a reliable forecast--now and forever. There's always another recession lurking. Timing, however, is a complicating factor. That's a reminder that we must consider the source--the model--for any recession prediction.
On that score, Forbes' analysis looks wobbly: "Raising taxes on capital, raising taxes on small businesses, which we will likely get now, particularly since the Republicans did so badly in the Senate races, that is going to pose a real burden."
Sounds plausible, in a warm and fuzzy way. But if you spend any time analyzing the business cycle, you'll quickly discover that the link between macro fluctuations and tax rates in the short-to-medium term is clear as mud. As a tool for deciding if recession risk is high or low, rising or falling, this approach is worse than useless. If it were otherwise, your first source for predicting recessions would be listening to debates in Congress and press conferences at the White House. Good luck with that.
Fortunately, there's a better way, although it doesn't lend itself to quotable commentary in 30-second sound bites: Analyzing and monitoring a broad set of economic and financial indicators. Aggregating and tracking the broad changes in the data is the idea behind The Capital Spectator Economic Trend Index (CS-ETI). It's not perfect—nothing is—but it's performed admirably since I rolled it out publicly in the summer (I tested it privately for nearly a year before that). There are pretty good odds that CS-ETI, after a long period of testing and tweaking, will continue to provide reliable real-time signals on recession risk in something close to real time.
On that note, not much has changed since October 17, when I last published a CS-ETI update. In other words, recession risk is still quite low, based on data through September. A few more data points for September have been released since October 17—personal income and spending—and the signals remain positive. As usual, I'll continue to monitor the incoming data from various sources and run the analysis for any statistical hints of trouble. That includes looking ahead several months via econometric techniques for projecting where CS-ETI appears to be headed and keeping an eye on the vintage data (see the third chart in the link above for a recent example). I also translate CS-ETI into probabilities via a probit model for another take on how the business cycle is faring. Crunching the data on GDP nowcasts adds another dimension to the analysis. (I'll have updates for all of these reports later in the month.)
The basic message: it's essential to look at the data from multiple angles, regularly, in an econometrically intelligent way. It's not rocket science, but you can't whip up an intelligent review in a few minutes either. What could go wrong? The main risk is that a bolt from the blue renders the latest data points irrelevant. That's a risk for every model, including CS-ETI. For example, new war in the Middle East that quickly sends oil prices to the moon, or a failure in Washington to resolve the fiscal cliff threat by January, could trigger a recession—risks that aren't reflected in the current numbers.
Keep in mind, however, that if the economy does start tipping over the edge, it'll be obvious in the data, and relatively soon. That is, over the course of two, three or four months, history suggests that clear signs of fatal macro deterioration, for any reason, will be increasingly conspicuous. But isn't that too late as a practical matter? Not necessarily. Most folks, and even many professional economists, don't recognize the early stages of rising recession risk until it's blindingly obvious. How could they miss it? I think one reason is that they're not routinely monitoring a broad set of numbers. Business cycle analysis that's focused on calling recessions in real time is a highly specialized field, and most of the time the analysis isn't practical for the simple reason that recessions are relatively rare events in the grand scheme of macro. No wonder that contractions and the associated signals mislead so many people.
That leaves a fair amount of opportunity for identifying high levels of recession risk several months ahead of the crowd. Sure, it'd be better if we could identify the exact moment when a recession begins, but that's impossible because a high-confidence assessment requires a wide array of data—most of which arrives with a lag.
The best-case scenario that's both practical and relatively reliable is looking for a high-probability signal that a recession has recently started—and identifying such a tipping point as early as possible. The good news is that this type of analysis is feasible, although it requires a fair amount of vigilance in tracking the numbers.
It also helps quite a lot if the analysis is transparent, replicable, and uses publicly available data. All of those points apply to CS-ETI, but that's hardly the norm. It's one thing to claim to have a great business cycle model, but if the understanding the mechanics requires a Ph.D. and deep insight into highly complex calculations, the result for most folks is that they're looking at a black box that relies on the kindness of strangers.
On that note, I'll have an update of CS-ETI soon—in a week or so, once more October numbers are released. Meantime, the early reports for last month look modestly encouraging for expecting that October will go into the history books as another month of growth for the U.S. economy. Monday's news on the services industry, for instance, looks decent. Ditto for last week's economic updates.
Meanwhile, don't let the economic porn that spews regularly from the usual suspects distract you from the necessity of a hard, objective look at the facts when it comes to business cycle analysis. There are lots of things that could go wrong (or right) in the months ahead, but there's a big risk of declaring a new recession before the data supports such a call. Ignoring the telltale signs of a new downturn is no trivial risk. But the same is true for yelling fire in the macro theater without sufficient cause. The goal is finding a reasonable compromise, and that takes hard work—day in, day out. Some pundits would have you believe otherwise. Fortunately, that's one risk that's easily avoided.
November 7, 2012
A Sober Wake-Up Call The Morning After
President Obama was re-elected yesterday, and we wish him well. But the news is already ancient, given the pressing demands of defusing the fiscal cliff threat--a deep round of tax hikes and spending cuts slated to start in January if politicians don't intervene. Failure isn't an option here, given the dire effects these cuts and tax hikes could inflict on the still-struggling economy. Unfortunately, that's the likely scenario if politics as usual prevails in the weeks ahead. It's hard to imagine anything else at the moment, given the rancorous, hyper-partisan atmosphere that's defined the Beltway bunch for the past year.
Maybe the sour mood will evaporate now that Obama has won a fairly decisive victory in the Electoral College—303 votes for Obama vs. Romney's 206, with 270 needed to clinch the deal. Maybe, but don't count on it. There are several factors that will impede a quick solution to the fiscal troubles that loom, starting with the fact that the U.S. government remains divided: A Democrat in the White House and a Democrat-controlled Senate paired with a Republican-dominated House of Representatives. In other words, nothing much changed yesterday in terms of the balance of power in Washington, and so the potential for political dysfunction is as strong as ever.
It's an open question if a lame duck Congress will work with the President to resolve the fiscal cliff risk that threatens to push the economy into recession. The same question can and should be posed from the perspective of 1600 Pennsylvania Avenue: Can the President work with a lame duck Congress? We're about to find out, and the stakes couldn't be higher.
The President, however, has an opportunity to lead the country away from economic disaster if he can rise to the occasion and forge a consensus. Perhaps he'll be mindful of his legacy and go above and beyond the call of duty and reach out to the Republican-controlled House and bridge the bitter divide that's brought the country to this perilous point of fiscal vulnerability. But it's not going to be easy. As The Wall Street Journal reminds:
Mr. Obama, whose relationship with business deteriorated over his first term, will face daunting economic decisions almost immediately. That is because the most pressing economic issue after the election is the so-called fiscal cliff, a combined $500 billion in spending cuts and tax increases that begin in January unless Congress and President Obama cut a deal to delay or replace them before then. The White House and congressional leaders postponed negotiations until after the election, waiting to see which party emerged with more leverage.
The best, and perhaps last hope is that the election changed the political climate in Washington, if only slightly. Republicans, relieved of the pressures of the election, can focus on resolving the fiscal cliff by truly working with the White House to defuse this ticking time bomb. Ditto for the President.
The real challenge is time—there's very little of it left before fiscal disaster strikes. “Getting a deal on long-term fiscal soundness is paramount to move forward and to see the economy really keep improving,” opines Bill Daley, former chief of staff for Obama..
Failure would be especially tragic. The economy, while still weak, continues to grow, as recent economic news shows. It's not inconceivable that stronger growth is possible, perhaps even likely, in the absence of fiscal cliff risk.
In other words, the fate of the economy in the near term is heavily dependent on political decisions in Washington in the coming days and weeks. That's a frightening thought for so many reasons, but it's reality. For once, maybe the politicians are up to the challenge. If they're not, we'll see the blowback in the economic reports, and perhaps soon. Meantime, hope and change is the only game in town.
November 6, 2012
Strategic Briefing | 11.6.12 | The Election & The Economy
Economy Set for Better Times Whether Obama or Romney Wins
Bloomberg BusinessWeek | Nov 4
No matter who wins the election tomorrow, the economy is on course to enjoy faster growth in the next four years as the headwinds that have held it back turn into tailwinds. Consumers are spending more and saving less after reducing household debt to the lowest since 2003. Home prices are rebounding after falling more than 30 percent from their 2006 highs. And banks are increasing lending after boosting equity capital by more than $300 billion since 2009. “The die is cast for a much stronger recovery,” said Mark Zandi, chief economist in West Chester, Pennsylvania, for Moody’s Analytics Inc. He sees growth this year and next at about 2 percent before doubling to around 4 percent in both 2014 and 2015 as consumption, construction and hiring all pick up. The big proviso, according to Zandi and Yale University professor Ray Fair, is how the president-elect tackles the task of shrinking the $1.1 trillion federal-budget deficit.
The Election Outcome Wall Street Wants Most
The Fiscal Times | Nov 6
Both candidates have devoted tremendous time and energy over the course of the year to date to spelling out their respective visions for the United States. The problem? Whoever is elected is going to have a tough time moving forward on any front, much less delivering on pledges to transform the country on Day One of their presidency, if in the weeks that elapse between tomorrow’s poll and New Year’s Eve, they fail to avert catastrophe. If the United States manages to run its economy off the “fiscal cliff” like a particularly demented lemming, those grand visions of the future have even less chance than ever of materializing.
The Election Won’t Solve All Puzzles
DealBook (NY Times) | Nov 5
Come Wednesday morning, we should know who our president will be. But the uncertainty hardly ends there. Almost immediately after the elections, the next big talking point on Wall Street and in Washington is going to be the now infamous “fiscal cliff,” a series of automatic tax increases and spending cuts that was the result of a Congressional compromise reached last summer and is to take effect on Jan. 1, unless Congress finds an alternative. Some economists say the tax increases and spending cuts in the existing agreement could shave as much as 4 percent off G.D.P. if they are not renegotiated. Already, executives say that the uncertainty over the outcome of the fiscal cliff is causing them to hold back from making new investments. But the greatest likelihood is that the fiscal cliff isn’t going to be resolved soon at all —the betting line of the political cognoscenti is that no matter who wins, Congress will find a way to kick the issue down the road, perhaps as far as the fall of 2013, providing a new cloud of uncertainty over the economy.
US Election: It's the economy, stupid
RTE | Nov 5
Barack Obama has said his job plan would strengthen US manufacturing, grow small businesses, improve the quality of education and make the country less dependent on foreign oil. He envisions 1m new manufacturing jobs by 2016 and more than 600,000 jobs in the natural gas sector, as well as the recruitment of 100,000 maths and science teachers.... Mitt Romney has promised 12m jobs in his first term, or about 250,000 jobs a month. Economists say the economy would likely generate that amount of jobs anyway. His plan focuses on tax reform, pushing the economy toward energy independence, cutting regulations and boosting trade, especially by reducing barriers to trade with China. Mr Romney says Mr Obama has not been aggressive enough in challenging unfair Chinese trade practices and that he would use both the threat of US sanctions and coordinated action with allies to force China to abide by global trade rules.
How the election will affect the economy
CNN Money | Nov 6
"Irrespective of whether the ship of state is captained by Noah or Ahab, the U.S. is on a collision course with reality," said Patrick O'Keefe, director of economic research for accounting firm J.H. Cohn. Whichever candidate wins needs to be able to reach a bipartisan agreement on long-term debt reduction, or else uncertainty about the future of taxes and spending will continue to hold businesses back, O'Keefe said. But he doesn't give an edge to either candidate's chances of doing that.
Last jobs report before election shows economy in 'virtual standstill'
Fox News | Nov 2
The final monthly jobs report before Election Day offered a mixed bag of economic evidence that quickly became political putty for the presidential candidates, with the unemployment rate ticking up to 7.9 percent but the economy adding a better-than-expected 171,000 jobs. At the same time, the number of unemployed grew by 170,000, roughly the same amount -- to 12.3 million. The October numbers allow President Obama to argue the economy is technically growing under his watch. But they also allow Mitt Romney to argue that the new jobs are not making much of a dent in the unemployment problem. Both campaigns quickly set to work putting their spin on data that, if nothing else, underscores the slow pace of the recovery.
Op-Ed: What to expect if Obama is re-elected: A look at the next 4 years
Digital Journal | Nov 6
What will happen with the economy over the course of the next four years is undoubtedly the most important issue for most Americans going into this election. It is also the issue most hotly disputed between the two campaigns. The Romney campaign hopes that they have convinced enough Americans that re-electing Obama is a death blow to the economy to ensure his election, however, the facts do not support this claim.
Election could determine future course of the economy
Ed Lazear (The Daily Caller) | Nov 5
The president has given no indication that he will alter course in a pro-growth direction if re-elected. A second Obama term would likely mean continued high government spending, full implementation of Obamacare, a heavy emphasis on regulation, a failure to promote an aggressive trade agenda and an unwillingness to reform our tax structure, except of course by increasing rates on the rich. Consequently, the economy would probably remain weak.
An Election About the Economy Will Really Be About Entrepreneurs
Carl Schramm (Real Clear Markets) | Oct 23
Starting more new firms is not only the best path to resolving the recession, they are the principal source of wealth for America's future. In fact, Republican speakers described the role they play in the economy 13 times while Democrats did 9 times. Joseph Schumpeter would be smiling that the little guys, the entrepreneurs, the people who challenge the incumbent firms with their upstart startups, the causers of all the "creative destruction" that drive government regulators crazy, the new companies that seem to relish what he called the "gales" of competition that big companies fear, are somehow beginning to be seen as the champions they are. Karen Mills, head of the Small Business Administration, said "America's entrepreneurs are our greatest asset" during her speech to the Democratic convention.
November 5, 2012
ISM Services Index For October Points To Continued Growth
Today’s update of the ISM Non-Manufacturing (Services) Index for October corroborates the upbeat news from its manufacturing counterpart. In short, the economy continues to grow, or so these two widely watched indicators from the Institute for Supply Management suggest. The expansion is still well short of strong growth, but it's hard to make the argument that the economy is in danger of shrinking any time soon.
Although the ISM Services Index slipped a bit to 54.2 last month from 55.1 in September, it’s still well above 50—a sign that the services sector overall is still expanding. That's no trivial point for the dominant slice of commercial activity in the U.S. Any reading above 50 equates with growth. On that note, the ISM indexes for new orders and employment indexes in services also remain well above 50.
Combined with the growth bias in ISM’s read on manufacturing, it all adds up to a convincing data set that implies that October’s economic profile will remain in the modest-growth camp when the final summary is published.
"Moderate growth in the U.S. economy continues," Joseph Trevisani, chief market strategist at Worldwide Markets, tells Reuters.
In fact, that’s been the general narrative all along. True, there have been a few bumps along the way, sometimes shaking confidence. But remaining focused on a broad set of indicators, primarily on a year-over-year basis, has offered valuable perspective on the primary trend, as shown by the regular updates of The Capital Spectator Economic Trend Index (CS-ETI). You can never really trust a handful of numbers, particularly if you're looking at how they've performed in recent months. A more reliable perspective requires looking across a broad spectrum of indicators, and filtering out the short-term noise.
The future, of course, can and does bring nasty surprises. But based on the numbers available so far, recession risk still looks low. That’s been a constant theme at CapitalSpectator.com for many months for a simple reason: the indicators, overall, tell us so. For various reasons, some analysts have been arguing otherwise, warning that the U.S. economy is poised to fall off the cyclical ledge, if it hasn’t already. A dark view of the business cycle, although understandable on an emotional level, has remained highly speculative and deeply flawed.
October’s macro profile is still in its infancy, and so anything can happen. But we’re off to a good start. Will the statistical support for anticipating modest growth continue in the days and weeks ahead? Stay tuned….
Q4:2012 U.S. GDP Nowcast Update | 11.5.2012
Will the rebuilding in the Northeast in the wake of Hurricane Sandy’s destruction juice the economy’s modest growth trend? It’s too early to know, but the possibility can’t be dismissed. For now, it’s time to establish a baseline of nowcasts for Q4:2012 GDP. The official estimate is scheduled for release via the Bureau of Economic Analysis in late-February, and so there's a long road ahead in terms of economic updates. The journey starts here: The current average of our five econometric-based nowcasts anticipates real annualized Q4 growth of 1.7%, or down slightly from Q3's official 2.0% estimate.
It's still early, of course, and so there's limited data for developing a robust estimate for Q4. But as the numbers roll in, we'll update the nowcasts and monitor the changes. The key issue to watch is how the nowcasts evolve—are they rising, falling, or holding steady? The trend changes will tell us quite a lot about what to expect for the government's initial estimate of Q4 GDP that's due to hit the streets next February.
For now, here's where we stand in terms of The Capital Spectator's econometric nowcasts, along with two estimates from other sources for perspective:
As new data is published, our nowcasts will adjust accordingly. We'll track the changes through time for a richer read on how the economic outlook's faring--changes that will be recorded on this chart:
Here's a brief profile of how each of The Capital Spectator's nowcasts are calculated:
4-Factor Nowcast. This estimate is based on a multiple regression of quarterly GDP in history relative to quarterly changes for four key economic indicators: real personal consumption expenditures, real personal income less government transfers, industrial production, and private non-farm payrolls. This model compares the data on a quarterly basis, looking for relationships with GDP within each quarter from the early 1970s to the present. The four independent variables are updated monthly and so the nowcast is revised as new data is published. In effect, this model is telling us what the data trends in the current quarter imply for the quarter's GDP growth.
10-Factor Nowcast. This model also uses a multiple regression framework based on historical data from the early 1970s onward and updates the estimates as new numbers arrive. The methodology here is identical to the 4-factor model above except that it uses additional factors—10 in all. In addition to the data quartet in the 4-factor model, the 10-factor nowcast also incorporates the following series:
• ISM Manufacturing PMI Composite Index
• housing starts
• initial jobless claims
• the stock market (S&P 500)
• crude oil prices (spot price for West Texas Intermediate)
• the Treasury yield curve spread (10-year Note less 3-month T-bill)
ARIMA Nowcast. The econometric engine for this nowcast is known as an autoregressive integrated moving average. The technique here is using only real GDP's history, dating from the early 1970s onward, for anticipating the current quarter's change in the broad economy. As the most recent quarterly GDP number is revised, so too is the ARIMA nowcast, which is calculated in R software via Professor Rob Hyndman’s “forecast” package, which optimizes the prediction model based on the data set's historical record.
ARIMA 4 Nowcast. This model is similar to the ARIMA technique above in terms of the econometric details, but with one key difference. Instead of using GDP's historical record as the lone input, the ARIMA 4 model analyzes four historical data sets to estimate GDP: real personal consumption expenditures, real personal income less government transfers, industrial production, and private non-farm payrolls.
VAR Nowcast. The vector autoregression model also analyzes four economic series in search of interdependent relationships for estimating GDP. The four data sets in the 4-factor and ARIMA 4 models above are also used to generate the VAR-based GDP nowcasts. As new data for each of the four series is published, so too is the VAR nowcast. The basic idea here is to let the data specify the model's parameters. The data sets are based on historical records from the early 1970s, using the "vars" package for R to crunch the numbers.
November 2, 2012
A Decent Week For Economic News
It’s been a horrific week for weather for the eastern seaboard of the U.S., but the economic numbers remain encouraging. There’s still no sign that the economy is poised to break free of the slow-growth gravity field, but the numbers generally continue to support the view that a new recession isn't an imminent threat.
Consider today’s payrolls update for October—private-sector jobs increased 184,000 last month on a seasonally adjusted basis. That’s the best monthly gain since February and a sign that the labor market is still growing, and perhaps at a slightly faster rate. It’s not growing fast enough to inspire rosy forecasts, but the expansion continues to roll along.
That’s also the message when we review the longer-term trend: the annual change in private payrolls rose 1.8% through last month, or roughly at the pace that we’ve seen since April (see chart below). That’s a sign that nothing much has changed in the nation’s capacity for minting new jobs: the middling expansion is still with us, despite what you may have heard elsewhere.
Yesterday’s weekly release for initial jobless claims also provides modestly good news on the margins: a 9,000 decline in new filings for jobless benefits to a seasonally adjusted 363,000. That still leaves new claims more or less unchanged from the past several months, but the fact that claims aren’t rising is a good sign for broad outlook.
Even better, the annual percentage change in new jobless claims before seasonal adjustment suggests that the slow healing for the labor market persists. Unadjusted claims fell 8.1% last week vs. a year ago. The rate of a decline is a bit slower than we’ve seen in recent months, but it’s still decent progress and one more data point on the side of optimism.
So is the news that manufacturing improved slightly last month, according to the Institute for Supply Management. “Economic activity in the manufacturing sector expanded in October for the second consecutive month following three months of slight contraction,” ISM reports in a press release. The ISM Manfacturing Index rose to 51.7 in October, up from 51.5 previously. That's far from a boom, but any reading above 50 implies economic growth. This is the second month of 50-plus territory and it lends further support for arguing that the summer slump for this index hasn't spilled over into the fall.
All of this should be considered in context with a broader review of the economy. A few weeks back, The Capital Spectator Economic Trend Index (CS-ETI) told us that recession risk was low, based on numbers through September. This week’s data releases imply that more of the same may be on tap for October. Yes, it’s still early and there’s a long road ahead for October's economic updates, but so far, so good.
To be sure, economic growth remains modest at best and there are still plenty of risks lurking around the world. But based on the data that’s published to date, the path of least resistance continues to look encouraging. That could change, of course, and perhaps quickly, but for now let’s recognize what’s been obvious for months: recession risk doesn’t look threatening because slow growth prevails.
Book Bits | 11.2.12
● How They Got Away with It: White Collar Criminals and the Financial Meltdown
Edited by Susan Will, Stephen Handelman, and David C. Brotherton
Summary via publisher, Columbia University Press
An international team of scholars with backgrounds in criminology, sociology, economics, business, government regulation, and law examine the historical, social, and cultural causes of the 2008 economic crisis. They also take stock of the long-term devastation done to governments, businesses, and individuals, and the ongoing, systemic issues that have so far allowed the perpetrators to get away with their crimes. Insightful essays probe the workings of the toxic subprime loan industry, the role of external auditors, the consequences of Wall Street deregulation, the manipulations of alpha hedge fund managers, and the “Ponzi-like” culture of contemporary capitalism. They unravel modern finance’s complex schematics and highlight their susceptibility to corruption, fraud, and outright racketeering. They examine the involvement of enablers, including accountants, lawyers, credit rating agencies, and regulatory workers, who failed to protect the public interest and enforce existing checks and balances. While the United States was “ground zero” of the meltdown, the financial crimes of other countries intensified the disaster. Internationally-focused essays consider bad practice in China and the European property markets, and they draw attention to the far-reaching consequences of transnational money laundering and tax evasion schemes.
● The Redistribution Recession: How Labor Market Distortions Contracted the Economy
By Casey Mulligan
Summary via publisher, Oxford University Press
Redistribution, or subsidies and regulations intended to help the poor, unemployed, and financially distressed, have changed in many ways since the onset of the recent financial crisis. The unemployed, for instance, can collect benefits longer and can receive bonuses, health subsidies, and tax deductions, and millions more people have became eligible for food stamps. Economist Casey B. Mulligan argues that while many of these changes were intended to help people endure economic events and boost the economy, they had the unintended consequence of deepening-if not causing-the recession. By dulling incentives for people to maintain their own living standards, redistribution created employment losses according to age, skill, and family composition. Mulligan explains how elevated tax rates and binding minimum-wage laws reduced labor usage, consumption, and investment, and how they increased labor productivity. He points to entire industries that slashed payrolls while experiencing little or no decline in production or revenue, documenting the disconnect between employment and production that occurred during the recession.
● Freaks of Fortune: The Emerging World of Capitalism and Risk in America
By Jonathan Levy
Q&A with author via Princeton Alumni Weekly
The role of capitalism and the size of the federal government are more at issue in contemporary American politics than they have been since the 1930s. Jonathan Levy, an assistant professor of history, has studied the ways in which our conceptions of risk and economic freedom have changed throughout history. He traces much of that history in his new book, Freaks of Fortune: The Emerging World of Capitalism and Risk in America, which will be published in 2012. Levy discussed some of his conclusions with PAW.
Q: What is your book about?
A: It’s a history of risk. The notion of personal assumption of risk as we know it was new to the 19th century. Instead of hedging risk outside of the market collectively, people started to do it within the market individually by doing things like buying insurance, putting their money in savings banks, and entering the futures markets.
● The Great Persuasion: Reinventing Free Markets since the Depression
By Angus Burgin
Summary via publisher, Harvard University Press
Just as today’s observers struggle to justify the workings of the free market in the wake of a global economic crisis, an earlier generation of economists revisited their worldviews following the Great Depression. The Great Persuasion is an intellectual history of that project. Angus Burgin traces the evolution of postwar economic thought in order to reconsider many of the most basic assumptions of our market-centered world. Conservatives often point to Friedrich Hayek as the most influential defender of the free market. By examining the work of such organizations as the Mont Pèlerin Society, an international association founded by Hayek in 1947 and later led by Milton Friedman, Burgin reveals that Hayek and his colleagues were deeply conflicted about many of the enduring problems of capitalism. Far from adopting an uncompromising stance against the interventionist state, they developed a social philosophy that admitted significant constraints on the market. Postwar conservative thought was more dynamic and cosmopolitan than has previously been understood.
● From Pleasure Machines to Moral Communities: An Evolutionary Economics without Homo economicus
By Geoffrey M. Hodgson
Summary via publisher, Chicago University Press
Are humans at their core seekers of their own pleasure or cooperative members of society? Paradoxically, they are both. Pleasure-seeking can take place only within the context of what works within a defined community, and central to any community are the evolved codes and principles guiding appropriate behavior, or morality. The complex interaction of morality and self-interest is at the heart of Geoffrey M. Hodgson’s approach to evolutionary economics, which is designed to bring about a better understanding of human behavior.
Major Asset Classes | October 2012 | Performance Review
Electricity is still MIA for The Capital Spectator, and more of the same is expected for the next several days, courtesy of the ongoing fallout from Hurricane Sandy. But through the generosity of the local high school there’s a bit of light in this tunnel and the opportunity to update the returns for the major asset classes.
October was a mixed bag for risky assets, with REITs, U.S. stocks, and commodities taking a mild tumble last month. Foreign corporate bonds, emerging market debt, and U.S. junk bonds offered a positive counterpoint, as did foreign equities in developed markets. The results overall tipped slightly negative, however, as suggested by the fractional loss of 0.4% for the Global Market Index. Nonetheless, GMI remains in the black so far this year by 9.0%.
November 1, 2012
Hurricane Sandy has taken a heavy toll on the East Coast of the U.S., and the destruction is particularly harsh in New Jersey. Unfortunately, that's where The Capital Spectator resides. The lack of electricity is, of course, the 21st century equivalent of getting kicked in the head, and your editor remains dazed at this point. Internet access is spotty and today's return to the digital world is a brief affair. I'm told that power won't be restored until early next week, and that's the optimistic forecast. In short, stuff happened and the usual routine at CapitalSpectator.com remains on hiatus. But not for long. Meantime, to all our East Coast readers, especially those in New Jersey: Be well, be safe.