Recently, a noteworthy trend has emerged: the widening gap between the nominal 10-year Treasury Note and its inflation-indexed counterpart, the 10-year TIPS. This yield differential is a critical market-based indicator of inflation expectations. Although it isn’t flawless, it remains a valuable gauge of market sentiment regarding inflation. Our chart below illustrates a growing unease among investors, suggesting an increasing anxiety about inflation prospects.
In absolute terms, the current inflation forecast of 1.73% for the next decade is relatively low by historical standards. As the chart reminds us, we are still far from the 2.5% forecast that dominated market expectations before the turmoil began last September.
While the exact timing of the recession’s end remains uncertain, the latest data on initial jobless claims suggests a possible slowdown in economic contraction. For the week ending May 16, new unemployment filings decreased by 12,000 to 631,000, according to the Labor Department. This is a clear indicator that the recessionary environment is still harsh. However, as we’ve pointed out over the past few months, a leveling off in new claims may indicate that the worst is behind us. This latest update implies we might be nearing the bottom of this recession, or if you’re optimistic, perhaps we’ve just passed it.
Historically, jobless claims serve as an early indicator of broader economic trends. Today’s figures offer a slight boost to the confidence that we may have reached or are nearing the trough of the recession. But it’s crucial to note that even if this is the case, numerous recessionary months likely lie ahead before growth resumes.
Former Federal Reserve Vice Chairman Alan Blinder has raised concerns about the risks of prematurely reducing the central bank’s liquidity measures, warning this could echo the missteps of the mid-1930s. He explains,
From its low in 1933 to 1936, GDP experienced remarkable growth (albeit from an extremely depressed level), averaging nearly 11% annually. However, the Fed and President Franklin D. Roosevelt reversed course in 1936.
During the summer of 1936, the Fed, observing the excess reserves in the banking system, decided that this liquidity could lead to future inflation dangers and began to withdraw it. This tightening continued into 1937, despite a weak economy that was unprepared for such measures.
Blinder’s caution about ending liquidity injections too soon is well-founded. However, that doesn’t imply that the support should continue indefinitely. Interestingly, he does not indicate when the Fed should pivot to tightening measures—a crucial point he avoids, likely because the timing remains uncertain. This ambiguity poses a significant challenge for the U.S. economy, a topic that Blinder notably sidesteps in his otherwise insightful article in the New York Times.
With hindsight, events often seem straightforward. The truth, however, is that the future remains both unclear and unpredictable. Fortunately, advances in financial economics over the past two decades suggest that returns can be somewhat predictable over medium to long-term horizons. In the short term, market momentum appears to play a significant role.
The challenge lies in merging these insights into a cohesive strategy. One component of this involves observing how asset classes relate to each other over time. To illustrate, the chart below presents a glimpse of our forthcoming analysis in the next issue of The Beta Investment Report. It depicts the performance of major asset classes from the end of 1997 through April 30, 2009. The chart is densely packed, so we recommend viewing a larger version for clarity.
The essential takeaway is that considerable volatility has colored the various components of the total market index. Speaking of which, our proprietary Global Market Index, representing a passive weight of major asset classes, has performed about as expected compared to global capital and commodity markets. This means that the GMI has provided more or less average performance. The heavy black broken line in the chart indicates GMI’s trajectory over this period.
In other words, while GMI has outperformed some asset classes since 1997, it has also lagged in others. The perennial question is: which asset classes will surpass GMI in the future? While it might be tempting to assume past winners will continue to perform well, this approach can be misleading. Diversification is essential over time, but it largely depends on the purchase price of individual components—especially if your objective is to outperform GMI. Pricing risk is therefore paramount.
Unsurprisingly, generating alpha compared to the beta available to everyone proves more challenging than anticipated, as evidenced by the mediocrity popular in the active management industry. That said, we shouldn’t resign ourselves to GMI as our ultimate goal but must recognize that exceeding Mr. Market’s asset allocation isn’t straightforward. Identifying the optimal point of engagement is our primary mission; after that, the details can become complicated.
Recent reports on wholesale prices and jobless claims strengthen the argument that the most severe part of the economic crisis may be behind us. However, as we mentioned previously, there may be an extended period between the recession’s lowest point and the recognition of a sustained recovery.
Two additional data points support a somewhat brighter outlook, albeit speculative, that the cyclical low may be approaching: starting with April’s Producer Price Index (PPI) report, which indicated wholesale prices increased by 0.3%, according to the government report. This contrasts with the 1.3% decrease reported in March. While the PPI remains volatile and year-over-year figures indicate a deflationary trend, these monthly results hint at potential price stabilization.
Yet, as the chart below indicates, volatility is likely to persist in the month-to-month numbers, and a subsequent sharp decline wouldn’t be unexpected. We must await further data to confirm or refute our suspicions regarding whether wholesale prices are stabilizing after the dramatic fallout from last year’s financial crisis.
That said, the fact that monthly prices are not rapidly declining suggests a decline in the deflationary threat. Preventing a deflationary spiral is crucial in allowing the economy to return to a more stable state. When prices fall unchecked, they can create stronger headwinds for growth, but there are reasons for mild optimism.
The latest retail sales data for April is mediocre at best. We anticipate more of the same for retail performance and other economic indicators. While the worst of the recession seems to be fading, a robust rebound is not yet apparent.
Last month’s retail sales fell a modest 0.4% on a seasonally adjusted basis, as reported by the Census Bureau report. This marks the mildest decline since the recession commenced in December 2007. Although this is an improvement, it is important to remember the gains seen in January and February have not been sustained, raising the possibility that we may be entering a stagnant phase.
While some sectors, such as automotive and building materials, showed positive sales, the overall trend in retail sales indicates a lack of momentum. A significant improvement in the labor market will be essential for altering this dynamic, but that turnaround is not expected anytime soon.
The latest employment data for April indicates that the downturn in the job market remains persistent. While one could attempt to frame a silver lining in the job losses, this may be overly optimistic. Nonfarm payrolls fell by 539,000 in the last month, an improvement from a loss of 699,000 in March, but still grim overall.
While this may suggest a slowing rate of job loss, expectations should be tempered. The decline in employment remains widespread across both goods and service sectors, demonstrating the ongoing severity of the situation.
Nevertheless, the worst of the labor market’s contraction could be behind us. A potential plateau in new jobless claims suggests a shift. Recent updates to weekly unemployment claims indicate such a trend. However, a declining rate of job loss does not equate to job growth; if employment continues to decrease at a lighter pace of around 200,000 jobs monthly, that still translates to 1.6 million fewer employed individuals by the year’s end.
In late March, we posed an important question: Is the economic stimulus working as intended? We referred to the significant liquidity infusion aimed at combating deflation and fostering recovery. At that time, we expressed cautious optimism, partly driven by a rising inflation forecast drawn from the yield differential of nominal and inflation-indexed 10-year Treasuries.
More than a month later, our optimism remains, possibly bolstered by emerging signs of recovery, or “green shoots,” that hint at a brighter future. Nevertheless, the inflation outlook has remained steady since late March, now showing a 10-year forecast of 1.4%, just a slight increase from approximately 1.3% at the end of the first quarter. Both figures contrast favorably with the flat inflation expectations witnessed at the end of 2008. Maintaining low inflation could be beneficial, but is it a sustainable expectation?
Looking ahead, the line between a healthy increase in inflation expectations and possible future inflationary pressures will be thin. While avoiding deflation is essential, the likelihood of mild inflation seems to be increasing as the recession shows signs of stabilizing. Is now the right moment for the Fed to consider tightening measures, or are the signs of recovery still too tentative?
April marked another month of recovery for capital and commodity markets, building on gains seen in March. However, the journey to mend the damage caused from September to February is still long. Indeed, it may take years for asset classes to return to previous highs. For now, though, there exists a cautious sense of optimism.
The standout performer in April was real estate investment trusts (REITs), which surged nearly 33%. Yet, given the severe declines over the past year, even such an impressive rally does little to offset previous losses.
The only asset class to post a loss was inflation-indexed Treasuries, which declined by 1.9% in April, though they remain up 3.6% year-to-date. All other asset classes registered gains. Our passive global market portfolio index rose by an impressive 6.6% last month, building on a roughly 5% gain in March. Year-to-date, the global market portfolio is down only 0.5% compared to a 1.4% decline in U.S. stocks as per the Russell 3000.
While it may be tempting to believe that the risks are behind us, caution is still warranted. As detailed in the upcoming May edition of The Beta Investment Report, strategically-minded investors should remain vigilant. Yes, anticipated returns appear enticing, but there are still substantial economic and financial hurdles ahead, and short-term volatility should not be underestimated.
In summary, these are productive days for strategizing asset allocation, yet achieving and maintaining every basis point of risk premium will require diligence. It starts with unwavering discipline; after all, there are no free lunches in this market.
The primary source of optimism from yesterday’s initial Q1 GDP report was the notable increase in consumer spending. However, the latest update on personal income and expenditures for March reminds us that uncertainty looms over the sustainability of this uptick.
A significant portion of the increase in consumer spending this year occurred in January, and we await a convincing continuation of this trend. As depicted in our chart below, the rise in disposable income and personal consumption prior to March 2009 signaled a welcome recovery from the downturn seen in late 2008. Yet, the trend appears to be waning, with consumption declining relative to February and disposable income remaining flat in March.
The key question is whether broader economic conditions are starting to weigh on American consumers confronting the toxic mix of declining home values, rising unemployment, and entrenched debt. While government stimulus measures have helped mitigate some of these issues, the correction in consumption and consumer sentiment is likely to persist.
Compounding the challenges is the recent increase in the 10-year yield. The Federal Reserve has exerted significant effort to keep long-term rates below 3%. However, the market has begun to push back, with the 10-year yield surpassing 3% for the third consecutive day. This marks the first incidence of crossing that threshold since the Fed announced on March 18 its intention to purchase long-dated Treasuries to maintain lower rates. Following that announcement, the yield plummeted by an impressive 50 basis points to about 2.5%; now, it has risen above 3% despite a lack of inflationary pressures.
One could interpret the apparent tapering off in new jobless claims as a signal that the recession may be reaching its lowest point. We have posited this before, citing prior data here, alongside our reasoning here. Today’s report on new filings for unemployment benefits provides further evidence that the business cycle could be at its nadir.
However, we must differentiate between reaching the recession’s bottom and the onset of economic recovery. If we enter a prolonged “L” recession, the low point could persist longer than anticipated. Considering the profound depth of the current downturn, it’s critical to hold both optimism and caution in equal measure—the balance between them will only become clearer over time.
