Today’s economic report has the potential to be both revealing and disruptive, often igniting extensive discourse and shifting market dynamics. Every new numerical update can provide insights reflecting overarching trends within the data series. However, one must remain cautious, as statistical noise can frequently obscure the underlying narrative.
This consideration is particularly salient following the recent report on durable goods orders. It remains uncertain whether the latest data is misleading investors or if the recent uptick is genuinely indicative of a positive shift. The clarity that comes with the passage of time is often the only reliable guide. So, what approach should a strategic investor take? It’s impractical to wait an entire year for answers, yet jumping to conclusions based solely on a single number isn’t advisable either. A balanced perspective involves considering the long-term trajectory while also remaining grounded in present realities. While the future is inherently uncertain, having a solid grasp of historical trends and how they relate to the latest report can prove valuable.
To illustrate this, we provide the following chart, which presents the 12-month rolling percentage change in new orders for manufactured durable goods, culminating in the December 2007 update. Notably, new durable goods orders last month experienced a robust increase of 5.2% from the previous month, marking the highest monthly growth since July. Furthermore, monthly gains exceeding 5% are relatively rare, occurring only 10% of the time over the last decade. Thus, the significance of last month’s report should not be underestimated. In addition, this increase signifies two consecutive months of growth in new durable goods orders, a crucial indicator of future economic activity.
But while the overall positivity is noteworthy, it is essential to frame last month’s gains within the larger historical context of durable goods orders over the years. As the accompanying chart highlights, December’s strong performance does not reverse the prevailing downward trend observed over the past two years, which is distinctly negative. By smoothing out the volatile nature of durable goods orders through annual comparisons, we discern a slowdown that seems to have gained momentum. Fortunately, the decline remains mild when contrasted with previous downturns in 2000 and 2001, during which new orders for durable goods frequently contracted by 5% to 20% annually.
It’s often wise to allow data to speak for itself. Without further ado, here’s a succinct overview of the 10-year Treasury yield, its counterpart in the 10-year real yield (TIPS), and the spread between them.
As is often the case, opinions on the implications of the chart will vary, so here’s your editor’s perspective, which may or may not hold relevance in the near term. One common observation is the sustained decline in the 10-year yields—both nominal and real—since July. It’s a consensus that the bond market has grown increasingly enthusiastic, driving up government debt prices and consequently lowering yields.
The nominal yield on the 10-year Treasury exceeded 5.0% in mid-2007. As of last night, this figure had dropped to 3.68%.
For TIPS, a similar narrative has unfolded, albeit with lower yields, which is typical when comparing real to nominal rates. Back in June 2007, the yield on the 10-year TIPS reached 2.83%, whereas it now stands at 1.44%.
Now, let’s examine the yield spread between nominal Treasuries and TIPS. This spread serves as a measure—though not the only one—of Mr. Market’s inflation expectations. Currently, the markets are pricing in an inflation rate of 2.24%, calculated as the difference between the current 10-year yield (3.68%) and the 10-year TIPS yield (1.44%). Notably, this spread has shown little fluctuation over the past six months, as depicted in the chart above. The takeaway: the inflation outlook appears to have remained largely stable, if not unchanged, since last summer.
However, this leads us to a more intriguing—and possibly concerning—point. The latest Consumer Price Index (CPI) data, widely regarded as the U.S. inflation rate, indicates a price increase of 4.1% in 2007. This figure starkly contrasts with the 2.24% inflation rate suggested by the spread between nominal and real Treasury yields.
It remains uncertain whether the Federal Reserve’s aggressive 75-basis-point rate cut will reassure the markets and stabilize the economy. A drastic reduction in interest rates alters the risk landscape, introducing both new opportunities and challenges.
Initially, it appears that the central bank’s decision was influenced by the significant decline in stock markets globally. This perspective holds some weight. With a mere week before the scheduled FOMC meeting, where a rate cut was anticipated, the Fed opted for an early, substantial reduction. But was this solely to bolster a faltering economy? Partly, yes, but there’s a deeper narrative. Why wasn’t there a rate cut the week prior? No newly surfaced economic data instigated the Fed’s action, but the global stock market’s upheaval clearly prompted a proactive measure on the first trading day in the U.S. following the downturn.
No central bank can afford to disregard market signals. However, there’s a fine line between maintaining prudence and capitulating to market pressure. Only time will reveal if the Fed is strategically executing its dual mandate of promoting economic growth while controlling inflation. Meanwhile, there’s a pervasive concern that the Fed is responding to Wall Street’s demands rather than addressing Main Street’s needs. Whether founded or not, if such perceptions take root, expectations may rise to levels that the central bank could struggle to meet.
Regardless of the rationale, the Fed’s rate cut represents a new reality, and rapid adjustments in rates inherently redistribute risk. For instance, Real Estate Investment Trusts (REITs) saw a surge yesterday, defying falling stock prices. The Vanguard REIT Index ETF (VNQ) rose 2.3% on a day when U.S. stocks dropped over 1%. Why were REITs viewed as a refuge? Partially because these real estate securities have faced declines for some time. However, more significantly, the newfound attractiveness of relatively high yields in REITs has become markedly appealing following the aggressive rate drop.
As panic and fear ripple through the markets, the recent 75-basis-point cut in the Fed funds rate presents an opportunity for investors to explore asset classes that have faced significant downturns.
However, caution is warranted; we don’t aim to predict market bottoms or tops. It’s impossible to know how long the current selling pressure will last—whether it will cease tomorrow or evolve into a prolonged bear market.
What is clear for strategic investors with long time horizons is that now could be a prime opportunity to capitalize on the downturn. Timing is crucial; however, there’s no universal signal to indicate when a bear market has hit its lowest point. Gaining clarity often comes only in hindsight, which carries the potential for opportunity cost. By the time the signs are evident, markets might already have rebounded.
Thus, the risk of waiting too long to seize upon a cyclical change in asset values is counterbalanced by the dangers of acting prematurely. Ideally, investors would buy low and sell high. In the reality we face, however, uncertainty reigns, and returns often deviate from those ideal scenarios, varying based on the investor’s approach.
Nevertheless, with lower prices comes the prospect of enhanced returns. After five consecutive years of bullish trends across many sectors, the cycle is shifting, risk is being recalibrated, and a new set of potential returns is emerging. While we don’t purport to know the optimal time to invest, we do believe that the coming year will present exciting opportunities for rebalancing across various asset classes. This newfound opportunity arises from the shifting economic and financial risks at play.
Recently, we’ve been contemplating the concept of alpha, or investment skill, which raises the ever-pertinent question: How much alpha is actually attainable? The conventional answer is that alpha is limited; for every investor who outperforms a benchmark, there must be another falling short. In this sense, alpha is considered a zero-sum game. This viewpoint is widely accepted, though its accuracy can vary based on how one defines key terms, as discussed in previous pieces published by this author in the January issue of Wealth Manager.
The Federal Reserve found itself with a fresh impetus for reducing interest rates today, courtesy of the latest economic report.
According to data from the Census Bureau, new housing starts fell significantly last month. Specifically, privately-owned housing starts dropped by 14% in December, reaching levels not seen since 1991. Additionally, building permits plummeted, leading to an even darker outlook for future housing activity.
“These numbers confirm the ongoing deepening of the housing recession,” remarked Mike Larson, a real estate analyst at Weiss Research, who shared insights with CNNMoney.com. “Declining consumer confidence and tighter lending standards have already impacted demand, and the broader economic slowdown is poised to worsen the situation.”
Today brings some relief for the Federal Reserve.
The December Consumer Price Index (CPI) report indicates inflation has returned to a more manageable level. After November’s unexpected 0.8% spike in CPI, December’s increase of 0.3% appears almost fortuitous. While inflation remains a concern, the pressure on prices eased sufficiently in December to provide the central bank with a clearer path toward a 50-basis-point cut at the end of the month during the FOMC meeting.
Expectations align with this anticipation. Currently, the February ’08 Fed funds contract is valued with an expectation of a 50-basis-point reduction.
It’s clear the economy is slowing and may even be contracting. In light of this, reducing interest rates seems prudent, and thanks to today’s CPI report, inflation appears less of an immediate threat, paving the way for the Fed to increase the money supply and potentially mitigate or avert an impending recession.
The market anticipated a minor gain but found itself confronting a significant downturn instead.
Consensus forecasts predicted a 0.1% rise in retail sales for December, as reported by TheStreet.com. However, the actual figure showed a decline of 0.4%, marking the steepest drop since June, as noted by the Census Bureau.
The monthly changes in retail sales tend to be volatile, so a single report doesn’t provide comprehensive insights. November had revealed a 1% surge, only to be followed by December’s decline.
Still, a closer look at the rolling 12-month trend reveals worrying signs. As illustrated in the accompanying chart, the recent trend has not been favorable. The robust growth that characterized retail sales from 2003 to 2006 has diminished significantly. While there was a temporary spike in buying last year, suggesting the downturn of 2006 was merely a blip, the momentum now seems to be building on the downside.
From an economic standpoint, this latest decline reflects a weary consumer base. Concerns about a slowdown in consumer spending have lingered for years, yet Joe Sixpack has consistently managed to keep spending afloat. Is this time different? It could be. Years of accumulating debt may finally be catching up with consumers. The ramifications from the housing market correction serve as one significant factor. Without the ongoing rise in home equity to stimulate purchases, the allure of the “buy now, pay later” mentality may have diminished.
There are numerous ways to approach central bank governance, each carrying the potential for varying success or failure. The real challenge lies in discerning whether one is likely to achieve success, and whether those expectations are already mirrored in bond and asset prices.
In this context, we consider the recent decision by the European Central Bank (ECB) to maintain its benchmark borrowing rate at 4.0%. During a related press conference, ECB president Jean-Claude Trichet indicated that persistent inflation influenced this decision.
While taking a firm stance on inflation may seem straightforward for a central bank, investors should not presume that the ECB’s hawkish stance is its default position.
In contrast, the Federal Reserve has recently shown a tendency to cut rates rather than maintain stability. Just yesterday, Fed Chairman Bernanke hinted at the possibility of further rate cuts: “In light of changing growth prospects and associated risks, additional policy easing may be necessary,” he stated, emphasizing a readiness to implement additional actions to support growth and provide a safeguard against downside risks.
Recent data reveal that the U.S. market capitalization, as a share of the global equity market, has dropped to its lowest ratio since 1995, according to information from S&P/Citigroup Global Equity Indices.
At the start of this year, U.S. stocks held a 40.6% stake in the global equity market, down from 43.9% the previous year. In January 2002, U.S. equities represented a staggering 57% of the global market cap. Since then, the U.S. share has consistently declined each year, leading us to the current figure of 40.6%, a level that ties with 1995’s low based on January 1 metrics.
A relative analysis indicates that if the U.S. share is down, other markets must be on the rise. The emerging markets, in particular, showcased a significant increase, with a 10.5% share of the global equity capitalization at the start of this year, rising sharply from 7.5% the year prior and tripling from 2002 levels.
Regionally, Europe achieved a slight increase while Japan saw a decline. The Asia-Pacific region, excluding Japan, increased to 6.4% of global equity capitalization, up from 5.3% a year earlier. Latin America has also seen growth, opening the year at 2.4%, compared to 1.6% on January 1, 2007.
What do these figures imply for strategic investors? To begin with, they provide a useful benchmark for global equity allocation if one lacks a specific opinion regarding regional attractiveness.
For those with confidence in their market judgments, this data offers insights for determining what constitutes over- or underweighting on a global equity scale. Investors might find it prudent to consider overweighting U.S. stocks while also contemplating an underweight position in emerging markets.
This may or may not be the right approach, as the market is notoriously unpredictable. What unfolds in the future remains uncertain, but the past data certainly paints a clear picture.
