Highlights

• Among the biggest surprises in financial markets this year has been a 35% drop in the price of gold, which has been accompanied by a broad-based decline in oil and other commodity prices.  Investors are now questioning what’s behind this development and the implications it has for the global economy and financial markets.
• Many commentators attribute the recent fall in gold and other commodity prices to weaker-than-expected data in the U.S., Europe and China.  There is also growing realization that quantitative easing by the leading central banks has not led to rising inflation; in fact, global inflation has declined over the past year.  Combined with a firmer dollar, these factors have taken some of the speculative element out of gold’s price.
• According to Edward Morse, Citi’s Global Head of Commodities Research, the recent separation of commodities from equity markets represents the end of the commodity super-cycle of the past decade. He believes movements in individual commodity prices will become more disparate in the future, and commodity indices will be less correlated with equity markets and currencies than in the past decade.
• If so, there could be wide-ranging implications for stock, bond and emerging markets that we consider.

What’s Behind the Plunge in the Price of Gold?

The steep drop in the price of gold this month caught most observers by surprise and left many wondering what’s behind it.  In my view, it represents the culmination of several developments. Read the rest of this entry »

On April 8-9, 2013 The International Economic Forum of the Americas presented The Palm Beach Strategic Forum – 3rd Edition. Nick Sargen was invited to be among the prestigious lineup of speakers that included foreign heads-of-state, U.S. state governors, central bank governors from around the globe, Fortune 500 chief executives and other influential market participants. The following is from Nick’s presentation at the Forum:

Dear Chairman,

Thank you very much for the opportunity to discuss the issue of financial market regulation after the 2008 financial crisis. My perspective is that of a Chief Investment Officer for a U.S.-based financial institution.  I will first discuss the factors contributing to the financial crisis, and then consider whether the Dodd-Frank Act or the pending Basel III Accord will pave the way for greater financial stability.

Causes of the 2008 Financial Crisis

I’ll start by considering the underlying causes of the financial crisis, which is commonly attributed to “market failure.”  At the outset, it should be noted that with the exception of AIG, most insurance companies and many small and mid-sized banks weathered the storm without requiring any federal assistance.  It was the leading securities firms and largest commercial banks that required the preponderance of bailouts.  Accordingly, they should be the focus of any reforms. Read the rest of this entry »

Highlights

•  As the U.S. stock market has set new highs, many observers remain skeptical that the advance can be sustained. They believe it is primarily supported by the Federal Reserve’s highly accommodative stance, but see the U.S. economy as being increasingly vulnerable to “fiscal drag.” 
• In our view, the skeptics ignore mounting evidence that the private sector of the economy is on the mend.  This is apparent in the improved balance sheet positions and income statements for consumers, corporations and financial institutions.  Indeed, private sector demand has expanded at about a 3% annual pace in the past two years, a full percentage point more than the overall economy.
• During the months ahead, consumer spending may slow in response to higher payroll taxes and the impact of sequestration. This could trigger a long-awaited pull-back in the market. However, other factors including more rapid jobs growth, improved financial conditions and a recovery in housing should set the stage for stronger overall growth later this year.
• What does this imply for the stock market?  Our call at the beginning of this year was that the stock market would test record highs this year, but we were unsure if the gains could be sustained.  In light of the evidence that the private sector is gaining traction, we now believe the stock market can continue to advance.

What’s Behind the Stock Market Surge?

One of the most noteworthy developments this year has been the strong surge in the U.S. stock market, which has sent the Dow Jones Industrial Average to new highs and the S&P 500 to a near-record high.  Previously, we thought the market could test its former highs this year, but we did not expect it to happen this quickly, considering that news on the U.S. and global economy has been mixed. Read the rest of this entry »

Highlights

• Following a strong showing in January, equity markets pulled back this past week amid talk the Federal Reserve may curtail quantitative easing before year’s end.
• We do not buy the story about the Fed, especially considering that fiscal drag from expiration of payroll tax cuts and pending sequestration along with higher gasoline prices will likely delay an acceleration of the U.S. economy.
• If so, the most likely outcome is that stock and bond markets will settle into trading ranges until there is a clearer reading on the economy.  Long-term, we expect bond yields to rise once the economy regains momentum, and we are overweighting stocks relative to bonds in balanced portfolios.

A Surprising Start to the Year

Our view at the start of this year was that the U.S. economy would accelerate in the second half from the current pace of about 2% growth, which could set the stage for the stock market to test its all time high set in October 2007.  This outlook reflected our belief that the private sector of the economy – consumers and businesses – had made considerable progress adjusting to the housing bubble and financial crisis.  We are encouraged by the rebound in auto sales and in residential housing – two sectors that typically lead expansions.  At the same time, we acknowledged that the economy would probably get off to a sluggish start owing to fiscal drag from a 2% increase in the payroll tax and higher taxes on the wealthy.

To our surprise, the market came within a few percentage points of its all time high in the first month and a half, even though news on the U.S. and global economy was mixed.  In the United States, retail spending appears to be off to a sluggish start as households have  to contend not only with the impact of higher taxes, but also with a surge in gasoline prices of about 45 cents a gallon.  At the same time, data from Europe confirm that recession there has spread from the periphery to the core countries including Germany.  Consequently, global GDP growth in the fourth quarter was the softest since the onset of recovery in mid-2009.

Why, then, has the stock market done so well? We believe the principal reason is that investors today are less fearful of a global recession or financial crisis than before.  While Europe is mired in recession, fears of a break-up in the euro-zone have diminished as a result of strong actions by Mario Draghi, head of the European Central Bank.  In Asia, there is now relief that China’s economy is expanding at a healthy pace of 7%-8%, lessening worries about a “hard landing.”  Moreover, there is new-found hope that Japan’s new government will act decisively to end two decades of deflation.

Finally, in the United States investors appear to be ignoring developments in Washington, D.C., as rumblings about the 2013 fiscal cliff turned out to be over-blown.  This premise is about to be tested, however, as it is unlikely the two political parties will reach an agreement that would avert sequestration, which is set to begin on March 1.  To be sure, the media is replete with horror stories about the impact that the scheduled cutbacks in government spending will have on the economy.  However, most economists believe the impact will be manageable, as the outlay reductions in 2013 are expected to total only about $44 billion, or roughly half of the $85 billion in cuts that are budgeted.  The consensus view among economists is that this will lower projected GDP growth by about three-tenths of one percent.

Enter the Fed into the Equation

The main factor that caught the market’s attention last week was the minutes from the December FOMC meeting. They indicated there was debate about whether the Fed’s quantitative easing program was distorting capital markets, and, if so, whether the program should be phased down before year’s end.

My reaction to this story is to discount the possibility of the Fed ending quantitative easing later this year.  I would hope that as part of meaningful discussion of monetary policy there is debate within the FOMC about this issue.  However, debate does not necessarily translate into action.

My view of the Fed is that monetary policy is being driven largely by the troika of Chairman Bernanke, Vice Chairman Janet Yellen and New York Fed President Bill Dudley.  They are the most powerful members of the Fed, and none of them has waivered from the view that unemployment is unacceptably high at 7.8% while inflation is well under control.  In fact, Janet Yellen recently gave a speech in which she indicated the Fed should not be in a hurry to tighten policy even if unemployment fell to 6.5% — the level the Fed had previously indicated as being a target.  While this does not mean that all FOMC members subscribe to the troika’s view, it is unlikely that the skeptics of quantitative easing will carry the day.

Implications for Financial Markets

My reading of the current situation is that the stock market has had a phenomenal run since the second half of 2012, but it is now likely to settle into a broad trading range until investors get a clearer picture of the U.S. and global economy.  In my view, the rally reflects diminished fears of a global recession or a major policy blunder. 

To sustain new record highs, I think investors will want to see clearer evidence that economic conditions in the United States are normalizing – meaning real GDP growth is approaching 3% per annum while monthly nonfarm payrolls are expanding by 200,000-250,000.  I do not foresee this happening in the first half of this year, and think the transition to higher growth will not be apparent until the second half, when the impact of fiscal drag should lessen.

Meanwhile, we anticipate that the stock and bond markets will settle into trading ranges.  Longer term, as the economy gains momentum, we look for the stock market to set new highs while bond yields will trend higher.  Accordingly, we are over-weighting stocks relative to bonds in balanced portfolios.

Highlights

• Following two decades of economic stagnation, Japan’s new Prime Minister, Shinzo Abe, has pledged to get Japan’s economy moving again.  The key components of his strategy include prodding the Bank of Japan (BOJ) to set an inflation target of 2% while the government has embarked on a fiscal stimulus program equivalent to about 2.6% of GDP.
• Investors have reacted to these developments by boosting Japan’s stock market by nearly 25% from its lows last autumn, while the yen has depreciated by 15% against the dollar and nearly 25% versus the euro in the past two months.
• Nonetheless, many observers remain skeptical that these policy measures will succeed.  In this blog, we assess the pessimistic case laid out by Martin Wolf of the Financial Times and a more optimistic case based on the views of John Makin of the American Enterprise Institute.
• Until recently, I had been very pessimistic on Japan’s prospects based on the country’s poor showing over two decades.  However, I am now encouraged that the new government is seizing the initiative to end two decades of deflation and lethargy, and think it may be a good time to increase exposure to Japanese equities.  That said, the challenges Japanese policymakers confront are formidable, as old habits rarely are changed easily.

The Case for Skepticism

In a recent FT article (February 5, 2013), Martin Wolf, the paper’s chief economic commentator, arrives at the following conclusion about the likely impact of “Abenomics” on Japan’s economy:

                “Will Shinzo Abe rescue his country’s economy from two decades of lassitude?  Or has “Abenomics” launched a currency war and pushed Japan closer to hyperinflationary collapse? The plausible answer is: neither.  The risk is that the policies of his government will fail to make a difference, in either direction.”

Wolf’s skepticism, in part, stems from the failure of previous monetary and fiscal programs to turn around Japan’s economy.  Despite an official interest rate target of 0.5% since mid 1995, the country’s GDP deflator – a broad measure of the overall price level– has fallen by 17% in the past 15 years.  Moreover, massive fiscal stimulus has had little or no impact on the economy, while gross debt of the central government has risen from 66% of GDP in 1991 to 237% currently.  At the same time, Japan has not experienced a debt crisis, as yields on JGBs have fallen from about 8% in the early 1990s to less than 1%.  Nor is there a sense of despair among the electorate, as the unemployment rate at 4.1% is low among the developed economies.

Wolf’s skepticism also stems from his belief that the thrust of “Abenomics” is directed at ending two decades of deflation in Japan; yet Wolf does not regard deflation as the underlying cause of the country’s problems.  In his view, the root cause of Japan’s problems is “excess private savings” especially in the corporate sector, where there is a huge structural excess of corporate gross retained earnings over investment.  While easy money facilitated deleveraging in the post bubble period, it was unable to raise the investment rate, which at 30% of GDP is high for a mature economy.

Nor is it clear that the government is planning on embarking on structural reforms to boost private sector demand, which Wolf favors. They include raising wages, forcing higher distributions to shareholders via changes in corporate governance, and increasing corporate taxation to shift distribution of profits to shareholders and to raise tax revenues.  Wolf concludes that the big danger is Japan will persist in treating its long-term structural problems as amenable to monetary and fiscal fixes.

A More Encouraging Assessment

By comparison, John Makin of the American Enterprise Institute, offers a more upbeat assessment in his latest commentary (January 31, 2013).  The principal reason is that Makin is a long-time critic of the Bank of Japan’s policies, and he is encouraged that the BOJ is about to embark on fundamental reforms that will end the deflationary environment:

                “Mr. Abe has threatened the reticent Bank of Japan with a new governing law that would take away much of its cherished independence.  The current governor, Masaaki Shirakawa, who as recently as February 2012 promised an aggressive program of reflation and then reneged, citing years of inflation, is in Mr. Abe’s sights.”

According to Makin, the most likely successor is University of Tokyo Professor Kazumasa Iwata. Mr. Iwata was deputy governor of the BOJ in 2007 when he was the sole policy board member to vote against hiking interest rates at the time – a decision which Makin contends proved to be disastrous, coming just before the global financial crisis.   Accordingly, as new board members are brought on to the BOJ’s policy committee, it is likely that the BOJ will become proactive in countering deflation.

One of the main challenges for Japan’s policymakers will be to steer a course where inflation expectations rise gradually, but do not spike above the targeted rate of 2%.  This is especially critical given the high level of central government debt in relation to GDP. Note:  Because interest rates have fallen so low, Japan’s government interest expense as a share of GDP has actually declined from a high of 3% in 1985 when the net debt/GDP ratio was about 25% to about 2% today with the net debt/GDP ratio at 140%. Makin envisions that as Japanese inflation approaches the 2% rate in the U.S., yields on 5-year JGBs would rise from 0.25% to 0.8% (roughly the same level as in the U.S.)  If so, the cost of financing Japan’s debt would increase nearly four-fold.  However, because Japan’s economy would be growing at a faster rate, its debt/GDP ratio would slow over time and become more sustainable.

In assessing Japan’s outlook, Makin is generally complimentary of the approach Prime Minister Abe is taking.  Makin acknowledges that the aim of the BOJ’s money printing and foreign bond purchases is to depress the value of the yen, but he counters that Abe can point out to critics that a Japanese economy growing at a 3% annual rate in nominal terms, is “a better trading partner than a stagnant, deflationary Japan with a stronger yen.”

Makin concludes his assessment by observing that most global portfolio managers have long since given up on Japan as a viable investment, having been burned by trying to predict recovery in Japan. (According to Goldman Sachs they are underweighting Japanese assets in global portfolios by at least $60 billion.)  Makin feels this skepticism was reinforced by the BOJ’s decision to back off of its reflation stance a year ago, which was accompanied by a stock market slide of 15%.  However, he is now more optimistic about the prospects for the Japanese stock market:  “It is likely, given the determination of the Abe government to pursue expansionary fiscal and monetary policies even in the face of foreign criticism that Japan’s stock market will rise further, perhaps even doubling in value over the coming year.”

Investment Implications

One of the biggest calls for investors to make in 2013 is whether to increase exposure to Japanese equities and to hedge yen exposure in light of the policies of the new Japanese government is pursuing.  Since Japan’s real estate and stock market bubbles burst in the early 1990s I have been reluctant to add to Japanese equity exposure on grounds that the country’s policymakers lacked both the will and the means to end Japan’s stagnation.  With Japan’s new prime minister having campaigned on the need to have new leadership at the BOJ to tackle deflation, I believe Japan is now committed to address one of its principal economic problems.

Ending the cycle of deflation is important to overcome the current psychology in which consumers believe there is no imperative to spend because prices will be lower tomorrow.  It is also vital to ensure that investors are not content to hold bonds that barely have a positive yield, because the return is higher after adjusting for deflation.  In this respect, I will be closely monitoring how effective the BOJ is in altering inflation expectations.  If its policies are successful, there are grounds for expecting the Japanese stock market to post further significant gains, as valuations are compelling.

At the same time, I believe addressing deflation is necessary, but not sufficient, to alter Japan’s long-term growth trajectory.  For three decades now, Japan has struggled to find a strategy in which economic growth is led by domestic forces and not by its once powerful export engine.  This is a key component that Japan’s new government needs to address to convince investors that it has finally turned the corner.

On January 17^th, Fort Washington held its annual Investment Forum at the beautiful Hilton Netherland Plaza in downtown Cincinnati, Ohio.  Managing Director and Senior Portfolio Manager Tim Policinski moderated a lively discussion among senior members of our Fixed Income team.  In addition to Tim, members of the panel included Zulfi Ali, Vice President and Senior Portfolio Manager; Dan Carter, Assistant Vice President and Portfolio Manager; and Scott Weston, Vice President and Senior Portfolio Manager.  Below are highlights of the discussion.

Q:  What is our outlook on rates for 2013?

A.      Dan Carter:  Based on our cautiously optimistic outlook on the economy, there will be modest upward pressure on interest rates later in 2013.  The key question will be whether or not the US economy will be growing fast enough to create enough jobs to reduce the unemployment rate towards the 6.5% target set by the Fed.  Our outlook assumes that the unemployment rate will decline in 2013 and the market will begin to anticipate the end of Treasury and MBS purchases by the Fed and put upward pressure on long-term rates. Read the rest of this entry »

As the New Year unfolds, investors have good reason to celebrate considering how well financial markets fared in 2012, with most markets posting double-digit returns (see Figure 1.)  Still, many are wary after all the twists and turns that occurred. After surging in the first part of the year, stocks and other risk assets plummeted in May-June before staging a strong second-half rally. The catalysts for these swings were shifting perceptions about the global economy and the fate of the euro-zone.

Looking ahead, questions about the global economy linger, with the U.S. and China experiencing sub-par growth, while Japan’s economy is stagnant and the periphery of the euro-zone is mired in severe recession. The over-riding issue is when global economic conditions will normalize. Views on this matter are divided.  Some observers contend the recent environment constitutes the “new normal,” while other research suggests it often takes a decade for countries to adjust to financial crises.  Read the rest of this entry

Highlights

• After two years of escalating tensions in the euro-zone, financial markets have calmed recently following the decision to grant the European Central Bank (ECB) authority to purchase sovereign debt of euro-zone members. This has caused some observers to question whether the worst of the crisis is past.  
• At a conference of international economists and policymakers this past week, the over-riding sentiment was decidedly negative.  The main concerns were: (i) austerity programs are de-stabilizing and (ii) there is little incentive for creditor countries to boost financial transfers. Therefore, many participants believe tensions will re-escalate at some point.
• My own take is less dire, as I believe the authorities will take necessary measures to avert a break-up. Also, while Europe is likely to remain in recession well into 2013, the deficit countries are embarking on much-needed structural reforms and their current account positions are improving.  The biggest challenge will be to transform the euro-zone into a full-fledged fiscal union, which is unlikely anytime soon.

Euro-zone Tensions Ease

Following two years in which tensions in the euro-zone escalated fairly steadily, financial markets have calmed in the past six months.  This is evident in a variety of indicators since June: (i) the Euro Stoxx 50 index, the leading index for blue chip companies in the region, has increased 17% and is currently hovering at its highest level in 18 months; (ii) credit spreads for troubled sovereigns – Greece, Ireland, Italy, Portugal and Spain – have narrowed substantially versus Germany; and (iii) the euro has strengthened against other key currencies. Read the rest of this entry »

Highlights

• A recent BCA report (The Bank Credit Analyst, December 2012) has examined the relevance of the views of John Maynard Keynes and his followers and those of Friedrich von Hayek (a leader of the Austrian school) for the 2008-09 financial crisis. It comes down squarely on the side of the Keynesean school as offering the more accurate prescription.
• The BCA report points out predictions of the Austrian school about large budget deficits and massive money printing leading to inflation and rising interest rates have not materialized. It also contends that fiscal multipliers are much higher than most economists believed just a few years ago, buttressing the Keynesean view.
• I maintain it is important to separate the causes of the financial crisis from the cures. Thus, I believe some criticisms of the Austrian followers about Fed policy contributing to the housing bubble are valid. However, once the bubble burst the Fed’s decision to flood the system with liquidity was critical to stabilize the situation. 
• It is very difficult to disentangle the effects of fiscal and monetary policies during the recovery phase. However, I suspect monetary stimulus was more important than fiscal stimulus in promoting recovery. That said, the Fed should heed the warnings of the Austrian camp about unintended consequences of maintaining artificially low interest rates indefinitely.

Reviving an Old Debate

In a recent report entitled “Hayek vs. Keynes: Weighing the Evidence”, Peter Berzen, Managing Editor of BCA, resurrects a debate that occurred in the early 1930s between John Maynard Keynes and Friedrich von Hayek about the role government should play in overcoming a severe economic downturn.  Keynes believed that the Great Depression was caused by insufficient demand from the private sector (both households and businesses) and favored government policies that would boost overall spending and end mass unemployment. In contrast, Hayek argued that the best way to destroy capitalism was to debauch the currency, and he argued that pro-active fiscal and monetary policies would worsen the Depression. Read the rest of this entry »

Highlights

• Financial markets have steadied after selling off post the 2012 elections amid new found hope the 2013 “fiscal cliff” may be averted.  While that would be a welcome development, the goal of achieving broad-based reform of the tax code and entitlement programs over the next 10 years is elusive.
• The most likely outcome is an agreement that falls well shy of the $4 trillion deficit reduction goal over 10 years that is the centerpiece of the Simpson-Bowles package.  If so, the stage would be set for the rating agencies to downgrade U.S. government debt. Such an outcome could produce a short-term market setback, but would likely have little near-term impact on the economy.
• Meanwhile, the main development we are monitoring is the response of U.S. businesses, which have pared back on capital spending pending resolution of the budget impasse.  If the business community lacks confidence in economic policies recovery will continue to be lackluster.

Long-term Deficit Reduction is the Over-riding Issue

In the aftermath of the elections financial markets immediately focused on the prospect of the two political parties being unable to reach agreement that would avert the so-called 2013 “fiscal cliff”  of scheduled tax increases and spending cuts totaling 5%  of GDP.  More recently, markets have stabilized amid hopes that the fiscal cliff will be averted.  What should not be lost in this debate, however, is that long-term deficit reduction is the central issue at stake, just as it was in the summer of 2011.  The pending fiscal cliff is pivotal, because it is forcing politicians to act within a deadline just as the debt-ceiling deliberations did in August of 2011. Read the rest of this entry »