The August employment report initially created quite a stir. More than a few observers of the economic scene thought the recession clouds were finally gathering. But a month later, the government revised its estimate of nonfarm payroll numbers up and the world suddenly looked brighter. One can only guess at how the Fed will react at the October 31 FOMC meeting.
For some thoughts on where the economy’s headed, and where it’s been, today we turn to Robert Dieli, president and founder of RDLB, Inc., an economic research and management consulting firm in Lombard, Illinois that publishes its reports for subscribers at NoSpinForecast.com. Bob’s a valuable source for this reporter, and a fresh visit with him is timely, given all the questions swirling about on matters of macro relevance. What follows is his take on the current economic climate, a view written by Dieli–exclusively for The Capital Spectator. As a preview, he doesn’t think a recession’s imminent. For the details, read on…
When the August employment figures were first released, we wrote to our subscribers that they should not take the number too seriously. Our first reason for saying that was because close inspection of the August jobs report showed that most of the decline was due to a drop in state and local education employment. That suggested that something was out of its normal seasonal pattern, or that there had been an incomplete response to the employment survey. In any case, the revision in the jobs report for September, which showed employment growth for August and September, confirmed our suspicion.
Our second reason is seen in the chart below. Note that significant revisions are common between the first and second editions of the employment report. It is on those grounds that we publish this chart in our analysis of the jobs figures every month.

Click for full-size chart
The chart above also shows that in September 2006, the initial estimate was quite small, suggesting some weakness might be developing. That impression was dispelled with the revisions. As a general rule, it’s best to wait for the second report before trying to draw conclusions. But, in the overheated atmosphere that prevailed in early September 2007, it was easy to get sucked in by the headline.

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Last week’s launch of the first foreign bond ETF in the U.S. has received a muted reception so far, but it looks like a big deal to us. Diversification is the reason.
Yes, actively managed funds targeting foreign bonds have been around for years. But with the arrival of SPDR Lehman International Treasury Bond ETF (Amex: BWX), the asset class’s beta is now finally available in something approaching its pure form. The first foreign bond index fund, in other words, is here.
That’s good news for a number of reasons, starting with the price of entry. Consider that there are 84 “world bond” mutual funds (distinct portfolios), according to Morningstar Principia software. (There are another 26 “emerging markets bond” portfolios, but we’re overlooking this group since the new ETF focuses on investment grade government debt.) The gross expense ratios for world bond funds range from a high of 4.99% (ouch!) down to 0.19%. Sixty-six of the 84 portfolios charge 0.51% or higher, which is to say that 66 world bond mutual funds charge more than the 0.50% expense ratio for new foreign bond ETF.
True, 0.50% isn’t cheap when compared with the lowest fees in the ETF universe, which is as low as seven basis points. But foreign bonds aren’t your garden variety asset class, which is why it’s taken so long to see this corner of the marketplace indexed. Meanwhile, 50 basis points isn’t so high as to destroy the fundamental case for buying this slice of beta.
The basic appeal of foreign bonds is the diversification benefits they offer to most other asset classes. As the table below shows, there’s low and in some cases virtually zero correlation between foreign bonds (represented here by the Citi World Gov’t Bond Index Non-$ Index, unhedged) and the major asset classes. You’d expect no less between stocks and bonds generally, and foreign bonds certainly live up to that expectation. But what’s surprising is the low correlation between foreign bonds and U.S. bonds, as measured by the 0.38 correlation for the three years through last month for the Lehman Bros. U.S. Aggregate and the Citi WGBI.

Strategic-minded investors should also take note that there’s low correlation between foreign bonds and commodities, REITs and high-yield bonds. Rarely has so much diversification been available for just 50 basis points. Indeed, how many investors are paying 2 and 20 for hedge funds on the belief that adding “alternative investments” will bring diversification benefits?

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By the government’s reckoning, inflation could hardly be less of a threat. Why, then, have inflation-indexed Treasuries performed so well in the 21st century?
TIPS, after all, are designed to thrive on higher inflation. The higher inflation goes, the better TIPS will perform. Conversely, lower inflation implies lesser performance for TIPS, in both absolute and relative terms. Meantime, if inflation’s under control, doesn’t that imply that the unhedged bonds paying nominal yields will do better? If not, why would anyone buy unhedged bonds if they’re doomed to underperform regardless of inflation’s pace?
Before you answer, let’s turn to the real world track records. For the year through August, the consumer price index (CPI) rose by just 1.9%. Rarely in the past 10 years has CPI’s annual pace been so low, which is to say that it’s usually been higher. This has a direct bearing on TIPS for the simple reason that the bonds’ principal is directly tied to the fluctuations in CPI. Higher CPIs translate into higher TIPS values, and vice versa.
Speaking of facts, inflation-indexed Treasuries have been the clear winner compared with a variety of relevant fixed-income benchmarks that are unhedged when it comes to inflation. One example can be seen in our chart below, which compares the Lehman Bros. U.S. Treasury TIPS Index to the Lehman Bros. U.S. Aggregate Bond Index, a popular measure of the domestic universe of investment-grade bonds sans inflation hedges.

As you can see, TIPS are winning the race and the triumph has been unfolding for some time. Most of the superior performance has come since 2001. For the five years through last month, the LB TIPS Index posted an annualized 5.35% total return, well above the LB Aggregate’s 4.13%. TIPS also held the lead for the past five years against other indices, such as the LB Government Intermediate and LB Government Long indices.
Why have inflation-indexed bonds enjoyed a performance edge over their nominal-rate counterparts? Conceivably, there are several answers, although one in particular begs for attention, namely: one corner of the bond market expects inflation will be higher than CPI suggests.
Skeptics might argue that the TIPS market is just wrong, and that inflation is contained and in no danger of causing trouble for the foreseeable future. The official inflation numbers published by the government suggest no less. Extending this line of thinking implies that TIPS have it all wrong. But can a liquid, widely analyzed corner of the government bond market be so wrong for so long?
It’s anyone’s guess if TIPS will continue to lead the fixed-income pack. Without benefit of knowing next year’s inflation numbers, much less next month’s, we’re at a loss to venture a guess. The safest route is, of course, to own TIPS and conventional bonds.
That said, we’ll conclude with one question: If TIPS have so done well in recent years when inflation has been officially reported as conquered, how might inflation-indexed Treasuries fare if inflation gathers a bit more upside momentum?

No one knows what’s coming, but as we write, the view looks pretty good. In fact, it’s downright amazing. Of course, seeing what looks like near perfection requires a rear-view mirror. If we choose that bias, ours is a golden moment. Let’s bask in it, fully aware that it may or may not offer clues for what awaits.
Year to date, through Friday, October 5, Latin America glitters brightest of all if we carve up the planet’s equity markets by the familiar labels. Advancing 49% in total return dollar terms is the standard by which most other carvings fall short, as our table below shows. Of course, “falling short” still looks pretty good for the most part in absolute terms. (All numbers throughout are courtesy of S&P/Citigroup Global Equity Indices.)

Meanwhile, the sick man of the equity markets within the developed world this year surely goes to Japan, which has advanced by less than 2% YTD. If this is the best the world’s second-largest economy can muster in a stellar investment year such as 2007, one might wonder what’s the outlook when times turn tougher?

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Gilda Radner’s Emily Litella on the Saturday Night Live of yore used to respond with a sheepish “Never mind” when proven wrong. That roughly approximates our reaction to this morning’s September employment report.
It turns out that the initial jobs report for August was wrong, and by more than a little. You may recall that the government’s first report for August showed the first net loss (-4,000) in nonfarm payrolls in four years. It wasn’t hard to jump to conclusions. But as we learned today, there was no loss in August, which actually posted a revised 89,000 gain. What’s more, the initial estimate for September showed a 110,000 rise in nonfarm payrolls–the highest since May.

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Inflation is a familiar subject on these digital pages. As a risk factor, however, it’s been mostly a non issue, or so the government’s official inflation numbers advise. We worry about inflation just the same. One reason arises from the possibility that commodities are in a secular bull market, energy in particular. We’ve discussed why that may spell higher inflation down the road. In the October issue of Wealth Manager, we looked into the topic in a bit more detail. Inflation may ultimately prove to be tame after all. But let’s not be hasty. Before you make a final decision, consider one of the risks that could derail the sunny outlook. To probe the darker side, read on…

Now more than an ever an upside surprise is needed.
Higher-than-expected earnings are always good news for the stocks market. But as third-quarter reports start rolling in the weeks ahead, another upside surprise would be extremely timely in the fall of ’07. Anything less may spell trouble above and beyond the usual risks.
Optimism has clearly been the dominant force of late. Despite the various financial blows that frightened investors in August and convinced the Fed to cut interest rates by 50 basis points two weeks ago, the stock market has more or less survived and even thrived. Equities are either at peaks or within shouting distance of all-time highs, depending on the index. The implication: the future looks rosy.
That’s a bold statement considering the lingering worries thrown off by real estate woes of late. Home sales, to cite one statistic, continue falling. There’s also the question of whether the labor market is set to contract, as suggested by the August employment report, which posted the first net loss in four years. Recession, in short, has been on the minds of many these past few weeks. But judging by the stock market, such worries are merely the stuff of overactive imaginations.
In fact, let’s not minimize the message emanating from Wall Street. The future looks damn good, equity traders are collectively shouting. “Equity investors clearly don’t see a significant risk of recession or a major slowing in corporate earnings,” Sal Guatieri, senior economist at BMO Nesbitt Burns, told The Globe and Mail on Monday.

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A casual observer of financial markets might have expected worse after August. Much worse. If you’ve been keeping up with the media reports, red ink looked like a sure thing for September.
In fact, the exact opposite graced September as all the major asset classes ran higher last month. One might reasonably be surprised at the outcome. After all, the Federal Reserve cut interest rates by an aggressive 50 basis points two weeks back, a decision in anticipation that the subprime/housing fallout would take a hefty toll on the economy and, by extension, the capital markets. Trouble may yet be coming, but as you can see from our chart below, everything was in the black for September.

If you weren’t reading the day-by-day analysis and instead looked only at monthly total returns, you might think that all’s well and by more than a little.
All was particularly well last month in emerging market equities, which was firmly in first place for September’s biggest gain. Indeed, EEM surged nearly 12% last month. Emerging market stocks have rarely performed better on a calendar month basis in dollar terms.
Commodities had an impressive month as well. DJP added 8% in September, driven by higher prices for oil and gold, to name but two of the more obvious climbers. In third place: EFA, a proxy for developed market stocks.

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Let’s get right to the point: the American consumer isn’t easily distracted. A recession may be looming, the housing market may be swooning, but Joe Sixpack isn’t easily discouraged from indulging in the great American pastime otherwise known as shopping.
As he has so many times in the past, Joe’s keeping the economy bubbling in 2007, as this morning’s update on personal income and spending reminds. In fact, the extraordinary staying power of the American consumer is that much more amazing as it comes in the face of lesser personal income last month. In theory, income and spending are joined at the hip. If you earn less, you spend less; earn more, spend more. No explanation needed. But that seemingly iron law only applies in the long run, and even then there’s room for debate in a world of easy loans and a myriad of innovations to keep shopping habits alive and kicking. And once you turn to the short term, well, let’s just say that logic and mathematical certainty are as ephemeral as the wind.
Consider the latest reading on consumer spending, which accounts for the lion’s share of GDP. The government today reported that personal consumption expenditures (PCE) rose 0.56% in August vs. July. As our chart below illustrates, that’s the highest monthly pace since April. Last month’s rise is all the more impressive considering that it was accompanied by a lesser rate of increase in disposable income.

The notion that the economy may be bubbling more than some think also finds support in yesterday’s initial jobless claims report. Last week’s new filings for unemployment benefits fell to a four-month low, which implies that the outlook for economic momentum still looks healthy. Then again, this encouraging news was tempered by Thursday’s report on new home sales for August, which confirmed what was already obvious: the housing market remains mired in a slump. Indeed, sales of new homes fell in August to the lowest annualized rate in seven years.

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In search of economic signs confirming or denying the gathering weakness, this morning’s durable goods report for August extends fresh support for the fear that the forces of darkness are indeed approaching. As our chart below shows, August witnessed the biggest monthly drop in percentage terms since January. It’s also the first decline since May. If you ignore defense orders, new orders dropped by an even steeper 5.9% last month.

It’s hard to put a positive spin on the latest durable goods report. The aura is that much gloomier when you couple today’s news with yesterday’s update on existing home sales, which tumbled more than 4% last month to the slowest annualized rate in five years.
It would be folly to dismiss the signs that the economy’s weakening. On the other hand, all’s not lost, at least not yet. Consider our second chart below, which puts today’s weak durable goods report into broader historical context. As you can see, the latest dip, while troubling, is hardly definitive proof that recession is imminent. We’re still within the range of volatility that’s prevailed in recent years.

But let’s be clear: the pressures are building and from the evidence in recent weeks it’s only prudent to expect that the news will get worse before it gets better. That, at least, is our guess. But the economy is still standing and, despite all the hits continues to hold up, as far as we can tell at this point. If there’s a deciding factor that will tip the balance one way or the other, that will probably be consumer spending, which accounts for more than 70% of GDP.

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