Today’s economic reports offer little good news. Inflation is rising again, as the government announced, with consumer prices increasing by 2.8% annually through September. This marks the same rate recorded in March, representing the highest level since August 2006.
Meanwhile, new housing starts have plummeted, according to the Census Department. The annualized figure for September shows a decline of over 10% from August, and nearly a 31% drop compared to last year. In fact, the September numbers reflect the lowest total of new housing construction since the early 1990s.
The combination of rising inflation and continued housing market weakness paints a bleak picture that should worry investors. Yet, as recent experiences have taught us, it’s important to avoid hasty conclusions, as data is often revised. What seems bleak now could be amended later. Nevertheless, the existing numbers are hard to overlook, and they do not suggest an optimistic future for the housing sector. The situation in September is merely another chapter in the ongoing narrative of challenges facing the housing market.
It’s been a long journey, but we’ve finally reached an important milestone.
Investors can now access betas for all major asset classes. The latest addition is the PowerShares Emerging Markets Sovereign Debt ETF (Amex: PCY), launched last week. This means that all ten major capital and commodity asset classes are now available through index-tracking, exchange-listed securities (see our accompanying ETF list in the left-hand column under Standard Betas).
PCY is significant as it represents the first opportunity for U.S. investors to engage with emerging markets debt in an indexed format. As with any new index fund, the foremost inquiry is: What benchmark underlies it?
PCY is based on the DB Emerging Markets USD Liquid Balanced Index. This benchmark ensures a focus on “the most liquid” dollar-denominated emerging markets debt, although it does sacrifice some breadth to meet regulatory and trading requirements. A similarly selective approach is taken for asset classes targeted by the SPDR Lehman International Treasury Bond ETF (Amex: BWX) and iShares iBoxx $ High Yield Bond ETF (Amex: HYG).
We won’t jump to any conclusions, but the latest producer price report for September warrants attention.
The PPI surged by 1.1% last month, marking the highest increase since February’s 1.2%. While recent trends in PPI have shown both spikes and dips, it’s crucial to remember that this data series is notoriously volatile and prone to adjustments. (Isn’t that a familiar refrain?)
Nonetheless, the troubling trend in PPI cannot be ignored, as illustrated in our accompanying chart.
On a rolling twelve-month basis, the annual PPI growth is on the rise once again, with a 4.4% increase over the previous year—the highest in over a year. It appears that the recent easing in wholesale price pressures may have come to an end, at least for now.
The August employment report initially stirred quite a debate. Many economic observers sensed that recession clouds were on the horizon. However, a month later, the government revised its nonfarm payroll estimates upward, brightening the outlook. Now, as we approach the Federal Reserve’s October 31 FOMC meeting, the question arises: how will they respond?
For insights into the economic landscape’s direction, we turn to Robert Dieli, president and founder of RDLB, Inc., an economic research and management consulting firm based in Lombard, Illinois. Dieli regularly shares his expertise with subscribers through his reports available at NoSpinForecast.com. His perspective is especially relevant given the current macroeconomic questions surrounding us. What follows is his analysis of the prevailing economic conditions, penned exclusively for The Capital Spectator. In short, he does not anticipate an imminent recession. Read on for a deeper dive into his analysis.
When the initial August employment numbers were released, we informed our subscribers not to take the numbers too seriously. For one, the most significant decreases were attributed to a reduction in state and local education employment, indicating a potential seasonal anomaly or an incomplete response to the employment survey. The upward revision in the September jobs report, indicating growth in both August and September, validated our concerns.
Our second point is illustrated in the chart below. It highlights the common occurrence of substantial revisions between the initial and subsequent editions of the employment report. We feature this chart in our monthly jobs analysis.
Click for full-size chart
The chart indicates that in September 2006, the initial estimate suggested weakness, but revisions later dispelled that notion. Generally, it’s advisable to wait for the second report before attempting to draw conclusions. However, given the heated atmosphere of early September 2007, it was easy to be swayed by the initial headlines.
Last week’s introduction of the first foreign bond ETF in the U.S. has been met with a somewhat tepid response, yet it marks an important development for investors. The key reason? Diversification.
While actively managed funds targeting foreign bonds have existed for years, the launch of the SPDR Lehman International Treasury Bond ETF (Amex: BWX) now provides access to this asset class’s beta in a more straightforward form. In essence, the first foreign bond index fund is now available.
This is promising news for various reasons, starting with the cost of entry. According to Morningstar Principia software, there are currently 84 “world bond” mutual funds (distinct portfolios) in existence. There are another 26 focused on “emerging markets bonds,” which we will not include here since the new ETF centers on investment-grade government debt. The gross expense ratios for world bond funds range considerably, from as high as 4.99% (ouch!) to as low as 0.19%. A staggering 66 of the 84 portfolios charge 0.51% or more, which means they exceed the 0.50% expense ratio for the new foreign bond ETF.
While 0.50% isn’t cheap compared to the lowest fees in the ETF market (which can be as low as seven basis points), foreign bonds are not typical assets, hence the delays in seeing this area indexed. Ultimately, a 50 basis point fee is not excessive enough to undermine the case for this category of beta.
Foreign bonds are appealing primarily due to the diversification benefits they provide to other asset classes. The table below illustrates that the correlation between foreign bonds (represented here by the Citi World Gov’t Bond Index Non-$ Index, unhedged) and major asset classes is low and, in some cases, nearly non-existent. Expectedly, there is low correlation between stocks and bonds in general, and foreign bonds align with this expectation. What’s particularly surprising, however, is the minimal correlation between foreign and U.S. bonds, demonstrated by a 0.38 correlation found over three years between the Lehman Bros. U.S. Aggregate and the Citi WGBI.
Investors with a strategic mindset should also note that there is low correlation between foreign bonds and commodities, REITs, and high-yield bonds. The availability of such diversification for just 50 basis points is noteworthy. Many investors are willing to pay 2 and 20 for hedge funds, believing that alternative investments will provide diversification benefits.
Officially, the government maintains that inflation is not a significant concern. Yet, the strong performance of inflation-indexed Treasuries in the 21st century seems to counteract this notion.
TIPS are specifically designed to perform well amid rising inflation; when inflation rises, TIPS tend to do better. Conversely, reduced inflation typically implies weaker performance for TIPS, both in absolute and relative terms. If inflation is controlled, why would unhedged bonds yield better results? If so, what would motivate investors to choose unhedged bonds if they are bound to underperform?
To gain clarity, let’s consider real-world data. As of August, the consumer price index (CPI) had increased by just 1.9%. This rate is notably low for the past decade, indicating that generally, CPI has been higher. This directly impacts TIPS, as the value of these bonds is tied to CPI fluctuations. Higher CPI numbers lead to increased TIPS values, and lower CPI numbers have the opposite effect.
In our analysis, TIPS have consistently outperformed various relevant unhedged fixed-income benchmarks. Our accompanying chart compares the Lehman Bros. U.S. Treasury TIPS Index to the Lehman Bros. U.S. Aggregate Bond Index, a central measure of domestic investment-grade bonds that lack inflation hedges.
The evidence indicates that TIPS have been consistently outperforming for some time. Most of this superior performance can be traced back to 2001. Over the five years leading up to last month, the LB TIPS Index illustrated an annualized return of 5.35%, compared to the LB Aggregate’s 4.13%. TIPS have also led other indices, such as the LB Government Intermediate and LB Government Long indices, over the same period.
What accounts for the performance advantage of inflation-indexed bonds over their nominal-rate counterparts? It’s conceivable that market participants foresee inflation rising beyond what CPI numbers indicate.
Skeptics may argue that the TIPS market is misreading the situation, and that inflation remains contained without impending threats. This perspective is echoed in the official inflation data published by the government. If one follows this line of reasoning, it implies that TIPS are indeed incorrect. However, can such a “liquid” and thoroughly scrutinized segment of the government bond market be consistently inaccurate for an extended period?
It’s uncertain whether TIPS will continue to lead the fixed-income sector. Lacking data on next year’s inflation, let alone next month’s, it’s challenging to predict. The most prudent approach remains to own both TIPS and conventional bonds.
In closing, we pose one question: Given that TIPS have fared well when inflation has been officially deemed controlled, how might they perform if inflation trends upward?
While the future remains uncertain, current observations present a positive outlook. In fact, it’s quite remarkable to witness. However, one must view it through a retrospective lens. If we analyze trends, we find ourselves in a golden moment—it’s essential to appreciate it while realizing it may not provide clear guidance on what lies ahead.
For the year to date, as of October 5, Latin America stands out in the global equity markets, boasting a total return of 49% in dollar terms, setting a benchmark that most other regions struggle to meet, as shown in our table below. That said, even other regions that “fall short” are performing admirably in absolute terms. (All figures provided here are from S&P/Citigroup Global Equity Indices.)
Conversely, Japan has lagged, showing a mere 2% increase year-to-date. Considering this is the best performance from the world’s second-largest economy during a stellar investment year like 2007, one might ponder what lies ahead as conditions grow more challenging.
Gilda Radner’s Emily Litella from Saturday Night Live famously used to say “Never mind” when proven wrong, and that resonates with our reaction to this morning’s September employment report.
It turns out that the initial jobs estimate for August was substantially incorrect. Initially, the government reported a net job loss of 4,000 nonfarm payrolls in August—marking the first decline in four years. However, today’s revision revealed that there was actually an 89,000 job gain in August, while September showed a 110,000 increase in nonfarm payrolls—the highest since May.
While inflation is a recurring topic in these discussions, it has not been perceived as a substantial threat according to official reports. Nevertheless, concerns about inflation linger. One reason is the potential for a secular bull market in commodities, particularly energy—an issue we’ve explored in detail in the October issue of Wealth Manager. Although inflation may ultimately prove mild, it’s vital to approach this conclusion cautiously. Before finalizing your outlook, consider the risks that could compromise an optimistic perspective. To delve into potential downsides, click here.
Now, more than ever, we require upside surprises.
Unexpectedly high earnings can positively influence stock markets. However, with third-quarter earnings reports shortly approaching, a positive surprise would be quite timely this fall. Anything less could signify troubles beyond the usual uncertainties.
Recent trends indicate robust optimism. Despite various financial setbacks that rattled investors in August, even prompting the Fed to cut interest rates by 50 basis points, the equity market has demonstrated resilience and growth. Many indices are hovering near their all-time highs. This situation implies a promising outlook.
This confidence stands in stark contrast to the ongoing concerns rooted in the real estate sector, as evidenced by the continuing decline in home sales. Additionally, there is speculation regarding a potential contraction in the labor market, suggested by August’s employment report, which reported the first net loss in four years. Many have been contemplating the possibility of recession in recent weeks. However, judging by stock market performance, these worries may simply be products of an overly anxious mindset.
In fact, it’s essential not to underestimate the signals from Wall Street. The collective sentiment among equity traders resonates loudly: the future is looking bright. “Equity investors do not perceive a significant risk of recession or a major drop in corporate earnings,” stated Sal Guatieri, senior economist at BMO Nesbitt Burns in a recent interview with The Globe and Mail.
