Yesterday, the Federal Reserve made a widely anticipated decision by lowering interest rates. While the 25-basis-point reduction appeared overly cautious to some analysts, today’s report on import prices raises an important question: Is a 1/4-point cut perhaps too much?
Indeed, the issues of a potential credit crunch and a decelerating economy weigh heavily on this decision, suggesting the central bank is fulfilling its role in mitigating economic pain. However, this cut raises concerns about the Fed’s other critical responsibility: maintaining price stability.
The dialogue surrounding inflation becomes increasingly relevant as investors process the recent data indicating a 2.7% rise in import prices last month—the steepest monthly spike since 1990, as reported by the Bureau of Labor Statistics. This surge elevates the 12-month increase in the import index to a staggering 11.4% up to November, a rate unseen since the 1980s, as illustrated in the chart below.
Optimists might assert that the increase is primarily due to soaring energy prices in November. While this is partially accurate—excluding petroleum, import prices only rose by 0.7% last month—the overarching reality remains that import costs are generally rising. Many categories of imports are now escalating at a rate exceeding the 3.5% annual inflation rate of the U.S. consumer price index.
In summary, the U.S. risks importing inflation at a level not seen in many years. While this may not pose an immediate threat, if left unaddressed, it could accumulate over time. The U.S., being the largest global economy, has a robust appetite for imports, amounting to nearly $200 billion monthly and increasing at more than 6% annually, as indicated by recent data from the Commerce Department.
The housing crisis, like all crises, brings forth significant lessons. The foremost is timeless: risk never takes a vacation, even if it seems dormant for extended periods.
This simple yet potent message remains overlooked by many. The signs are often clear, as they were during the housing boom that has since morphed into a downturn.
Whenever a financial strategy or investment product relies on the belief that the underlying market is immune to downturns, it’s wise to proceed with caution.
Unfortunately, caution was in short supply as Wall Street securitized a staggering $2 trillion in home mortgages over the past decade, partly based on the belief that housing prices would never undergo significant declines. As highlighted by the Wall Street Journal today,
much of the premise behind this financial framework and its presumptions has turned out to be an illusion. As housing prices drop and homeowners default on their mortgages at distressing rates, the repercussions have become widespread. The resulting crisis is akin to some of the most significant financial calamities in recent history.
Transforming assets into securities is not a novel concept. From credit card debts to commodities, the securitization boom has been bubbling in the financial sector for two decades. However, this time the underlying asset was believed to be impervious to market downturns.
One can understand why some believed this, given that national housing prices displayed no losses for decades. Indeed, one would need to look back to the 1960s to find negative trends, and even then, those declines were minimal and fleeting. Such a history paints a legend of a resilient asset class: housing without interruption.
The issue with this assumption, however, is its inaccuracy. While housing prices rarely fall, the concept of “rarely” does not equate to “never.” Historically, significant price declines occurred, though they require a look back to the 1930s and 1940s for evidence, which can be viewed through long-term housing price charts courtesy of Professor Robert Shiller via Grant’s Interest Rate Observer.
This morning’s employment report for November confirms what many have already suspected: job growth is decelerating.
The economy added 94,000 net new jobs last month, as noted by the Labor Department. While there have been months with fewer gains, such as the modest rise of 44,000 in September, 94,000 new jobs in a labor force of nearly 154 million isn’t particularly exciting.
Rather than fixating on any single month, it’s essential to consider the overall trend. As illustrated in our chart below, the slowdown in job creation is unmistakable.
The only uncertainty revolves around the extent and duration of this deceleration and whether it will evolve into outright job losses. During the previous downturn from 2000 to 2003, the economy experienced job losses exceeding 300,000 per month at one point. Thankfully, current conditions are far from such extremes, particularly since the substantial losses then correlated with the tech bubble’s collapse. Today, the labor market is leaner and more resilient, making a sharp decline in job creation unlikely. However, the full effects of headwinds from the real estate market and other challenges remain uncertain as we approach the upcoming year.
On a positive note, the unemployment rate remains stable at 4.7%, having not exceeded 5.0% since late 2005.
Nonetheless, we anticipate that the slowdown in job creation will persist through at least the first quarter of 2008. The cycle is shifting, and given the size of the U.S. labor market, this change results from substantial economic factors. Momentum typically favors macro trends influencing the labor market. This sentiment aligns with the Fed’s likely move next Tuesday at their FOMC meeting, which may lead to another rate cut.
Will the Fed cut interest rates once more at its FOMC meeting on December 11? There is significant speculation suggesting the answer is “yes,” and Fed funds futures appear to align with this expectation.
As of this morning, the January ’08 contract anticipates Fed funds to hover just under 4.14%, approximately 36 basis points below the current rate of 4.50%. This indicates a likely 25-basis-point cut, but there’s ongoing debate regarding the possibility of a more aggressive 50-basis-point reduction.
Notably, bond expert Bill Gross from Pimco has suggested that the Fed may need to lower rates even further. “To revive a near-recessionary economy, we may ultimately need to reduce rates to 3% or lower,” he expressed in his latest commentary published yesterday.
With the resurgence of volatility in global capital markets, an astute investor might wonder: What has volatility recently done for me?
This is a pertinent question, one this writer regularly considers regarding global equity diversification. In search of answers or approximations, we turn to recent data. As of November 30, Europe appears appealing relatively speaking, according to insights from S&P/Citigroup Global Equity Indices.
Volatility has evidently never left; perhaps it merely went dormant for a few years. As evidenced by November’s mixed performance among major asset classes, the notion of investing in anything for a solid return now seems conspicuously absent.
The numbers narrate the tale. As shown below, selection played a crucial role last month. In fact, TIPS emerged as the top performer, gaining over 4% in November, whereas REITs suffered a notable decline of 9.5%. Year-to-date returns depict an almost opposing scenario: TIPS increased by 11.9% as of November 30, while REITs encountered a loss of 11.7% YTD.
Losses have increasingly become evident on our table above, underscoring the return of volatility. While uncertainties abound, it appears that nuance and variability are re-entering the investment game. This shift highlights the importance of details in constructing and managing diversified portfolios. Agility in asset allocation is once again becoming a key advantage, or so we predict.
Investing often incites unwavering and often opposing beliefs about effective strategies. Consider the divide between advocates of active management and those favoring indexing. Many incorporate both approaches, yet some rigidly adhere to one or the other while dismissing the alternative. Is it prudent, however, to categorically reject either passive or active management indefinitely? Or might it be beneficial to approach both options with an open mindset, acknowledging that each side could occasionally offer valuable insights?
This notion is supported by Matthew Rice, CFA, in a recent interview with the editor. In this Q&A, originally published in the December edition of Wealth Manager, Rice argues for exploring all available alternatives when examining investment options. This philosophy guides his work at DiMeo Schneider, a Chicago-based consultation firm where Rice holds a principal role. He emphasizes that indexing isn’t universally the best choice for every asset class, nor is active management always superior.
Admittedly, many may disagree or remain skeptical of this perspective. For instance, the editor favors betas for constructing multi-asset portfolios. Nonetheless, Rice has co-authored an intriguing study released earlier this year that warrants examination, if only to challenge one’s foundational beliefs. For more insights, check out our recent conversation with Rice, which begins now…
For an unsuspecting alien freshly arrived on Earth, yesterday’s GDP report might seem like a significant achievement. Indeed, on the surface, there’s cause for celebration. Real annualized GDP for the U.S. saw an impressive surge of 4.9% in the third quarter, based on the revision released yesterday by the Bureau of Economic Analysis. This rate represents the fastest growth in four years and appears robust compared to historical data.
Now that we’ve acknowledged this optimistic figure, it’s essential to explore why this assertion may be misleading or at the very least, requires greater scrutiny. First, it is important to remember that GDP is a lagging indicator. Consequently, the third quarter’s performance might feel as distant as the Jurassic Period for anxious investors today. While GDP reports are generally outdated, this typically poses little issue if growth trends are steady and last month closely mirrors this month, providing solid forecasts for next.
Unfortunately, the current economic outlook is shifting more rapidly than a politician’s pledges. An abundance of conflicting information exists, complicating the situation. For example, while the third quarter displayed remarkable growth, what might the fourth quarter hold given the labor market’s apparent weakening, as suggested by the latest jobless claims data?
As demonstrated in our chart below, new claims for unemployment benefits have surged. While still within recent historical ranges, the upward trend is concerning. From mid-September through last week, jobless claims have risen by 40%, reaching a nine-month high.
Given these concerns, it is no surprise that the Fed is expected to reduce interest rates once more. Currently, Fed funds stand at 4.50%, down from 5.25% a few months ago, and economists suggest further cuts may be essential to counteract the escalating economic challenges.
The economy’s trajectory is uncertain, but it’s evident that the stock market remains enthusiastic about the prospect of rate cuts.
Take, for example, yesterday’s comments from a Federal Reserve vice chairman. “Uncertainties regarding the economic outlook are exceptionally high at the moment,” Don Kohn stated to the Council on Foreign Relations yesterday, as reported by Reuters. “Such uncertainties necessitate flexible and pragmatic policy-making — nimbleness, as I mentioned weeks ago.”
For those unfamiliar, this may sound like casual conversation among peers. However, for astute traders, this is subtle confirmation that the Fed is likely to CUT rates at the upcoming December 11 FOMC meeting. Fed funds futures seem to agree, with the January contract hinting at a 25-basis-point reduction.
It wouldn’t be surprising if another Federal Reserve official soon added fodder for the stock market’s rise, potentially pushing the Dow up another 300 points. This is the current environment for speculative opportunities in the stock market, albeit one that’s increasingly reliant on less-clear statements from central bankers.
Fortunately, we’re in a multi-asset world, accessible through ETFs and other publicly traded options. For strategic investors, numerous varying levels of risk and return exist. U.S. stocks, in our view, do not appear exceptionally appealing, though they don’t seem overpriced. This isn’t reminiscent of early 2000 when valuations soared. However, it’s also not comparable to 1982 when equities were as unpopular as a pandemic.
While some remain skeptical about an impending recession, the bond market seems confident otherwise.
The yield on the benchmark 10-year Treasury plummeted to 3.85% yesterday, marking the lowest point in three years. This surge in bond buying, which leads to lower yields, reflects an escalating belief that challenges are on the horizon for the U.S. economy. In essence, fixed-income investors are feeling quite positive.
This sharp decline in yield begs the question of whether the previous low again comes into play. Back in June 2003, the 10-year yield dipped to 3.07%, prompting forecasts suggesting that this would represent a generational low. At that time, it seemed credible. Yet, a month later, in July 2003, the 10-year yield reversed course, closing at 4.47%.
For now, it remains uncertain if a similar pattern will emerge anytime soon. Meanwhile, the ongoing bull market in bonds confirms the validity of fixed-income allocations this year. Investors who shunned bonds previously are now facing the consequences. When U.S. equities falter, bonds reaffirm their traditional role as a key diversification tool.
