+ Jobs report comes in much better than expected
with the private sector generating 65,000 jobs, while prior months were
revised higher. This is the nail in the “we are about to enter a
double-dip” coffin. We are only experiencing a soft patch. The economy
will pick up steam in the 2H of 2010 and 2011.
+ Chicago PMI showed continued expansion
and came in higher than expected. New orders came in expansion
territory and doesn’t point to contraction in this region in the months
ahead, while jobs continue to be created. This result led to a strong
Manufacturing ISM reading which surprised everyone. Finally, the American Association of Railroad’s weekly report shows the highest carload reading of the year.
These indicators show that the prospect of soft landing and steady
growth are not only possible, but likely. Double dip fears are way
overblown. These factors will buoy consumer confidence and loosen
wallets in the months ahead.
+ China PMI comes in better than expected and points to a soft landing in China, followed by steady growth. Meanwhile, Eurozone GDP rises the most in a year. The global economic recovery has legs, it’s just taking a breather. This can be seen from shipping indexes, which have been rising at a healthy clip. (Link Courtesy of Calafia Beach Pundit)
+ Sentiment continues to side more with the Bulls as analysts are growing exceedingly pessimistic.
Many are expecting a double dip, therefore there’s a growing chance
that things aren’t as bad as most believe. (Link Courtesy of The Big Picture)
+ PCE metric shows that consumption increased more than expected, while August chain store sales rise more than analysts expected. Why? The job market is indeed recovering as per the Gallup Job Creation Poll.
It has been steadily increasing over the past three months. Need more
proof? The ISM Manufacturing employment sub-index hit its highest
level since 1983, while jobless claims have been steadily coming back down.
+ Housing prices as per the Case-Schiller index rose more than expected (third positive reading in a row)
and points to continued stabilization in housing prices. This will
help consumer confidence and help bank balance sheets. Meanwhile,
pending home sales for July rose 5.2% and shows that the fall in demand
from the tax credit has stabilized.
Bearish
- ECRI Leading Indicator Growth Rate shows continued weakness
and is once again below the historically important -10% level, which if
broken, has always presaged a recession in subsequent months. Contrary
to bullish news regarding the jobs report, this indicator is leading,
not coincident. (Link Courtesy of Zero Hedge)
- The manufacturing sector, which has been responsible for most of
the recovery in the economy, is about to falter. Factory orders rose less than expected
coming in at +0.1% for July, while inventories are rising at an
accelerating clip, a sign that demand is not as strong as supply,
factories will eventually need to reduce production. Meanwhile, ISM Service Index came in below expectations with most sub-indicies showing weakness.
Employment for this sector, which comprises the bulk of the US
economy, showed contraction for the first time since January. New
Orders also showed its weakest reading this year.
- Unit Labor costs were revised up much higher, while productivity
has been coming back down. Most of the rise in earnings has been due to
extensive cost cutting (look at the unemployment rate!) — ie margin
expansion. With margins near all time highs, productivity declining and
Labor Costs rising, end demand will have to carry earnings growth from
here. Survey on end-demand says….
- …PCE metric shows that income growth continues to struggle.
Slow income growth will anchor consumption growth as there is debt to
be repaid and savings to accumulate. Worse, what’s the unemployment
rate at? High supply of workers vs. low demand for labor points to wage growth crawling or worst case scenario, contracting.
This could be seen in the Conference Board index of Consumer
Confidence as less people expect a wage increase than people who expect a
wage cut. (See link in Bearish point below)
- Consumer spending is slowly decreasing as the Gallup Poll points to a very tepid August (smack in the middle of back-to-school). The 4 week average for August is down 5%+ from the prior month, which was also down 3%. Why is this occuring? Look at the Gallup, ABC, and Conference Board
(average recession reading = 72 for some perspective) polls. They show
confidence is still in the dumps. There is clearly a trend of
reduced/cautious spending. This is further evidenced in the Goldman and
Redbook metrics, which have shown a falling YoY growth rate over the
past month as well.
- More signs of a consumer slowdown as the growth rate in auto sales in the US has all but vanished.
New sales rates are lower now than they were in 1990/1991. If there
is no significant growth in end demand soon, the flashy manufacturing
numbers are not sustainable, plain and simple. (Link Courtesy of CalculatedRisk Blog)
Observations/Thoughts
Here’s a great example
of everyone trying to export their way out of their respective economic
difficulties. Unfortunately, this means that everyone is attempting to
weaken their currencies (beggar thy neighbor policies). That’s why
you’ve seen Gold outperforming all asset classes this year. How far
down does the rabbit hole go? Rumors are now surfacing towards the Fed
initiating QE2 but instead of buying mortgage or treasury bonds, it
would begin buying stocks, real estate, etc in an attempt to cut out the
middle men that are the banks. I’m not buying this for a couple of
very important reasons. The Fed would effectively and blatantly be
screwing all savers, the prudent, and the retirees seeking income by
plowing their wealth into bond funds for the better part of a year now
(note, this cohort is the strongest political bloc in the country).
Second, pursing this policy would also signal to the rest of the world
that full blown monetization is ongoing and the dollar would take a
drastic turn lower. Inflation would surely become more potent in
commodities, while companies, having no pricing power would have their
margins squeezed even more. A dangerous stagflationary situation would
develop, however, given that we may indeed be in a modern day depression
I’ve come up with a new name. We would be inviting a “Hyper-depression” if such policy were pursued.
Are problems in China worse than assumed? Inflation troubles continue to surface,
despite the government’s statistical office announcing rather muted CPI
readings. One thing is certain, high growth rates in wages are
certainly not helping matters for them. Additionally, we can begin
speculating that officials may be a little more forceful in deflating a stubborn real estate market. However, they need to be careful in their policies as this is delicate process.
More articles are popping up regarding the Fed’s impotence in battling the recession. This is something that I was thinking about at the beginning of the year.
While the Fed had helped the banks out with a large interest rate
spread, demand for loans has been negligible. Lack of credit creation
and expansion is severely disrupting investment and recovery. There’s
really little the Fed can do in a balance sheet recession. In general,
the consumer is paying back all the debt he/she amassed over the past 2
decades. Unfortunately, there’s not a quick fix to this problem in my
view. Lowering taxes will certainly help in the healing process, but
current consumption would probably increase only marginally as consumers
would sock away the extra cash for their retirement as their most
important asset, their home, is not what it used to be, especially if
the tax cuts were only for a year. Maybe a massive jobs program similar
to the New Deal that put people back to work to rebuild our
infrastructure (the Recovery Act didn’t really help). The problem is
that if there is deadlock, can we really count on our politicians to
agree and spend on another BIG stimulus package?
The Democrats are starting to lose control of the election
and possibly their majority in congress. Filibusters will become
commonplace and important legislation may not get to a contracting
economy on time.
Barton Biggs is at it again. “This is not a time where you want
to be underinvested. The odds of a significant slowdown are one in
five, pretty remote”. This guys been flip flopping more than a pancake,
and short-term, he’s been wrong at every turn last time I checked.
Meanwhile, the most pessimistic on the street right now as far as GDP
growth is concerned is Goldman Sachs with a forecast of +1.5% for the
rest of the year and a 66% of sustainability in this recovery. Clearly
there hasn’t been capitulation, so we continue on our “slope of hope”
IMHO.
David Rosenberg pointed out this article
on the Economist regarding the current US job market’s woes. After
reading it, I decided to check out the jobs section in my Q1 outlook and found that my thoughts were quite similar. I also wrote this in
late 2009, where I mention technological innovation as a cause for
recent jobless recoveries. It appears that I am on the right track.
Since the beginning of the recession/depression there have been over 7.6 million total job losses (not just private jobs, which is all that the government is suddenly focusing on. What next: emphasizing the dramatic surge in janitors and trash collectors?). So which occupations are the biggest winners and losers over the past 33 months? Curiously, the split in job losses is spread about evenly between manufacturing and service jobs, with the top 2 biggest absolute losers are construction and manufacturing occupations. Things are not better in services either, as the bulk of professional segments have lost hundreds of thousands, with two exceptions: healthcare and education. Of course, the one sector that has never seen cumulative job losses in the recession is the government - for state and federal employees the recession has not only ended, but it never started.
Those who wish to see the carnage across various jobs over time can do so below at the following WSJ interactive chart.
Since the beginning of the recession/depression there have been over 7.6 million total job losses (not just private jobs, which is all that the government is suddenly focusing on. What next: emphasizing the dramatic surge in janitors and trash collectors?). So which occupations are the biggest winners and losers over the past 33 months? Curiously, the split in job losses is spread about evenly between manufacturing and service jobs, with the top 2 biggest absolute losers are construction and manufacturing occupations. Things are not better in services either, as the bulk of professional segments have lost hundreds of thousands, with two exceptions: healthcare and education. Of course, the one sector that has never seen cumulative job losses in the recession is the government - for state and federal employees the recession has not only ended, but it never started.
Those who wish to see the carnage across various jobs over time can do so below at the following WSJ interactive chart.
Daily analysis of the US Forex market trading session with DailyFX Currency Strategist John Kicklighter. Includes coverage of economic and financial market news, as well as an outlook for the day ahead and trading ideas.
Should Alan Greenspan, the former Chairman of the Federal Reserve Board (1987–2006), be tried for Crimes Against the Economy, put up against a concrete wall, handed a cigarette, offered a red blindfold, and then executed by firing squad?
Yes—absolutely. No question. (And this coming from an anti-death penalty, anti-abortion Catholic.) Herewith, the case for the prosecution.
There are four main charges against the so-called “Maestro”:
One—Irresponsible Market Liquidity, Which Created Rampant Moral Hazard:
The Accused was instrumental in creating the pernicious policy mentality of “providing markets with necessary liquidity”—essentially, throwing money at every problem.
This first started within days of Greenspan’s assuming the role of American central banker: The frenzy that caused the stock market crash of October 1987 was doused by Greenspan’s pledge to provide “all necessary liquidity, should the need arise”. This instantly soothed the markets as surely as a hit soothes a heroin junkie—within a few months, it was as if the panic had never happened.
After that, and throughout his tenure and that of his successor, Greenspan applied the same remedy, time after time, to every single problem. He became the living embodiment of that old saw: “If all you have is a hammer, every problem looks like a nail”. Or maybe Curtis Mayfield’s famous refrain would be more apropos: “I’m your pusher-man”.
This addiction to market liquidity reached a peak with the Long Term Capital Management (LTCM) fiasco of the Fall of ‘98. LTCM made a series of bad bets that went sour due to the Russian Crisis—therefore, to pay off its losses, LTCM would have to stage a fire-sale to come up with the cash. To avoid this disorderly unwind and subsequent fire-sale—which would have led to an across-the-board run on LTCM’s counterparties, and eventually a wholesale market panic—the Fed under Greenspan organized LTCM’s counterparties, and effectively underwrote the firm’s break-up, providing essentially a bridge loan to finance the whole mess.
Whether LTCM should have been bailed out by the Fed in order to effect an orderly unwind is debatable. Some believe that LTCM had to be bailed out, others believe it should have been allowed to fail, and let the chips fall where they may.
What is not debatable, however, is that, as a direct result of LTCM, two things happened: One, every Wall Street firm realized that, if they were ever hard-up for cash, Easy Al would come through with liquidity—which meant effectively that firms could begin figuring out ways to leverage themselves even more, in the pursuit of profits. They were one and all confident that Uncle Al would bail them out with liquidity, if they ever got into any real trouble.
The other thing that happened was what didn’t happen. Once the bail-out and liquidation of LTCM was carried out, Greenspan failed to learn the obvious lesson from the experience: Sophisticated financial products created under his chairmanship had directly led to the collapse of the firm, and put at risk the entire U.S. financial markets.
If brainiacs like Merton and Scholes, with killer-traders like John Meriwether at the wheel, could drive LTCM off a cliff, what about the hoi polloi of Wall Street, strapping the same financial weapons of mass destruction as Merton, Scholes & Meriwether had been wielding? What kind of trouble could they get themselves into, with all of these fabulous “innovations”?
Did Greenspan put a stop to such suicidally risky practices after LTCM?
In a word: No. Which leads directly to the second charge—
The Accused was instrumental in creating a Do-Not-Touch attitude towards the banks, both investment and commercial—which of course led the financial sector to pursue incredibly stupid products and strategies: All in the name of “maintaining financial markets’ ability to innovate”. These “innovations” were directly to blame for the Global Financial Crisis, as they created unsustainable liabilities which sooner or later would lead to system-wide collapse. As what happened.
LTCM was the canary-in-the-coal-mine: What occurred in 2007–‘08, and the virtual freezing of the financial markets on September 18, 2008, was a direct result of the Fed’s failure to regulate the financial markets. It’s what happened when the aforementioned hoi polloi on Wall Street did more or less what Merton, Scholes & Meriwether had done—only magnified.
Not only that, in this urge to “innovate”, Greenspan was key in having the Glass-Steagall Act repealed in 1999. This allowed commercial lenders to act as investment banks.
The timing of this repeal has to be emphasized: This was just over a year after the LTCM fiasco. Effectively, repealing Glass-Steagall meant that commercial banks could build their own LTCM’s right in the comfort of their own back yards. Yet here was Greenspan, egging on the repeal of the Act.
There was a reason why Glass-Steagall existed: Precisely so as to prevent large commercial banks from using their assets to become gigantic LTCM’s.
But Alan Greenspan—knowing full well the history of Glass-Steagall, and ignoring the object lesson of the LTCM debacle of a mere fourteen months earlier—ushered in the era of commercial banks as hedge funds with a smile: Or in other words, he was the midwife of the monsters now known to us all as the Too Big To Fail banks.
All in the name of “financial innovation”. I’m sure Dr. Victor Frankenstein said something similar, back in his day.
Three—Subsidized Money, Which Radically Distorted The Economy:
This is probably the biggest crime Alan Greenspan committed as Federal Reserve Chairman: The so-called “Greenspan Put”.
For the twenty years of his tenure, the Accused—supposedly an avowed free marketeer—subsidized the cost of money. Rather than let the Fed funds rate more or less mirror what banks were lending among themselves, and tighten interest rates when the economy overheated (as his predecessors had done), Greenspan instead goosed the markets: His “targeted” Fed funds rate was forever undercutting what the financial markets were dictating, as to the true price of money.
What happenes when a good—any good, including money—is subsidized? Simple: It creates market distortions. And the higher the subsidy, the greater the distortive effect.
The market distortions Greenspan’s monetary policies created led to one asset bubble after the other—each of which was bound to pop, as they eventually did. Each of which was worse than the last, which they were: Equities, dot-coms, tech, real-estate—they all ballooned, then they all popped. The latest bubble—which I have argued is the Final Bubble—are of course Treasury bonds.
The reason these bubbles popped was that the “market innovations” previously discussed, combined with Greenspan’s guarantee of liquidity, as well as the subsidized money, led to an unprecedented expansion of credit through various non-regulated, over-the-counter products, such as Mortgage Backed Securities and other Collateralized Debt Obligations.
This is why there was such a severe distortion in asset prices in the American economy starting in 1987: Rampant credit creation, a product of the Greenspan Put. It was not supply-and-demand that led assets to accrue value exponentially and seemingly without reason: It was the unregulated, uncontrolled expansion of credit, brought about by the cheap, subsidized money Greenspan was pumping out into the economy.
Furthermore, the Accused was aware of the serial bubbles blistering through the U.S. economy, and in fact warned against these bubbles—and yet did nothing, even though he had the power as Fed Chairman to stop them.
Who can forget that famous line: Irrational exuberance. Nobody can—it’s simply too memorable, too on-the-money. However, everyone seems to forget when Greenspan uttered that famous line: December 5, 1996.
Before all the bubbles—that’s when Greenspan said those famous words. He anticipated the bubbles—yet allowed them to percolate, and then pop.
This regime of subsidized money not only created the various bubbles—dot-com, tech, real-estate—which finally burst in September 2008 with the Global Financial Crisis. This regime has created the condition for the final bubble—the bubble in U.S. Treasury bonds.
The subsidy in money that Greenspan created allowed the U.S. Federal government to go into more debt than it can possibly repay in real terms. It allowed the Federal government to go into much more debt than it would have been able to, if interest rates had been market-dictated. Current U.S. debt pays interest of 25¢ for every dollar borrowed—that interest would have been higher much earlier, had Greenspan not subsidized money. This would have curtailed U.S. Federal government borrowing at a much more manageable level to GDP, instead of the 100% debt-to-GDP ratio it is today, and 110% ratio it will in all likelihood be next year.
This excessive debt level of the U.S. Federal government insures that Treasury bonds will never be repaid in real terms. The market is aware of this situation—the bond market is aware that Treasuries are in a bubble, floating on nothing but air. Therefore, when—not if—the bubble in Treasury bonds finally bursts, there will be a run on comodities, most likely, which will start the hyperinflationary phase of the current Global Depression. From here, the endgame of the U.S. economy.
Unfortunately, the profession and academic discipline of Economics—and all of its current practitioners—are unaware and unprepared for the popping of the final bubble. Which leads to our final charge against the Accused—
Fourth and finally—Turning Economics Into a Religion with the “We Are Right Because Our God—Math—Is On Our Side” Fallacy, and Marginalizing the Heterodox:
Because of the length of his tenure, and because of the prestige that the Federal Reserve has traditionally embodied within the academic discipline of Economics, the Accused created a rigid, inflexible, and supremely arrogant mind-set within the Federal Reserve itself, as well as in the Economics profession as a whole.
Greenspan didn’t accentuate currents of thought within Economics. Rather, he fomented a near-religious approach to math-based macro-economics, while ignoring the human aspect of society and of people. In other words, Greenspan fell for the McNamara Fallacy—and made sure that the rest of the discipline of Economics fell for the same fallacy as well, by dismissing the ideas of the heterodox, and marginalizing them from professional consideration.
Greenspan certainly didn’t invent math-based macro-economics. Math has been part of the game since Adam Smith. (And by the way, don’t let my history and philosophy degrees fool you—I’m a big old math geek. High-end philo eventually turns into math, JSTYK.) But Greenspan certainly made math-based macro reasoning not only de rigueur—he effectively excommunicated anyone who did not share his McNamara Fallacy.
Such a meretricious approach gave priority to quantitative measurements of macro-economic performance, rather than qualitative distinctions among policy options. In other words, “more in numbers is good, better in quality is irrelevant”.
This has led economists and Economics as a discipline—across all schools of thought—to value aggregate levels of whatever metric they were interested in, rather than qualitative differences which are not so easily measured.
On the political Left and Right—especially among the elites, to which Greenspan shamefully catered to—each side has become addicted to measuring the health of the U.S. economy by its aggregate demand levels (on the Left), and by its aggregate asset levels (on the Right).
Yet during the twenty years of Greenspans’s tenure, though both metrics improved drastically, there is no question that the American economy deteriorated. Why?
My brothers and sisters on the non-elite Left complained—bitterly—about how workers in third world countries were being exploited worse than slaves, to make the goods and products which American consumers were herded like cattle into demanding.
Meanwhile, my brothers and sisters on the non-elite Right complained—bitterly—about how American workers were being laid off in massive numbers, entire industries ripped out of the country and outsourced overseas, leaving only fast-food jobs and dead cities, all in the name of “Globalization”.
Both of these complaints are perfectly true and accurate. Both of these complaints stem from the same drive that Greenspan had such an integral part in encouraging: Quantitative improvements in aggregate demand levels and aggregate asset value levels as the only measures of economic “progress”.
These two metrics were considered by the Fed under Greenspan as the only “serious” metrics by which to measure economic performance. And thus it was inculcated among America’s political and business elites as the only measure of an economy’s worth.
But they are most certainly not. Anyone with eyes that see and a mind that works can tell you that a healthy economy is not how much you buy, or how much your stock price rises. A healthy economy is dependent on the worth of the work: The sense that people in the economy have that they are building something worthwhile, and not merely selling something worthless, or providing a meaningless “service”.
But these human measures of worth were dismissed by Greenspan’s calculations. They did not fit his equations, or the equations of all the other economists who wanted to be taken “seriously” by the high-priests of the Federal Reserve.
His famously opaque pronouncements as Chairman also led Economics as a discipline to favor opacity over clarity, obscurantism over elucidation. It wasn’t Greenspan’s fault that his Congessional testimony and various speeches were so famously hermetic; as a central banker, he had to maintain a poker player’s dispassion, so as not to unnecessarily influence the markets. But it was his fault that he seemed to encourage such oracular dictates from the profession itself. Ask any reader of technical Economics papers: They are incomprehensible. And that’s being kind.
Thus his Delphic opacity, combined with the undue reverence for math-based ratiocinations, plus the near-religious dismissal of all criticisms from the “uninitiated heathen” outside the white marble halls of the Fed and academia, led Economics as a profession to completely miss out on the Global Financial Crisis, and the subsequent (and currently under way) Global Depression.
In other words, because of Greenspan, Economics failed to call the biggest crisis in our lifetimes.
Regarding the past three years of crisis: Collectively, economists and Economics have tried to wash their hands of the whole mess, by acting completely surprised while shouting to the rooftops, “Whocouddaknownit?!?” (For my foreign friends and readers: “Who could have known it?!?”, or in other words, “Who could have predicted that this once-in-a-lifetime crisis could have happened?”)
Well, the fact is, a lot of people knew this was going to happen—and they said so. They in fact bet that it would happen. Michael Lewis’ fine new book describes three such people who made fortunes off of these bets. But not only traders, many people outside of Wall Street realized something was rotten in Denmark.
Many housewives realized that there was something wrong—I personally know one, in fact: My mother. She was approached by her bank, and offered (cajoled, wheedled and sweet-talked, actually) into getting a second mortgage on her home: “Rates are so low! And house prices in your area are booming! Go on! Give yourself a treat! Take out a second mortagage and spend-spend-spend!”
To this, my mother asked the obvious question: “But what if house prices fall?” She was answered, “They can’t fall.” And she asked, “Why not?” “Because they can’t.” “Yes, but why not?” Back and forth it went for a while, until the loan officer shook his head, said my mother was “difficult” (I could have told him that), and didn’t call her again. He probably found an easier mark.
But my point is, If a housewife, without any sophisticated training in economics, could figure out the obvious, yet an entire discipline failed . . . then maybe the discipline’s torch-bearer has led them down the wrong path.
Greenspan: It’s Greenspan.
To conclude: The Accused—Alan Greenspan—reneged on his sworn mandate to maintain low inflation and full employment, and instead pursued a policy of maintaining—and increasing—aggregate asset values, whatsoever the cost. In other words, he actively pursued bubble-creation and inflated asset values, to the benefit of the financial services industry, and to the detriment of the U.S. and world economies as a whole.
He furthermore created rampant moral hazard, and declined to carry out his sworn duty to regulate and monitor financial markets, and to curb usurious or unsafe financial products and services. Finally, he created the conditions that—quite possibly—will lead to a Treasury bond collapse and a hyperinflationary catastrophe.
SocGen has a useful tracker of Consensus vs Actual economic data, or a +/- Surprise indicator, which is presented below as updated for everything through today’s NFP, excluding the disappointing Service ISM. While it is unclear how the firm’s assigns a surprise relevance rating to any given economic data point, if the firm finds the Mfg ISM worthy of a +2, then it should finds today’s Service ISM at about -3, which unfortunately would not help out the firm’s pretty squiggly regression line, and would certainly eliminate the upward slope.
Citi’s Robert Buckland is out with the must read report of the weekend, especially for all the optimists who believe that despite the ongoing depression (and as many have demonstrated, all the talk about a double dip is moot, as America has never left the depression, or as Rosie calls it a period of prolonged economic subpar activity: the latest NFP number merely reinforces the theme of economic deterioration), and despite the 17 weeks in retail equity outflows (which would be a contrarian signal if there was hope that retail would ever feel safe enough to return in stocks. After nearly 5 months of no change in trend, the debate can be put to rest, if at least for 2010) there is still hope. There very well may not be – Citi has just pronounced the “Equity Cult” dead: “It has taken 10 years, and two 50% bear markets, to reverse this cult. European and Japanese equities are already trading on dividend yields above government bond yields. US equities are almost there as well. An immediate reincarnation of the equity cult seems unlikely. Global corporates, especially the mega-caps, rushed to exploit cheap financing as the equity cult inflated. They have been slow to redeem equity now that the cult has deflated. Equity oversupply remains a drag on share prices.” And as more and more companies and investors shift to a de-equitization theme, the trendline in allocation for the US pension assets will soon revert to that seen when the “Equity Cult” began, or roughly 20% of all assets, with bonds taking on an ever greater precedence of asset allocation (incidentally the UK is already back to the equity/debt relative investment levels of the early 1960s). What does this mean for capital flows? “A reduction in equity holdings back to pre-1959 levels (around 20% of total assets) would indicate considerable selling pressure to come. For US private sector pension funds alone, that would imply a further $1900bn reduction in equity weightings.The evidence suggests that there could still be considerable institutional selling to come.”
So let’s recap what the medium- and long-term trends for the market are:
$2 trillion in equity sales from pension funds alone as capital flows normalize now that the “Equity Cult” is dead
A seemingly endless push into fixed income by an aging demographic meaning billions more in ongoing monthly domestic stock mutual fund redemptions
Hedge funds which are underperforming the market massively, and which will see an explosion in redemption letters as the end of Q3 approaches
An inevitable change in the tax regime over the next 4-5 months, which as Guggenheim pointed out, will force investors to sell billions in stock to catch a sunsetting beneficial capital gains tax.
And yet what happens – the market surges on a negative NFP number that was negative but better by a factor of noise, compared to whisper expectation, as robotic traders pick up on the positive feedback loops to take the market higher one more time as soon everything collapses.
For all those who believe in 17x forward P/Es (expecting a 20% rise in corprate earnings in 2011 with a flat GDP indicates a serious overdoes on medicinal hopium) – Good luck chasing the bouncing ball.
For all those others, who feel like micturating upon the grave of the “Equity Cult” here are the highlights from the Citi report.
Bond vs Equities – Then and Now (this will be familiar to all those who have read Albert Edwards’ recent pieces):
In July, global equities rebounded despite continued falls in government bond yields. This defied the strongly positive relationship between equities and bond yields seen since 2000. Many equity investors worry that this decoupling will be resolved by the bond markets being proven “right”. The implications of this are worrying — the last time US treasury yields were down at these levels, the S&P (currently 1050) was nearer 800.
We have pointed out that equities actually have a decent track record when these decouplings have occurred in the past1. Certainly Citi’s equity and bond market forecasts suggest that this current breakdown in the relationship is more likely to be resolved through rising bond yields than falling equity prices. However, we also understand that many investors think we will be proven wrong.
We can’t help but suspect that this hot debate about the relative attractions of bonds against equities — whether one is pricing in the double dip but the other is not, whether one is pricing in deflation but the other is not — is mere froth on top of a much more profound reassessment of the merits of the two asset classes. In particular, has the “cult of the equity” been replaced by the “cult of the bond”? To answer this we first take a look at the origins of the cult of the equity.
The rise of the cult of the equity is reflected in institutional asset allocations. Figure 3 shows the weighting of US private sector pension funds in equities and fixed income as derived from the Fed’s Flow of Funds data. Back in 1952, US private sector pension funds held just 17% of their assets in equities compared to 67% in fixed interest. Over the next 50 years, these weightings reversed — at the peak in 2006, the same funds held 69% in equities and 18% in fixed interest. Of course, some of the increase in equities will reflect the outperformance over the period.
The picture looks similar in the UK (Figure 4). Back in 1962, ONS data suggest that UK pension funds held more in bonds than equities. That reversed in the 1960s, as equity weightings increased aggressively. At the peak in the early 1990s, UK pension funds held 76% of assets in equities compared to just 12% in bonds. It seems that UK pension funds embraced the cult of the equity more enthusiastically than their US counterparts, perhaps as a result of a desire to buy equities as a hedge against the UK’s more significant inflation problems.
We can also see the rise (and fall) of the equity cult in mutual fund flows. Figure 5 shows US mutual fund equity inflows going back to 1984. These peaked above $300bn in 2000. European fund inflows peaked in the same year at €180bn (Figure 6). US equity inflows recovered as markets rallied in 2003-07. European equity inflows did not.
Why the cult is now dead?
It seems that the cult of the equity began in the late 1950s. Why? Many justifications have been put forward. Most obviously, the 1950s marked the beginning of a welcome period of peace and prosperity following a tumultuous 50 years that included two world wars and a major economic depression.
The rise in equity weightings coincided with Markowitz’s first considerations of modern portfolio theory. This promoted the belief that a well-diversified equity portfolio could achieve superior returns while helping to reduce risk. It was clearly the view of George Ross Goobey, manager of the Imperial Tobacco pension fund who was generally perceived to be the godfather of the cult of the equity in the UK. Ross Goobey liquidated his entire fixed interest portfolio in the 1950s and invested the proceeds in equities. This was highly controversial at the time — he was banned from teaching students at the UK Institute of Actuaries.
Other factors may have helped to promote the cult of the equity. Most pension funds were relatively immature back in the 1950s, so giving them a better ability to absorb short-term equity volatility in search of longer-term returns. Equities were seen as a good match against the wage-driven liabilities of defined benefit pension schemes. Equities offered a decent inflation hedge long before index-linked bonds were ever invented. This characteristic was particularly attractive in the 1970s and 1980s. The list of academic justifications goes on and on.
Performance-chasers
But perhaps most convincing is the argument that the cult of the equity was the product of a period of spectacular outperformance from the asset class. This became self-fulfilling. Pension funds bought more and more equities because they kept outperforming. Insurance companies (except in the US, where their exposure to equities has been limited by law) and retail investors couldn’t resist the same trade. Figure 7 shows the annual returns from US equities and government bonds divided into decades since the 1920s. We also show the annual returns for the total period.
Since 1920, even including the dreadful experience of the last decade, US equities have generated a healthy annual return of 10.9% compared to a bond return of 6.1%. The most spectacular equity performance (especially relative to bonds) was not in the roaring 1920s, 1980s or 1990s, but in the 1950s. Perhaps this is what brought investor attention back to equities. It took many years for the wounds of the 1929 crash to heal — US equities only managed to regain their pre-1929 crash levels in 1954. But from there, a new 40-year love affair with equities began. The 1970s were tricky, but equities did no worse than bonds. Indeed, by the end of the 1990s, the long-term outperformance of equities over bonds looked truly spectacular. $100 invested in US equities in 1950 would have been worth $58,380 at the end of 1999 versus $1,651 in treasuries. Those two numbers probably say more about the cult of the equity than any long academic study.
Why Is There A Cult Switch?
The evidence suggests that the cult of the equity began in the 1950s and peaked in the late 1990s — that’s a 40-year bull market. Since then, it seems that the investor love affair with equities has soured.
Many of arguments associated with the cult of the equity have since come under attack. Inflation seems much less of a problem. Equities have never been particularly good at hedging inflation anyway, and now index-linked bonds can do a much better job. The long duration of the equity asset class becomes less desirable for pension funds as populations mature and retirement dates approach. Defined contribution investors (where the individual takes the risk) may be less willing to tolerate volatile equity returns than the old defined benefit plans (where the employer takes the risk).
But most importantly, it is dreadful returns that are increasingly putting investors off equities. Since the end of 1999, global equities have returned just 4% in total. Not only have equity returns been trivial, but the volatility has been brutal. Having two 50% bear markets in one decade is enough to test the patience of the most determined equity cultist. Just as strong returns helped to build the cult of the equity in the 1950s, so weak returns are tearing it down now.
Investor appetite for global equities is falling. Figure 3 shows that in 2009 US private sector pension funds held 55% of total assets in equities compared to 70% in 2006. Figure 4 suggests that UK pension funds cut their equity weighting to 39% in 2009, down from the 76% high in 1993. The 2009 rebound in equity prices has helped to reverse some of this decline in equity weightings, but most investor intention surveys suggest that the secular reduction in equity weightings is likely to continue.
How much worse will it get?
How far could this go? A reduction in equity holdings back to pre-1959 levels (around 20% of total assets) would indicate considerable selling pressure to come. For US private sector pension funds alone, that would imply a further $1900bn reduction in equity weightings. The story looks similar amongst retail investors. Equity inflows into US mutual funds have not recovered from the 2007-09 bear market (Figure 5). European equity inflows never recovered from the 2000-03 bear market (Figure 6).
The evidence suggests that there could still be considerable institutional selling to come. Developed market pension funds have cut their equity weightings from peaks but there is still a long way before they get back down to pre-cult levels. For a broader global comparison, we look at the 2010 Towers Watson Global Pensions Assets Survey (Figure 8). Given different data samples, this might not correspond with the long-term historical data series that we have already shown for the US and UK, but it is a useful guide to regional variations.
What does Japan teach us?
Japan may be a useful guide to an unwinding equity cult. According to Towers Watson, in 1998 Japanese pension funds held 55% in equities, still remarkably high given the dire performance of the Japanese market through the decade. Japanese pension funds now hold 36% of total assets in equities and that number seems likely to head lower. Bonds have been the key beneficiaries of equity outlflows. Elsewhere in the world, Australian pension funds have a high equity weighting although our local strategists have argued that the compulsory superannuation fund structure has embedded the equity culture more firmly than in other parts of the world. Continental European funds are already firmly tilted away from equities towards bonds, so the scope for further equity outflows might be more limited.
Emerging Markets remain one bright area amidst the gloom. Figure 9 shows annual global equity inflows as measured by EPFR. This confirms the sorry state of developed market inflows, but it also shows that the appetite for Emerging Markets equities has been much more robust.
The cult is dead. Long-live the cult
As the cult of the equity fades, it is being a replaced by a new cult of the bond. It is argued that bonds are more appropriate in a world where deflation, not inflation, is the main threat. Liability Driven Investing (LDI) advocates usually promote the liability-matching benefits of bonds over equities. Ageing populations would seem to favour bonds over equities — most “lifestyle” pension schemes automatically switch equities into bonds as a worker approaches retirement age. Perhaps most importantly, bonds have handsomely outperformed equities in the past decade. Since 2000, global equities have returned 4% (0.3% per year), while global government bonds have returned 103% (6.9% per year). The list of factors favouring bonds is as long as that favouring equities back in the 1990s.
These arguments are reflected in rising pension fund bond weightings (Figure 3 and Figure 4). We can also see that mutual fund inflows now favour bonds, although not yet as consistently and heavily as they favoured equities in the late 1990s (Figure 5 and Figure 6).
But even if there is no bond cult, the stock chasing era is over: Conclusion
Of course we can (and will) carry on arguing about whether bonds or equities will be proven “right” after the recent decoupling. We can (and will) carry on arguing about the likelihood of a double-dip in the global economy. We can (and will) carry on arguing about whether the developed world is heading into a Japan-style deflationary spiral. Each outcome should have meaningful implications for the direction of global equity and bond prices.
However, we can’t help wondering if this misses the point. With the notable exception of Emerging Markets, what is really going on is a long-term shift in investor appetite for equities and bonds. It will take more than the avoidance of a double-dip to turn the equity outflows around. Sure equity prices would probably rise in the short term if that were to happen, but a sustainable rerating could only be achieved if investors were to be attracted back to the asset class. Although likely to be painful in the short run, an inflation-inspired global bond sell-off would probably offer the best chance of that happening. That still seems pretty unlikely for now.
The Citi view on the outlook for the global economy could be best described as “uninspiring, but not disastrous”. But rather than furiously arguing about whether that view is right and if it is already reflected in share prices, perhaps we would be better served by accepting that, from a valuation perspective, it is what it is. For all sorts of reasons, both cyclical and structural, equities are likely to remain “cheap” against bonds for some time yet.
So it is what it is. Investors are unlikely to pile back into global equities any time soon. It looks like they are likely to sell weightings down and move further into bonds. This is convenient for government bond issuers given that they have such vast amounts of bonds to sell. Equity and bond valuations will continue to reflect these flows. Maybe global equities can move higher with rising profits but, outside Emerging Markets, the prospect of a 1980/90s-style rerating still seems a very long way off.
Indeed, it is what it is: you can’t fund a trillion dollar bond bubble, and see equity allocations at the same time. There is a reason why Albert Edwards sees the S&P in the 400 range: you can’t have an increasingly more frugal investors buying both, and you can’t have central banks buying everything without risking a completel collapse in the faith of all currencies. In retrospect, it is really simple. There are those who believe they are immaculate daytraders, and believe they can make money chasing everything dip in stocks. We wish we had their skill. Since we don’t we would rather put our bet on where the age old adage of follow the money says stocks willl end up going. And that is much, much lower.
A have come to know a fellow who does fixed income for a living. He
can’t write about it. He works for a name firm and moonlighting is
“frowned upon”. The reason for this policy is that one man’s opinion may
not be the published opinion of the firm. So my friend is kept in the
dark. Sort of. His interesting thoughts on the NFP today. Also a strong
recommendation on how to play it.
A quick look at the data this morning, and an attempt to quantify the Labor Force Participation Rate:
This is one of the first KEY data above expectations in quite a while,
so it’s a good start, but 33 months after the recession started, we’re
still LOSING jobs… so take the number into context.
Overall though, the data is good – note the revisions to prior month:
Bonds should / will read into potential inflation on the MoM Hourly Earnings data at 3x expectations…
Two key factors I look at in this monthly report are Avg Weekly Hours
Worked (as a clue to direction of future hiring) and Labor Force
Participation (to make sense of the Headline UE number).
…hours worked was steady after an upward trend since late 2009 – not too
much to read into; will reserve judgment til next month…
Labor Force Participation bounced up to 64.7% from 64.6%…. though on
its own it has a negative effect on the Headline UE, it’s a good sign
overall…
To put this Labor Force Participation drop into perspective, let’s look at the raw numbers in UE Rate (all numbers SA)….
The fact of the matter is that we have more folks working this month than last:
July: 138.96mil Aug: 139.25mil Change: +290k
…but we also have more people unemployed (‘counted’ as unemployed, that is):
July: 14.60mil Aug: 14.86mil Change: +260k
…and let’s look at that in the context of the Labor Force:
July: 153.56mil Aug: 154.11mil Change: +450k
UE July: 14.6/153.56 = 9.50%
UE Aug: 14.86/154.11= 9.64%
so, obviously, jobs are “better”, but the UE is “worse” due to more participation in job searching… what to believe?
I’ve mentioned many times in the past that the UE Rate is a faulty data
point to consider in a debt deflationary cycle as the participation rate
skews the data too much. (Actually, a case could be made that it is a
contrary indicator at the turns)
What’s been happening is that while the Civilian Population has been
growing, the declining Labor Force Participation has not captured that
in the UE Rate. Both the Labor Force and the number ‘counted’ as
unemployed has leveled off to participation.
Since Aug 2009, from the BLS Report:
Civilian Population: +2.01mil
Civilian Labor Force: -316k
Number Employed: -183k
Number Unemployed: -133k
While that bottom line looks ok, it is also precisely the problem:
there exist many more people who are out of a job but have given up
looking, so they are not counted as part of the Labor Force. As a
result, it looks like we’re improving in the numbers of unemployed.
And as a result, we’ve seen headline UE in the 9.5-10% range since mid-2009:
Aug 2009: 9.6%
July 2010: 9.5%
June 2010: 9.5%
May 2010: 9.7%
April 2010: 9.9%
Aug 2009: 9.7%
That looks steady, perhaps a base to build upon, but notice that this is
exactly when Labor Force Participation Rate dropped off:
To give better perspective, let’s quickly look at what would the jobs
picture look like this month without the drop-out rate in Labor Force
Participation:
As seen in the chart above, current Labor Force Participation is at
64.7% having fallen off in the last 18months or so, from a baseline of
66.0% in 2008. Assuming that baseline held, we’d have a Labor Force of
157.145mil today (from current 154.11mil). Said differently, using this
math around 3mil people left the Labor Force in the last year (reported
BLS numbers are around 2.3mil). Using the Aug number of Total
Employment (139.25mil), we calculate that the number counted as
Unemployed would be 17.9mil today (up from the ’official’ 14.86mil).
Hypothetical Aug UE at 66% Labor Force participation: 17.9mil / 157.145mil = 11.4%
Here is that same exercise, using a hypothetical 66% Labor Force
Participation Rate, and the real BLS data for Population and Number
Employed, for the last few months and last year:
Aug 2010: 11.4%
July 2010: 11.5%
June 2010: 11.3%
May 2010: 11.1%
April 2010: 10.9%
Aug 2009: 10.5%
So the August data really was better, but adjusted for drop in Labor
Force Participation, the past year has been brutal; in stark contrast to
the Headline UE Rate. Again, I’m going to put off concluding a trend
for this month. At some point we will begin to run out of jobs to lose,
so perhaps we’re getting there… I will say a “V”-shaped recovery this
is not.
From here I’ll let you draw your own conclusions on where we’ve been and
where we’re going. While most of you know what I think, if you do
not, I’ll just say I think it’s a great day to buy long duration,
positively convex hi-grade paper. 8-15yr Agency bullets and even USTs
are particularly out of favor at the moment….
Ever get the feeling that the Bureau of Truth is not being completely truthful? Feel like the ADP is to the NFP like the ISM to the regional Fed Surveys, and as the surging Mfg ISM employment diffusion index is to the plunging Service ISM employment diffusion index (i.e., both can not possibly be correct)? You are not alone. David Rosenberg summarizes which recent data releases are so blatantly incomprehensible, one wonder when the government will announce an AXA Rosenberg-like computer glitch and say all its data for the past 12 months has been compromised. Either that, or we await the introduction of the Birth/Death adjustment to every single data series released in America imminently.
Here is David with much more on the topic (from Gluskin Sheff):
The latest batch of data has been highly confusing, to say the least. The chain store sales data were skewed by one-offs, such as retroactive jobless benefit checks that were mailed out in early August and the growing number (17 this year) of States offering sales tax holidays. We estimate that absent these influences, year-on-year sales growth would have been closer to 1% than 3%. The spending data also belied the information contained in the Conference Board’s consumer confidence survey, as the facts-on-the ground ‘present situation’ index sagged to 24.9 in August from 26.4 in July — only 5% of the time in the past has it been so low. The ISM manufacturing index, which really got the ball rolling on this ‘take out the double-dip’ trade, managed to spike even though the three leading sub-indices — new orders, backlogs and vendor performance — all declined in what was a 1-in-100 event.
Not only that, but the employment component of the ISM surged to its highest level since December 1983, and yet the manufacturing employment segment of the payroll survey fell 27,000 — the first decline this year and the sharpest falloff since last October. Furthermore, the manufacturing diffusion index slumped to a seven-month low of 47 from 53 — in other words, fewer than half of the industrial sector was adding to staff requirements last month. It begs the question as to what exactly the ISM is measuring.
The list of inconsistencies in the data didn’t stop there. The entire increase in private sector employment in August was in the service sector — mostly health and education, which says little about the cyclical state of the economy. Yet 90 minutes after the jobs number was released, we got the ISM non-manufacturing survey and it flashed a contraction in services employment to a seven-month low of 48.2 from 50.9 in July.
Just a tad confusing, but the newly found bullish view of the economy is sort of corroborating evidence.
The employment report did not detract from the view that the economy is losing steam. The fourth quarter of a recovery typically sees real GDP growth of over 6% at an annual rate, but in this post-bubble credit collapse, what we got this time was 1.6% at an annual rate in Q2.
Moreover, there is nothing in the data to suggest anything but a further slowing in Q3, and the only reason why there is no contraction this quarter is because it looks as though we are getting another lift from inventories — though now the buildup looks involuntary, which will cast a cloud on fourth-quarter GDP barring a sudden reversal in the declining trend in real final sales.
Private payrolls were +247,000 when the equity market peaked in April, it slowed to +107,000 by July and was +67,000 last month. What does that suggest about the trend? Ditto for goods-producing employment, which was +67,000 in April, subsequently softened to +37,000 by July, and in August was the grand total of zero.
One can easily draw the conclusion from the data that we have dodged a bullet. But that does not mean we are out of the woods. Employment is a coincident indicator. Leading indicators, such as the ECRI, continue to deteriorate and to levels still consistent with nontrivial double-dip risks. Keep this in mind — private payrolls came in at +97,000 in November 2007 and the “Great Recession” began the next month. In other words, the +67,000 tally we saw today basically tells you nothing about how the pace of economic activity is going to unfold as we move into the fall.
BN 10:03 *GOLDMAN SACHS SAID TO PLAN TO CLOSE PROPRIETARY TRADING UNIT BN 10:03 *GOLDMAN PRINCIPAL STRATEGIES TRADERS IN NY MAY JOIN OTHER FIRM BN 10:03 *GOLDMAN PRINCIPAL STRATEGIES HEAD SZE MAY START A HEDGE FUND
So as long as you do one flow trade a year, you are considered a flow trader? Brilliant.
Fri, Sep 3, 2010
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