Economic Indicators: A Mixed Bag
The Institute for Supply Management releases indices that are closely monitored on Wall Street, with two in particular drawing significant attention. Recently updated, these indices present contrasting insights into the economy.
Last week, the ISM Manufacturing Index for January was published, revealing a discouraging trend. As demonstrated in the chart below, this manufacturing index has plummeted to its lowest level in almost four years. The persistent decline over the past year indicates that this weakness is likely not just a short-term fluctuation. A reading below 50 denotes a contraction in manufacturing activity, making January’s result of 49.3 unmistakable.
Examining Inflation Trends
Note: An earlier version of this story incorrectly classified the median CPI as a primary index when it is actually an alternative gauge of core inflation. Below, we present a corrected version.
The consumer prices report for January will be released on February 21, but it’s never too early to consider the inflation outlook. Based on the last update for December, there are still uncertainties regarding upcoming trends. Last year, core consumer prices (excluding volatile food and energy) increased by 2.6%, up from 2.2% in 2005. Will this trend continue?
No one can say for sure, but if you’re looking for more reasons to be cautious, consider an alternate (and arguably superior) gauge of core inflation. The Federal Reserve Bank of Cleveland calculates the median core consumer price index, aimed at minimizing temporary “distortions” in price trends that challenge the conventional core CPI. The median method is said to provide a more accurate forecast of inflation, as stated by the Cleveland Fed. They note, “The weighted median CPI is easy to calculate and correlates more strongly with past money growth than other inflation measures, leading to improved future inflation forecasts.”
With this context, we compared the current median core CPI figures to the conventional CPI. The findings reveal that inflation appears significantly higher using the median benchmark compared to the standard measure from the Department of Labor. Specifically, the Cleveland Fed’s median core CPI rose by 3.5% last year, compared to 2.6% for the standard core CPI. (While there are some discrepancies in the Cleveland Fed’s data, we rely on the historical series showing the latest 12-month change in the median CPI at 3.5%, although other sections of the website cite 3.7%.)
As illustrated in the chart below, the median core inflation rate has historically been higher than the conventional measure. Therefore, there’s ample reason to hold off on definitive judgments regarding inflation’s role in the economy for 2007.
Employment Trends: A New Perspective
Interestingly, the expected mid-cycle slowdown isn’t occurring as gradually as some members of the Federal Reserve had anticipated. This shift in thinking is largely due to the unexpectedly robust GDP growth in the fourth quarter, as noted in our previous post.
This morning, the employment report for December revealed a nonfarm payroll increase of 111,000, marking the smallest rise since a 103,000 increase in May. Should this prompt a reevaluation of the economic growth narrative that has recently gained traction? Not quite, at least not for now.
The January uptick in nonfarm jobs represents a modest 0.08% increase from the previous month. While this figure is on the lower end of recent trends, it remains within the growth range seen in 2006. Both May and October saw similar rates of increase. Previously, such minor declines in growth sparked warnings of imminent job stalls, potentially leading to recession. However, those predictions did not materialize then, and they may not now either.
The labor market’s transitions between growth and contraction are rarely abrupt. Warning signs typically build over months or even quarters. For instance, the labor market downturn of 2000-01 unfolded fairly rapidly, largely due to the bursting of the tech bubble. In contrast, the current economic landscape does not exhibit the same stark catalyst. With high corporate profits and active consumer spending, the labor market continues to grow, while investors display more caution. Although a recession may be on the horizon, it is not the time to panic.
Fourth Quarter GDP Report: A Silver Lining
The fourth-quarter GDP report serves as a reminder that forecasting the economy can often lead to unnecessary pessimism.
According to a government report released this morning, annualized real GDP grew by 3.5% in the last quarter of 2006, a surprising uptick for investors and economists alike. Most analysts had predicted a growth rate of only 3.0%, according to TheStreet.com.
This 3.5% growth is impressive, marking the swiftest expansion since an explosive 5.6% growth in the first quarter of 2006. Furthermore, this robust growth occurred during a quarter widely considered to be hindered by a real estate correction. Larry Kantor, managing director at Barclays Capital in New York, highlighted this as he reflected on the GDP news during a press conference, emphasizing that the recent economic drag was not as severe as previously believed.
TIPS Market: Shifting Perspectives on Inflation
Earlier this month, we noted that the inflation-indexed Treasury market seemed to be factoring in the belief that inflation was becoming less of a concern. However, recent trends indicate that the TIPS market is reassessing this view.
On December 4, a 10-year TIPS yielded a real (inflation-adjusted) yield of 2.11%, according to U.S. Treasury data. By last night’s close, the 10-year TIPS yield rose to 2.50%, the highest level since last October.
The bond market appears increasingly anxious regarding inflation in recent weeks, evidenced by the nominal 10-year Treasury yield now nearing 4.90%, the highest since last August.
Understanding Equity Risk Premium
Predicting future trends by analyzing past data is a risky venture, akin to parachuting or wrestling crocodiles. However, this undertaking can also be exhilarating and provide valuable insights—provided one remains cautious.
Our focus here is on the world of investing, where we routinely assess the equity risk premium (ERP). The ERP represents the excess return of stocks compared to the risk-free rate, defined here as the 12-month rolling total return of the S&P 500 relative to 3-month T-bills. Although there’s much debate around the rationale behind the ERP, it has historically proven to be a substantial phenomenon. The pressing question is whether this trend will persist in the future—and if so, to what extent?
Our chart below illustrates that the ERP fluctuates significantly over time. In July 1997, the trailing 12-month ERP was an astonishing 47%, whereas it turned negative at -31% in September 2001. The average ERP has hovered around 7.9% from 1987 through the end of last year.
In recent years, the ERP has stabilized within a range of 4-12%. Over time, such levels could yield significant returns for patient long-term investors. However, determining whether an ERP of 4-12% is favorable, subdued, or average remains a challenging task for asset allocators, given the uncertainty surrounding future return predictions and the various factors that will shape upcoming economic developments.
Reassessing the Housing Market
Recent reports on existing home sales for December reveal enough weaknesses to maintain a cautious outlook for the economic landscape in 2007. Despite this, the bond market has not waited for clear indications and has instead reacted decisively.
Update: Following our morning post, new home sales data for December has been released, showing a 4.8% increase. This uptick marks the highest level of new home sales since April, providing a positive counterpoint to the less encouraging news about existing home sales.
Yesterday’s trading led to a significant increase in the yield on the 10-year Treasury, which closed around 4.87%, the highest since last August. This move reflects a growing belief that the economy will remain relatively strong, leading bond traders to anticipate that interest rates may rise before declining again. For those in fixed-income markets, this sentiment justifies a more defensive posture.
However, despite the bond market’s current concerns, signals from Fed funds futures indicate no impending rate changes. The array of upcoming contracts suggests that the prevailing expectation is for the Federal Reserve to maintain rates at 5.25% for the foreseeable future, a consensus that has persisted based on recent trends in Fed funds trading.
Milton Friedman’s Legacy on Monetary Policy
The late, prominent economist Milton Friedman greatly influenced our understanding of the links between monetary policy, inflation, and the economy. He effectively argued that the money supply is a fundamental element of economic health. Ignoring or mismanaging it can lead to severe consequences, a lesson historically illustrated by the Federal Reserve during the Great Depression.
While Friedman did not produce a formal treatise on this subject after co-authoring the seminal A Monetary History of the United States in 1963, he remained an influential public figure through numerous articles, interviews, and papers over the decades. Edward Nelson, an economist at the St. Louis Fed, has undertaken the task of categorizing Friedman’s thoughts over these years, capturing his evolving views on monetarism. While he primarily maintained his foundational beliefs, his approach became more adaptable as empirical evidence emerged to challenge his earlier assertions.
The Volatility Shift in the Markets
The past few years have witnessed impressive gains across major asset classes, accompanied by a notable decline in volatility.
Our chart below illustrates the rolling 36-month annualized standard deviation of monthly equity returns through December 31, 2006. The overall trend indicates that stock markets have become less volatile and more stable. This trend is particularly evident in emerging markets, as reflected in the MSCI Emerging Markets Index, which showed a volatility of 17.6 at the end of last year, a decrease from over 30 in 2001.
Economist Perspectives: Bonds vs. Stocks
Recently, a debate has emerged between the bond market and the stock market regarding the future direction of the economy. While the fixed-income market has adopted a somewhat pessimistic outlook for 2007, stocks seem to project a brighter future. An economist recently opined that the stock market has gained the upper hand in this discussion.
According to Nariman Behravesh, chief economist for Global Insight, U.S. economic growth appears stronger than previously feared. He anticipates that corporate earnings growth for 2007 will be “decent,” albeit slower compared to 2006. “There’s a lot of strength in the U.S. economy,” he stated confidently.
