The Economy and Bond Market Radar (August 20, 2012)

Sunday, August 19th, 2012

The Economy and Bond Market Radar (August 20, 2012)

Treasury yields rose for a fourth week in a row.  Additionally, the benchmark 10-year yield is on the verge of breaking above the technically significant 200-day moving average.

Strengths

• The Thomson Reuters/University of Michigan preliminary August index of consumer sentiment increased to 73.6, the highest level since May, from 72.3 the prior month.
• The four-week average for initial jobless claims remains at its lowest level since March.
• According to the Conference Board’s gauge of Leading Economic Indicators, the economic outlook for the next three to six months increased 0.4 percent last month after a revised 0.4 percent drop in June. Economists projected the gauge would rise by 0.2 percent.

Weaknesses

• Initial jobless claims rose slightly to 366,000 this week, somewhat muddling the picture for the job market.
• Manufacturing in the Philadelphia region contracted in August for a fourth consecutive month as orders and employment declined.
• China July foreign direct investment fell 8.7 percent year-over-year to $7.58 billion, its lowest level in two years, which fuels concern that a slowdown in confidence in China’s growth prospects may restrain any economic rebound.

Opportunity

• The ECB appears ready to implement some form of QE in the very near future.
• With further weak economic data out of China, the odds of additional easing measures continue to move higher.
• Interest rates are likely to remain very low for the foreseeable future.

Threat

• Europe remains a wildcard with the markets shifting focus on a weekly basis.
• China also remains somewhat of a wildcard as the economy has slowed and officials appear in no hurry to take decisive action.

Tags: Bond Market, Decisive Action, ECB, Economic Data, Economic Outlook, Economic Rebound, Foreign Direct Investment, Growth Prospects, Index Of Consumer Sentiment, Initial Jobless Claims, Leading Economic Indicators, Market Radar, Philadelphia Region, Qe, Reuters, S Gauge, Shifting Focus, Slowdown, Treasury Yields, Wildcard
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The High Yield Trade: Crowded, or Crowd Pleaser? (Tucker)

Monday, May 7th, 2012

by Matt Tucker, iShares

A frequent question that I’ve been getting from our clients is around the outlook for high yield bonds.  With record low rates creating an income challenge for investors, many are now willing to take on the extra risk involved in a high yield investment in order to potentially add yield to their portfolios – as evidenced by the $29.0 billion in flows into HY mutual funds and ETFs so far this year.  Companies have responded to all this demand by issuing $115.1 billion in new high yield bonds YTD, with most of the proceeds going to refinancing existing debt or to fund general operations.  But all this high yield hubbub begs the question:  Is the high yield trade too crowded?

First, let’s review how much more room exists for positive returns.  Almost half of high yield’s 4.55% year-to-date return can be attributed to coupon payments, while the remainder was due to capital appreciation from tightening HY credit spreads (currently hovering around 5.5% over US Treasuries, compared to their average level of 6% over the past 10 years).  Today’s spreads are lower in part because the level of corporate bond default has been low, at around 2%.  In fact, spreads have typically been 4-5% in similar favorable credit environments, so spreads are actually wide relative to the level of corporate defaults (see chart below).

So why are spreads higher than default rates would seem to suggest?  The answer is volatility and uncertainty.  The forward path of the US economy is still somewhat murky.  Our view is that we will remain in a period of low but steady growth for a while, but there are risks that we could see another downturn.  The European debt crisis is the other major market dynamic weighing on investors.  As the crisis continues without a clear long term solution, investors are naturally more skittish.  This skittishness, along with the concerns about the US economic outlook, results in investors demanding a higher level of yield for taking on high yield corporate bond risk.  The extra risk premium is what is keeping credit spreads higher than the default outlook would suggest.

Overall, high yield spreads appear to be at a reasonable level, since investors are being paid both for the level of defaults as well as the level of global investment uncertainty.  If you are an investor with a long-term time horizon and can handle some volatility, then high yield could still be an attractive place to invest.  If high yield spreads reach levels seen in 2004-2006, the bonds could have additional capital appreciation.  However, investors have to be aware that negative economic surprises, especially in the US or Europe, could impact prices along the way.

With all this discussion of high yield bonds, it’s important to think about the suitability of these investments in your portfolio.  While HY experiences about half the volatility of equities, the bonds are still more volatile than investment grade bonds.  However, with yield levels around 7%, yield-hungry investors may find them worth the risk.

Sources: Barclays Capital, Moody’s, Morningstar and Bloomberg as of 3/30/2012

Bonds and bond funds will decrease in value as interest rates rise. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity.

Tags: Bond Default, Capital Appreciation, Corporate Bond, Corporate Defaults, Coupon Payments, Crowd Pleaser, Debt Crisis, Default Rates, Downturn, Economic Outlook, ETFs, Favorable Credit, Frequent Question, High Yield Bonds, High Yield Investment, Hubbub, Long Term Solution, Matt Tucker, Outlook Results, Treasuries
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Gary Shilling Still Looking for a Recession in 2012 Part I

Wednesday, April 11th, 2012

Gary Shilling has been more dour than most on the underlying economy the past 3-4 years, and that could be argued was a relatively good call.  Despite never before seen levels of federal government and central bank intervention, the economy continues to limp along at what I call a “meh” pace.  Normal recoveries sans massive intervention should have had some sustained periods of 4-5%+ type GDP growth; we’re happy with 2-3% nowadays.  Gary’s long U.S. Treasuries call has been against the grain, and mostly right the past few years, and he’s had quite a few other prescient calls as well.  Shilling posted 2 articles on Bloomberg, stating the case for a recession in 2012 – which is now again an outlier view.  We’ll look at part 1 today, and look at part 2 which focuses on the labor market tomorrow.

Here are some of his views as he looks at the main pillars of the economy:

• For several months, I’ve been forecasting a recession in the U.S. this year, arguing that weakened consumer spending – the key to the economic outlook — would tip the economy back into a downturn.  But what about recent positive data and markets? Do they affect my forecast?
• Consumers Are the Linchpin: The U.S. economy is being fueled these days by strong consumer spending, which increased in February by 0.8 percent, its best showing in seven months, after rising 0.4 percent in January. Retail sales rose 1.1 percent in February — the fastest pace in five months — while same-store sales advanced 4.7 percent. These numbers correlate with recent gains in consumer confidence and sentiment.
• I don’t see this pace continuing. Personal-income growth continues to be weak — up just 0.2 percent in February — meaning this recent exuberant consumer spending is being fueled largely by increased debt and tapping of savings.
• At the same time, pay per employee is rising slowly and continues to fall in real terms. So increased job growth remains the key to any increases in real household after-tax income, which declined in February for a second straight month and gained a mere 0.3 percent, compared with February 2011.
• Spending, Saving and Debt: The support that consumer spending has received from less saving and more debt appears temporary. Household debt – including mortgages,student loans, and auto and credit-card loans — has fallen relative to disposable personal income, though. In my analysis, this is largely because of write-offs of troubled mortgages. Nevertheless, revolving consumer credit, mostly on credit cards, is no longer being liquidated.
• Non-revolving consumer credit continues to rise in response to growing sales of vehicles — most of which are financed — and in student loans, as the poor job market keeps students in school or sends them back. Tuition increases encourage more borrowing, while interest costs on past-due loans mount.  [Mar 8, 2012: What Drove Yesterday's Surge in Consumer Credit? Massive Upswing in Federal Student Loans]
• It would seem, then, that contrary to my steadfast belief that consumers are being forced to save more and reduce debt to rebuild net worth, they have been doing the opposite lately.
• Consumer Retrenchment: The data so far aren’t conclusive, but evidence of U.S. consumer retrenchment is emerging. Consumer confidence has moved up recently but remains far below the levels of early 2007 before the collapse in subprime mortgages set off the Great Recession. Real personal consumption expenditures growth has been volatile in recent months and falling on a year-on-year basis. Voluntary departures from jobs, another measure of confidence, may be decreasing. And consumer spending will no doubt have a big slide if my forecast of another 20 percent drop in house prices pans out. (Mark’s note: that seems aggressive!)
• Housing activity remains depressed, with the only signs of life coming from the multifamily component, which is being driven by the appetite for rental apartments as homeownership declines.
• What Oil Threat?: Recently, there has been great concern about $4 per gallon gasoline and whether, as in 2008, those high prices will act as a tax on consumer incomes and force drastic cutbacks in other purchases.  These concerns are overblown. American consumers have reacted to rising gasoline prices as you would expect in tough times: by consuming less. Demand (DOEDMGAS) in the mid-February to mid- March four-week period was down 7.8 percent from a year earlier, mainly due to more efficient vehicles.
• As a result, the recent surge in gasoline prices has had a relatively small impact on consumer purchasing power. The $14.8 billion increase from October 2011 to March 2012, compared with the year-earlier period, amounts to about 0.3 percent of consumer spending.

Conclusion:

• Consumer spending is the only major source of strength in the U.S. economy this year. State and local-government spending remains depressed because of deficit woes and underfunded pension plans. Housing suffers from excess inventories and may face a further 20 percent drop in prices. Excess capacity restrains capital spending. Recent inventory building appears involuntary. So consumer retrenchment will tip the balance toward a moderate and overdue recession.

Tags: Bloomberg, Central Bank Intervention, Consumer Confidence, Downturn, Economic Outlook, Federal Government, Five Months, Gary Shilling, GDP, GDP Growth, Market Tomorrow, Massive Intervention, Personal Income Growth, Pillars, Recession, Retail Sales, Sentiment, Seven Months, Tapping, Treasuries
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Presidential Election Year: Good for Stocks?

Wednesday, April 11th, 2012

by Columbia Management

With the election season upon us, have you been wondering what the stock market will do in a presidential election year? To be sure, no one has the answer, but looking at stock market performance during election years can provide some helpful insight.

Election year market cycles

Historical data suggest that the stock market and presidential election years follow predictable patterns and traditionally result in better performance if the incumbent party wins. A look at the historical returns of the Dow Jones Industrial Average (DJIA), the oldest equity market index that tracks 30 significant stocks, helps illustrate this point.

Over the past 29 presidential election years since the Dow was first published in 1896, the index has delivered an average return of 7.18%, slightly off from the average of 7.35% seen in a non-election year according to Dow Jones Indexes. Keep in mind that this data represents past performance and there’s no guarantee that patterns and results will continue in the future.

The political landscape

Generally, investors haven’t suffered big losses during election years. However, the market did decline as recently as the last U.S. presidential election in 2008 during the financial crisis and subsequent bear market. While historical analysis offers an interesting snapshot, it’s important to remember that each election year brings its own unique characteristics. Currently, the economic outlook for 2012 holds a tremendous amount of uncertainty with many factors up in the air ranging from corporate earnings to unemployment. In addition, the European debt crisis continues to weigh on global markets and the effects will remain unknown while problems go unresolved. All of these factors can potentially have a bigger impact on the market and your portfolio than the presidential election itself.

Politics and your portfolio

The political environment and upcoming election can certainly influence the stock market, as ultimately, the president plays a crucial role in directing the nation’s economic policy, tax rates, budgets, etc. But making any financial decisions based on election year market cycles is not a prudent investment strategy.

Stick with your long-term asset allocation strategy. Don’t let an election year influence your financial decision-making or your investment goals.

Copyright © Columbia Management

Tags: Bear Market, Columbia Management, Corporate Earnings, Debt Crisis, Dow Jones, Dow Jones Indexes, Dow Jones Industrial, Dow Jones Industrial Average, Economic Outlook, Election Season, Election Year, Historical Returns, Incumbent Party, Market Cycles, Market Index, Political Environment, Political Landscape, Predictable Patterns, Stock Market Performance, Upcoming Election
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Explaining the Stir over Recent “Fed-Speak” (American Century)

Friday, March 23rd, 2012

Explaining the Stir over Recent “Fed-Speak”

by Robert Gahagan, Senior Vice President, Senior Portfolio Manager, American Century Investments
and John Eichel Investment Writer

March 20, 2012

The official statement from the Federal Reserve’s March 13 interest rate policy committee meeting was relatively ho-hum (no significant changes from January’s statement), but other recent Fed communications have raised more of a stir. In particular, we explain what “fiscal cliff” and “sterilized QE” mean, and help put them into context. It’s all part of a mixed, uncertain economic outlook in which slower mid-year growth, like last year, can’t be ruled out, but higher inflation by next year is also a possibility.

The U.S. Federal Reserve (“the Fed”—the U.S. central bank) announced no immediate significant changes or tweaks in U.S. monetary policy after its latest Fed Open Market Committee (FOMC) meeting on March 13. The Committee voted to keep the federal funds rate target for short-term interest rates at a historically low 0–0.25% (where it’s been since December 2008), continuing, as it did in January, to say that it “anticipates that economic conditions…are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”

The Committee also voted to continue “Operation Twist”-related selling of short-term U.S. Treasury securities and purchases of long-term Treasury securities. This strategy is intended to rebalance and refocus the Fed’s balance sheet toward longer maturities, designed to help keep long-term interest rates (such as home mortgage rates) low (see “Our Take on the Fed’s 50-Year Anniversary Revival of ‘Operation Twist,’” American Century Investments Blog, posted September 26, 2011).

Swirling Speculation about Inflation Risks

But the lack of change in the Fed’s last policy statement doesn’t mean that all is quiet and calm at the central bank. Despite the mostly status-quo nature of the statement, speculation has been swirling in the background among economists and other market participants and observers (and, reportedly within the Fed itself) regarding the Fed’s next policy moves or announcements.

Much of the speculation has centered on the accuracy of the Fed’s economic assessments and projections, especially its ability to accurately assess inflation risks. Up to this point, the Fed’s front-line position has left no doubt that the majority of its key current policy-makers remain much more concerned about the sustainability of the post-Great Recession economic recovery than about inflation, as demonstrated by the Fed’s continued extremely accommodative monetary strategies.

Uncertainties about the Actual Strength of the U.S. Economy

But some Fed critics (and governors within the Fed) think that the economic recovery is significantly stronger and more sustainable than the Fed is stating. They argue that the Fed is risking higher inflation and the formation of new speculative asset bubbles (like subprime mortgages and housing, before the Great Recession, or the Tech Bubble in the late 1990s) by continuing such a sustained period of unprecedented monetary accommodation.

One of the trillion-dollar questions of 2012-13 is whether the Fed will further stimulate the recovering U.S. economy (with more measures beyond the low federal funds rate target), or if it will have to scale back the accommodation to address the potentially inflation-fueling/bubble-building momentum of nearly five-straight years of unprecedented accommodative policy moves (dating back to 2007). Or, will it somehow have to both stimulate growth and contain inflation?

Busy Weeks for Fed Communications

Some of the speculation has been fueled by the Fed itself, from its recent statements and speeches, and also from selective releases of information via the central bank’s unofficial (but widely acknowledged) mouthpiece at the Wall Street Journal (WSJ), veteran Fed beat writer Jon Hilsenrath.

The two weeks just prior to the latest FOMC meeting—the weeks beginning February 27 and March 5—were particularly intriguing from a recent Fed communications standpoint. On February 29 and March 1, Fed Chairman Ben Bernanke gave his semiannual monetary policy report to the Congress (what used to be called Humphrey-Hawkins testimony), appearing before the House Financial Services Committee on February 29, and before the Senate Banking, Housing, and Urban Affairs Committee on March 1.

The Approaching “Fiscal Cliff”

Among the biggest attention-grabbers from those legislatively mandated Bernanke appearances was a fiscal-policy warning to Congress, outlining what could happen early next year if Congress continues to waffle and stall on budgetary matters.

Bernanke doesn’t typically highlight fiscal policy (government spending and programs to aid the economy), in his remarks, but in this case he pointedly warned that the U.S. economy faces a potential “massive fiscal cliff” on January 1, 2013 if President George W. Bush-era tax cuts, President Obama’s payroll tax cut, and extended unemployment benefits are all allowed to expire at that time, and $1.2 trillion in automatic mandatory across-the-board spending cuts agreed to last August are allowed to kick in.

As reported by the WSJ and the Congressional newspaper, The Hill, Bernanke warned: “Under current law, on January 1, 2013, there’s going to be a massive fiscal cliff of large spending cuts and tax increases. I hope that Congress will look at that and figure out ways to achieve the same long-run fiscal improvement without having it all happen at one date.”

An Argument to Remain Accommodative

Bernanke warned that allowing tax cuts to expire and trimming fiscal spending could slow economic growth. “You … have to protect the recovery in the near term,” he said. The idea that the recovery might be threatened by the fiscal cliff helped put downward pressure on U.S. stock indices on February 29, according to financial media reports that day.

Because of its potential economic impact, the possible fiscal cliff has been cited by some analysts in defense of the Fed’s continued accommodative policies, adding it to the list of significant headwinds facing the economy this year, which include the weak housing market, high unemployment, tight consumer credit conditions, high gas prices, and unsettled conditions in Europe and the Middle East.

Considering QE3

With short-term U.S. interest rates effectively at 0% for over three years, the Fed hasn’t had much maneuvering room in terms of making monetary policy more accommodative. One alternative that the Fed has pursued pretty aggressively over that period has been quantitative easing (QE—buying U.S. government securities to increase liquidity in the financial system and to keep long-term interest rates low).

We have already seen two recent waves of Fed QE in the U.S. (QE1, from 2008-2010, and QE2, from 2010-11) and a third is being considered, depending on the direction of economic data in 2012. (There’s a favorite saying of economists and analysts that “the decision to execute QE is data-dependent.”)

The primary data that QE depends on are economic growth signals and short-term interest rates—if the economy appears to be in recession or sliding in that direction, and short-term interest rates are too low to cut further, QE may be (and has been) called for.

The Case for “Sterilized QE”

But one of the risks of QE is inflation—adding liquidity and keeping interest rates low can eventually create demand pressures that can push up prices. It can also devalue the dollar relative to other currencies, which is also inflationary. As we mentioned earlier, the Fed now finds itself in a position where it’s still considering another round of QE (QE3) because of economic uncertainties, but it doesn’t want to trigger more potential inflation pressures.

The result: so-called “sterilized QE”—a form of QE described by Hilsenrath in the WSJ on March 7 (in what many speculated was a Fed-planted article) as follows: “The Fed would print new money to buy long-term mortgage or Treasury bonds but effectively tie up that money by borrowing it back for short periods at low rates…employing new market tools they have designed to better manage cash sloshing around in the financial system. Transactions like those… are called ‘reverse repos.’ A related program called ‘term deposits’ also ties up short-term money held by banks.”

Later in the article, Hilsenrath also provided this clarification: “The Fed hasn’t literally printed more money, but it has electronically credited the accounts of banks and investors with new money when it purchased their bonds under quantitative easing.”

Basically, “sterilized QE” is QE with more liquidity controls. We can elaborate on its details in future updates if it looks like it will actually be implemented—we should get more clues from the April and June FOMC meetings. For now, the Fed appears to be just letting us know what options it is considering.

Another interesting thing about this Hilsenrath article was its timing—it appeared the day after the U.S. stock market’s worst performance day of the year (when the S&P 500 dropped over 1.5%, and was down 2.2% over a two-day period), raising speculation that it was timed to help boost the market and confidence (which it apparently did—the S&P 500 rallied 3.9% over the next five sessions). This, along with the “fiscal cliff” example, show how closely tuned the markets are to what the Fed is saying and how they’re tracking what its intentions are.

The Continued Case for Inflation Protection

What’s the lesson for investors from all of this? We suggest being prepared for several different economic and market scenarios in 2012. In other words, stay diversified. If the Fed—with all of its research tools and economic brainpower at its disposal—is uncertain about the economic outlook, we all should tread lightly.

As the President and Chief Executive Officer of American Century Investments, Jonathan Thomas, has been writing to fund shareholders in our shareholder reports this year: “More market volatility appears likely in 2012…as uncertainties regarding European debt, economic strength, government budget deficits, and the U.S. presidential election sway investors. We believe strongly in adhering to a disciplined, diversified, long-term investment approach during volatile periods.”

We also believe in striving for inflation protection. Both the Fed and its critics appear to be giving serious consideration to the longer-term inflation implications of the past nearly five-straight years of accommodative monetary policies, and we suggest investors should too. To serve investors’ needs, American Century Investments offers a suite of funds that aim to provide various forms of inflation protection, utilizing holdings that include commodity and precious metal-linked securities, foreign securities and currencies, and inflation-linked bonds.

American Century Investments^® offers a wide variety of stock, bond and asset allocation funds. Visit americancentury.com for more information: Individual Investors | U.S Investment Professionals

Download a PDF of this post.

The opinions expressed are those of Robert V. Gahagan and the fixed income portfolio management team at American Century Investments, and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.

Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.

Diversification does not assure a profit, nor does it protect against loss of principal.

Copyright © American Century Investments

Tags: American Century, American Century Investments, Economic Outlook, Federal Funds Rate, Gahagan, Home Mortgage Rates, Inflation Risks, Interest Rate Policy, Investment Writer, Maturities, Open Market Committee, Policy Committee, Portfolio Manager, Qe, Rate Target, S Central, Senior Vice President, Term Interest, Treasury Securities, U S Treasury
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Where to Find Value in Emerging Asia

Tuesday, February 7th, 2012

This week, I’m updating my views on some of the emerging market countries in Asia.

While I’m upgrading Chinese equities from neutral to overweight, I’m downgrading South Korean and Indian stocks from neutral to underweight.

Starting with China and South Korea – the two countries are both highly exposed to global growth, but China currently appears to be the better positioned of the two and is likely to hold up much better from a growth perspective.

First, while Chinese equities have performed well year to date, they are down over the past 12 months. As a result, Chinese equities are cheap compared to other Asian emerging market countries, trading at 1.6x book value.

Recent economic data also suggests that growth in China is stabilizing and supports a soft landing. The most recent purchasing managers index, a key measure of manufacturing activity, came out last week at a better-than-expected 50.5, and retail sales growth is actually up to 18.1% year over year. Finally, Chinese inflation, which we all know was a big problem in 2011, is falling. It’s down to 4.1% from 5.5% in November and 6.5% in August.

To be sure, South Korean equities are also cheap compared to other emerging markets. This, however, is normal. South Korea typically commands a big discount due to ongoing uncertainty over North Korea. The cheapness of South Korean stocks is also justified given the country’s worsening economic outlook. South Korea’s economic readings have particularly suffered recently.

Finally, I’m downgrading India in response to the country’s recent surge in valuations and persistently high inflation. Indian stocks appear expensive once again. They are up more than 20% year to date and are currently trading at 2.6x book value. This compares with the Asian emerging market average of 2.4x book value.

In addition, growth in India is still strongly below trend and while the country’s profitability is respectable, it has been on a downward trend over the last couple of months. Finally, Indian inflation, while down from a couple of months ago, is still in the danger territory at 9.3%. All in all, Indian stocks are simply too expensive given current fundamentals (potential iShares solutions: MCHI, ECNS).

Source: Bloomberg

International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country may be subject to higher volatility.

Copyright © iShares

Tags: 6x, Countries In Asia, Downward Trend, Economic Data, Economic Outlook, Emerging Asia, Emerging Market Countries, Emerging Markets, Global Growth, Growth Perspective, Indian Stocks, inflation, North Korea, Overweight, Profitability, Purchasing Managers Index, Retail Sales Growth, South Korea, South Korean Stocks, Valuations
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James Paulsen: Investment Outlook (January 23, 2012)

Tuesday, January 24th, 2012

Main Street Misery Sets Wall Street’s Valuation

Investment and Economic Outlook, January 23, 2012

by James Paulsen, Chief Investment Strategist, Wells Capital Management (Wells Fargo)
During 2011, the stock market suffered a significant erosion in its price-earnings (PE) multiple. On a trailing four-quarter basis, the PE multiple on the S&P 500 finished 2011 at about 13 times compared to about 15 times at the end of 2010. Rising earnings were offset by a declining valuation resulting in a flat stock market last year. Will the stock market’s valuation revive in 2012? And, what is the outlook for PE multiples during the next several years?

The valuation of Wall Street often reflects the character of Main Street. Indeed, for the last several decades the PE multiple of the stock market has been closely related to the Misery Index (sum of the U.S. unemployment rate and the core consumer price inflation rate) on Main Street. A higher (declining) unemployment rate and/or inflation rate tends to lower (raise) the valuation investors are willing to pay for stocks. In the aftermath of the 2008 crisis, “Main Street Misery” remains high suggesting that Wall Street valuations could rise substantially in future years should Main Street fortunes slowly improve.

PEs and MISERY

The accompanying chart overlays the S&P 500 PE multiple with the Misery Index. The PE multiple is based on the trailing five-year moving average of reported earnings and the Misery Index is shown on an inverted scale (misery rises when the dotted line declines). Since 1970, the sum of the unemployment rate and the core consumer inflation rate has done a good job duplicating the movements of the stock market PE multiple. That is, the valuation of the stock market is consistently impacted by the rate of inflation and labor unemployment on Main Street.

The collapse of the PE multiple in the 1970s resulted from both runaway inflation and stubbornly high rates of labor unemployment. Conversely, the Great Bull Run of the 1980s and 1990s occurred against the backdrop of a steady decline in both the inflation rate and unemployment rate. From 1980 until 2000, the core consumer price inflation rate declined from about 13 percent to 2 percent. The unemployment rate fell from a post-war high of 10.8 percent in 1982 to a low near 4 percent in the 1990s. Lower inflation and declining unemployment combined to improve the Misery Index from about 20 percent to only about 5.5 percent which produced about a four-fold increase in the S&P 500 PE multiple! Since 2000, however, although the core inflation rate has trended sideways, the unemployment rate has surged causing a near doubling in the Misery Index, and a halving in the S&P 500 PE multiple. It appears “Misery on Main Street” establishes “Valuation on Wall Street.” Therefore, what is the outlook for “Main Street Misery” and what does it imply about future stock market PE multiples?

A Little “Misery Math” for Stock Investors?

Currently, the Misery Index is 10.7 comprised by an 8.5 percent unemployment rate and a 2.2 percent core inflation rate. The stock market’s trailing 5-year PE multiple is about 16.5 times. What does a little “Misery Math” imply for the stock market in 2012?

The pace of job creation finally appears to be strong enough to produce a slow but steady decline in the unemployment rate. A modest assumption for 2012 would be the unemployment rate declines to between 7.5 percent and 8 percent. The core consumer price inflation rate is also likely to moderate this year. A significant decline in commodity prices last year, a recent moderation in core producer price trends (sixmonth annualized core PPI inflation slowed to 2.3 percent in the second half of 2011 versus a 3.7 rise in last year’s first half) and a continued deceleration in wage inflation suggest a mild decline this year (perhaps to between 1.5 and 2 percent?) in core consumer price inflation. Assuming the unemployment rate declines to 7.7 percent and the core consumer price inflation rate drops to 1.8 percent, the Misery Index would fall to 9.5 percent in 2012. The accompanying chart implies about a 19 to 20 PE multiple with a 9.5 percent Misery Index. Finally, assuming 2012 S&P 500 earnings per share reach current consensus expectations of $105, the trailing five-year average earnings would be about $80. A 19 PE multiple applied to $80 yields a S&P 500 target price for 2012 of 1520.

What does the Misery Index suggest for the stock market longer term? Looking out a few years is, of course, much more uncertain. However, if the recovery continues for the next four years, the unemployment rate would likely slowly decline to between 4 and 6 percent. The real wild card for the Misery Index and therefore the stock market longer term is what happens to core consumer price inflation. Assume the unemployment rate declines to 5 percent, but consider three different inflation scenarios—a high inflation outcome of 10 percent core inflation, a medium inflation outcome of 5 percent, and a low inflation outcome of 2 percent. It seems reasonable that as the recovery matures, core consumer inflation will not likely be much lower than it is today and could be substantially higher.

Finally, we conservatively estimate that four years from now, five-year trailing S&P 500 share earnings would reach $120, $115, and $110 respectively in the high, medium, and low inflation scenarios. What are the implied four-year forward S&P 500 price targets for each of these scenarios? The high inflation scenario implies a 15 percent Misery Index and from the accompanying chart this yields a PE multiple of about 11.5 and a future price target of 1380. The medium inflation scenario yields a PE multiple of 18.2 and a price target of 2093. Finally, the low inflation scenario implies a 27 PE and a price target of almost 3000!

Summary

As the accompanying chart illustrates, Main Street and Wall Street are closely connected. Misery on Main destroys the Valuation on Wall!

For 2012, the stock market could be driven higher by improved optimism and renewed confidence resulting from a slow but steady decline in the unemployment rate. Indeed, the relationship between the Misery Index and the PE multiple suggests a 1500 price target for the S&P 500 is reasonable assuming only modest declines this year in the unemployment rate and core inflation.

Long term, however, what will prove most important for Wall Street is the inflation outcome. If the character of the contemporary recovery is ravished by surging inflation, the stock market may reflect ongoing Main Street Misery by extending its decade long sideways trading channel. Alternatively, should inflation remain reasonably contained during the next few years of this recovery, stock market valuations may surge higher as the Misery Index on Main Street steadily improves.

Tags: Chief Investment Strategist, Consumer Inflation, Consumer Price Inflation, Core Consumer, Dotted Line, Economic Outlook, Flat Stock, Future Years, Inflation Rate, Investment Outlook, Misery Index, Moving Average, Price Earnings, Quarter Basis, Rate Of Inflation, Runaway Inflation, Stock Market, Unemployment Rate, Wells Capital Management, Wells Fargo
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Fixed Income in 2011: The Year of Opposites (Tucker)

Wednesday, December 21st, 2011

by Matt Tucker, Fixed Income,  iShares

Expectations of rising interest rates. Fears of massive municipal bond defaults. Heading in to 2011, those were the two strong trends that investors expected would shape the fixed income market. But as we know now, 2011 turned out to be almost the opposite of expectations.

At the end of 2010, investors were positioning their portfolios to respond to rising interest rates. To hedge rising interest rates in the first three quarters of the year, investors turned to fixed income ETFs, moving into short duration funds or investing in leveraged and inverse funds. Leveraged and inverse fixed income funds almost doubled in size by September¹.

But contrary to expectations, rising interest rates never materialized. The Federal Reserve kept its benchmark Funds rate near 0% and in August communicated for the first time that it intended to keep rates between 0% and 0.25% until 2013.

This was an unprecedented move on the part of the Fed. Previously they had communicated changes in the Fed Funds rate, as well as their view on the economic outlook and the likely path the Fed Funds rate would take in the future. Never before had they indicated to the market that they would maintain a target Rate for a specific period of time.

In September, the Fed once again took action to keep interest rates low, unveiling “Operation Twist.” The Fed said it would sell shorter-term Treasuries from its own portfolio and use proceeds from the sales to buy long-term Treasuries – a move designed to lower long-term interest rates.

The net result of these actions, illustrated in the chart below, was that US Treasury rates actually declined over the course of year. Short end Treasury rates remained low because they are primarily driven by the Federal Funds rate, which remained at 0%. Longer maturity Treasuries actually moved lower in yield, driven by the Fed actions as well as by increased investor concern over European sovereign default risk.

At the start of 2011, there was also a great deal of fear about the health of the US municipal bond market. Numerous states were facing budget deficits and cities were grappling with everything from falling tax revenue to rising pension costs. Wall Street analysts meanwhile were predicting that municipal defaults would be large in both size and quantity, with some fringe analysts even predicting that defaults could total hundreds of billions of dollars.

Well, it’s nearly one year later. While a few high-profile defaults and bankruptcies were announced — like the Jefferson County bankruptcy — wide-scale defaults never materialized.

According to S&P, municipal defaults in 2011 are down 69% compared to the same period in 2010. Year-to-date monetary defaults in the S&P Municipal Index total roughly $750 million, representing less than 0.5% of the index. This compares with 2010 defaults of $2.4 billion.

Despite the dire predictions, most municipalities have a number of tools at their disposal – like raising taxes, cutting spending or laying off government workers — to help them make timely payments on their debt and to avoid defaults.

What’s the lesson learned from 2011? Diversification and liquidity are key, especially in volatile markets. All markets rise and fall, and the fixed income markets are no exception. Having a diversified portfolio can help to insulate your holdings, while being in liquid investment vehicles allow you to make timely, tactical investment decisions based on changing market environments.

Footnotes: 1 Source: Investment Company Institute: Estimated Long-Term Mutual Fund Flows report data as of 11/22/2011

Diversification may not protect against market risk. Liquidity of investments is not guaranteed.

Bonds and bond funds will decrease in value as interest rates rise.

Tags: Economic Outlook, Fed Funds Rate, Federal Funds Rate, Federal Reserve, Fixed Income Market, Investor Concern, Matt Tucker, Maturity, Municipal Bond, Opposites, Period Of Time, Portfolios, Rising Interest Rates, Target Rate, Term Interest, Three Quarters, Treasuries, Treasury Rates, Unprecedented Move, Unveiling
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Fitch Downgrades Portugal To Junk On General Strike Day

Thursday, November 24th, 2011

Just a step behind the Chinese as usual, and just in time to kill a modest EURUSD rally. Also on the same day as the first mass strike in Portugal which reminds us that everyone will want a piece of the debt reduction pie.

From Reuters:

Rating agency Fitch downgraded Portugal’s rating to junk status on Thursday, citing large fiscal imbalances, high debts and the risks to its EU-mandated austerity program from a worsening economic outlook.

Fitch cut Portugal to BB+ from BBB-, which is still one notch higher than Moody’s rating of Ba2. S&P still rates Portugal investment grade.

Fitch said a deepening recession makes it “much more challenging” for the government to cut the budget deficit but it still expects fiscal goals to be met both this year and next.

“However, the risk of slippage – either from worse macroeconomic outturns or insufficient expenditure controls – is large,” Fitch said.

Portugal’s 10-year bond yields rose sharply to around 13.15 percent after the downgrade from 12.71 percent late on Wednesday, with the spread over benchmark German bunds rising 21 basis points on the day to 1,095 basis points.

Portugal sought a 78-billion-euro bailout from the European Union and IMF earlier this year and has adopted sweeping austerity measures to bring public accounts under control.

Under the loan programme Portugal must cut the budget deficit to 5.9 percent of gross domestic product this year from around 10 percent in 2010. Next year it must cut the deficit further to 4.5 percent.

Fitch said the state-owned “enterprise sector is another key source of fiscal risk” and has caused a number of upward revisions to the country’s debt and budget deficit figures this year. The government has said there was an unexpected fiscal shortfall of about 3 billion euros this year.

“Given these downside risks, Fitch sees a significant likelihood that further consolidation measures will be needed through the course of 2012,” Fitch said.

In the meantime, Syntagma goes to Lisbon where, unlike Italy, austerity does not mean increasing the retirement age by 48 days every year for the next 15.

Portuguese workers launched a general strike on Thursday to protest against austerity measures imposed as the price of an EU bailout designed to keep Portugal afloat and stem a deepening euro zone debt crisis.

Planes were grounded, trains halted and public services interrupted as workers across the nation of 11 million protested against job losses, tax and pay cuts agreed between Portugal and the troika of lenders — the European Commission, European Central Bank and International Monetary Fund.

All international flights to and from Lisbon and Porto were cancelled for the duration of the 24-hour walkout, according to the website of the airport authority ANA, and only minimum services connecting mainland Portugal with the islands of Madeira and the Azores were operating.

“The strike is general, the attack is global!” chanted protesters in a picket line at the Lisbon airport, referring to what unions say is an attack on workers’ rights.

Snapshot of Portugese bond spread to Bund on viagra:

Tags: Austerity Measures, Austerity Program, Ba2, Bailout, Basis Points, Bond Yields, Budget Deficit, Bunds, Downgrades, Downside Risks, Economic Outlook, Expenditure Controls, Fiscal Goals, Fiscal Imbalances, Investment Grade, Junk Status, Mass Strike, Public Accounts, Slippage, Upward Revisions
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Emerging Markets Radar (November 21, 2011)

Saturday, November 19th, 2011

Emerging Markets Radar (November 21, 2011)

Strengths

• China’s foreign direct investment growth accelerated to 8.8 percent year-over-year in October from 7.9 percent in September, as the country’s competitive labor productivity and public infrastructure continued to attract multinationals.
• Indonesia sold $1 billion 7-year Islamic bonds at a yield of 4 percent, less than half of the yield in its 2009 sale and 200 basis points lower than Italy’s, as the country’s credit quality continued to improve toward investment grade.
• Malaysia’s third quarter GDP growth surprised on the upside at 5.8 percent year-over-year, accelerating from 4.0 percent in the second quarter, driven by commodity exports and domestic investments.
• Colombia’s current account deficit, which is 3.4 percent of GDP, has been largely financed by foreign direct investment rather than portfolio inflows.

Weaknesses

• Growth in Philippines’ overseas workers remittance, which accounts for around 10 percent of GDP, slowed to 8.4 percent year-over-year in September from 11.1 percent in August, and led by intensifying European crisis.
• Hong Kong’s unemployment rate rose to 3.3 percent in October from 3.2 percent in September, which is the first increase in six months, as volatile global markets started to affect business sentiment and corporate hiring plans.
• Singapore’s non-oil domestic exports declined by a larger-than-expected 16.2 percent year-over-year in October—the deepest slide in 30 months—as electronics shipments contracted 31.2 percent from a year earlier due to dampened demand from Europe and the U.S.
• Central and Eastern Europe’s economic outlook worsened in November as the euro-area debt crisis undermined growth prospects in Turkey and Poland. The growth will slow to 2.5 percent next year, according to the International Monetary Fund.Opportunities

Opportunities

• According to McKinsey’s 2011 Annual Chinese Consumer Survey, 91 percent of Chinese consumers receive product information from TV commercials, and only 28 percent from internet advertisements, a far cry from the 73 percent penetration of internet advertising in the U.S. Tremendous growth potential of online advertising, coupled with China’s plan to spend RMB 1.6 trillion through 2015 on broadband network infrastructure, should benefit established internet companies in China.

• Hungary’s government has started negotiation on an agreement with the International Monetary Fund and the European Union, according to the Economy Ministry in Budapest.

Threats

• In October, new home prices dropped in 34 out of 70 major cities in China on a month-over-month basis, and existing home prices witnessed sequential declines in 38 out of 70 cities. Average home prices registered a 0.14 percent decline for the first time this year, as a result of the continued stringent government policy dampening property and credit. Investor sentiment towards property-related sectors such as construction and materials may stay cautious.
• Headlines raised the prospect of copper and silver mining royalties in Poland. The government is looking to raise as much as 3 billion zloty under the scheme.

Tags: Business Sentiment, Central And Eastern Europe, Chinese Consumer, Chinese Consumers, Commodity Exports, Consum, Consumer Survey, Credit Quality, Current Account Deficit, Debt Crisis, Domestic Exports, Domestic Investments, Economic Outlook, GDP Growth, Growth Prospects, International Monetary Fund, Investment Growth, Labor Productivity, Public Infrastructure, Quarter Gdp, Unemployment Rate
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