The latest economic data from the U.S. brings both concerning and expected news. Last month, retail sales experienced a slight decline, dropping by 0.1% compared to June, according to government reports. However, when looking at the annual perspective, retail sales saw a modest growth of 2.7% for the year ending in July. On the surface, these numbers may not seem too alarming, as year-over-year growth is still a positive sign. Yet, within the broader economic context, the recent slowdown raises substantial concerns.
The chart below illustrates the monthly and yearly percentage changes in retail sales through July 2008. The red line indicates that July marked the first monthly decline in retail sales since February, while the black line shows that year-over-year sales continue to decline when relative performance is considered.
It is clear that the slowdown in retail sales cannot be overlooked. While previous trends reveal a concerning pattern, two pressing questions remain: How much longer will this downtrend continue, and to what extent will it worsen?
Is a singular focus on asset allocation a flawed approach or a strategic advantage? Specifically, does consistently prioritizing one asset class to the exclusion of others offer wise long-term benefits?
Anecdotal evidence suggests that many financial strategists advocate for a diversified asset class approach for their clients. History supports the efficacy of diversification as a prudent strategy when considering portfolio performance in terms of risk adjustment. Additionally, decades of financial theory reinforce this concept.
Nonetheless, it can be enlightening to explore differing perspectives, potentially validating one’s own strategy or prompting valuable new insights. Recently, your editor encountered a financial advisor with a distinct viewpoint on asset allocation. This advisor eschews diversification entirely, instead opting exclusively for investment-grade bonds as the sole asset class for clients.
This approach is certainly extreme by the standards of contemporary financial wisdom. The question arises: why would an advisor advise clients against the majority of asset classes, limiting them to high-grade U.S. bonds? In the current issue of Wealth Manager, we’ve posed this question and more to the advisor who champions bonds exclusively. For detailed insights, read on…
In financial management, setbacks often yield more valuable lessons than successes. Triumphs can foster overconfidence, while failures encourage a reflective examination of mistakes, motivations, and methods to avoid repeating them.
Progress within finance and economics frequently relies more on lessons learned from failure than from success. This notion resonates when considering the reflections shared by a risk manager at a major global bank, as discussed in the latest issue of The Economist.
Is it possible to anticipate problems before they arise? While it is a hopeful endeavor, the inherent nature of risk complicates this prospect, often presenting itself under misleading circumstances. As the anonymous risk manager notes, risk can emerge unexpectedly, even when the economic climate seems stable.
“In January 2007, the environment appeared nearly risk-free,” the manager recalled. “I gathered my team to pinpoint our top five risks for the year ahead. We were responsible for identifying potential downsides, but it was challenging to envision where issues might stem from. The preceding four years had been characterized by falling credit spreads, low interest rates, negligible defaults in our loan portfolio, and historically low volatility levels—it was the most favorable risk environment in two decades.”
Yet, that’s precisely when trouble brewed. The fact that few foresaw it, including professionals trained to recognize such risks, underscores the importance of continuous vigilance in risk management, particularly in seemingly tranquil times.
This morning’s update on labor statistics presents more troubling news. Briefly put, new claims for unemployment benefits increased again last week, along with the number of individuals continuing to receive jobless benefits.
The first graph below highlights the ongoing deterioration in jobless claim trends, signaling a growing unemployment population. Last week, fresh applications rose to 455,000, a level not seen since 2002.
Continuing claims for unemployment also worsened, as illustrated in the second graph. The number of individuals continuing to collect unemployment checks surged again to 3.311 million for the week ending July 26, a figure that hasn’t been seen since 2003.
These two trends are not unexpected, given the prevailing economic weakness, as previously discussed. While the worsening of job statistics may be anticipated, it offers a jolting reminder for those who believe a swift recovery is imminent. In essence, the economic downturn appears set to deepen before any noticeable improvement occurs. This doesn’t guarantee that the situation will worsen significantly, although the possibility remains. The major question lingers—what will the duration and intensity of this trend be?
With the release of the final economic data for June, it’s time to provide an update on the CS Economic Index, which is compiled monthly. Our findings, backed by anecdotal evidence, indicate a continued weakening of the U.S. economy.
The black line in the chart above represents our broad measure of U.S. economic activity, derived from 17 variables—including nonfarm payrolls, retail sales, and business loan data. Notably, leading indicators make up over 40% of our index, consisting of measures such as new building permits and disposable personal income that signal future economic activity. Another 30% of our index is composed of coincident indicators, and the remaining 30% comprises lagging indicators. Thus, the CS Economic Index is specifically designed to gauge overall economic health, with a slight emphasis on leading indicators.
Considering this framework, we’re particularly concerned by the sharp decline in the leading component of our index (the red line). As illustrated, leading indicators have been sounding alarms for an extended period, with negative momentum intensifying since late last year.
This morning’s update on personal income and consumer spending presents a complex picture. At first glance, it appears that there has been a significant setback in the overall income scenario. However, this initial interpretation may not fully represent the underlying reality.
A critical point in analyzing today’s report on personal income and expenditures is the evident decline in disposable personal income, which dropped by 1.9% (seasonally adjusted) in June. Disposable personal income reflects the funds remaining after essential bills are paid, serving as a key indicator of consumer ability to spend—an essential driver of economic growth.
While a 1.9% decrease in disposable personal income—the first drop since April 2007 and the largest decline since August 2005—sounds worrisome, as our chart indicates, not all is as dire as it seems.
Notably, the June drop may be misleading, as it follows a significant spike in May, attributed to government stimulus checks. As these temporary boosts fade, financial analysts anticipate a return to more typical levels of disposable personal income, although some retrenching may occur due to ongoing economic challenges.
The critical consideration remains how much disposable personal income may further decline. Without another round of stimulus, the outlook depends on consumer sentiment and spending habits. There is a reasonable expectation that disposable personal income will settle around the $10.6 trillion mark for August or September, suggesting that the market should brace for more disappointing figures. Such declines may be concerning but reflect the transitory effects of stimulus checks rather than a more profound crisis, at least until a point is reached where economic maladies may extend the downturn in disposable personal income longer than currently hoped.
July 2008 proved to be a particularly challenging month for strategic investors. As shown in the table below, significant losses were recorded, with the overall economic headwinds even stronger than the losses suggest.
Notably, commodities suffered immensely last month. The DJ-AIG Commodity Index dropped a staggering 11.9%, marking its largest monthly decline based on historical records dating back to 1991. Our ETF benchmark experienced even more significant losses, sliding over 12% during the same timeframe.
Foreign stocks also faced losses, though to a lesser extent compared to commodities. On a positive note, REITs showed resilience, bouncing back with considerable gains in July. Overall, we can confidently say that while REITs surged, commodities floundered.
The sharp drop in commodity prices primarily resulted from a significant decline in oil prices last month. Since oil and energy typically dominate commodities indices, it is unsurprising to see broad benchmarks suffer in July. This price correction in commodities has been anticipated, given the unusual rally in prices over the past years. It was expected that some downward adjustment was necessary, and further adjustments in the following months would not be shocking, given the asset class’s inherent volatility.
At first glance, the latest economic news appears promising. However, a deeper investigation reveals a less robust reality.
Today’s release of the preliminary figure for second-quarter GDP indicates an annualized growth rate of 1.9% for the quarter ending in June, a notable increase from the 0.9% in Q1. Should we celebrate and declare an end to the slowdown? No, not at all. The adjustments and corrections in the economy have merely begun.
The reasoning hinges on the fact that while the 1.9% growth is an improvement, it falls short compared to historical performance. More concerning is the nature of the factors driving this growth in the second quarter.
Notably, consumer spending, which represents a key driver of GDP growth, increased by 1.5% in Q2, up from 0.9% earlier. While this seems positive, it’s essential to consider how much of this growth can be attributed to stimulus checks issued since May. Such payments are inherently temporary and will not provide sustained boosts forever. Once their effect wanes, consumer sentiment and spending ability will be crucial.
Moreover, most of the uptick in consumer spending during Q2 stemmed from nondurable goods, while there was a significant decline in durable goods spending. This trend raises concerns—especially considering the back-to-back drops of 3.0% in durable goods spending in Q2, following a 4.3% decrease in Q1. Such consecutive declines are rare, hinting at potential challenges on the consumer front.
It’s a relatively straightforward calculation, but its implications could be significant.
Adjusting the 10-year Treasury yield by consumer price inflation reveals what many already suspect: liquidity is abundant, by design. The Federal Reserve has actively injected liquidity into the economy to address various economic challenges. However, with real (inflation-adjusted) 10-year yields at historically low levels, it’s worth questioning what this all signifies.
The chart above indicates that the CPI-adjusted 10-year yield fell to -0.8% in June—marking the lowest negative real yield for this benchmark since 1980. Using last night’s closing yield of 4.09% and June’s 4.9% 12-month CPI change, we maintain a similar -0.8% figure.
What implications arise from this scenario? The answer is largely contingent on expectations. It might suggest that we are inadvertently fueling inflation, potentially allowing it to take deeper root in the coming years. Alternatively, it could serve as a mechanism to alleviate the economic contraction that appears poised to escalate.
Predicting which path we will take is inherently challenging. Rather than trying to foresee the future, we can examine how we compute real Treasury yields to offer some context regarding our economic trajectory.
For the chart above, we utilize the monthly average for the constant maturity of the 10-year Treasury, as outlined by the St. Louis Fed. We then adjust this number according to the 12-month trailing change in CPI as reported by the Bureau of Labor Statistics.
Redesigning indices for tracking market securities and commodities can potentially open new strategic avenues. In theory, at least. The challenge lies in proving these capabilities in practice. However, if financial engineers can indeed create improved benchmarks, and if index fund managers launch products linked to these new indices, it may enhance asset allocation by incorporating these innovative index funds. Ultimately, success—or failure—depends on the effectiveness of these new indices.
This ongoing exploration often raises the fundamental question: can we develop better alternatives to capitalization-weighted indices?
A growing number of index providers assert that the answer is yes. In recent years, there has been an explosion of new benchmarks, many claiming to be “new and improved” in some way. While it is too soon to make firm assessments on their impact, it is nonetheless prudent to explore the potential strategic opportunities they may offer.
In the latest issue of Wealth Manager, your correspondent took up this topic, pondering what—if anything—new indices could contribute to asset allocation. For further insights, read on…
